Where We Stand

A key driver was the mini-taper tantrum spurred by ECB official comments indicating
that the central bank was on a gradual path toward the exit. 
The
yield on the 10-year German Bund, the benchmark in Europe, is lower for the
third consecutive day.  The ECB may have
spurred the rise in yields, but it will likely resist the premature tightening
of financial conditions.  

The key metric is not growth, which continues somewhat above trend,
meaning the output gap is closing.
  The ECB’s mandate is for price
stability.  By the ECB’s own
reckoning,  it has not achieved its goal.  Inflation is not on a
sustainable and durable path toward the target of near but below
2%.  

The mini-taper tantrum meme has been
superseded
by three developments in the US: 
Yellen’s
semi-annual testimony before Congress last week, disappointing US inflation and
consumption data, and now, the collapse of the Senate’s effort to repeal and
replace the Affordable Care Act.   These developments are uniformly dollar negative.  Last year’s euro high near $1.1615 is coming into view and then the high from August 2015 near $1.1715 will be targeted.  There continues to be interest in $1.20 strikes for 2-3 months. 

Many observers have argued that there was a shift in the Fed’s view that
Yellen articulated in her testimony.
  In particular, many economists
and journalists claim she expressed “increasing concern” about the
softer inflation readings.   We demur and do not think that there was
a fundamental change in the Fed’s stance between the June 14 FOMC statement
when it hiked interest rates, and Yellen’s testimony last week.  

Core measures of inflation did ease in the four months from February
through May. 
Yellen said,
“It is something we are watching very closely…” This is repeating what was in the FOMC
statement: “The Committee will carefully monitor actual and expected inflation
developments relative to its symmetrical inflation goal.”  

The FOMC minutes explained how the past decline in inflation was understood by
officials
.
“Most participants view the recent softness in these
price data as largely reflecting idiosyncratic factors, including sharp
declines in prices of wireless telephone services and prescription drugs, and
expected these developments to have little bearing on inflation inflation over
the medium run,”  

One media report was built around
one analyst who had previously thought the Fed would hike in September. 

The journalist quoted the analyst explaining how the shift from the FOMC
minutes from explaining the softness in FOMC minutes as due to
“idiosyncratic factors” to “unusual” in Yellen’s testimony to justify his
abandonment of the Sept call.   

The fact of the matter is that the September Fed funds futures contract,
the most direct metric of expectations for the September FOMC meeting was
unchanged at an implied yields of 1.165% every day last week
.  It has
been steady at that rate from July 7 through
yesterday.  It is off half a basis point
today.      

Many journalists cited developments at the long end of the curve and the
rally in stocks as evidence of Yellen’s dovishness.
  After nearing
formidable resistance near 2.40% after the robust employment report on July 7,
US yields were backing before Yellen spoke.  

Following the June hike and no press conference after next week’s
meeting, the July FOMC meeting was never live.
  We continue to expect
that at the September FOMC meeting the Fed will announce that it will begin
allowing the balance sheet to shrink in October.   This will allow officials to monetary the
evolution of inflation and inflation expectations.   

Making a couple of reasonable assumptions, if our analysis is correct,
the Fed’s balance sheet will shrink by almost $200 bln before the ECB stops
expanding its balance sheet (conservatively mid-2018).
  We also expect
the Fed to raise rates at least two or three more times before the ECB will
lift its deposit rate out of negative territory.

For its part, sterling rallied from a little below $1.26 on June 21 to a
high today near $1.3125.
  The media was abuzz about a rate hike after
a close vote at the last MPC meeting and what some saw as confusing comments by
BOE Governor Carney.    Talk of a rate hike in August was exaggerated from the get-go and today’s
unexpected decline in some inflation measures drove home the point.  

Recall that at the end of January, the September short-sterling futures
contract implied a yield of about 50 bp, 
By the middle of June, it had fallen back to 30 bp.  The rate hike scare pushed it to an about 43 bp at the end of June.  Today
it is at 34 bp.  

The next hurdle for sterling is the
June retail sales report due Thursday.
  A modest recovery is expected after sharp declines were recorded in May.   As the CPI
figures showed earlier today, clothing and footwear was discounted and this may have helped bolster
consumption.   Note that retail sales averaged a monthly gain of 0.4%
in 2016.  It has been averaging 0.1% a month this year through
May.  

The Bank of Canada increased rates last week.  Officials staged
a nearly month-long campaign to convince the market that it would take back
some of the accommodation provided in 2015 after oil prices collapsed. 
Financial conditions in Canada are the tightest in three years.  The
implied yield of the December BA futures has
risen more than 50 bp since mid-May.  

Canada’s June CPI will be reported ahead of the weekend.  Headline pressure is
expected to ease to 1.1% from 1.3% in May.  It would be the slowest pace
since last November.  The Bank of Canada has introduced several adjustment
measures, but all of them are also
falling.  

Also tempering the extent that the Bank of Canada can raise rates is the
housing market.
  The slowdown appears to be accelerating.  Consider
yesterday’s news.  Existing home sales fell 6.7% in the month of June, for
the third consecutive month.  Activity began slowing before the official
efforts to prepare the market for a hike. 

Consider the two hot housing markets in Canada, the Toronto area (Greater
Golden Horseshoe) and Vancouver.
  In the Toronto area, existing home
sales fell 15.1% in June and are off nearly 38% year-over-year.  It is
experiencing the lowest level of sales since 2010, and the three-month slide is
the fastest since at least the late 1980s.  Macro-prudential policies that
tighten mortgage eligibility and tax foreign buyers are prompting people to pull back
and reconsider market conditions.  

Existing home sales fell a more modest 4% in Vancouver for a 12.2%
year-over-year decline.  Average prices fell 14.2% in the Toronto area,
but only 3.2% in Vancouver.
  House prices in Vancouver are up about
2.7% from a year ago.  Macro prudential measures were introduced earlier
in Vancouver, and after an adjustment period, the market appears to have recovered or at least
stabilized.    Given the indebtedness of Canadian households,
and the exposure to real estate, this coupled with low inflation may deter more
aggressive BoC action.  

One of the takeaways from this review is that low price pressures continue
to frustrate policymakers attempts to normalize monetary policy.
 
Growth in the eurozone and Canada are not a problem.  Low price pressures
limit the room for central banks to maneuver.    A September rate
hike was never very likely.  The odds have been
halved
since the mid-June FOMC meeting from about 20% to 10%. 
However, barring additional shocks, the Fed is likely to announce the beginning
of its balance sheet operations at the September meeting.  The Fed’s
thinking about its balance sheet has evolved,
and most do not seem to be as concerned that gradually unwinding it will
tighten financial conditions. 

The CAD1.25 level corresponds to $0.80 and is the next important target for the US dollar.  It reached almost CAD1.2580 earlier today.   Last year’s greenback low was set in May near CAD1.2460.  A break of this area would likely spur talk of CAD1.20. 





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