Yellen Pushes Divergence Front and Center

With 17 simple words and the help of clarification from her deputy, Yellen changed
the near-term dynamics in the capital markets.
  By saying
that “…I believe that case
for an increase in the federal funds rate has strengthened in recent
months,” Yellen placed her marker down.

Yet the market was initially confused.  It thought the Chair was indicating a December hike
not a September move, and that meant one hike not the two the June dot plots
implied was thought to be appropriate by
the FOMC.  Vice Chairman Fischer quickly followed his boss and explained
that she implied no such thing.
 Nothing she said had ruled out a September hike or two hikes this year.
And to sweeten his treat, Fischer advised
watching this week’s employment data closely.
  What more can be said?   The
employment figures are among the most significant reports in the monthly cycle.
 They are also volatile and difficult to forecast, as the May’s drop out
of the blue reminds us. From nearly any other central banker it would seem
reckless to link monetary policy so directly to a high frequency number, but
Fischer is Fischer.  He has had a distinguished career as the chief
economist at World Bank and the Governor of Israel’s central bank.  He was
on both Bernanke and King’s dissertation committees.  
Still, it does not set right, but the
market took the bait and ramped up the odds of a September hike to 42% from 32%
the previous day.  
 It is the greatest probability in a month.
  Most economists do appear to be forecasting the US economy to
accelerate.  The Bloomberg survey median has the economy growing 2.6% at
an annualized pace in Q3, and 2.3% in Q4
snapped the three-quarter streak of sub-2% growth.  The Atlanta Fed GDPNow
tracker has it at 3.4%, and the NY Fed’s
tracker is at 2.8%. 
The immediate challenge, however, is that
in the past two months (June and July), net job growth overshot its trend.
  Consider that the two-month average is at 274k.  This is the highest of the year and was only surpassed twice last year.
 This year’s average is 186k, and the 12-month average is 204k.   The
median guesstimate is for around 180k.   A  report of less than 144k
would be disappointing.  That was job growth in April, the second lowest
of the year besides May’s inexplicable 24k increase.  
Consumption has also grown faster than
sustainable.
  Consumption
in Q2 was revised to 4.4% from 4.2%.
 It is only the third quarter since the Great Financial Crisis that
consumption exceeded 4%.  This will
b evident in the July personal consumption expenditures.  In Q2 PCE rose
by an average of 0.6% a month.  This is
twice the 12-month, 24-month and 36-month average of 0.3%.  The median forecast
for July is 0.3%.   The same will be evident in real spending.  The
Q2 average of 0.4% is twice the long-term averages, which are stable at 0.2%.
  Auto sales in August are also expected to have slowed, though remaining
at elevated levels above 17 mln annualized vehicles.
For most investors and market
participants, it might not make a significant difference whether the Fed hikes
in September or December. 
 The Federal Reserve’s leadership has
put the market on notice that it is coming.   This is an example of transparency as well as taking into account
the interests of other stakeholders.  However, the increased prospects of
a Fed hike may spur profit-taking in many summer rallies in risk assets, like
the 16%+ rally in emerging market stocks since late-June, or the 11.25% rally
in the MSCI World Equity Index of developed countries.  
The Federal Reserve stands in stark
contrast with the European Central Bank, the Bank of Japan and the Bank of
England.
  These central banks are actively engaged in easing monetary
policy and, if anything, the next steps will be more not less.   This
week’s data from the eurozone will favor
those forces on the Governing Council that want to extend the asset purchase
program from the current soft end date of March 2017.  
CPI for August is expected to be confirmed at 0.3%.  It has averaged 0.1% over the past three months, which matches the 24-month
average.  It is better than the six-month average of minus 0.1% or the 12-month average of
zero.  However, officials cannot be satisfied.   Unemployment may
ease, but at 10% it is still too high in most countries.  The PMI reports
are give no reason to think that the eurozone economy is accelerating.  
The Bank of Japan learned last week that
despite its unprecedented and aggressive easing policy, deflationary forces
continue to grip the world’s third largest economy.
  The BOJ’s core measure, which
excludes fresh food fell for five months through July, and the minus 0.5% reading is the lowest in
three years.   This week’s data is expected to show that while the labor
market remains tight, consumption remains poor,
and still contracting on a year-over-year basis.   Industrial production
may have extended the June bounce (2.3% ), but not enough to prevent the
year-over-year rate from moving deeper into negative territory.  With weak
domestic demand and falling exports, the risk is an increase in output builds
inventories that have to be run down.
Survey data in the UK is running ahead–and to the downside–of the
actual economic data. 
 The manufacturing and construction
PMIs are the focus this week.  Both are expected to remain below the 50
boom/bust level, but less so than in July.  A new headwind may emerge in
the form high bond yields, despite BOE weekly purchases, if rising US yields
pull other yields higher too.   In the current environment, we suspect that a
strong US dollar environment may correspond to a sterling gains against
the euro.  
Canada cannot keep up with the Fed either.  This week Canada is expected to report that Q2’s 1.5%
contraction in GDP was the largest since the recovery began in H2 09. It is the
only G7 economy that contracted in Q2 (France and Italy were stagnant).  A
few days before the GDP report (August 31), Canada will report a current account shortfall in Q2 that may match a record of
C$20.2 bln in Q3 10.  
The economic and monetary policy
divergence may overwhelm the speculation that OPEC could agree to a freeze in
output as early as next month. 
 One key hurdle has been the Iranian
need to boost output back to pre-embargo
levels.  The latest reports suggest it is close, but still a little shy of
its four mln barrel per day target.
  Also, it makes sense, assuming rational actors, that ahead of a possible
freeze, output increase, so the freeze at a more advantageous level.  
Meanwhile, US output is still slipping
and imports rising.  A rising US dollar may help spur a correction to the
nearly 24% rally off the early-August lows.
China’s PMI figures will also be released.  The market is less interested than
it was last summer in China.  Its economy, to
the extent that one has faith in the data, appears gradually slowing,
while credit growth has been strong, it has long passed the point of
diminishing returns.  More central to investors concerns at the moment is
what appears to be a change in PBOC operations.  It has been using 14-day
reverse repos to drain excess liquidity
that had been driving bond yields sharply lower. 
China is hosting the upcoming G20 meeting
as it does, the yuan is likely to come under new downside pressure.
  The dollar appears poised to rise to
new highs for the year against the yuan.  The high so far this year was
set on July 18 near CNY6.7050.    As of the end of last week, the
dollar had risen 4.5% against the yuan in 2016.  
In addition to the G20 meeting, there are
a few other political events/issues that investors are watching.
  First, after two elections and
months of negotiating, Spain’s Rajoy will stand for a vote of confidence in a
new minority government.  He needs a majority on the first ballot, which
he is unlikely to secure.  Of more interest is the second ballot that requires a plurality.  This in turn requires around 11 Socialists (or
a combination of others) to abstain.  If
they do not, Spain would likely be headed for a third election, late this year
or early next.  
Second, two German states hold elections
in September.  
  Mecklenburg-Vorpommern’s election is
on September 4, and Lower Saxony election
is on September 11.  Mecklenburg-Vorpommern has had Social
Democrat-Christian Democrat government since 2006. Many see the election as a
referendum on Merkel, though of course, she is not on the ballot.  In
2011, the CDU received 23% of the vote 5.8 percentage points less than in 2006.
 It seems like a rather modest bogey.  The Left Party is the third
largest in the state, but the SPD refuses to form a center-left coalition.
  
Another issue that investors will be
mulling is a UK press report at the end of last week suggesting that government
lawyers do not think Parliament approval
is necessary to invoke Article 50, which formally begins the negotiations for
separation. 
  Many observers are still skeptical
that it Article 50 will be triggered next year.  However, nearly all the
indications we see is for it to invoked next spring.  Our understanding is
that this is what has been broadly indicated
to EU officials. 
One of the domestic issues has been over
the authority to invoke Article 50.
  A majority of Parliament favored
remaining in the EU.  Having to secure its approval was one of the
considerations that made some skeptical that it would be triggered.  There
is bound to be a push back from Parliament, whose legal advice will no doubt
favor its role.  
US presidential polls typically become
more accurate after Labor Day.
  A change among the top Trump
campaign managers has corresponded with what appears to be a small bump in the
polls.  He is trailing in nearly all of the swing states, and a few states that
are regarded as safe for Republicans
appear in play now.   This week there are
two primaries that will draw attention.  In Arizona, former
GOP-nominee McCain faces a primary challenge.  In Florida, former chair of
the Democrat Party, Wasserman-Schultz is also in a primary contest.  Both
incumbents are expected to win.  

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