The Dollar in the Week Ahead

The US dollar bottomed against nearly all the major currencies on May 3.  The hawkish April FOMC minutes that began swaying opinion about the prospects for a summer rate hike were not published until two weeks later, and the confirmation by NY Fed President Dudley was not until May 19. 

Nevertheless, the shift in expectations for a resumption of the Fed's gradual normalization of monetary policy is a potent force that has fueled the greenback's recovery.  The place to look for investors' anticipation of a rate hike is not in the long-end of the curve but the very short-end.   For medium and long-term investors, it is immaterial whether the Fed hikes in June or July.  The implied yield of the August Fed funds futures contract (which is the closest proxy for June and July) has risen 15 bp, while the US 2-year yield has risen 20 bp.  

Anything that shifts these expectations would impact the dollar.   There are two broad categories of events that could alter expectations for US monetary policy:  foreign and domestic.   The biggest foreign threat, which several, though not all, Fed officials have identified is the UK referendum on June 23.  

Even though a vote to leave the EU would not entail an immediate separation, but rather begin a two-year negotiations that would lead to the dissolution of the marriage, it could cause a significant disruption in the global capital markets.  The recent polls appear to have suggested a shifted away from Brexit.  Yet even if there is a 20% chance (the events market, PredictIt has it as 22%) of UK voting to leave the EU because the potential impact could be so serious, policymakers, like investors, have to take it seriously. 

Through a risk-management point of view, the question facing Fed officials is what kind of error is preferable, assuming the economic conditions for a rate hike exist. The Fed could raise interest rates, and the UK could vote to leave, and there could be a significant increase in volatility and a tightening of financial conditions.  The Fed could wait for its next meeting, six weeks later to hike rates, and the UK votes to stay in the EU and there is not instability in the financial markets.    Assuming rational actors, we think that the Fed would prefer the second error than the first.  

OPEC meets on June 3.  Investors and observers recognize that there is little chance of an agreement to freeze output.  While most producers have little spare capacity, the key remains Saudi Arabia.  On political and economic grounds it cannot cede market share to Iran.  Moreover, the combination of Saudi Arabian influence and the cooling effect of US financial sanctions (as opposed to the embargo that has ended) are contributing to a more gradual recovery of Iranian output. 

With oil prices near $50 a barrel, Saudi Arabia's strategy of squeezing out high-cost producers would seem to be working.  US production has fallen by around 500k barrels a day, but the other supply cuts have not been the result of lower prices and the Saudi strategy.  Libyan and Nigerian oil output has fallen due to domestic violence.  Canada's output fell due to forest fire and is already coming back online.    

The outcome of the OPEC meeting will have little impact on whether the Fed decides to hike rates in June or July.  The meeting is still important because it will be an opportunity to see/hear Saudi Arabia's new Energy Minister Khalid Al-Falih who replaces Ali al-Naimi who had the position for the past 20 years.  Al-Falih is reportedly a close confidant of Prince Mohammed, who has emerged as a key figure driving the Kingdom's policy.  

In addition Brexit and next week's OPEC meeting, developments in China could inject new volatility in the financial markets, which may serve to deter the Fed.    Last summer and again earlier this year, volatility emanating from China created significant disturbances.   However, among the most remarkable developments in recent months is that global investors have become less sensitive to the yuan, which has been trending lower for two months, and the Chinese equities, which are among the worst-performing stock markets this year.  The Shanghai Composite is nursing a 20% loss through the first five months.      

China's official and Caixin purchasing managers indices will be announced in the week ahead. The data is likely to confirm what investors already know.  The world's second largest economy appears to be stabilizing, but the risks are aligned on the downside.  

Turning to domestic developments, recent economic data point to a strong snap back to the US economy after a disappointing six-month soft patch.  The NY Fed's GDP tracker is at 2.2% (its final Q1 estimate was 0.7% before last week's revision from 0.5% to 0.8%), while the Atlanta Fed's model sees 2.9% growth in Q2.  The Beige Book should confirm more activity.  

The survey data has been lagging behind the US economic recovery.  This looks set to continue with the May readings to be released in the coming days. Of note, non-manufacturing ISM, whose employment reading is an input in forecasts for the monthly jobs report, will not be released until after the employment report next week.  

The April personal consumption expenditures is expected to confirm the strong retail sales (which account for about 40% of PCE).  May auto sales are expected to remain firm but little changed sequentially.   The PCE core deflator, the inflation measure the Fed targets will likely remain at 1.6%. The US 10-year breakeven continues to trade around there as well. 

Due to a 40k person strike, the US nonfarm payroll data will not be clean, and the risk is on the downside.  The internals, like hours, worked and hourly earnings are likely to be little changed.  If there is a place to look for a pleasant surprise, it would be with the unemployment rate.  A tick down to 4.9% could offset some disappointment.  

Fed Governor Brainard, who speaks after the employment data, may be an important barometer. Although we don't put here in the inner sanctum of the Fed's leadership,  first her cautiousness and then her sensitivity to international developments seemed to anticipate broader developments.   Yellen speaks again on June 6.  

Given that the dollar has rallied four weeks, and the risk-reward favors waiting until after the UK referendum, we suspect that the market is ripe for a correction.  Such a correction could be spurred by expectations for a rate hike being shift from June to July.  The main hurdle for a July hike is a communication challenge stemming from the absence of a pre-scheduled press conference.   We anticipate a dollar correction and will be particularly attentive to short-term reversal patterns in the coming days.  

The week begins off slowly with US and UK holiday's on Monday, and the correction may begin around the middle of the week or after the employment report at the end of the week.  For investors, who share our constructive dollar outlook, this means being careful about adding to dollar exposure after the four-week rally without much of a correction.  For those who think the four-week dollar rally itself was a correction after a three-month down move, a  new selling opportunity may arise soon.   

Next week's events in the eurozone and Japan will be of interest to investors but are unlikely to change the investment climate.  A modest improvement in economic data will provide the backdrop for the ECB meeting.  While the headline CPI is likely to show deflationary forces remains, they probably slackened a little.  Money supply and lending likely increased, as did retail sales (after March's decline), while unemployment may have slipped to 10.1% from 10.2$%.  

What has gone unnoticed by many observers, and appears to have gone unremarked by ECB President Draghi, is that the eurozone growth experienced last year, and projected for 2016-2017,  is near what economists regard as trend or the long-run average.  And perhaps a little better than trend growth, which suggests the output gap may be reduced.     

Ironically, the fact that growth is near trend and stable could be a powerful argument for Draghi's critics, but the problem is that to put much emphasis on this would require a broader mandate than the ECB is given.  Many if not most of the critics of eurozone money supply are loath to expand the ECB's mandate.  The ECB's mandate is price stability.  It appears it will take stronger growth for longer for the ECB to reach its single-mandate objective.  

It is unreasonable to expect the ECB to take fresh monetary policy initiatives.  Not because there is a secret Shanghai Agreement, but because the already announced measures have not been implemented.  Even after they are implemented, the impact must be assessed.  We reckon this will take the ECB most of the rest of the year.    

The ECB's staff forecasts will be updated.  With the help of higher oil prices, the staff may tweak higher its inflation forecasts.  The risk is on the upside for growth forecasts.  The market may also look for more details of the corporate bond purchases and the new TLTROs that expected to be launched in June.  

With Greece having passed the first review of its third assistance program, the ECB could once again accept Greek bonds as collateral from Greek banks.  This would be consistent with ECB's rules.  However, not reacting immediately would also be consistent with bureaucratic inertia.  Greek bonds (and bank shares) are vulnerable to a delay.  If Draghi does not volunteer it,  perhaps a reporter will ask about including Greek bonds in the ECB's asset purchases.  The proximity of the technical cap (33%) of a country's outstanding debt may offer a way skirt the issue, for the time being.  Greece is gradually paying down the debt it owes the ECB, which will keep the issue near the surface.  

If eurozone growth is under-appreciated, Japan's deflation is over-appreciated.  Last week Japan reported that its core measure of consumer inflation (excluding fresh food) was minus 0.3% year-over-year.  Because it includes energy, it overstates the deflation.  Excluding food and energy, consumer prices have risen 0.7% from a year ago.  This is still well below target but is not deflation. As we have noted before, due to structural rather than cyclical factors, rents in Japan are declining, and if they were excluded inflation in Japan would be closer to 1%.  

Ultimately the problem has is growth.   The first estimate of Q1 GDP was 1.7% (annualized pace) was surprisingly strong.  The capex  figures due in the week ahead could give the doubters of the first estimate something upon which to hang their expectations of a downward revisions.  

Other data over the course of the week will likely show the economy has not begun the second quarter on strong footing.  An expected fall in industrial production is likely aggravated by supply chain disruptions following the recent earthquake.  A soft retail sales report is anticipated.  It is difficult to imagine significant improvement in the Japan's labor market.  The unemployment rate is expected to be unchanged at 3.2% compared with 12 and 24-month averages of 3.3% and 3.4% respectively.  

A key issue next week is not so much about the economic data as the policy response.  Earlier this year, there were expectations that Abe would look to postpone the sales tax increase.  Then Q1 GDP was stronger than expected and Finance Minister Aso indicated at the recent G7 finance ministers and central bankers meeting that Japan would push ahead with the retail sales increase from 8% to 10%.

The plot took another turn at the G7 heads of state summit.  Abe tried to get a rather dire warning of a Lehman-like event into the final statement.  This apparently was Abe's way of trying to get cover for delaying the tax.  The final statement recognized the world economy was slowing, but drew back from a Cassandra-like prognostication.

Nevertheless, local press reports over the weekend have signaled that the tax increase will, in fact, be delayed, perhaps into 2019.  The postponement of the tax increase (Abe's second delay) may be part of a larger fiscal package combining rebuilding from the earthquake to new economic stimulus. 

Some reports suggested the overall fiscal effort may be in the area of the equivalent of $90 bln (JPY10 trillion).  Abe may confirm the delay in the middle of the week.  It is when the current parliamentary session ends.  The upper house election will be held this summer, and Abe has indicated he would formally make a decision before it.  There is a small chance that a decision to delay the tax increase would see Abe dissolve the lower house as well and have a general election.  Meanwhile, the general stability in the dollar-yen rate reduces the perceived need to intervene, while the lack of G7 support raises the bar.  

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