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The mini-taper tantrum meme has been superseded by three developments in the US:  Yellen's semi-annual testimony before Congress last week, disappointing US inflation and consumption data, and now, the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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