The data from Europe today
Implied that, from Spain to Norway,
The outlook for growth
May make Draghi loath
To soon take the ‘punch bowl’ away
The dollar continued to perform well overnight, edging higher again vs. most of its counterpart currencies and actually trading to its highest level in more than six weeks. While I wouldn’t necessarily characterize it as strong, it certainly has started to regain some momentum with a 3% rally over the past two weeks. The proximate cause today was the release of PMI data from around the world, which hinted at the idea that the recent pace of growth seen throughout the G20 may, in fact, have peaked. The direct result of this is that all those who expected the ECB would be sounding more hawkish next week have had to re-evaluate their strategies. In fact, one of the tell-tale signs that I saw was commentary by Bundesbank President Jens Weidmann, an arch-hawk, that QE is likely to remain in place through the end of 2018 and interest rates unlikely to rise before late 2019. To me that is groundbreaking stuff, and I am shocked it has not gotten more play. (I read it in an article about German wage settlements; it was not a headline!) At any rate, by combining this modest adjustment in the outlook for growth with Chairman Powell’s comments on Tuesday, it is easy to understand the recent change in sentiment.
So will this change have staying power? While it is anybody’s guess, my vote is with yes. As I have been discussing, inflation remains the key driver in central bank eyes these days. Certainly for the G10 that is the case. And it is also clear that due to the way it is calculated, on a year over year basis, we are very likely to see inflation in the US run higher than we have seen for the past twelve months. This will be the elimination of Yellen’s ‘idiosyncrasies’ from the data, such as the hedonic adjustment for unlimited data use in cell phones, to name one. The point is that inflation in the US is set to rise, and the Fed will be very attuned to that process. In fact, this morning we get the latest reading of PCE (exp 1.7%, core 1.5%), which is the number they plug into their models. My gut tells me that we could see those come in a tick higher which would almost certainly be enough to cement more hawkish attitudes amongst the majority of the FOMC.
At the same time, the inflation story in both Europe and Japan remains one of absence. Neither of these economies has shown any hint of rising inflation and so it remains increasingly difficult to maintain the idea that either central bank is going to tighten policy any time soon. My point is that all of the hype over a tighter ECB or BOJ while the Fed lags its own estimates must surely have been dispelled at this point. If anything, I would argue things would be the other way round, with a tighter Fed and an easier ECB (especially if Weidmann has changed his stripes.) And that will lead to dollar strength. Remember, too, that there are very significant short USD positions built up in the markets, so at some point, if the dollar continues its recent rise, these positions will be unwound and the dollar will find an even more substantial bid. Hedgers, you are forewarned.
What can change this view? Essentially, we will need to see US data start to crack, especially the inflation data. If that continues to lag estimates, then I suspect that the Fed will change its tune. But until that is the case, I would look for the Fed to remain in the lead regarding policy tightening amongst central banks.
Is there anything else? Well, there is one thing that is gathering more press lately but doesn’t feel to me like it is priced into markets and that is trade tensions. Headlines this morning indicate that President Trump may be imposing tariffs or quotas on imported steel and aluminum, this after his tariffs on solar panels and washing machines. Not surprisingly, other nations are looking at retaliation and a full-fledged trade war cannot be ruled out. While it is not my base case, what is certain is that a more protectionist stance by the US (and in truth by any nation) is going to result in higher inflation. Whether it is price rises due directly to tariffs, or price rises due to higher costs of local production, prices will rise. Since the US is in the lead on this front, (a dubious distinction at best) it is quite likely that the Fed will find itself behind the curve before any other nation. And this, too, is a reason for the Fed to move faster than currently priced. In fairness, we have seen markets adjust somewhat over the past sessions with Fed Funds futures now pricing in about a 40% probability of a fourth rate hike this year. But on a relative basis, I continue to believe the market is under pricing the eventual interest rate differential between the US and other major economies. Hence my still bullish dollar view.
This morning, in addition to the PCE data, we will see Initial Claims (exp 230K); Personal Income (0.3%); Personal Spending (0.2%); ISM Manufacturing (58.6) and Construction Spending (0.3%). Of course, we also hear round two from Chairman Powell, and we hear from NY Fed President Dudley as well. It will be interesting to see if Powell tries to walk back any of his comments from Tuesday, but the very fact that there has been no attempt in the interim means to me that he is comfortable with the market’s interpretation. Equity markets have been behaving poorly of late, with early rallies giving way to late day sell-offs. That is a very interesting change in tone, and one that I feel bodes ill for future gains. Treasury prices have been behaving well, almost as though we are back to a risk-off scenario, which with declining stocks and stronger Treasuries and a stronger dollar could be the case. I see no reason for these recent trends to change and expect that the dollar will continue to edge higher for the rest of the session.