Drag the Dove

In Frankfurt the hawks stole the show
Declaring QE will ne’er grow
But Draghi the dove
Would not dispose of
His view QE’s still apropos

The market response was to buy
The euro up to the day’s high
But after he spoke
The hawks’ spirit broke
By day’s end the buck felt quite spry

There is much to discuss today as to what happened yesterday and what we might expect today. To begin, the ECB left policy on hold, as universally expected. However, they surprised one and all by removing the paragraph from their statement promising that they could increase QE if they thought it was appropriate. The initial market response was to take the euro higher by about 0.5% as the hawks were feeling quite smug. Alas for those who jumped on that news, when Draghi spoke at the press conference forty-five minutes later, it became clear that he was not really so hawkish after all. One of the key changes was in the staff economic update where the forecast for CPI in 2018 was decreased by 0.1% to 1.4%. Now it seems awfully hard to believe that the ECB is going to be aggressively withdrawing stimulus if they officially expect inflation to grow more slowly than previous expectations. In addition, a surprising twist was that the forecasts were based on QE of €30 billion/month continuing through the end of the year, rather than ending abruptly or tapering further in September as many had mooted. The upshot was that the euro reversed course and fell steadily all session, closing the day lower by some 0.8%. This morning it continues under pressure, falling another 0.1% and is back around the 1.23 level, which seems to have become a trading pivot.

Next up the BOJ, with their meeting concluding last night and again, no actual policy changes being revealed. Rather, Kuroda-san is still working to walk back the comments he made about the end of QE occurring next year and has thus extended his dovish rhetoric at the press conference as follows, “We’re not thinking at all about weakening the degree of easing, or changing the current monetary easing policy framework, before we achieve 2 percent.” So he has come full circle, after first saying that they would consider how to end QE when they achieve their target in 2019, they have now indicated that while their goal is to achieve that elusive 2.0% inflation rate by then, they have less confidence in doing so and will not act, in any case, before they have achieved the target. In other words…just kidding! Remember, CPI ex fresh food, the BOJ measure, is running at 0.9%. It astounds me that they are willing to continue to say they expect to reach that level so frequently while, except for the GST increases a few years ago, they haven’t sniffed that level in decades! Needless to say the market took heart that the BOJ would remain more dovish and sold the yen further after the meeting, with the dollar higher by 0.5% overnight and a solid 1.4% this week.

Which brings us to this morning and the US payroll report. No one has forgotten the market response to last month’s payroll report, where the jump in AHE to a 2.9% annualized rate completely spooked markets. The resulting decimation of the short volatility trade wound up reintroducing everyone to the idea that markets can go down as well as up. So it is not surprising that much commentary is focused on that number today, because if it were to tick up even slightly, to 3.0%, I think the market response would be quite large. However, there are many economists who point to the idea that last month’s number was a statistical anomaly because of the number of days in the period and how weather related issues impacted the weekly hours number. While I don’t have my own econometric models, my observation is that we have seen a broad swath of commentary and data showing that wages are, in fact, rising more rapidly than at any time in a number of years. My gut tells me that the number was no fluke. At any rate, here are the current expectations:

Nonfarm Payrolls 205K
Private Payrolls 195K
Manufacturing Payrolls 17K
Unemployment Rate 4.0%
Participation Rate 62.7%
Average Hourly Earnings (AHE) 0.2% (2.9% Y/Y)
Average Weekly Hours 34.4

Remember, too, ADP Employment was a much stronger than expected 235K and that the Fed’s Beige Book highlighted that employers were raising wages. We have also seen that in the NFIB survey as well as in PMI data. The point is that while it has taken a long time to see the apparent tightness in the labor market lead to higher wages, that process has clearly begun. And there is one other thing to note, look at the Manufacturing payrolls expectation. For quite a while, growth in manufacturing payrolls was stagnant, and actually negative, but lately we have seen those numbers pick up quite nicely. And remember, manufacturing wages tend to be significantly higher than the average wage, so as that process continues, the average number should continue to see upward pressure. As always, I would contend that inflation is very real in the economy and that the data measurements will reflect that eventually. It is becoming clearer that eventually is now.

In the end, for the dollar I think the market response will be perfectly logical, with strong data resulting in a strong dollar on the basis of faster Fed tightening and vice versa. For equity markets I think we are in the good news is bad scenario, and a strong print will undermine equities, while for bonds it is a toss-up. The case could be made that higher inflation will drive yields higher, or that flight from risky assets could drive them lower. My own view is that we will see another set of robust data, with NFP something on the order of 225K, Unemployment at 4.0% and AHE at 3.0%. I like the dollar higher in that scenario.

Good luck and good weekend