Signs of Decay

According to data today
From Europe and from the UK
Those stories ‘bout growth
Depicted by both
Are now showing signs of decay

Remember when the Eurozone was growing above potential? Yeah, me neither! But in fairness, in 2017, the bloc did have a (relatively) blockbuster year, where GDP in the Eurozone grew 2.4%, which is well above most economists’ estimates of how fast it can grow over time. And it was faster than US growth as well, which of course was one of the reasons that the euro rallied 11% vs. the dollar last year. You might remember the meme that arose from that story, ‘global synchronous growth,’ which was going to be the key behind the ECB exiting QE and starting to normalize monetary policy. That was also the rationale behind the UK preparing to raise rates despite Brexit, and the main argument as to why the dollar was destined to fall much further.

But that is so last year. We are now five months into 2018, a pretty good chunk of the way, and the data we continue to see from both the Eurozone and the UK has basically demonstrated that 2017’s growth meme seems to have ended. Thus far, the euro bulls have relied on the idea that the slowdown in Q1 was a result of extremely cold weather, a flu epidemic and some labor strife. But now we are two-thirds of the way through Q2 and the data is simply continuing to trend lower with no sign of slowing down. (For example, German manufacturing PMI fell to 56.8, its lowest level since February 2017, with all the major subcomponents falling.) The point is that Mario Draghi and his compatriots at the ECB have to be looking at the data and starting to ask themselves just how anxious they are to change their current monetary policy settings. Continuing down the path of reducing accommodation amid slowing growth will be very difficult to explain to both the markets, and perhaps more importantly for them, to the politicians across the Eurozone. Ask yourself how the new antiestablishment government in Italy will respond given that nation’s desperate need for both NIRP and QE to continue.

In fact, the breadth of disappointing data today was impressive. From the Eurozone, we saw weaker than expected flash PMI data from Germany, France and the Eurozone as a whole, most of it the weakest since the beginning of 2017. We also saw French Unemployment tick higher to 9.2%, above expectations although not yet sufficient to describe as reversing a trend. From the UK we got both disappointing PMI data and lower than expected inflation data, with CPI falling to 2.4%, continuing its retreat from the November highs of 3.1%, and reducing the probability that the BOE will feel compelled to raise rates this year. Two things seem to be driving the inflation data, and both seem likely to continue. First is the fact that in the immediate wake of the Brexit vote nearly two years ago, the pound sold off sharply and remained there for quite a while. That led to higher import prices, which pushed up inflation. However, since then, the pound has rebounded quite smartly and as time has passed, that initial wave of price increases has passed out of the data. The second is that the overall growth rate in the UK economy is very clearly slowing down, thus undermining the idea that higher demand will drive prices up.

It can be no surprise that given the data releases, both the euro and the pound are sharply lower this morning (EUR -0.7%, GBP -0.9%) and plumbing depths not seen since December. In fact, both currencies are now lower YTD, and as I’m sure you must be aware by now, in my view have further to fall.

But today’s story is more than simply poor data from Europe; it really has the feel of an old-fashioned risk –off session. For example, the yen has rallied more than 1%, US Treasuries are up nearly half a point with the yield back down to 3.03%, and equity markets around the world are falling, with most down 1% or more. It seems that adding to the poor data story are some broader issues, things like a less sanguine attitude by markets regarding the trade situation between the US and China, the sudden sense that the meeting between President Trump and North Korea’s Kim Jong-Un may not occur after all, thus unwinding so much good will that the market had embraced, and the ongoing collapse of the Turkish Lira, which has fallen another 4% this morning and is working hard to catch up to Argentina for the title of worst-performing currency this year.

It is with all this in mind that we look forward to today’s session, where the FOMC will release the Minutes from its meeting back on May 1st and 2nd. If you recall, the big story then was the use of the word symmetric twice with regard to the inflation target of 2.0%. Pundits read that to mean there was a growing willingness by the FOMC to allow the inflation rate to run above target for a while before tightening too aggressively. Now, everyone is looking for a deeper explanation as to the rationale behind the change in language, and to see if we can get a clearer view of the future rate path. Remember, the market is currently pricing in rate hikes in both June and September, with a ~50% chance of one in December. Given that the data we have seen since the meeting has continued to show solid economic growth, I continue to look for that fourth rate hike, and for the markets to continue to favor the dollar as the year progresses. While I understand that long term questions about fiscal sustainability and its impact on the currency, which are decidedly negative in the dollar’s case, we are going through a period where cyclical relationships dominate the structural, and where long-established relationships, like the dollar following the path of US rates, have resumed their trends. This morning’s New Home Sales data (exp 677K) seems unlikely to change any views. Rather, the market is likely to remain in thrall to the ongoing deterioration of Europe and assorted emerging markets while it awaits those Minutes. In other words, look for the dollar to continue to perform well today.

Good luck