Terribly Slow

From Germany data did show
That Q1 was terribly slow
As well, for Q2
Recession’s in view
Their hope remains Q3 will grow

Meanwhile last night China revealed
‘twill be a long time ere its healed
Despite what they’ve said
‘bout moving ahead
Consumers, their checkbooks, won’t wield

While the market has not yet truly begun to respond to data releases, they are nonetheless important to help us understand the longer-term trajectory of each nation’s economy as well as the overall global situation. So, despite very modest movement in markets overnight, we did learn a great deal about how Q1 truly fared in Europe. Remember, Covid-19’s impact really only began in the second half of March, just a small slice of the Q1 calendar. And yet, Q1 GDP was released early this morning from Germany, with growth falling at a 2.2% quarterly rate, which annualized comes in somewhere near -9.0%. In addition, Q4 data was revised lower to -0.1%, so Germany’s technical recession has already begun. Remember, prior to the outbreak, Germany’s economy was already in the doldrums, having printed negative quarterly GDP data in three of the previous six quarters. Of course, those numbers were much less dramatic, but the point is the engine of Europe was sputtering before the recent calamity. Forecasts for Q2 are even worse, with a quarterly decline on the order of 6.5% penciled in there despite the fact that Germany seems to be leading the way in reopening their economy.

For the Eurozone as a whole, GDP in Q1 fell 3.8% in Q1 as Germany’s performance was actually far better than most. Remember, Italy, Spain and France all posted numbers on the order of -5.0%. The employment situation was equally grim, as despite massive efforts by governments to pay companies to keep employees on the payroll, employment fell 0.2%, the first decline in that reading since the Eurozone crisis in 2012-13. One other highlight (lowlight?) was Italian Industrial Activity, which saw both orders and sales fall more than 25% in March. Q2 is destined to be far worse than Q1, and the current hope is that there is no second wave of infections and that Q3 sees a substantial rebound. At least, that’s the current narrative.

The problem with the rebound narrative was made clear, though, by the Chinese last night when they released their monthly statistics. Retail Sales there have fallen 16.2% YTD, a worse outcome than forecast and strong evidence that despite the “reopening” of the Chinese economy, things are nowhere near back to normal. Fixed Asset Investment printed at -10.3% with Property Investment continuing to decline as well, -3.3%. Only IP showed any improvement, rising 3.9% in April, but the problem there is that inventories are starting to build rapidly as consumers are just not spending. Again, the point is that shutting things down took mere days or weeks to accomplish. Starting things back up will clearly take months and likely years to get back close to where things were before the outbreak.

However, as I mentioned at the top, market reactions to data points have been virtually nonexistent for the past two months. At this point, investors are well aware of the troubles, and so data confirming that knowledge is just not that interesting. Rather, the information that matters now is the policy response that is in store.

The one thing we have learned over the past decade is that the stigma of excessive debt has been removed. Japan is the poster child for this as JGB’s outstanding represent more than 240% of Japan’s GDP, and yet the yield on 10-year JGB’s this morning is -0.01%. Obviously, this is solely because the BOJ continues to buy up all the issuance these days, but in the end, the lesson for every other nation is that you can issue as much debt and spend as much money as you like with few, if any consequences. Central bank reaction functions have been to support the economy via market actions like QE whenever there is a hint of a downturn in either the economy or the stock market. Both the Fed and ECB have learned this lesson well, and look set to continue with extraordinary support for the foreseeable future.

But the consequence of this in the one market that is not directly supported (at least in the case of the G10), the FX market, is what we need to consider. And as I observe central bank activity and try to discern its economic impacts, I have become persuaded that the medium-term outlook for the dollar is actually much lower.

Consider that the Fed is clearly going to continue its QE programs across as many assets as they deem necessary. Not merely Treasuries and Agencies, but Corporates, Munis and Junk bonds as well. And as is almost always the case, these ‘emergency’ measures will evolve into ordinary policy, meaning they will be doing this forever. The implication of this policy is that yields on overall USD debt are going to decline from a combination of continued reductions in Treasury yields and compression of credit spreads. After all, don’t fight the Fed remain a key investment philosophy. Thus, nominal yields are almost certain to continue declining.

But what about real yields? Well, that is where we get to the crux of the story and why my dollar view has evolved. CPI was just released on Tuesday and fell to 0.3% Y/Y. Thus, strictly speaking, 10-year Treasuries show a +0.31% real yield this morning (nominal of 0.61% – CPI of 0.3%). The thing is, while current inflation readings are quite low, and may well fall for another few months, the supply shock we have felt in the economy is very likely to raise prices considerably over time. Inflation is not really on the market’s radar right now, nor on that of the Fed. If anything, the concern is over deflation. But that is exactly why inflation remains a far more dangerous concern, because higher prices will not only crimp consumer spending, it will create a policy conundrum for the Fed of epic proportions. After all, Paul Volcker taught us all that raising interest rates was how to fight inflation, but that is directly at odds with QE. The point is, if (when) inflation does begin to rise, the Fed is certain to ignore the evidence for as long as possible. And that means we are going to see increasingly negative real rates in the US. History has shown that when US real rates turn negative; the dollar suffers accordingly. Hence the evolution in my medium- and long-term views of the dollar.

A quick look at this morning’s markets shows that yesterday’s late day equity rally in the US has largely been followed through Asia and Europe. Bonds are also in demand as yields throughout the government sector are mostly lower. And the dollar this morning is actually little changed overall, with a smattering of winners and losers across both G10 and EMG blocs, and no truly noteworthy stories.

We do see a decent amount of US data this morning led by Retail Sales (exp -12.0%, -8.5% ex autos). We also see Empire Manufacturing (-60.0), IP (-12.0%), Capacity Utilization (63.8%), JOLTs Job Openings (5.8M) and finally Michigan Sentiment (68.0). Only the Empire number is truly current, but to imply that a rise from -78.2 to -60.0 is progress really overstates the case. As I’ve pointed out, the data has not been a driver. Markets are exhausted after a long period of significant volatility. My expectation is for the dollar to do very little today, and actually until we see a new narrative evolve. So modest movement should be the watchword.

Good luck, good weekend and stay safe
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