FX Week Ahead: Discretion And Common Sense Not Easy For "The Machines"

Submitted by Shant Movsesian and Rajan Dhall MSTA of fxdailyterminal.com

Coming off the back of a mixed payrolls report which saw the headline number recording a negative balance for the first time in 7 years, the USD initially gained on the rise in wage inflation which recorded a 0.5% increase in average hourly earnings.   Into the weekend, we saw these moves tamed to a modest, but varying degree(s), with the market still very much of the mind that this remains a USD correction at best.  We still feel this has more to run, but it will be anything but smooth as the larger fund managers are happy to stay short on the greenback for the longer term.  As such, no material sign of this positioning being lightened.  

Nevertheless, the Fed are signalling their intention to hike in Dec, and Fed chair Yellen continues to communicate this as subtly as she can.  The odds for adding another 25bps onto the Fed Funds rate have been over 70% for a few weeks now, and we expect the next significant USD push will come from solidifying expectations for 2-3 hikes next year - 2 is a safe based on the trajectory of data, with the ISM reads last week strong in both manufacturing and non manufacturing industry.  Little to get excited over until the end of  next week when we get the Sep inflation readings.  Many will be looking at the incremental changes with a certain sense of apathy.  Core CPI is expected to rise from 1.7% to 1.8% as the oil prices are expected to help lift the headline rate through 2.0%, but for the purposes of monetary policy, we expect current levels are strong enough to keep the Fed on their normalisation path.  Once again, equity markets need a reality check, and it will not come from the level of balance sheet reduction now under way.  

So where now for the lead USD pairings?. Going on the trade weighted index, EUR/USD is set to continue the fight to find a base and set off for the next trek higher.  This is what we saw when the pair dipped under 1.1700 again on Friday, with the retail market excited to see a test on 1.1660 and jumping in aggressively to buy the dip here for a return to 1.2000 and beyond. 

We can look at the German industrial production data on Monday, followed by trade stats on Tuesday. EU wide industrial production is due later on the week accompanied by French and German HICPs, but does any of this concern the market which has been fed by a constant stream of forecasts that the EUR is heading back to value levels at 1.2500?  I take issue with the fact that so many see value here, as PPP metrics are flawed in many ways given its rigidity against the ever changing dynamics of the global economic structure.  

Any aggressive move higher should be capped in the 1.2000-1.2100 in the lead EUR rate, and in that we factor in time-frame on the pace of gains seen.  Focus on the the political backdrop is starting to look like "old news" already given the price action, with markets generally desensitised to risk themes that come and go with the familiar transitory shift into safe havens.  Consequently, EUR/CHF is also turning higher again, with the dip under 1.1400 here again all too brief.  However, Germany"s undercurrent of unrest with immigration is just as unsettling as the fragmentation in Spain, and as many quickly forget, Italy"s contentious elections next year will also jolt EUR gains ahead, but it is all about positioning for the ECB"s unavoidable adjustment to monetary stimulus at present, and I for one am not going to get excited.  Range trading in the EUR for me. 

In the UK, it was only a matter of time before the Pound was going to come back off its lofty levels, which in the broader context are still pretty low historically.  However, at times, I get the sense that the market does not appreciate the full extent of this material sea change in the aftermath of Brexit, and calling for a Cable move to 1.4000 and 1.4500 at this stage is "head in the sand" analysis at its best (worst).  We shifted our range from 1.2000-1.3000 to 1.2500-1.3500, and we are not ready to shift it again, well, not higher anyway.  

The BoE can call for the market to price in higher rates on the curve further out, but at this stage, I believe this is a policy mistake, just as it was to cut pre-emtively last Aug straight after the referendum.  Any move this year, to correct that, will be just that and that only, with uncertainty set to keep the MPC sitting on their hands until we get some sign of agreement at the UK-EU negotiating table in order to genuinely revive hopes of business investment here in the UK.  Progress we are told, has been nowhere near enough, so that is all we need say on Brexit at this stage.  On Theresa May, I echo the words of ex PM John Major who also calls for unity in the Tory party and her leadership, and calling her weak due to a mid speech coughing fit is ridiculous and unnecessary, not to say unsettling at a time when the UK needs some stability at its core.  GBP sales on the latter should have run its course, but over the longer term, developing rate spreads (with US Treasuries) are now more likely to pull Cable back towards 1.2500-1.2600.  

Expectations for EUR/GBP to parity over the longer term also remain a possibility, but I am a little more comfortable with 0.9500 over the longer term.  For now, we may struggle with 0.9000 due to European unrest.  UK industrial production is one for the algos, but of interest is the trade balance which should benefiting from broad based GBP weakness these days.  

In Canada, last week"s data schedule reported its trade deficit widening, and with the contraction seen in the US balance, the natural shift higher took us above 1.2500, testing 1.2600 either side of the US and Canadian payrolls reports.  The latter came in pretty much as expected in the headline (gain of 10k), but the "make up" was a complete turnaround of the Aug data which saw a wholesale shift from full to part time jobs.  We are not quite sure what to make of this reversal - perhaps a reporting or accounting error - but the subsequent CAD retrace reflected some of this change, but not too convincingly as yet.  Even so, short term metrics suggest we have pushed far enough for now, and circa 1.2500 looks about right until we get the next round of growth data in particular, after the flat reading we saw for Jul.  Nothing of note in the week ahead.  

It is equally barren on the Australian and NZ data schedule, not that it would matter much. Recent prints have had such a modest response from the respective currencies, which in all cases are trying to push lower against the USD, and coming up with dip buyers - much as they are in the EUR.  This is more so the case for AUD rather than NZD, where the leading National and Labour parties continue to fight it out for government after the former fell short of majority in the elections - votes all now in and finalised.  Business confidence is slipping, and on this development it is not hard to see why, but NZD/USD has retraced some way from 0.7500+, and now 0.7000 will likely attract the arbitrary test from intra day day traders.

For AUD, and with the CAD to a lesser degree, we watch the commodity markets, where industrial metals have adjusted lower.  Copper has dipped under $3.00, but has since stabilised, though we have China back this week which should liven up activity here to some degree.  Oil prices are now coming off their better levels, but as we have consistently said, this will not disturb the CAD unless we gather pace on the downside and/or WTI retests $45.0 a barrel.  

Still no breakout in NOK/SEK, but it looks as though we will continue to pressure the downside, as parity beckons here.  Inflation numbers in both Sweden and Norway out this week, and on current levels, SEK out-performance looks justified but for rate differentials and a Riksbank refusing to let go of its cautionary stance.  

Deutsche: "Recession Risk Is The Highest In Ten Years; It's Time For The Fed To Pause Tightening"

Even before Harvey and Irma were set to punish Texas and Florida, erasing at least 0.4% GDP from Q3 GDP according to BofA and costing hundreds of billions in damages (contrary to the best broken window fallacy, the lost invested capital more than offsets the "flow" benefits from new spending, which is why the US does not bomb itself every time there is a recession to "stimulate growth"), things were turning south for the US economy, so much so that according to the latest Deutsche Bank model, which looks at economic data that still has to incorporate the Irma/Harvey effects, the risk of a recession starting in the next 12 months is near the highest it has been since the last recession.

As Deutsche Bank"s Dominic Konstam writes, at first glance, the modeled probability is admittedly low at about 8% as of the end of August (down a touch from near 10% in June), but it has been generally trending higher despite a brief post-election dip. As a result, the bank "sees appeal to buying SPX put spreads and bull flatteners in Eurodollars given the emergence of downside risks."

How does Deutsche estimate recession risk?

"We use a probit model to estimate the probability that a recession will start in the next 12 months using the 1s10s Treasury yield curve, the unemployment rate less CBO’s NAIRU, annual core CPI ex-shelter inflation, aggregate hours worked growth, and the year-on-year change in oil prices. Unemployment’s proximity to NAIRU and soft core inflation are the key factors contributing to the appearance of some recession risk currently. Aggregate hours worked remains on a relatively healthy trend and oil prices are slightly positive year-on-year, however. While it has flattened significantly, the yield curve is also relatively steep."

On the other hand, as we discussed two months ago when observing the imminent Y/Y contraction in C&I loans, traditionally a guaranteed leading indicator of future recessions, other metrics demonstrate a far higher recession risk:

Konstam admits as much, saying that "if we look elsewhere we can find reasons to believe our 8% estimate is too conservative. We noted the slowing in C&I loan growth last week, which has rolled over from a recent peak near 13% to just 1.6% y/y at the end of July. This type of rolling over is consistent with what is typically seen during recessions, not in the build up to them. As we’ve noted, Fed reserve draining against the backdrop of a flat yield curve and potentially tepid loan demand may simply result in an outright contraction of bank lending as banks choose cash assets over loans, which would push this indicator further into what would be “recession levels” by historical standards."

When considering the more practical recession indicators, the Deutsche economist concedes that when working with the bank"s rates strategy team, who previously produced a recession probability model that used the yield curve adjusted for the level of yields, shown a few higher recession probability:

Regressing the curve on front end rates shows that the curve is quite flat versus the level of short rates, and when we re-estimate our recession probability model using this metric instead we find a recession risk closer to 20%, having been as high as 25% in the Brexit aftermath. Outside of the last several years, such divergence between the two recession probability estimates has been highly unusual.

So what does the above mean for risk asset returns? Here is Konstam"s answer for equities:

Given its construction and purpose to predict recessions over the next 12 months, there should be some forward looking information for asset returns. There is some evidence of a bias in risk assets in the months following a recession probability of greater than 15% (as is currently reflected in the adjusted yield curve probit model). On a 6m look ahead, the S&P sells off 32% of the time since 1968, but that rises to 45% in the 6m following a recession probability of at least 15%, and the median return falls about 2%. A recession probability of 30% is consistent with the S&P selling off 50% of the time. In addition to the negative skew to returns, delivered volatility rises more frequently in instances of an elevated recession probability. We have previously discussed the risk of volatility/ risk-off feedback loops, which the modeled recession risk suggests are a higher likelihood in the months ahead.

Next, for junk bonds:

High yield widening increases in frequency from 47% to 65% (since 1985) after conditioning on a 15% recession probability, and the median 6m change is a 40bp widening (versus ~10bp tightening unconditionally). Note in high yield there is a significant increase in probability of widening up to +250 bps (to date recent widening is quite muted, around +30 bps). Despite these biases in risk assets, there is less evidence of any consistent behavior in yields or FX when the recession probability breaks above a given threshold.

The biggest take-home message, however, is what these rising recession odds mean for the Fed"s upcoming tightening actions, and while there is a discrepancy between various measures and indicators of recession risk which in turn complicates the ability to draw a firm conclusion, there are enough warning signs for Deutsche Bank to say that this uncertainty in and of itself "furthers our argument that the Fed would do well to take a pause in its tightening for the time being." 

In other words, a Fed Funds rate just above 1.00% may be all the massively levered US economy can take before rolling over into recession, something first suggested by the various R-star analyses conducted here in 2015. It also means that in just a few months the US may be discussing NIRP and QE4 all over again.

DB"s conclusion: "while we are relatively optimistic in our medium term equity view – falling equity risk premia in a low inflation equilibrium world mean equities are more likely to rally to bonds than bonds sell-off to equities – we maintain our near-term caution. While we don’t see recession as imminent, the blinking yellow lights mean that upside may be contained for now."

Passport Global Slammed With Over 60% In Redemptions In Q2

Back in April, we reported that the Long-Short Strategy Fund of John Burbank, one of the handful of investors who made a killing from shorting subprime, and head of what was at the time the $2.4 billion Passport Capital, was shutting down after a series of negative returns: according to HSBC, the fund - which had an AUM of $636 million as of March - had lost 2.1% in the first two months of this year and was down 11.8% in 2016. As we further reported, a catalyst for the closure appears to have been the January 2017 decision by the San Bernardino employees fund to pull its funds from Passport.

Fast forward to today, when in his latest letter to investors, Burbank reports that at what was once a multi-billion fund, total firm assets at Passport Capital have as of June 30 shrunk to just $900 million as a result of net outflows (not including the Long Short hedge fund strategy liquidation, effective 4/30/2017) which totaled a whopping $565 million, or a nearly 40% loss of AUM due to redemptions.

Worse, Burbank also reports that his flagship Passport Global fund has been virtually wiped out, and following $480 million of outflows, or a stunning 63% in assets under management, net of redemptions Fund assets as of June 30 stood at only $275 million, to wit:

Capital Flows: For the second quarter, the Fund had net outflows of $480 million. Firm-wide, net outflows (not including the Long Short hedge fund strategy liquidation, effective 4/30/2017) totaled approximately $565 million. At quarter-end, net of June 30th redemptions, Fund assets stood at $275 million and Firm assets totaled approximately $900 million. 

That said, aside from these devastating capital outflows, Burbank marches on, and reports that the funds was up 1.6% in Q2 net of fees. Additionally, following the shuttering of the Long/Short fund, Burbank says that the firm"s new focus will be as follows: "Lower gross exposure: ranging between 160% and 170% for most of the quarter; Lower turnover; Lower number of holdings (halved since the first quarter, from 150 names to 70). Despite higher concentration, with risk diversification of the long book, lower gross exposure and maintenance of risk limits, we have maintained realized volatility at the low end of recent historic averages at approximately 11%, as well as low realized correlation with the broader equity market."

Finally, here are some additional observations from Burbank in his latest letter. First, on Macro:

As mentioned, we intentionally reduced our directional macro bets and U.S. policy-dependent exposure which appears to be the right positioning, as this year has provided some surprises, most notably with regard to the USD, as well as its typical relationship with gold and oil. Contrary to expectations, the trade-weighted dollar index peaked on January 3rd and is now below its level immediately prior to the presidential election in November 2016. It is clear there has been very limited follow-through on pro-growth policies promised by the current administration, and as a consequence broad expectations, as measured by the Citi Economic Surprise Index, peaked in mid-March and have dropped precipitously since then; it is now at a five-year low. The University of Michigan Consumer Confidence is also at its lowest levels since November 2016 (election month) and is in a downward trend. The bond market is reinforcing this view (yields lower/curve flatter). Even after the recent bounce following discussion of rate normalization, the 2/10yr remains at pre-election levels after almost reaching the post-crises lows set in August 2016.

Dollar weakness could easily persist; economic growth in many places around the world is faster than the U.S., and the $23 trillion of foreign capital invested in the U.S. post the financial crisis could be reversed triggered by faster growth and increased optimism.

We believe a weak-dollar environment could be good for commodities, but surprisingly the fundamentals of oil, in particular, have overwhelmed the weak dollar (this is consistent with our view on oil and represented in our neutral oil construct).

Further, core CPI inflation remains weak, and we believe the bond market is not yet convinced that the U.S. will sustain sufficient nominal demand growth momentum to push inflation sustainably back to the Fed’s  2% target. We are carefully monitoring discussions regarding the debt ceiling, given the Trump administration’s push for a debt limit increase before the August recess. In our opinion, if an agreement is not reached, the Treasury may use interest receipts held at the Fed (approximately $150 billion) to pay bills. Perversely, this could act as incremental fiscal stimulus—as it represents an injection of more cash into the market.

The potential consequences of Fed balance sheet normalization are also important. We understand the Fed intends to gradually reduce securities holdings by decreasing its reinvestment of the principal payments it receives, which would potentially reduce principal reinvestment by an aggregate of $10 billion per month (Treasuries & MBS) and would increase in steps of $10 billion at three-month intervals over 12 months until it reaches $50 billion per month.

Some estimates suggest that global quantitative easing (“QE”) will turn negative in 2019 after being consistently positive by about 2% of Global GDP in every year since 2011 (e.g., since 2007, the Fed’s balance sheet has increased by approximately $3.5 trillion). While it is believed this could result in a much steeper yield curve and tighter financial conditions, the Fed continues to give itself substantial policy leeway.

However, the consequences of balance sheet normalization may be limited, given that the pace of reduction will be much slower than the ramping up of QE, and some of the effects of balance sheet reduction are already priced in (the pace has been communicated). Balance sheet normalization could be offset by the Fed adopting an easier path for short-term interest rates than it otherwise would have chosen, and the Fed is going to be cautious out of concern that any decision to shrink the balance sheet might be seen as tightening monetary policy. Ironically, reducing the balance sheet could have a stimulating effect, by reducing excess reserves on deposit (which sit idle) and freeing up Treasuries which provide liquidity to the market. It will also potentially allow the collateral reuse rate to increase as balance sheet space on banks becomes more available. Although the Dodd-Frank Act and Basel accords make it more expensive for collateral to be reused, the increase in balance sheet space of the banking system may outweigh the regulatory cost.

Finally, our view on China has been that after the massive credit stimulus of 2016 that led to rapidly rising housing prices and rising levels of leverage and system risk, the Chinese government would tap the brakes with restrictions on housing and credit. This would be detrimental for commodity demand in the second half of 2017. In fact, so far this year the Chinese government has put a number of restrictions in  place such as raising short-term lending rates and enacting housing regulations on a number of Tier 1 & 2 cities. However, the negative impact on industrial production, investment and commodity demand has not yet materialized, as the government has continued to inject credit into the economy via infrastructure and support for housing in Tier 3– 5 cities. Recent economic data has in fact been supportive of a continuation of strong growth near-term, with a slowdown possibly pushed to 2018. In its effort to crack down on shadow banking the authorities have encouraged a flow of capital into commodities given the limited number of investment options available to Chinese investors—which benefited commodity prices, particularly steel. We maintain a portfolio with a short tilt to Chinese IP, but we continue to monitor incremental data out of China that may impact our thesis and positioning.

... on Energy:

We remain bearish on oil. Currently the market is slightly undersupplied, with inventories peaking now but likely to decline sharply in Q4 and then flip into an oversupply during the first half of 2018.

OPEC, and its attempts to manage price higher, is frustrated by U.S. shale oil producers’ indifference to OPEC’s desire, and seems eager to hedge production in the high-$40s to lock in positive rates of return and mobilize rigs. We believe this dysfunctional dynamic is now appreciated by OPEC, putting future compliance at risk. The downside risk to price is a consequence of 1) robust U.S. production that we expect will inflect higher during the second half of this year, 2) sustained gains in Libyan and Nigerian production (not subject to OPEC compliance), and 3) increasingly poor compliance by OPEC members. The potential upside risk to prices stems from stronger than expected demand, disruption in supply (Venezuelan production, for instance, continues to drop), and U.S. underwhelming on production increase.

... and on AMD and Cryptos:

AMD has been executing in line with our expectations, with successful product launches across the PC, server, and graphics markets. Beyond its traditional markets, AMD is benefiting from an unexpected tailwind from the rising interest in cryptocurrencies, as its graphics cards are particularly well suited to the application of mining several cryptocurrencies. Recent market share studies also show AMD to be gaining meaningful share vs. Intel (over 5% in one quarter), and we expect those trends to continue, possibly even accelerate, in the server market. Based on these trends, our expectation is for AMD to generate earnings significantly ahead of sell-side estimates for 2018 and 2019.

We have been monitoring block chain technology and cryptocurrencies for some time. We believe this technology represents a secular change with the potential to profoundly disrupt many markets. AMD is the first position in the portfolio that has been a net beneficiary of this trend, but we expect our understanding of block chain technology’s potential to be an increasingly relevant factor in stock selection.

FOMC Preview: Just 2 Things To Watch For In Today's Fed Statement

Unlike the June Fed meeting, the FOMC announcement at 2pm today is expected to be an uneventful affair: as DB"s Jim Reid pointed out earlier, "given its late July and given the Fed will likely announce an end to balance sheet reinvestment in September (starting from October), this could be a relatively dull meeting."

Big picture: the FOMC is expected to keep interest rates unchanged at this meeting at 1.00%-1.25%, after hiking last month. According to RanSquawk, all analysts surveyed by Reuters expect the Fed to keep rates unchanged. The market agrees with them: Fed Funds currently price in a 0% chance of a rate hike today.

And, as BofA notes, the market is clearly not expecting any Fed balance sheet reduction today either:

With no press conference from the Fed Chair Yellen or Summary of Economic Projections released at this meeting, focus will be on the accompanying statement for the Fed’s views on inflation and any timing on the beginning of normalising the balance sheet.

Indeed, there are just two things to watch in today"s press conference-free FOMC statement: (1) any hints that Fed balance sheet reduction will be announced in September and (2) adjustments to the language discussing the recent disappointment in the rate of inflation (after 4 consecutive CPI misses).

• On inflation: the previous statement said the Fed still expects inflation (PCE) to stabilise around the Committee’s objective of 2.0% in the medium term, although on a 12-month basis was still expected to remain below 2.0%. Deutsche Bank say the Fed “will need to acknowledge the further decline in inflation since the June meeting” but should keep their medium-term view unchanged. Since the last meeting, Yellen spoke to Congress and although she noted that it was mostly temporary factors holding inflation down, she said she “recognised the dangers of persistently undershooting the Fed’s 2.0% target.”


• On the balance sheet: The Fed appears to be committed to shrinking its balance sheet, with most analysts expecting an announcement by the end of the year. The Fed’s most recent forward guidance has suggested that the start of balance sheet normalisation will be implemented in 2017, provided the economy evolves in line with expectations. Most analysts are not expecting an announcement of the start date of balance sheet normalisation at this meeting but there could be a tweak in the language. HSBC say the Fed could announce that they will begin balance sheet normalisation “relatively soon”, opening the door for a September announcement, to begin shortly after. In her semi-annual testimony to Congress, Yellen said she “expects balance sheet reduction to begin soon”.

In terms of explicit phrasing changes to the FOMC statement, according to BNP"s Paul Mortimer-Lee - who has been relatively bearish on the US economy recently - one of most important potential changes to the FOMC statement will be whether the Fed drops "somewhat" in its description of core inflation below target. It would be a "big sift if dropped and would show Fed losing faith in its own projections." Mortimer-Lee also lays out "what could be a shocker at FOMC? 1 rate hike - close to impossible; 2 announce balance sheet adjustment <20%;  hoist white flag on inflation = 25%"

What could be a shocker at FOMC? 1 rate hike - c. impossible; 2 announce balance sheet adjustment <20%; hoist white flag on inflation = 25%

— Paul Mortimer-Lee (@MortimerleePaul) July 26, 2017

In similar vein, Citi thinks that it is more likely than not that the revised statement will use a phrase like “relatively soon” to signal that the committee plans to announce balance sheet reduction in September.

"This should provoke little market reaction as (1) most clients we speak with expect such a change (2) Chair Yellen used this phrase in Congressional testimony two weeks ago (3) Fed balance sheet reduction related news has provoked little reaction from long end rates and currencies and (4) this is a marginal change from the current language: “The Committee currently expects to begin implementing a balance sheet normalization program this year.”

Citi concedes that even if there is no change to the balance sheet normalization language the bank"s call would "remain for a September balance sheet reduction announcement followed by a December rate hike." The June FOMC meeting followed three significant downside misses to core CPI for March, April and May. June core inflation (received subsequent to the June FOMC) was stronger than March-June but still weak at 0.12% MoM.

In June the committee noted that inflation “declined recently” and “is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term.” It was noted that “the Committee is monitoring inflation developments closely.” This language still characterizes well the FOMC view of inflation, suggesting only small tweaks may be in order.

In the June press conference Yellen focused on the transitory nature of the slowing. But subsequently, Fed officials, including Chair Yellen, have been a bit more inclined to attribute some persistence to the slowdown in inflation. The medium term view of inflation returning to 2% has not changed substantially for the core of the committee. The July statement may acknowledge that risks to inflation are “two sided,” but we would be surprised to see, and take as dovish, any wavering in confidence that inflation will stabilize around 2 percent. Apart from inflation, the statement that “job gains have moderated” may be revised to indicate they remain robust.

* * *

Parsing the statement, Bank of America expects the following textual changes:

Paragraph 1: Current conditions

We think the language is likely to be tweaked to reflect the latest data. As such, we expect a more positive assessment about job growth given the strong gain in June, but a more cautious tone around household spending. The FOMC may also note the recent weakness in core inflation is *partly* a result of a few unusual reductions in certain categories of prices. As Chart 1 shows, even trimmed measures of core inflation have continued to slide, making it hard to argue the recent weakness is entirely transitory.

Paragraph 2: Economic outlook:

The FOMC is unlikely to change the characterization of economic activity or the labor market, in our view. We also think it will note that near-term risks to the economic outlook appear roughly balanced, as Chair Yellen reiterated at the semi-annual monetary policy testimony. On the inflation outlook, we expect them to note that inflation has remained subdued despite the low rate of unemployment. However, they are likely still to reiterate that they expect inflation to stabilize at the 2% target over the medium term. This would be a way of implying that the Phillips Curve relationship has weakened, as we demonstrate in Chart 2, but that Fed officials are still assuming that it is relevant.

Paragraph 3: Policy decision

We expect the FOMC to double down on the commitment to normalize the balance sheet. In the June statement, the statement read as "the Committee currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated". We think this will likely be changed to read that the Committee expects to begin implementing a balance sheet normalization program *soon*. This would, in our view, send a message that the FOMC is on track to announce the change at the September meeting. It is possible the FOMC goes a step further and explicitly signals the B/S normalization in September by stating the change will occur at the "upcoming meeting".

It is also possible, although a low probability in our opinion, that the FOMC announces balance sheet normalization at the meeting tomorrow. Fed officials have been consistent in the view that the time has come to begin shrinking the balance sheet. They have also made it clear that it is data independent; low inflation will not take them off course from starting the process. They believe it will be a non-event in the markets when it begins and it will be able to continue on autopilot. As such, we think it is possible Fed officials do not see a reason to wait for the September meeting. This would come as a surprise to the markets, however, and it is not the Fed"s intention to deliver surprises.

* * *

Market reaction:

Overall, this meeting should not be a game changer as the Fed tend to communicate changes to policy relatively far in advance and there has been no indication that they will venture too far from the script at this meeting. Barclays say that “an announcement on balance sheet normalization in July would leave open the possibility of two additional rate hikes this year. This would likely send a more hawkish signal than warranted given the incoming data on activity and, in particular, inflation.”

What the Banks are saying:

Finally, courtesy of RanSquawk, here is a breakdown of what various sellside desks are expecting will be announced today: 

• Goldman Sachs: We do not expect any policy changes at the July FOMC meeting and expect only limited changes to the statement, which will likely upgrade the description of job growth, but might also recognize that inflation has declined further. We think the statement is also likely to acknowledge that the balance sheet announcement is now closer to hand, and we continue to expect the FOMC to announce the start of it’s balance sheet normalization in September.


• JPM: We expect no change in the funds rate target and no change in balance sheet policy (we think there is a ~20% chance for the Fed to begin the balance sheet normalization process at the Jul meeting). The policy guidance will likely signal an inclination to begin the normalization process in Sept but we don’t anticipate changes to the Fed Funds outlook. We expect the statement will sound more upbeat on the labor market, about similarly confident on growth, but more cautious on inflation.


• Morgan Stanley: We expect the Fed to leave its interest rate target unchanged. The statement will likely indicate that the normalization of the central bank’s balance sheet will begin relatively soon, solidifying expectations for a September announcement. The Fed will also make a benign update on conditions, by saying that the economy continued to expand at a moderate pace and that the labor market is still strengthening; the Fed should also say that inflation is running below its 2% goal. Weak inflation data will continue to be a thorn in the Fed’s side for several months to come. The Fed will resume hiking rates in December.


• Deutsche Bank: We do not expect the Fed to take any policy firming actions this week, partly because inflation has continued to surprise to the downside of late. In our view, policymakers will need to acknowledge the further decline in (PCE) inflation since the June meeting, but their medium-term view that inflation will return to target should remain unchanged. This would keep the door open for the Fed to begin its balance sheet normalization program as well as raise interest rates another 25 basis points by year-end. While it is possible that the Fed announces the former on Wednesday, we believe this holds a low probability. We continue to view the September meeting as the most likely timing for the Fed to announce the tapering of SOMA reinvestments, which would ostensibly begin in October.


• Barclays: We expect the Fed to keep the target rate for the federal funds unchanged and expect few changes to the statement outside of balance sheet normalization. We believe the statement could point to an announcement on balance sheet policies at the September meeting. The risk to our view is that the FOMC announces its balance sheet normalization program at the July meeting since we believe the committee is eager to begin the process. That said, an announcement on balance sheet normalization in July would leave open the possibility of two additional rate hikes this year. This would likely send a more hawkish signal than warranted given the incoming data on activity and, in particular, inflation.


• SocGen: We expect the Fed to announce the start of its balance sheet normalisation plan in September, but we acknowledge that it is a coin toss between this week’s meeting and the next one. In any case, we do expect a tweak in the paragraph on the balance sheet that should confirm the market’s expectation that the Fed will announce the shift in September.


• HSBC: We expect the FOMC to leave the target range for the federal funds rate unchanged until December. We do not expect much change in the policy statement"s assessment of current economic conditions or the economic outlook. We expect the FOMC to say that it expects to begin implementing a balance sheet normalisation programme "relatively soon," a change from the June policy statement that indicated the programme would begin "this year". This would allow the Committee to formally announce the start of disinvestment in September, for commencement in October. However, there is also the possibility that the FOMC could simply announce the change in balance sheet policy at the July meeting, for commencement in October.


• RBC: This should be one of the more boring Fed releases in a while. There should be only modest adjustments to the characterization of the economic backdrop and we expect no change to the policy language. We think the announcement regarding the start of the balance sheet run-off comes at the September meeting when we also believe the committee will stand pat on rates (we expect the next hike in December).
  

The Fed Has An Alarming Low-Inflation Problem

With all the talk of central bank hawkishness in the last week, one might assume there was some inflation to point to. It is quite the opposite. It is one thing to talk about inflation being below the Fed’s target of 2%, it is an entirely different issue to see it flirting with deflation! Shorter-term trends of core-inflation are very near to 0%, levels we haven’t seen since the great recession and the advent of quantitative easing.

In its most common form, inflation is quoted by measuring its percentage change compared its level 12 months ago, the so-called year-over-year (YoY%) metric. But, shorter-term periods can be measured to get a sense of more recent trends as well as if there is acceleration or deceleration in the metric. The shorter the period measured, the more volatility the metric has, and so year-over-year (YoY%) has become the standard. It also has the added benefit of eliminating any seasonal effects.

In the charts below, we show the two top-tier measures of consumer price inflation, the Fed-preferred core PCE deflator, and the core CPI; with its common year-over year (YoY%) format, 6 months back annualized, and 3 months back annualized. Comparing the three gives a sense of acceleration of deceleration. If the 3mo. is less than the 6mo. is less than the 12mo., there is deceleration and vice-versa, there is acceleration.

 

But, beyond these charts, evidence of low inflation abounds. The headline versions of these numbers (including oil and food) are negative over the last three months, the ‘prices paid’ component of the manufacturing ISM number fell by a large amount in a release on Monday (7/3), the ‘prices paid’ component of the Service-sector ISM is now contracting, inflation expectations in all indicators have been falling since February, and the OECD published a report yesterday (7/4) that the inflation rate has fallen for four straight months in G-20 economies.

Despite the excitement last week at the prospect of global central banks moving away from easy money policies, there is no fundamental basis for this. We expect that the Fed will soon need to move to a neutral from tightening bias.

Goldman: The Fed Will Hike This Week, But Here Are "The Two Most Interesting Questions"

On Wedensday the FOMC will hike rates by another 25 bps - an event which the Fed Funds market prices in with near virtual certainty, while Goldman calls the rate increase "extremely likely" - and only a "tail" event like an extremely weak CPI report on Wednesday morning, hours ahead of the Fed announcement, has any chance of preventing  this outcome. So with the next rate hike virtually inevitable, questions are focused on not only the Fed"s exit strategy for balance sheet normalization and what the "dots" or funds rate path will look like, but how the Fed squares rising rates with the recent string of inflation misses.

As Goldman"s Jan Hatzius writes, data since the March meeting has sharpened the dilemma that both sides of the mandate are sending increasingly different signals about the urgency of further tightening. "The unemployment rate has fallen 0.4pp since the March meeting and our current activity indicator and real GDP estimates signal that above-trend output growth will produce further labor market improvement. But the year-over-year core PCE inflation is now 0.2pp lower than at the March meeting."

While conceding that a hike is guaranteed, Goldman notes that two issues should make this meeting particularly interesting.

• First, will Fed officials alter their policy views in response to the increasingly different signals that both sides of the mandate are sending about the urgency of further tightening?


• Second, will the press conference provide some clarity on what the next tightening step following the June hike will be?

As a result of the weaker than expected inflationary prints, Goldman believes the recent data do not call for a major change in the Fed’s policy outlook. While Hatzius expects the FOMC to lower its estimate of the structural unemployment rate by a tenth next week, even with that assumption, the new data have broadly offsetting implications for the policy outlook in standard Taylor rules. Highlighting recent Fed communications, Goldman believes the Fed will follow "a balanced approach in dealing with the dilemma."

It also means that the statement will likely characterize economic activity as "picking up but recognize that inflation slowed since earlier this year." On the other side, Goldman sees a signal of heightened inflation concern as the main dovish risk and an upgrade of the balance of risks as the main hawkish risk.

Previewing the Fed"s Summary of Economic Projections (SEP), expect a modest downgrade to GDP growth for this year, coupled with declines in the unemployment rate to 4.3% this year and 4.2% next year. At the same time, projections for core PCE inflation are likely to fall to 1.8% this year and probably 1.9% in 2018. Reflecting the offsetting data news, expect the “dot plot” to show relatively stable funds rate projections.

On to Yellen"s press conference, which should provide some clarity on whether the next tightening step after June will be balance sheet normalization or a third funds rate hike. Goldman, as well as much of the street, expects balance sheet adjustment to start in September and the Fed hiking cycle to resume in December. With respect to the balance sheet, the Fed will initially cap the amounts of securities that can run off in any given month of $10bn for UST and $5 billion for MBS, that rise over four quarters to caps of $40 billion and $20 billion, respectively.

* * *

Some more details. Here is Goldman on the current economic situation, and how it will be (mis)read by the Fed.

Another rate increase from the FOMC next week is now extremely likely. Only an extremely weak CPI report on Wednesday morning or another tail event would prevent the committee from hiking. The committee probably also still expects a total of three hikes and the start of balance sheet adjustment in 2017.  

But two issues should make this meeting particularly interesting.

• First, will Fed officials alter their policy views in response to the increasingly different signals that both sides of the mandate are sending about the urgency of further tightening? We expect both lower unemployment and inflation paths in the Summary of Economic Projections (SEP) but relatively stable funds rate projections as the labor market and inflation data surprises, in the words of San Francisco Fed President John Williams, roughly “wash out”.


• Second, will the press conference provide some clarity on what the next tightening step following the June hike will be? We expect a detailed balance sheet announcement in September and a third rate hike in December but the reverse order is also plausible.

We believe both labor market and growth data in hand make a strong case for a rate increase next week and to remain upbeat about the outlook. Both our current activity indicator —down from 4.0% in February to 3.0% in May— and real GDP estimates—up from 1.2% in Q1 to our 2.3% Q2 tracking estimate—signal above-trend output growth (Exhibit 1, left panel). The medium-term growth outlook is also decent despite the lower odds of significant fiscal easing. The more important reason why growth should stay firm is the easing in financial conditions. Our FCI is at the easiest level since early 2015 and has  eased by 50bp since the March FOMC meeting. As the right panel of Exhibit 1 shows, the expected effect on GDP growth from changes in financial conditions for 2018H1 is now more than 0.3pp higher than at the March meeting.

Spare capacity continues to diminish, and the unemployment rate has fallen 0.4pp since the March meeting to a 16-year low of 4.3% (Exhibit 2, left panel). While nonfarm payroll growth has recently softened a bit, the average monthly gain of 162k year-to-date is still double our 85k estimate of the “breakeven” rate needed to keep the unemployment rate unchanged. While slack measures have declined more than expected, weak inflation data in April and especially March pushed the year-over-year pace of core PCE inflation 0.2pp lower than at the March Meeting (Exhibit 2, right panel). Both a Taylor rule framework and recent Fed communications suggest that the new data have broadly offsetting implications for the policy outlook.

Exhibit 3 translates the labor market and inflation surprises into changes in the appropriate funds rate via a standard Taylor rule framework. The original Taylor rule implies that a 0.2pp decline in inflation lowers the appropriate funds rate by 30bp while a 0.4pp reduction in the unemployment rate raises the appropriate funds rate by 40bp. In a modified “Taylor 1999” rule, the impact of employment is doubled  relative to the original version. This means that the impact of a 0.4pp reduction in unemployment rises from 40bp to 80bp. The left panel of Exhibit 3 thus suggests a 10-50bps higher appropriate funds rate.

But the decline in the unemployment rate may overstate the surprise if some decline was expected. Similarly, the decline in inflation can understate the surprise if some firming was expected. The middle panel of Exhibit 3 therefore compares actual unemployment and inflation moves to our expectations as of the March meeting and has less hawkish implications than the left panel. Finally, a lower estimate of the structural unemployment rate also reduces the decline in the unemployment rate gap. On net, we estimate the new data—combined with a 0.1pp downgrade of the structural rate—would have an exactly neutral effect in the Taylor 1999 rule that Chair Yellen has discussed repeatedly.

What has the Fed communicated in recent week.

Recent Fed communication suggests that the committee will also consider surprises on both sides of the mandate as roughly offsetting. As Exhibit 4 shows, several Fed officials have emphasized that there is now little labor market slack left. The inflation language in the May minutes was quite balanced as ”most participants viewed the recent softer inflation data as primarily reflecting transitory factors, but a few expressed concern that progress toward the Committee’s objective may have slowed.”

Since the May meeting, inflation for April has been weak for core CPI (0.9% annualized) but roughly in line for core PCE (1.8% annualized). The April inflation reports and recent comments by some Fed officials including Chicago Fed President Evans suggest that additional signs of heightened inflation vigilance are a dovish risk relative to our expectations. Governor Powell said that “there are good reasons to expect that inflation will resume its gradual rise but it is important to demonstrate a strong commitment to achieving our symmetric 2 percent objective” while Philadelphia Fed president Harker said that “we’re still on track for inflation” and that he is “looking at the trend.”

In light of these developments we expect to the committee to make three key changes to its post-meeting statement next week. First, we expect the committee to replace “consumer prices declined in March” by “inflation slowed since earlier this year” reflecting the core CPI miss in April. Second, we expect the statement to upgrade the growth assessment with verbiage along the lines of economic activity “appears  to have picked up” and to note that household spending “appears to be accelerating”. Third, we expect the committee to tacitly signal balance sheet run-off later this year by adding the qualifier “for the time being” to the description of its existing reinvestment policy.

A signal of heightened inflation concerns is the key dovish risk. The committee may, for instance, drop the “somewhat” from “inflation continued to run somewhat below 2 percent”. In terms of hawkish risks, an upgrade of the balance of risks is possible through the removal of “roughly”, reflecting improved domestic and international growth. We also expect Minneapolis Fed President Neel Kaskhkari to dissent as he recently described the move of inflation in “the wrong direction” as “concerning”.

What about the revised Summary of Economic Projections

The June FOMC meeting will include the quarterly update to the SEP. We expect significant changes to the unemployment and inflation projections but relatively stable funds rate forecasts, reflecting offsetting job market and inflation news.

1. Slightly lower GDP growth: Assuming our Q2 GDP tracking 1. estimate of 2.3%, GDP growth will average 1.7% annualized over the first half of 2017, so it would take a 2.4% growth rate in H2 to meet the policymakers March SEP estimate of 2.1%. We expect the 2017 median to fall to 2.0%, with risk tilted to the upside. We forecast that the median estimates for GDP growth in 2018-2019 and in the longer-run will remain unchanged.

2. Lower unemployment rate. The unemployment rate fell 0.4pp since the March meeting when the median unemployment rate projection was 4.5% for the forecasting horizon. We expect the median to fall to 4.3% in 2017, 4.2% in 2018 (with risks of 4.3%) and 4.3% in 2019. The estimate of the structural unemployment rate is quite likely to fall further from 4.7% to 4.6% in response to large declines in the actual rate and recent news on prices and wages. The decline in NAIRU would limit somewhat the projected employment overshoot but is a close call.

3. Lower core PCE inflation. We expect the 2017 median core PCE projection to fall to 1.8% and perhaps 1.7%. To reach 1.8% by year-end, monthly core PCE inflation would need to accelerate to an annualized rate of at least 1.9%. We believe the 2018 forecast also drops a tenth to 1.9% as some members now likely feel a bit less confident about the inflation outlook.

 

4. Relatively stable median dots. We expect most participants, especially those in the center of the committee, to stick to their March dots reflecting offsetting inflation and unemployment moves. We also believe that the committee probably still expects a total of three hikes in 2017. The retirement of Tarullo lowers the numbers of participants to 16 from 17 in March and is likely to move up the median 2018 dot from to 3 to 3-1/2 hikes next year. As the FOMC is extremely likely to hike for the second time this year next week, we expect that the 2017 one-hikers will shift to projecting 2 hikes in total for this year. We also assume that the new Atlanta Fed President Bostic votes like his predecessor Lockhart and that the new Richmond Fed President Mullinix lowers the Richmond Fed dots a bit.

Finally, how will the Fed "renornalize" its Balance Sheet.

We expect to get some more clarity next week on balance sheet runoff at the press conference and possibly also with an augmented Policy Normalization Principles and Plan. We continue to look for normalization to be announced in September. Here we update our projections for balance sheet runoff:

1. Start Date: We expect a detailed announcement in September  but would not be surprised if it came in December as guidance has been mixed. The May minutes suggest a start in September as an announcement at the December meeting would leave little time to “begin reducing the Federal Reserve’s Securities this year”. But guidance on the start of runoff by Governor Brainard after the funds rate gets midway to its long-run value of 3.0% and by New York Fed President Dudley “sometime later this year or next year” supports December. We think that announcing the start of balance sheet adjustment in September and keeping open the option of foregoing the third 2017 hike is the more prudent course of action given the mixed recent data and the potential for fiscal turmoil in Washington in Q3 related to the need for a debt ceiling hike and an extension of spending authority. We think the detailed announcement in September will be followed by the actual start of runoff of assets in October.

2. Process for phasing out reinvestment: The May minutes signaled that the committee will preannounce a schedule of gradually increasing caps to limit the amounts of securities that can run off in any given month. Our assumption is that that the initial caps are $10 billion a month for UST and $5 billion a month for MBS. The caps would rise each quarter by $10 billion and $5 billion to $40 billion and $20 billion respectively. Exhibit 7 shows that caps allow for a gradual runoff and deal with the variability associated with MBS prepayment and the irregular monthly schedule of maturing assets. The caps will remain in place after the phase-in but then only bind in roughly a third of the months for Treasuries until mid-2020 when the balance sheet reaches its projected terminal size.

3. Terminal size: We expect the Fed to maintain a balance sheet that 3. is relatively large by historical standards given several advantages of a large balance sheet related to monetary policy implementation and regulatory needs. Our calculations suggest that a monetary policy implementation through a floor system implies a terminal size of roughly 15.5% of GDP. While support from the New York Fed for the large balance scenario makes this outcome quite likely, there is no urgency yet in deciding on the size and on the composition of the terminal balance sheet.

Goldman"s conclusion:

A third consecutive quarterly rate increase next week is now extremely likely, in our view. Only an extremely weak CPI report on Wednesday morning or another tail event would prevent the committee from hiking. The data news since March has sharpened the dual mandate dilemma policymakers are facing. Our own view is that the inflation and unemployment surprises have been roughly offsetting but that the range of outcomes has widened somewhat. While the inflation outlook is uncertain, the dilemma will most likely resolve itself as inflation gradually accelerates. We therefore expect policymakers to remain focused on tightening mostly with the funds rate but also soon with the balance sheet tool.

And while we agree with Goldman in theory, one thing the bank has omitted in principle is that according to the Fed"s own commercial loan data, the US economy may be just 4-6 weeks away from posting its first negative C&I loan print since the financial crisis: a virtually failsafe indication of an imminent (or concurrent) recession.

Which means that, as we explained yesterday, the Fed is about to hike in not only a disinflationary phase of the economic cycle (which is largely a function of the slowdown in the Chinese commoity bubble, and the collapse in the Chinese credit impulse), but also into what may be an outright recession in the US. If so, look for the yield curve to do what it has always done in the past after the Fed hikes rates: flatten, then flatten some more, than go horizontal, and eventually invert.

Albert Edwards: "What On Earth Is Going On With US Wages"

When Albert Edwards predicted in late 2016 that a surge in wage inflation was imminent, we were confused by this prediction from the world"s preeminent deflationist: after all, not only had not a single economic indicator validated a tighter labor market despite unemployment just above 4%, but as we have have repeatedly demonstrated what little wage inflation existed, was attributable to managerial-level, supervisory positions while the bulk of job creation remained with minimum-wage jobs, which have continued to see virtually no wage growth. Even Morgan Stanley, a far greater bull than Edwards, one month ago admitted that "wage growth is leveling off, may be slowing."

Which is why we have to give Edwards credit: some 6 months after his initial call, he had the courage to do what is never easy and admit he was wrong, and that contrary to his expectations wages are not going up after all.

Talking about wrong, I have to put my hands up. I have been expecting US wage inflation to roar ahead over the past three months to well above 3%, yet every data release has surprised on the downside. Wage inflation, as measured by average hourly earnings, has actually levelled off at close to 2½% while wage inflation for ‘the workers’ is actually slowing (see chart below)! Strictly speaking, "the workers" are defined (by the BLS) as "those who are not primarily employed to direct, supervise, or plan the work of others. Hey, that"s me!

So with the concession aside, Edwards is left with even more question, starting with "What on earth is going on with US average hourly earnings?"

Three consecutive Employment Reports have seen this key measure of wage inflation surprise by its weakness. I feel especially foolish as I had written that wages were set to accelerate sharply, forcing the Fed to tighten aggressively and thereby driving both bond yields and the dollar higher. Doh! While many commentators last year, including the Fed, expressed surprise that US wage inflation had been so quiescent despite a tight labour market, I thought there was a simple explanation. I believe that nominal wages had not accelerated more rapidly through 2016 primarily because headline CPI inflation had been so subdued, staying in a 0-1% range for most of the last couple of years. Hence nominal wages did not need to accelerate rapidly for workers to be much better off as 2-2½% nominal wage inflation translated into  strong real wage rises of around 1½-2% - the most rapid for years (see circled area in chart below).

As headline CPI inflation surged this past six months, rapid real wage growth turned into real wage stagnation (see chart above). I believed that a tight labour market would prompt an aggressive reaction from "the workers" to maintain the previous 1½-2% rate of real wage inflation they had enjoyed and got used to through 2015 and 1H 2016. Hence I expected nominal wage inflation would roar upwards in 1Q this year. How wrong I was!

There is even more confusion in the data, because Edwards points out another disconnect: while the BLS" measure of hourly earnings has gone nowhere, and real earnings have in fact tumbled, the employment cost index has spiked, "with wage and Salaries jumping from a 0.5% rise in 4Q to rise by 0.8% in 1Q 2017 ? the fastest quarterly rise since 2007. On a yoy basis, this measure of wage inflation still showed a 45 degree upward trajectory into 1Q 2017 (see left-hand chart below). Adding benefits to wages and salaries, total compensation also rose by 2½%."

Then there is the issue of declining productivity, because when calculating productivity and unit labour cost growth, the BLS estimates non-farm businesses saw their workers compensation jump from the 3% average rate seen in 2016 to just shy of 4% yoy in 1Q 2017?. This has implications on corporate profits:

"Together with sluggish 1% productivity growth, this means that unit labour costs are rising by almost 3% yoy, well in advance of the rate by which corporates are able to raise their output prices (see right-hand chart above). The bottom line is that US corporate margins are suffering a savage squeeze and have been for some time. What then do I make of the heady 1Q company reporting round? Not much."

Perhaps in retrospect, between the divergent AHE and ECI data, Edwards was not entirely wrong, as he suggests:

The truth is that the closely watched average hourly earnings measure of wage inflation has not accelerated in response to a surge in headline CPI in the way I had expected. So strictly speaking I have been wrong and as such I must throw myself upon your bountiful mercy. But let me say in my defence that other measures of wage inflation have shown exactly the acceleration I had expected. The fight-back by labour to secure their rightful share of the economic pie is ongoing, but it seems likely that the savage downward trend in the share of labour compensation that had been in place since the 2001 recession seems to have at last been broken (see chart below). The laws of economics have not been abolished after all ? at least not in the US.

Yet while the jury may still be out on US wages between two contradictory data sets from the BLS, when one looks outside the US, things are clear: despite years of QE, there is no wage growth. For evidence, look no further than Japan. Edwards again:

Japan is becoming an economic enigma. Last week saw some truly astonishingly weak wage inflation data ? so weak that it sent the yen sharply lower on expectations that the Bank of Japan might need to step up their already ridiculously outsized QE programme to even higher levels. Wages for March fell by 0.4% yoy, well below both the expected 0.5% gain and February"s 0.4% rise. Even the far less erratic underlying wages (excluding overtime and bonus payments) weakened sharply and declined yoy in March. In real terms, total cash earnings were miserable too, falling by 0.8% from a flat reading in February (see charts below). Certainly on this measure Abenomics has been a total and utter failure.

The idea was simple, QE (or QQE as the Japanese call it) would as an indirect consequence send the yen sharply lower (as it did in 2013/14), which would push up headline CPI inflation (also buoyed by the 2014 VAT hike) and drive wages higher in what was a tight labour market.

And when I say tight, I mean properly tight. This is not the US, where most commentators agree there is likely to be more slack than the low headline unemployment numbers suggest due to the sharp decline in the participation rate since the last recession. By contrast, the Japanese labour market is unambiguously as tight as it ever has been in history (see left-hand chart below). Yet wage inflation remains moribund.

Without any real cost-push wage pressures, and with the initial inflationary impulse on headline and core CPI of the declining yen of 2013-14 receding into a distant memory, core CPI inflation (ex food and energy) has begun to fall once again (for this see right-hand chart above, and note that headline and CPI ex-food are rising moderately only because the yoy impact of the oil price has gone from negative last year to positive this year). So after all the trillions of dollars of QE and huffing and puffing, Abenomics has failed to deliver its much touted exit from the deflationary mire.

And before readers respond with "there is always more QE", the problem is that for both the ECB and BOJ, the answer is increasingly, "there isn"t" as both central banks are just months away from running out of eligible bonds to buy, beyond which point the entire bond market may simply lock up, or the central banks will have to even more actively start buying equities, with both outcomes effectively a nationalization of capital markets. And the last time we checked with the USSR, that strategy did not work out too well...

JPM Cuts 10Y Yield Forecasts "Significantly Lower" Due To Weaker Inflation Outlook

Just one day after Goldman reluctantly cut its 2017 year end forecast on the 10Y yield last Friday from 3.00% to 2.75%, "reflecting some added uncertainty on the US macro outlook" while conceded that "bond bears", i.e., those clients who have listened to it, "have had a difficult 2017" it was JPMorgan"s turn, and over the weekend JPM announced it was adjusting its US rate forecast "significantly lower", slashing its year end 10Y yield target to 2.75% from 3%, reflecting “a weaker outlook on core inflation and reduced expectations around tax reform and infrastructure spending.”

In the note by JPM"s Jay Barry, the bank also trimmed most other tenor forecasts by 15bp-35bp lower, saying that the inflation outlook “has changed markedly” over past month based on weakness in core CPI in March and April. JPM also said that  as for fiscal stimulus, odds are rising that it “gets pushed into FY18.”

And also just like Goldman, JPM tried to hedge adding that "even so, UST yields should rise in coming weeks,” because markets "continue to underprice the risk of further Fed tightening,” and yields “have consistently risen” ahead of FOMC meetings that include SEP and press conference; also, Treasuries “appear locally rich to other DM government bond markets.”

Finally, JPM maintains its recommendation to hold shorts in the 3-year sector and urges 10s30s flatteners, as the curve is ~3bp too steep adjusted for market’s medium-term Fed and inflation expectations.

Meanwhile, the fed funds market continues to be blissfully disconnected from the recent sharp slowdown in US economic data surprises, which as noted previously has posted one of the biggest drops on record, and if the disappointment persists, it is not impossible that the Fed will punts its June rate hike which the market now assumes is virtually assured.

Gold Surges, USDJPY, Yields Slide As Markets Finally Respond To Latest Set Of Economic, Geopolitical Shocks

With markets shut on Good Friday, even as the one-two knockout punch of the worst monthly core CPI print in 7 years hit...

... coupled with a miss in March retail sales, which suffered their biggest two month drop in 2 years...

... on Sunday night traders were desperate to catch up, or rather down to, the USDJPY which was the only instrument that traded through Friday"s data dump, and which at last check was trading at 108.34, nearly 100 pips below the Friday open, sliding further in early Japanese trading as the last holdouts on the reflation trade capitulate in panic, further pressured by fears over the rapidly deterioating situation in North Korea.

As one would expect, a surge in the yen means continued weakness in the dollar, and sure enough on Sunday night, Donald Trump"s recent bid for a weaker greenback has been the market"s command.

Predictably, and contrary to virtually every sellside analyst"s prediction for ongoing levitation in interest rates, US TSY yields have tumbled across the curve, with 5-year yields down as much as 5bps at 1.72%, lowest since Nov. 18, while the benchmark 10-year yield has slide 4bps to 2.20%, also the lowest since the election.

Perhaps the one asset class where the reflation revulsion has not been observed yet is S&P futures, as the E-mini stubbornly holds out to selling pressure and is barely lower on the session following Thursday"s sharp drop.

However, while equity markets may be ignoring the moves in FX and rates, gold is hardly waiting, and on Sunday night evening was trading above $1,290/oz, the highest price since the Trump electiomn... 

... and poised for a key double resistance breakout.

While the spike in gold is hardly a surprise in light of last week"s economic data and this weekend"s North Korean events, with spot not trading there was little opportunity for traders to take advantage of what many expected would be a sharp jump in the yellow metal. Except... that"s not quite true: as we noted on Friday, while spot may have be closed, physical vendors such as Ampex were happy to sell gold, and even better, at Thursday"s depressed price.

Gold arb trade: Physical dealers like Apmex are still stuck at Thursday"s gold price

— zerohedge (@zerohedge) April 14, 2017

Finally, before we forget, there was another asset class that was surging overnight: the Turkish lire, which has been on fire ever since Erdogan won the popular mandate to become dictator, and which just as Barclays predicted, would lead to a spike in the Turkish currency... if only for a the very near future.

Central Bank Hubris Bubbles To The Surface

Authored by Mike Shedlock via MishTalk.com,

Albert Edwards at Societe General commented yesterday on Central Bank Hubris, deflation, and the flattening of the US yield curve. Here are some email snips.

How’s this for Grade 1 central bank hubris?

Peter Praet, the ECB’s chief economist said in a recent interview that, “Since the crisis, we have had serious concerns about deflationary risks on several occasions in the euro area, but now we can say they have disappeared.”

Really? Has he seen the chart above, which shows core CPI in the Eurozone heading sharply lower and now approaching its all-time low seen at the start of 2015! Not only that, but Eurozone inflation expectations are also declining again, after surging in the aftermath of Donald Trump’s election. To be fair, Praet was focusing on the rise in headline inflation in the Eurozone, which touched 2% in February before dropping back in March to 1½%. After some 18 months bobbing around the zero mark, I can understand why central bankers might be heaving a sigh of relief, but for them to take credit for a recovery in headline inflation is totally disingenuous given it has been entirely driven by a recovery in the oil price.

Similarly, Janet Yellen was quoted saying the Fed is “doing pretty well” in meeting its congressionally mandated goals of low and stable inflation and a full-strength labor market. It’s this sort of comment that has led Marc Faber to want to short central bankers, the only way being to buy gold. The increasing volume of central bank hubris may even explain the recent breakout of gold to the upside!

It is not just eurozone inflation expectations that seem to be in retreat. The same thing is happening in the US too (see chart below). I am always surprised how dominated 10y inflation expectations are by short-term movements in the oil price and headline inflation, but it was noticeable just how rapidly inflation expectations ran up in the wake of Trump’s election – way in advance of what might have been expected by the bounce in the oil price.

One might have thought the surge in the oil price from its trough some 12-18 months ago might have had more impact on wage inflation, but so far that does not seem to be the case.

Despite the euphoria in the markets about the “reflation trade”, survey inflation expectations have continued to drift downwards. One thing is certain: for central banks to call victory over deflation may prove very premature indeed. Nemesis awaits.

Reflation Trade Is Over

The reflation trade is over. It is fitting central banks now brag about oil-related and Trump-related phenomena over which they had zero control.

"If All Goes According To Plan": What Global Central Bank Normalization Would Look Like, In One Chart

AS a result of countless failures by central banks to normalize monetary policy over the past 7 years, the market - especially bonds and rates - has become openly cynical and outright skeptical regarding the possibility of a successful renormalization of policy by global central banks. After all, Japan has been trying to do that for over 30 years and has yet to succeed; the ECB hiked in 2011 resulting in near collapse of the Eurozone. Ironically, the recent Trumpflation trade - which few expected as a result of the "shocking" Trump election victory - has emerged as the most credible catalyst to prompt inflation not only in the US but around the globe, resulting in two Fed rate hikes in rapid succession.

Still, now that Obamacare repeal has failed, and questions are rising whether Trump will be able to implement his proposed Tax reform, the market has aggressively faded not only the broader Trumpflation trade, but also all of the recent dollar strength since the US election: in short, bets on a "bening" global reflation are rapidly fading, suggesting that the latest push to normalize monetary policy will once again result in failure.

And yet, "what if it goes according to plan" this time? That"s the question posed by Barclays" Christian Keller who notes that, at least for the time being, "The synchronized upswing in the global economy continues, supporting sentiment, which thus far has ignored elevated policy uncertainties. Headline inflation is increasing due to stable oil prices, while core inflation rates are mixed." And, assuming nothing ahcnes, this sets the backdrop for monetary policy normalization, albeit at different speeds and modes.

Taking this thought experiment one step further, what would happen if indeed this time central banks are successful to renormalize monetary policy without leading to a market crash. In that case, Barclays expects three Fed hikes in 2017 and 2018, respectively. The ECB is likely to taper further in 2018 and to start increasing depo rates in parallel (in 2018).

Conveniently, Barclays has created the following chart which lays out what "coordinated global renormalization" would look like. It can serve as a benchmark to those keeping tabs on where various central banks are in the current attempt to restore monetary normalcy.

For those curious, here are some further thoughts from Barclays:

Policy normallization at different speeds

With growth improving across regions and deflationary threats fading, the monetary policy cycle has started to turn. Market interest rates have been suggesting this for several months. Recently, central bank communication has also become decidedly more confident about the outlook. While the activity upswing is synchronized, the pace of expansion remains diverse and economies are at very different positions in the cycle. Thus, despite the signals are clearly for policy normalisation, we think such changes are likely to occur at quite different speeds.

Fed: A more confident FOMC leads the way

In contrast to 2015 and 2016, when economic developments at home and abroad thwarted the Fed’s plans for a four-hike pace in the coming year, 2017 has started out differently: the Fed now faces decent US growth, supported by buoyant sentiment, easier financial market conditions and no complications from ‘international developments’. This has given the FOMC more confidence to finally implement its game plan of a gradual hiking cycle; we now expect it to hike two more times in 2017 (Sep and Dec) and three times in 2018 at a pace of 25bp each time. A hike this June – not our baseline – would suggest a faster pace of four hikes per year, in our view.

Along with this firmer tightening cycle, we also expect the Fed to begin earnest discussions over when and in what manner to reduce the size of its balance sheet. Even so, we continue to believe that the Fed is far from taking any concrete action and we expect its balance sheet to remain substantively unchanged through at least the end of 2018.

ECB: complicated normalization ahead

Better growth and the rebound in inflation has significantly improved the balance of risks for the ECB by reducing the threat of a deflationary ‘Japan’ scenario for the euro area. However, the euro area is still far away from comfortable self-sustaining inflationary dynamics, and it still faces the looming risks associated with fragile public debt dynamics. The latter is particularly sensitive with regard to the euro area’s third largest economy and world’s third largest debt market, Italy, where there still appears a lack of political resolve for reform and uncertainty about the political outlook remains high. While this calls for caution, abovetarget headline inflation in Germany and the adverse effects of negative deposit rates on financial institutions are creating pressure on the ECB to start normalizing monetary policy.

In an attempt to balance these factors, we expect the ECB to implement a mixed strategy:

• We first expect in June (after the French presidential election) a change towards less dovish forward guidance that would open the door for deposit rate hikes in 2018, even before QE ends.


• We then expect a reduction in QE to EUR35-40bn per month in H1 18 and EUR15-20bn H2 18 as well as two 10bp hikes in the deposit rate in Q2 18 and Q4 18. We assign low probability to rate hikes in 2017 and PSPP purchases to stop in early 2018. In other words, we expect both QE and negative deposit rates to remain in place until at least H2 2018, even if at less-accommodative levels than in 2017.

This would clearly be a significant shift from earlier communication that suggested rate hikes would only follow once the asset purchase program had been terminated – which was the sequence the Fed and BoE used. Of course, neither the Fed nor BoE ventured into negative policy rates or had to implement QE across a diverse sovereign debt market. Such a multipronged exit strategy by the ECB would present a delicate communications act, as markets would have to decipher the net effects of a simultaneous tightening via deposit rate hikes and continuing expansion via asset purchases, even if at a reduced pace. Given the risk of adverse shocks (on inflation or debt dynamics) and memories of past episodes of premature tightening, we expect the ECB to move cautiously.

BoJ: ready to follow

The BoJ stood pat in March, as widely expected, and did not provide any hints of a future move or change in related communications. However, as the global environment remains supportive, we expect the BoJ to:

• raise its YCC target for long-term yields (+0%) by 10-20bp in Q3 17, assuming y/y core CPI inflation is accelerating at that stage, and


• hike a further 20bp each in Q1 18 (prior to the end of BoJ Governor Kuroda’s term in April 2018) and in Q3 18, due in part to a tailwind from expected continuing rate hikes by the Fed and, indeed, the start of an exit strategy by the ECB (hike in the deposit facility rate/reduction in asset purchases).

This will leave the BoJ in a reactive position as its yield-targeting policy since September has allowed it to ‘import’ passively the tightening in the US and other core markets. Overall, our inflation forecasts suggest that while the BoJ may have overcome deflation, the 2% target – which it promises to overshoot – is still not on the horizon.

BoE: still sitting on the fence

Surprisingly resilient data have made the BoE more confident about the economic outlook. March meeting minutes reported some members moving closer to supporting a hike, with MPC Forbes (outgoing in June) even voting for an immediate hike. However, we expect the rest of the MPC, in particular Governor Carney, to move more cautiously, waiting for data to crystallize before considering adjusting its  monetary policy stance. Given our expectation for a slowing economy and only a temporary FX-driven boost in inflation, the MPC will most likely remain on hold over the forecast horizon, while markets have started to price some probability of a hike in 2018.

PBoC: Focused on stability

The PBoC continues to balance multiple objectives: supporting the growth target, while containing the build-up of financial vulnerabilities and the outflow of capital. Its recent increases of short- (OMOs) and medium-term (MLF) policy rates seem targeted to the latter goals and we expect the PBoC to follow up with more 10bp hikes in OMO and MLF rates in the coming months, especially if the domestic housing market continues to perform strongly and the Fed hikes rates further. At the same time, we expect it to leave the benchmark interest rates unchanged through 2017, to support growth, given that the bulk of China’s total financing is still dominated by bank lending (guided by the 1y benchmark lending rate). However, if CPI inflation developments look to exceed the 3% target and/or growth stayed above 6.5% q/q saar, the PBoC could consider benchmark rate hikes as well.

By using the shorter-term policy rates (10bp each time), rather than the traditional  benchmark deposit and lending rates (usually 25bp each), the PBoC’s is attempting to achieve multiple objectives at the same time: guiding banks’ borrowing costs higher to promote financial deleveraging, while keeping benchmark rates unchanged to support growth: the bulk of China’s total financing is still dominated by bank lending (guided by the 1y benchmark lending rate at 4.35%), and the transmission from changes in the costs of the central banks’ liquidity instruments to banks’ lending rates will only be gradual. This strategy likely also serves the PBoC as an experiment, as it explores the transmission process of its various monetary tools with the objective to move its policy framework away from direct quantity-based measures to indirect price-based measures.