Central banks on a predefined course reduce the importance of high-frequency data
The most important data for next week is undoubtedly the PMI flash. It is not available for all countries, but for the generally large G10 economies, the preliminary estimate is often close enough to the final reading to steal his thunder. Additionally, and this applies more broadly to high-frequency data, given inflation overshoot in most countries, with a few exceptions, notably in Asia, central banks appear to be on fixed paths.
Short-term data is interesting if you’re into that sort of thing, but the Federal Reserve and the Bank of Canada seem determined to get the key rate back to neutral quickly. The hawkish deal struck by the Bank of Canada has the market favoring moves of 50 basis points in its next two meetings. It’s hard to see the market becoming more aggressive even though the March CPI (April 20) probably accelerated above 6.0% (from 5.7%). The housing market (sales of existing homes and housing starts) seems to be holding up better than in the United States. However, February retail sales appear weak after a strong January.
The fed funds futures market nearly priced in three 50bp gains and 3 quarter-point moves before the end of the year. Perhaps it is more accurate to say the market is split, there is a third 50 basis point move or the Fed is back to 25 basis point moves. One way those who are worried about the procyclicality of the Fed’s course have expressed it is to say that the central bank will keep rising until it breaks something. The swap market is consistent with a rate of around 3%.
It is reasonable to expect that the first thing to break will be the interest rate sensitive sectors, which also stems from the fact that the market partly because of the anticipation of what the Fed is going to do. The housing market is particularly sensitive to interest rates. The average 30-year fixed-rate mortgage fell to 5% last week for the first time in more than a decade. Mortgage applications fell for five weeks until April 8. Future reports should show that housing starts, permits and existing home sales in March have weakened.
The market expects the ECB to stop buying net new bonds in June and make the first hike in July. Expectations for the Bank of England have been lowered. It is expected to go slowly, increasing the discount rate by 25 basis points per clip for future meetings. The Reserve Bank of Australia is expected to begin a fairly aggressive tightening cycle after next month’s election. Spot rate futures have rates higher by nearly 190 basis points by the end of the year. The Reserve Bank of New Zealand has raised its cash rate target four times since the start of its cycle in October. There had been three moves of 25 basis points and then, last week, a rise of 50 basis points. The swap market priced in another 170 basis points before the end of the year.
The Bank of Japan and the Swiss National Bank are a different story. The Swiss National Bank’s deposit rate remains at less 0.75%. Its 10-year bond yields less than 0.8%. The March CPI rose 2.2% year over year and the base rate rose 1.4%. It remains immobile for the foreseeable future. The pressure on the BOJ comes from two sources. First, rising global rates pulled the 10-year JGB yield close to the yield curve control ceiling of 0.25%. There is something to be said for the IMF’s advice to aim for a shorter maturity.
Second, overall inflation in Japan has increased, but that’s mainly due to fresh food and energy. In March 2021, the year-over-year rate for the headline CPI was -0.4%. It is expected to have risen to 1.0% in March 2022 when released at the end of next week. A year ago, excluding fresh food and energy, Japan’s CPI was stable. Last month, it was expected at -0.8%. Starting with the April report, the base rate will increase. Additionally, it will turn positive as last year’s wireless price reductions fade from the 12-month comparison. As a result, real interest rates will fall further.
It is common for observers to discuss a run to the bottom, with everyone looking for weaker currencies. But this is not true. What is true is that central banks generally want the currency to be consistent with its monetary policy stance. A stronger currency can dilute efforts to ease financial conditions, for example. Similarly, a weaker currency when financial conditions tighten is counterproductive.
Nor do businesses always want a weaker exchange rate. Consider Japan. The yen fell to its lowest level against the dollar in 20 years. A Reuters survey recently found that three-quarters of Japanese businesses say the weak yen is hurting their business. A common fear is that the depreciation of the yen will weaken consumption and capital investment. Nearly half thought the change in the exchange rate would hurt earnings, more than a third said it would hurt earnings “somewhat” and an eighth said the impact would be “considerable”.
Some press accounts refer to Japan as an exporter, and other observers allude to Japan’s export prowess. They are wrong. Last year, Japan recorded an average monthly trade deficit of 139 billion yen (~$1.2 billion). In 2020, it recorded an average monthly surplus of 32 billion yen. In 2019, before Covid, Japan had an average monthly deficit of just over 100 billion yen. Japan releases March trade figures on April 20. A slight deficit is expected. Otherwise, consider that the United States exports about 12% of GDP. Japan’s exports account for about 17.5% of GDP. Australia exports almost a quarter of its GDP. The UK and Canada export just over 30% of GDP, while Germany exports 47% of GDP.
In some monetary valuation models, the broader measure of the external balance, the current account, is used. At the risk of oversimplifying, the idea is that exchange rates should tend towards equilibrium in external accounts. The current account includes some capital flows from investments, such as dividends and coupons, but also profits, license fees, royalties, etc. The weakness of the yen reinforces the value of this foreign income, which will be positive for the current account. Rising energy, commodity and food prices are boosting imports faster than a weak yen is boosting exports. Indeed, this is what the J-curve theory suggests, that the trade balance initially deteriorates after a devaluation because prices adjust faster than quantities.
At the end of last week, China disappointed by not reducing the benchmark 1-year medium-term lending facility (2.85%), and its use declined. Hours later, the PBOC announced a 25bp cut in reserve requirements and 50bp cuts for some rural banks. The move is estimated to free up around 530 billion yuan (or ~$82 billion). That still seems like a small beer compared to the growing economic challenge. About a quarter of China’s population (or 375 million people, about 10% more than the entire US population, to put it into perspective) is subject to various social restrictions in an arguably ill-conceived effort to contain Covid. Shanghai, a city of about 25 million people, is jammed with no end in sight.
Before markets open on April 18, China will release Q1 22 GDP. The Bloomberg survey’s median forecast calls for a 0.7% quarter-on-quarter pace after 1.6% in Q4 21. Risks appear to be on the downside, and the world’s second-largest economy does not there is no momentum here at the start of Q2, judging by the PMI. More stimulus will be needed. Reducing reserves, the PBOC’s apparent lever of choice, is obviously a limited strategy, and some believe that limit is being approached.
The other highlight from China next week is the fixing of prime lending rates on April 20. The reluctance to lower the MLF rate makes it more difficult to lower the one-year loan prime rate (3.70%), but this cannot be completely ruled out. The five-year loan prime rate (4.6%) can also be reduced. China’s economic policy response has been mild.
Beijing has also exercised restraint on the exchange rate. Consider that it has become more common for the PBOC to set the daily dollar benchmark rate below expectations (median projection in the Bloomberg survey). The 100 basis point premium offered by China over the United States on 10-year rates is now slightly discounted. The Federal Reserve has begun what is expected to be one of the most aggressive tightening cycles in a generation, with 50 basis point hikes expected in May and June. Yet, at the end of the day, the Chinese yuan is losing 0.25% against the dollar this year. Given this economic backdrop and currency divergence, a weaker yuan would not cause much official friction. This may still develop in the coming weeks.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.