10 Macro Thoughts to Start the Week

1.  The monthly establishment survey of the US employment report was stronger than expected and sufficient to lift the 3-month private sector average (190k) above the 6-month average (175k).  Yet it is little different from the 12-month average (196k), which suggests that despite some volatility, the trend is little changed.  The household survey, apparently more prone to being skewed by the government closure continues to under-perform.  Over the past three months, it has recorded an average loss of 239k jobs.

This coupled with other measures of the labor market, such as hours worked and average earnings do not show a marked improvement in the US labor market.Similarly, the preliminary estimate of Q3 GDP, which is subject to statistically significant revisions, was flattered by inventory accumulation, which will either be revised away or act as a drag on Q4 GDP.  The underlying trend in final demand has remains unchanged.

2.  With the core PCE deflator not moving toward the Fed’s target and fiscal uncertainties looming, the increased speculation of tapering at the December meeting remains premature. On one hand, there are some in the blogsphere who do not think the Fed can ever taper (“QE-infinity”) and while many bank economists continue to err on the side of seeing a greater urgency to taper than appears to be the case.  We continue to see a more compelling case for tapering in March 2014.

3.  Janet Yellen’s confirmation hearings begin on Thursday.  Appearing before the Senate Banking Committee, which has seen her a few other times in her illustrative career, Yellen is unlikely to be controversial.  She is neither dove nor hawk, but an independent thinker, responding to her remarkably prescient understanding of the economy, and this will likely be borne out in her testimony.   Yellen is a gradualist.   The risk is that she appears more centrist than dovish.  

The Senate Banking Committee is not where Yellen will meet her stiffest opposition.  That will be on the Senate floor itself, where 60 votes are needed for procedural issues, though a simple majority is needed for approval.  This creates some space for obstructionist tactics.  Nevertheless, Yellen’s confirmation hearings this week may provide the news wires with headlines, but not offer investors much real news or insight into Fed policy under her leadership.  

4.  The European Central Bank surprised last week with a 25 bp cut in the repo rate and extended the period of full allotment of its regular refi operation for another year.   It appears to have a controversial decision as news wires report that nearly a quarter of the Governing Council had preferred to wait at least another month.  The ECB persists with the easing bias, as in rates will this low or lower for an extended period.   Yet its measures are unlikely to prove effective in the triple threat of deflation, weak money supply growth and lending, and the decline in excess liquidity that may soon pressure money market rates.  The key EONIA trades closer to the deposit rate (zero) than the repo rate (now 25 bp).  In effect, lowering the ceiling is not really material in the current environment.  The ineffectiveness of the ECB’s measures means that additional steps will have to be forthcoming.  There are no good options (that are also politically realistic).  A new LTRO, while mentioned by Draghi, will unlikely be taken up by the strong banks, ahead of the Asset Quality Review and stress tests, which means there will be a stigma of its use and suggest a low take down.

Draghi also mentioned the possibility of additional rate cuts.  Another cut in the repo rate (to zero) may improve financial conditions temporarily, but not address the underlying deflationary pressures or the causes of the year and a half contraction in lending to businesses and households.  Since the deposit rate was cut to zero, banks have reduced their use of that facility.  Pushing the deposit rate below zero could distort money markets and have other unintended and unforeseen consequences, as no other major central bank have offered negative deposit rates.    If that is the downside, the upside is even less clear. Lower rates by themselves are unlikely to arrest the deflation and contraction in lending.  

5. European finance ministers have a two-day meeting starting Thursday.  Although the review of Greek, Portuguese and Irish programs is anticipated, the real interest will be in progress toward the banking union.  An agreement between Germany’s CDU and SPD over the weekend strengthens Schaeuble’s negotiating position.  Essentially, Germany will insist that the European finance ministers will decide when to close failing banks, not the European Commission, and that the European Stabilization Mechanism, (ESM) will not be used to wind down troubled institutions.  Until the Single Resolution Mechanism is sufficiently financed by financial institutions, national authorities.  If national authorities lack resources, Spain’s ESM program looks to be the model that Germany wants to follow.   While Germany has some allies, most countries seem to prefer greater access to ESM funds to wind down individual problem banks.

6.   The UK will report the latest inflation and employment data prior to the Bank of England’s Quarterly Inflation Report.  While disinflation or deflationary pressures are evident among most of the high income countries, the UK is a notable exception.  That said, base effects suggest modest easing here in Q4.  The core rate is also likely to ease at 2%, which is the consensus forecast would match its lowest reading in four years.  The claimant count is expected to fall again and this is consistent with a further decline in the unemployment rate to 7.6%.  This is the backdrop of the BOE’s inflation report.

The pessimistic outlook BOE Governor Carney offered when he took office in July is likely to be substantially revised.  The central bank’s growth forecast is likely to be revised higher and a faster decline in unemployment is likely to be anticipated.  Even if the medium term inflation forecast is lowered, the market appears to be discounting the likelihood a rate hike late next year or arguably early 2015.  The implied yield of the December 2014 short-sterling futures contract is currently 80 bp compared with the current base rate of 50 bp.   Whereas former Governor King’s desire to provide more stimulus was repeatedly out-voted by the MPC, Carney’s assessment and forward guidance has been given little credibility by investors.   Carney, rather than the market, is likely to change its stance.  

7.   Standard and Poor’s cut France’s sovereign rating to AA from AA+ last week and changed the outlook to stable from negative.   The euro was under pressure from the ECB’s surprise rate cut and the US jobs data, but the reaction in both the bond and the credit default swap supports our general view that the rating agencies views of major industrialized economies, reliant as they are, completely on publicly accessible and available information, are of marginal significance.  There appears nothing in S&P decision that has not appeared in numerous economic analyses. There is little confidence among economists (and apparently many officials in Brussels) that the French government has put the economy on a sustainable path.  We have argued that fall of the Berlin Wall eventually forced a restructuring of the German economy and the crisis is forcing the periphery to reform (especially the public sector). France has had the  privilege of neither spurs of reform.

S&P projects French government spending to be 56% in 2015, which is the second highest among developed countries after Denmark.   The EU’s Economics Commission Rehn warned earlier last week, prior to the  S&P action, that contrary to pledges by Hollande, French unemployment would rise until 2015.   At the same time, French officials see the low interest rates (benchmark 10-year yield below 2.25%) as investors’ vote of confidence in the government’s course.  The 5-year credit default swap actually slipped slightly before the weekend, and although the 10-year bond yield rose, it increased less than Germany, allowing the premium to narrow by a couple of basis points.   The New York Times headline that said that “S.&P. Downgrade Downgrade Deals a Blow to the French Government” must refer more to appearances than substance.

8.  The Abe government is struggling to implement its so-called third arrow of structural reforms.  The first two arrows, which consisted of fiscal and monetary stimulus were relative easy to enact.  In many ways it is the traditional LDP salve, though on steroids, as the quantitative easing is nearly as large as the Federal Reserve’s for an economy less than half the size.   The foreign exchange market had discounted Abenomics by taking the dollar-yen exchange rate from about JPY75 to a little over JPY100 in roughly the six months through May.  The economy itself appears to have peaked in Q2.   The economy appears to have slowed significantly in Q3.   Indeed when the GDP figures are reported this week, they will likely show the expansion at less than half of the Q2, or around a 1.3%-1.6% at an annualized pace.

With shrinking population and excess capacity in a number of key industries, it is little wonder that Japanese businesses are reluctant to increase investment at home.  At the same time, they are not sharing with the workers the windfall created by the weaker yen.   In September regular wages, which exclude overtime and bonuses, fell 0.3% on a year-over-year basis, the 16th consecutive month of declines.  While winter and summer bonuses did help spur consumption, the rise in inflation (a five-year high was reached in August at 0.8% before slipping to 0.7% in September) is eroding purchasing power and the real return on savings.  In anticipation of the hike in the retail sales tax on April 1 from 5% to 8% may  boost the demand for household durable goods, but unless incomes rise, the economy may falter again.  Abe’s honeymoon is over. Businesses are balking.  And just when new efforts are needed for his economic agenda, Abe may be spending his diminishing political capital on a controversial visit to the war shrine, which will do mend fences with its neighbors, not just China.  

9. China has reported a slew of data that generally confirm the stabilization of the economy, as officials have directed.  The purchasing manager surveys had already indicated the stabilization the October industrial production, investment and retail sales reports confirmed it.  Industrial output and retail sales ticked from September, though fixed asset investment eased slightly.

The news that more likely will capture the market’s attention is that more than doubling of the October trade surplus to $31.1 bln form $15.2 bln in September.  Imports increased slightly to 7.6% (year-over-year) from 7.4%, but the larger surprise was in exports, which jumped to 5.6% from -0.3%.  Some feared that the 2.3% rise in the yuan this year would curb exports, but as we have argued, the limited valued-added work done in China (largely assembly) means that exports are unlikely to be very sensitive to small changes in foreign exchange prices.  The strength of foreign demand also appears to be more important than the controlled currency changes.

Meanwhile, Chinese inflation did edge higher in October to a 3.2% year-over-year rate, an eight month high.  Consumer inflation stood at 3.1% in September.  The Reuters polls put the consensus estimate at 3.3%.  Food prices remain the main culprit.  They were up 6.5% in October from 6.1% in September.  Chinese measured inflation appears to be more a case of relative price changes rather than a general price increase.  It is the increase in house prices that seems to be of greater concern (~20% in the large urban centers) than consumer inflation.  At the same time, producer prices continue to fall.  October’s 1.5% decline is the 20th consecutive negative print.  It follows a 1.3% decline in September.  This divergence between falls in producer prices and increases in consumer prices suggests a source of profit-margins.   Taken as a whole and at face value, the latest data is unlikely to spur a change in PBOC policy.    

10.  The much-heralded Third Plenary Session of the Communist Party in China has begun.  Direct news has, as expected, been very light.  It is widely acknowledged by officials that reform of its growth model is needed.  There are three areas in which reform is likely to be concentrated:  the government, as in reducing bureaucracy, the market, to provide greater competition and flexibility, and state-owned enterprises, which still dominate key sectors of the economy.  The latest reports have tended to focus on the state-owned enterprises.    In the financial sector, the new Chinese government has announced a number of reforms that give market forces greater sway, including abolishing the floor for lending rates and developing a market-based prime rate.   Continued gradual movement in this direction is expected.

Even after the plenary session ends, it may take observers some time to understand the results. There are two main obstacles to dramatic change in the Chinese model.  First, President Xi Jingping continues to consolidate his power, but has been frustrated by continued influence of past presidents Jiang Zemin and Hu Jintao.    Second, it is not clear that Xi or Prime Minister Li are as interested in political reform as they are economic reform.   Henry Ford once quipped that a customer can have any color Model T as long as it was black.  Despite the factions within the Communist Party, Chinese officials seem to agree the government stays Red.   That is to say, challenges to the rule of the Communist Party will not be tolerated.  In a country of contrasts, economic reform can go hand-in-hand with a crack down on human rights and civil society activists.   This includes the Zhi Xian Party (which means Constitution is the Supreme Authority) formed last week by the supporters of Bo Xilai.  The contradiction between the modernizing and flexible economy on one hand, and the archaic and rigid political system on the other, is unlikely to be resolved, but rather intensify in the period ahead.
This piece is cross-posted from Marc to Market with permission.