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13 September, 2020 | By Mark Chandler
The critical week ahead
Many macroeconomic and geopolitical issues remain open and are unsettling. Europe is wrestling with the Turkey-Greece dispute over territory of potentially significant value in the Mediterranean. The trade negotiations between the UK and EU have deteriorated, and the window of opportunity for an agreement is closing quickly. Meanwhile, the poisoning of a Russian opposition leader, apparently using the same nerve agent that has been used on other "enemies of the state," is threatening to undermine even the remaining commercial link of the Nord Stream II gas pipeline directly to Germany. At the same time, Russia's relative isolation increases the risk that it takes actions in Belarus that increase its sphere of influence.
High-frequency data include the US, China, Japan, and the eurozone's latest industrial output figures. In Europe, Germany and France disappointed expectations, but Italy surprised to the upside. The US and China also report retail sales. The early reads on September are provided by the Fed's Empire State and Philadelphia manufacturing surveys. Germany's ZEW survey is also a preliminary look at how things are shaping up this month. The general pattern across many countries is that the sharp recovery since in May and/or June has moderated, but Q3 still looks a substantial improvement from Q2.
The US presidential cycle is once again coinciding with escalating tensions with China, which itself is having yet another border skirmish with India. The security law in Hong Kong, its treatment of Uighurs, the repression of foreign journalists, and its petty reaction to even to the smallest of slights, like the visit to Taiwan by the Speaker of the Czech Senate (which did not have the backing of the government which sets foreign policy), have brought widespread criticism of Beijing.
The new week starts with a virtual trade summit between the three European presidents (Merkel, as the holder of the rotating EU presidency, von der Leyden, the EC President, and Michel, the European Council President) and China. The importance is not about trade despite the agenda. After all, the negotiations have been going for seven years. One of the sticking points has been the aid to state-owned enterprises, giving the Chinese companies a competitive advantage. One of Beijing's recent initiative was to enhance their role.
The talks will be among the last formal opportunities for China to create some goodwill ahead of the US election. If Biden wins, the trans-Atlantic ties will likely strengthen. Every crisis, someone claims it is worst. It is hard to compare other crises, like US deployment of a medium-range ballistic missile in Europe or the French decision to pull out of joint NATO command, or Europe's insistence on US gold instead of Treasuries, leading making the dollar-gold link no longer tenable. Fair to say, though, that US and European relations are at a low ebb.
Meanwhile, the UK and EU trade talks will continue, though with clearly diminished prospects of success, which we did not think were particularly good to begin. The UK does not appear to have come to grips with the fact that the Good Friday Agreement is predicated on no hard border between Northern Ireland and the Irish Republic. Leaving the EU, as the UK has done, requires all sorts of mental gymnastics and tortured processes. After not only did Johnson lead Parliament to accept the Withdrawal Agreement, but he ran a campaign on the premise that it was in the UK's interest. Monday's second reading of the new Internal Market bill could spur a legal challenge by the EU.
Now the claim is that the agreement was hurried and does not protect Northern Ireland. Johnson wants Parliament to approve a bill that would eliminate the need for export documentation for goods moving from Northern Ireland to Great Britain and prevent Northern Ireland from having to adopt EU state aid rules. The EU may seek legal recourse, and in the US, the presidential candidate Biden and Democratic Speaker of the House and the Chair of the powerful House Ways and Means Committee, which vets trade agreements, defended the Good Friday Agreement and noted the US was a guarantor of it. UK interest rates and implied sterling volatility have risen. The broader dollar move has driven sterling, but it has fallen by about 3.5% against the euro since September 3, reflecting its general underperformance. The 4% loss against the dollar makes sterling easily the worst performing currency so far this month.
It is in this context that the Bank of England meets on September 17. The August CPI will be reported before the MPC meets. Although Governor Bailey has warned of a higher inflation trajectory, the risk is that August's price pressures subsided. It preferred measure, CPIH, which includes owner-occupied housing cost, is expected to fall from 1.1% in July to 0.3% (year-over-year). The core rate is forecast to fall to 0.7% from 1.8%.
The central bank will also see August employment data before it meets, but the furlough program is giving an appearance of greater strength than there may be. Currently, the furlough program will be terminated at the end of October, though there is pressure to extend it. The Bank of England forecast 18% growth in Q3, and after the pre-weekend report showing a 6.6% expansion in July, it is on track, though seem appears optimistic. A dissent from the more activist doves, like Saunders, who has already acknowledged that additional easing will likely be appropriate, is possible. But November looks like a better time frame for further easing, which could include bringing the base rate down 10 basis points to zero and increasing Gilt purchases. The BOE has made a point of refusing to rule out negative rates, and ahead of the weekend, Her Majesty's Treasury sold six-month bills with a negative yield for the first time. In the middle of last week, the two-year Gilt yield hit a record low just beyond minus 15 bp.
The big event of the week, though, is the FOMC meeting that concludes on September 16. It is the first meeting since the Fed formally adopted the average inflation target and indicated the labor market would be judged on how far it is from full employment. The meeting will also present a new set of forecasts.
The economy has evolved mostly in line with the Fed's expectations. All signs point to a strong expansion here in Q3, though some momentum appears to have waned. In public remarks, Fed officials still see downside risks to the economy and have advocated new spending (fiscal) to complement the central bank's lending. Congress has not found common ground, but Trump has used executive powers to extends some unemployment insurance and deferred payments for Social Security and Medicare.
Investor interest is on the forward guidance it provides and on Powell's press conference, where he will likely be peppered with questions about the average inflation target and full employment metrics. The Fed modified its operational target that many suspect had already been adopted de facto if not de jure. It is casting aside the Philipps curve and pledging not to raise interest rates simply because the unemployment is low. By not defining the average period that inflation will be judged, the Fed is also eschewing rule-based decision-making, such as the Taylor Rule, for ad hocery.
The Fed is not expected to take new measures or adopt fresh tools to ensure that its new target is achieved. It consistently undershot the old target of 2% on the headline PCE deflator (which is still a source of misunderstanding as many astute analysts still claim the Fed targets the core measure that it does talk about). To be sure, it is not just the US that has undershot its inflation target, but most of the high-income countries have. It is simply not clear what else the Fed is prepared to do to lift the general price level besides scaling its current efforts.
The Fed seems to be reluctant to take new actions. Its balance sheet is about $100 bln smaller than it was at its peak in early June. In comparison, the ECB's balance sheet has increased by over 220 bln euros since the end of June. The Bank of Japan's balance sheet has grown roughly JPY33 trillion (~$310 bln). The Fed is not expected to ramp up its Treasury purchases or introduce yield curve control, where it would target say a 3-5 year yield in addition to overnight money (fed funds).
Without defining the period of that "average" inflation will apply or announcing new tools, to achieve its target, the Fed may be making a tactical error. Its claim does not seem credible. Market-based measures of inflation expectations, such as the 10-year breakeven rate (the difference between conventional and inflation-protected yields) have hardly changed. It again stalled near 1.80%, and in any case, has not been above 2.0% since 2018. Perhaps one of the considerations behind the decision not to introduce yield-curve control is that if the Fed is successful in lifting inflation expectations, the yield curve would be expected to steepen. The 2-10 year curve is in the middle of the 50-60 bp range that has confined it for the past month, which is still relatively flat from a historical perspective. Supply concerns may also account for some of the recent steepening, and the auctions for the long-end have seen lukewarm receptions.
From an operational perspective, many of the facilities the Fed launched with much fanfare are not being used very much. Chairman Powell has defended them, arguing that they remain a backstop. However, there is one area that the Fed ought to consider, and that is the commercial real estate market. The problem in this space is likely to worsen. One industry report found that nearly one in four US hotels were at the risk of foreclosure. More than $20 bln of commercial mortgage-backed securities from hotels are reportedly more than 30 days delinquent. Retail is another distressed sector, and an estimated 25k stores will close this year. Nearly a quarter of retailers have reportedly indicated a need for relief. Commercial rents are falling.
The hunt for yield meant that the CMBS may have been frothy and in unlikely portfolios before the crisis hit, though the market is dominated by professionals. The default protections for higher-rated tranches appear to have been diluted. Strains in the $1.4 trillion market of CMBS could have broader knock-on effects. The Fed ought to consider a facility to help support the sector.
What else could the Fed do to help bolster inflation and address the disparity of wealth and income? It could aid the one organization whose mission is about improving the lives of working people, namely unions. Many critiques of unionization include the inflationary element of higher wages being passed on to the consumer rather than necessarily cutting profits. The Fed could unionize its staff and in the dozen regional federal reserves. It could encourage its members (financial institutions) to do likewise. But it won't. The main barrier is not some mathematical equation or an accounting identity, or some imaginary variable like r*. The chief reason it will not be done is ideological.
On Tuesday in Tokyo, the Liberal Democratic Party will choose a successor to Abe as party head. Cabinet Secretary Suga is widely favored. Given the parliamentary system, the leader of the LDP will be voted on in the Diet as the new Prime Minister. While there are clear alternatives to Abe, there still seems to be a lack of options to Abenomics, and if Abenomics is to remain, then Suga represents the greatest continuity. His commitment to fiscal activism underscores the likelihood of a supplemental budget in the Q4. Structural reforms are also part of the Abenomics, which Suga embraces. Suga may add deregulation initiatives as well.
Suga would complete Abe's term that runs through next September. However, there is some thought he would want to call a snap election, while the LDP enjoys a bump in the polls, and receive his own mandate. The Komeito Party is part of the governing coalition, and strains between it and the LDP under Abe were evident. It reportedly was the Komeito Party, for example, the forced the reduction in the initial JPY300k monthly cash payment per adult during earlier this year to only JPY100k. It has also managed to limit Abe's efforts to change the Constitution. Suga has a better relationship with the Komeito Party, which does not want a snap election.
Another integral arrow in the Abenomics quiver is the monetary policy. The Bank of Japan meets on September 17, a few hours after the conclusion of the FOMC meeting and Powell's press conference. It may be too soon to expect the BOJ to do more. Although it has escaped much attention, the BOJ's balance sheet has been expanding by about 3.2% of GDP per month for the six months through August. At the end of last month, it stood at 128% of GDP, up from 103.5% at the end of last year. In comparison, the Fed's balance sheet is roughly a third of GDP, while the ECB's is a little more than 57% of GDP.
There are two areas the BOJ may explore. The first is draws inspiration from the ECB's targeted long-term refinancing operation, which are three-year loans, and the rate at the June offering was minus 100 bp if specific loan targets were achieved. This is understood as a dual-rate as the deposit rate (at the ECB) is minus 50 bp (but does not apply to all deposits). Despite the now-commonplace references to the "Japanification" of this country or that, the ECB adopted negative interest rates around 18 months before the BOJ.
The second is to increase the amount of government bills it buys. Like in the US, the dramatic increase in government spending is first financed with bills. Some dollar-based institutional funds swap for yen at a discount and buy Japanese bills. The return really lies with the fx swap and/or other financial structures, more than the T-bill itself, which has negative yields. International funds are large holders of Japanese T-bills, but the government's supply, net of what the BOJ is purchasing, is greater. In early August, the three-month bill yield reached minus 6 basis points, its highest since Q1 2016.
On August 28, the day that Abe announced his resignation, after some speculation, the dollar traded between JPY105.20 and almost JPY107.00. It has remained in the range since and shows little sign of breaking out any time soon. The median year-end forecast in the Bloomberg survey is at an uninspiring JPY106.