Looking for the Signal? Expect No Fresh Help from Yellen and Draghi at Jackson Hole
There are four main issues that investors will be wrestling with in the week ahead. First, as we saw before the weekend, geopolitical developments can still roil the markets. Second, economic data from the US, Europe and Japan has been disappointing. This has helped extend the rally in the bond and stock markets.
Third, the euro was fairly resilient, unable to take out the August 6 low last week. The dollar remained in the upper end its four-month trading range against the yen, even though US yields fell to their lowest level in 14 months.
Fourth, in light of the recent economic developments, the Kansas City Federal Reserve's Jackson Hole confab at the end of next week, is hoped to generate new insight into the thinking of policy makers. Both, Fed head Yellen and ECB's President Draghi will speak there on August 22.
There are three geopolitical flash points on investors' radar screens: Gaza, Iraq and Ukraine. There have been some encouraging developments that suggest near-term stabilization in Gaza, though the basis for a sustainable and politically viable resolution still does not appear at hand. Moreover, once again, though, in a different way, Israel's deterrence doctrine appears to have failed again. It is this failure of deterrence that then requires Israel forces to act in ways ensures that its military victories lose in the court of public opinion.
The inability to protect the territorial integrity of Iraq has seen the conflict escalate there. Outside of a brief market reaction when the US decided to strategically bomb part of Iraq to slow the advance of the ISIS insurgents and/or to defend US personnel, this conflict has generally not had much-direct impact on the capital markets. One dimension of this conflict that continues to appear under-appreciated in the media is the role of the larger Saudi Arabia-Iran confrontations through proxies.
Of these geopolitical flash points, the situation in the Ukraine stands out. Russia is integrated into the world economy as both a customer and energy provider, especially in Europe. A disruptive impulse will hit an already fragile economic situation in the euro area. It can only add to the downside risks to growth and prices. Developments remain fluid amid conflicting media reports. However, despite that some observers interpreted at conciliatory by Putin, it seems clear that he has not abandoned his goal of destabilizing Kiev and carving another piece out of Ukraine.
US: The highlight of the week is the July CPI figures on August 19. The consensus expects the headline rate to tick down to 2.0% from 2.1% and the core rate to be unchanged at 1.9%. We place the risk on the upside. The rental market is tight, and this may translate into higher core prices. Medical care costs may be rising, and to filters into core prices. In addition to the CPI, the US reports housing starts. In June, the seasonally adjusted annualized rate fell below 900k for the first time since September 2013. They are expected to have rebounded in July. On the other hand, existing home sales, reported later in the week, trended up in Q2 after weakening in Q1. They may pullback in July. Lastly, following the disappointing Empire State August Survey (14.69 from 25.60; the consensus forecast was 20.00), this week's Philly Fed survey will also draw attention. Some economists have already revised down Q3 growth forecasts; more may follow.
EMU: The preliminary PMI reports are of chief interest. The unexpected stagnation of the euro area economy in Q2 and the outright contraction in Germany was disappointing to say the least. While the US economy will likely slow sequentially in Q3, the euro area can do better. A small decline in the manufacturing and service sector readings will translate into a softer composite, but it will remain in the 52-54 range that has confined it since the end of last year. This is consistent with slow growth. We look for a 0.1-0.2% Q3 GDP.
UK: The consensus expects the UK to report lower inflation and stronger retail sales. We suspect there is some upside risk to CPI, partly owing to the base effect. Retail sales should bounce back after the weakness seen in May and June. The risk here also seems to be on the upside.
Japan: We have suggested that Japanese policy makers had likely written off Q2 due to the sales tax and that any policy response would depend on the economic performance in Q3. In the week ahead, Japan reports July department store sales. Investors and policy makers will learn whether consumers remain on strike. Foreign demand likely improved. Exports are expected to have risen by 3.8% after falling 1.9% year-over-year in June. Imports may have fallen. As a consequence, the trade deficit is likely to have been reduced.
Central Bank Minutes: Minutes from the recent FOMC and BOE meetings will be released. While there is a clear consensus to wind down QE on schedule, other issues, like the timing of the first rate hike and which instruments will be used to neutralize the excess reserves, are unresolved. That said the nature of minutes gives greater expression to a wider range of opinion than may be found among the voters on the FOMC. The key policy signals come from the Yellen, Fischer and Dudley.
The Bank of England's MPC meeting may have been more contentious. A dissent or two is within the realm of expectations, which seem to carry more weight that dissents at the Federal Reserve. Some observers see MPC member David Miles as the most likely to dissent, though we are less sanguine.
The pendulum of market sentiment has swung quite hard in response to Carney's presentation of the Quarterly Inflation Report, driving interest rates and sterling lower. It is difficult to envision the minutes being as dovish, which highlight the risk that the pendulum swings back, lifting sterling and short-term interest rates. In addition, in an interview in the Sunday Times, Carney seemed to contradict what he appeared to have signaled last week by saying that the BOE will not wait until real wages rise before raising rates.
What economists euphemistically call "temporal inconsistencies" with Carney's forward guidance is frustrating investors goes beyond the strategic ambiguity often seen from central bankers. The Federal Reserve, the ECB and the Bank of Japan communications have challenges, but none appear to be as self-contradictory as the BOE, which has made some observers raise questions of the credibility of its forward guidance.
Several times in recent year, investors have thought the US economy was on the verge of accelerating, and have been disappointed. It is being played out again now. The disappointment comes after a strong dollar rally and leaves the greenback vulnerable. The inability euro to fall to new lows following its own poor data and the inability of the Dollar Index to make new highs may be warning signs. The drop in US yields argues against buying dollars for yen. There is nothing that says sterling has bottomed after shedding 5.5 cents since mid-July, but we are more inclined to look for a near-term bounce.
The decline in US yields remains a critical element shaping the investment climate. Nearly half of the decline in the 10-year yields, thus far, this quarter, took place last week (9 of 19 bp). The same is true for the UK (16 of 34). In Germany, the 10-year bund yield fell below zero for the first time, and the 11 bp decline last week brought the quarter-to-date decline in 29 bp. For its part, the 10-year JGB yield fell be 50 bp for the first time in sixteen months.
Given growth and inflation expectations it is difficult to see the value in US 10-year bonds with 2.34% prevailing yields. Technical analysis warns that a break of the 2.30% area could spur a move toward 2.16%. German 10-year yields are in record low territory and hence in uncharted waters. The 2-year yield is negative. As noted above, we are concerned that the pendulum has swung too hard in the UK, and this warns of some backing and filling with rates.
The DAX and CAC suffered dramatic downside reversals before the weekend. The price action was not quite a damaging in the FTSE, but it did settle on its lows too, surrendering most of its earlier gains. The US S&P 500 was turned back from a key level. It is difficult to see the core bond yields rising if the equity markets see follow through selling at the start of the week.
The Sept oil futures contract fell to five-month lows last week near $95.25 a barrel. It staged an upside reversal before the weekend. A move above $95.70 would suggest the leg down from $106.65 in June is over. More broadly, commodity prices (CRB) are also technically poised to move higher in the near-term.
Many observers play up the significance of the Jackson Hole gathering of monetary officials. We demur. By the time that Yellen and Dudley speak on August 22, the market will be winding down before next weekend. Yellen will likely use her talk on "Re-evaluating Labor Market Dynamics" to argue the case of there being significant slack (under-utilization) in the labor market. Moreover, because she is likely speaking as herself, and not representing the Federal Reserve as she does, for example, before Congress and in her post-FOMC press conferences, the risk is her tone may be somewhat more dovish. Her leadership style seems to preclude signaling any new initiative in Jackson Hole.
For Draghi too, Jackson Hole does not seem like a particularly likely forum for some policy revelation. He will likely use this opportunity to discuss, even candidly, the challenges that the euro area faces and how its policy framework differs from the US. September and October will be important months for the euro area. The TLTRO facility will be launched. Updated forecasts from the ECB staff and the results of the asset quality review and bank stress tests will available (before the ECB formally take on supervisory responsibility).
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