Understanding Fed Actions and Global Trends ????

PERSPECTIVE

How do you get into the mind of a policymaker??This is the question that preoccupies Fed-watchers this week. The big unknowns are how the Fed will react to the mixed picture presented by US and overseas economic data, whether they are at the end of their current rate-hiking cycle or not, and whether their Jackson Hole symposium later this week will give more clues as to their thinking – or even explicit forward guidance. As with all forward-looking questions in financial markets, it is not hard to find market ‘gurus’ who pretend to have sure answers to these questions. Beware of all such false certainty. It is likely that the Federal Open Market Committee (FOMC) members themselves are not sure how to react to current conditions, and their most recent release of meeting minutes certainly points to division over this question. There is also doubt over whether signs of weakness in parts of the US banking system will play any part in their deliberations, or whether they will adopt the hawkish stance that monetary policy should focus on inflation and unemployment while other policy instruments deal with issues in the banking system.

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US DOLLAR

• The US Dollar has seen five weeks of gains against a trade-weighted basket of six other major currencies. On Friday it traded at a two-month high. It lost some ground on Monday morning, but not to a significant extent. The recent uptrend of the Dollar has been driven partly by high bond yields, with yields on ten-year treasuries now close to a 15-year high. This, in turn, is the result of speculation that the Federal Reserve might not be done with its current rate-hiking cycle, and a recent downgrade of the US government by rating agency Fitch. The other significant factor has simply been the travails of other economies in recent weeks: the Yuan has been battered by concerns over deflation and a potential financial crisis, the Yen by easing of massive monetary stimulus in the form of Yield Curve Control, and the Australian Dollar by an interest rate pause and concerns over reduction in demand from China.
• All eyes are now on what the Fed will do next. The indicators that will drive the Fed’s decisions are unemployment and inflation itself. US unemployment is running at 3.5%, well below what has historically been considered the level consistent with stable inflation, which is a jobless rate of more like 5-6%. However, data showed fewer jobs than expected created in July, which may be a sign that the labour market is cooling. After a succession of rate hikes by the Fed, inflation is now running at 3.3%, down from a peak above 9% in summer 2022, but it is not forecast to hit the 2% target until 2025 on current policy. Polls of economists are showing a majority expecting a halt in rate rises, possibly lasting until March, but a majority is not a consensus and the Fed’s most recent minutes show division on the issue, with the Chair advocating a ‘wait and see’ approach contingent on data releases. The Fed’s Jackson Hole symposium later this week may reveal more.
• Total outstanding bank credit in the US dipped slightly in the most recent data releases, the first time it has done so since the 2009-2011 period, amidst the fallout from the 2008 banking crash. The financial system as a whole is on much sounder footing than it was back then, but pockets of weakness exist in mid-sized US banks which over-extended themselves on a combination of long-term locked-in interest earnings on the asset sides of their balance sheets, combined with more fluid interest payment commitments on the liability side, which have risen faster than these banks expected as the Fed hiked rates to fight inflation. Rating agencies have several banks on downgrade watch. If the situation worsens, it may complicate the Fed’s decision-making as they will not want to cause banking stress, although regulators do have other tools at their disposal besides interest rates for this issue.

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ASIA-PACIFIC

• In China we saw unemployment jump up to 5.3%; the main story here is that youth employment (16-24) has tipped above 20% which marks a near doubling since 2017. China also stated they will no longer be publishing these figures moving forwards, which hints at a desire to avoid disclosing bad news, and is not the first time there have been doubts about China’s economic data. Weaker than expected retail sales data pushed the Yuan to 7.3 against USD, approaching levels last seen in 2007, at a time when the currency was managed to be deliberately under-valued. China’s struggles are continuing, and we have seen the PBOC step in to support the currency as Chinese state banks increased their CNY holdings last week by selling USD reserves. This has largely been offset, however, by cuts in medium and short-term interest rates, negatively affecting the attractiveness of the currency. The PBOC unexpectedly held their 5-year loan prime rate steady at 4.2%. Markets have largely seen this as bearish for the economy as further stimulus measures were expected. As a result, we have seen the Yuan weaken further.
• This all comes off the backdrop of China’s second largest real estate developer, Evergrande, filing for bankruptcy protection in New York after several missed debt payments. The real estate sector counts for a quarter of China’s GDP and has been in crisis mode for 2 years, with tumbling prices and a number of scrapped and incomplete projects. In yet further bearish news for the economy, shadow bank Zhongzhi missed several payments with a default seemingly on the horizon, raising further doubts over the state of China’s $3 trillion shadow banking system. The coming months will be crucial for the direction of the economy and the currency, as China attempts to stimulate the economy whilst propping up the currency using its vast FX reserves. At this point nearly all news is bearish, but China does possess the tools and reserves to remedy its currency slide and markets will be keeping a keen eye on the world's second largest economy.
• In Japan, we saw a huge jump in Quarter-on-Quarter annualised growth (6% against 3.2% forecast). This is due to a weak Yen making exports more attractive for foreign buyers. JPY, however, was fairly unmoved at 145 against USD due to still weak private consumption. The weak picture domestically lowers the chances of tighter monetary policy coming into effect as has been reported recently. A higher than expected inflation print came in on Friday, but this had little effect on the currency as analysts note that this is largely imported inflation rather than being driven by domestic demand. Once the global inflation picture improves, it remains to be seen if inflation will dip back to the low or negative levels we saw pre-pandemic. The BoJ intervened late in October 2022 when JPY hit 150 against the dollar to support the currency; it remains to be seen if they will follow suit this time.
• In Australia, last week we saw wage increases miss expectations and unemployment tick up to 3.7%. After the RBA unexpectedly held rates steady the week prior, we have seen a 5.5% drop in AUD against USD over the past month. Interest rate differentials are taking a larger effect on AUD-USD as a majority of economists polled are expecting the Fed to hold rates until Q2 next year and RBA rate expectations are being lowered. Another bearish indicator for the Aussie is the struggles of its major trading partner, China. Australia relies on a strong China to buy its commodities, and a severe dip in business activity, as we have seen this year, has a knock-on effect to the Australian economy. Australia has almost been a recession-proof economy in recent decades due to the high demand for cheap Chinese goods in times of low or negative growth. If China’s struggles continue this could have negative implications for Australia’s economy and its currency.

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SOUTH ASIA

• INR was largely unchanged last week despite a hot inflation print on Friday, mainly down to recent increases in oil prices. Imports and exports showed a slight downturn month on month and it remains to be seen what effect Chinese stimulus plans will have on Asian economies. Otherwise, nothing significant to report out of India in the past week, as INR hovers around 83 Rupees to the Dollar.
• Further political woes in Pakistan have weighed on PKR over the last week. Since Anwar ul-Haq Kakar overtook as caretaker earlier this month, acts of violence against Christian communities have raised questions over his ability to maintain social and political calm. In a relative sense, however, PKR is still trading at a much more stable level than before the IMF bailout in June, despite a dip of 2.5% last week.

MIDDLE EAST AND AFRICA

• After a much-lauded devaluation and consolidation of official exchange rates in June, the Nigerian Naira appears to have hit fresh trouble. Last week, we argued that the steadiness of the official rate since June looks more like a managed float than the freer float authorities claimed when the policy package was launched. This seems to be vindicated by reports on Friday last week that the parallel market rate for NGN had hit 860 to the dollar, an all-time low, and well below the official rate of closer to 770 to the dollar. This suggests a) that the official rate continues to be managed towards a higher level and b) that market confidence in Nigeria’s package of currency reforms has dipped. The danger now is capital outflows placing further pressure on the exchange rate, possibly leading to further adjustments to the policy regime, announced or unannounced.
• Kenyan Shilling has continued its slide against the dollar, which has been gaining pace for two years now, driven by global stresses and local issues of drought, political upheaval, and high public debt. It dropped by a further 1.2% in Monday data. Economic weakness in China, which has become an increasingly significant trade partner for East African economies is likely to add to this trend, and a further surge in food commodity prices after Russia exiting the Black Sea grain deal remains a risk. Easing of global inflation and of rate hiking by the Fed point in a more favourable direction for Kenya, and the World Bank has emphasised that Kenya’s GDP is now growing at around its sustainable long-run potential. On balance, there is no clear reason to expect the current downtrend in the Shilling to let up any time soon.
• Tanzanian Shilling was stable against the dollar up until March this year, and has been on a sharp decline since then, driven by global economic stress, and fears over the stability of the domestic banking system. This downtrend has paused in the past seven days, with the Shilling holding steady against USD. Reasons for this are unclear, and we must be wary both of strong conclusions from a few days of data and FX rate data that comes from the Tanzanian central bank, but it is possible that graphite mining deals that the country struck with Australian mining companies on August 18th have played some role.
• Since our last report, South African Rand has held steady against USD, but it is still down 5% in the month and over 10% in the year to date. This reflects domestic institutional problems, including problems in the delivery of basic services, along with fears of weaking Chinese demand for primary commodities. Significant new trade and investment initiatives announced at the BRICS summit this week could alter the picture for South African, but with fragmentation in economic situation and political priorities amongst the BRICS economies, don’t count on anything big.

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EUROPE

• UK inflation is dropping but remains higher and stickier than in other major economies, running at 6.8% in data released last week. At the same time, UK employment has unexpectedly risen, and wages grew at 8.2% year-on-year in data to July. The latter suggests a labour market running hotter than expected and – taken together – these data point to yet more rate rises by the Bank of England in the remainder of 2023. In consequence, Sterling is up by 0.4% against the Dollar compared to where it was at the time of our report last week. Differential easing of inflation and interest rates and consequent moves in exchange rates remain one of the big themes to watch in the weeks and months ahead.
• Annual inflation in the eurozone eased from 5.5% in June to 5.2% in July, according to data released last week, at the same time as the block moved into an overall trade surplus, driven mainly by a plunge in energy imports from Russia. These changes are unlikely to completely ease the concerns of inflation hawks at the ECB and analysts expect one more interest rate hike in the single currency area this year, but these new developments have had the effect of softening consensus expectations of forward interest rates. Over the four days since the data were released, the euro has held steady against the dollar, suggesting that markets have similar probability estimates for one more rate hike in both currencies. The euro is, however, down against the dollar this month, driven by data pointing to softer business conditions than in the US earlier this month.

OTHER NEWS ?

• Since Hafize Faye Erkan took over control of Turkey’s central bank, she has opted for more traditional monetary policy measures, unwinding 5 years of Erdogan’s unorthodox policies. Interest rates have already more than doubled and we have seen some steadying in the currency slide affecting the Lira. One controversial piece of legislation, that is now expected to be repealed, is banks being required to hold $125bn in protected deposit accounts, amounting to about a quarter of total deposits. The gradual unwinding of these forex protected savings accounts will be seen as positive by markets as it will mean the Lira is not as closely tied to the performance of the overall economy.
• Russia’s central bank raised its key interest rate by 3.5 percentage points up to 12% in an emergency meeting last Tuesday. Since then, we have seen the Rouble move from lows of 102 against the dollar to back trading above 95. The sanctions placed on Russia in 2022 now seem to be taking full effect on the economy and its currency, as circumvention becomes more difficult and alternative energy suppliers have been sourced by the West. Putin is reportedly hearing proposals in which exporters are required to convert some of their foreign currency. This would require exporters to sell up to 80 per cent of their foreign currency revenue within 90 days after delivery and ban companies that refused to comply from receiving government subsidies. Other proposed measures include a ban on paying out dividends and extending loans abroad, cancelling import subsidies, limiting currency swaps, and reducing the amount of foreign currency exporters are allowed to take out of Russia. The proposals indicate growing concern in the government about the effect the war is having on the country’s economy, which could in turn have political implications.

CHARTS OF THE WEEK

We’ve noted that all eyes are on the Fed’s Jackson Hole symposium later this week, to look for clues as to the forward direction of interest rates and the Dollar. In our charts this week, we look at the economy in the same way as the Fed does, using economic theory and long-run historical data, to put in perspective what they will consider and what they might decide.

In macroeconomic theory, unemployment, wages, inflation, and real GDP growth are determined jointly. Theorists posit a Natural Rate of Unemployment (NRU), also referred to as the Non-Accelerating Inflation Rate of Unemployment (NAIRU), a level of unemployment at which jobseekers do not have so much bargaining power that wages and prices are bid-up, or so little bargaining power that the opposite happens. Inflationary pressures arising from unemployment being below the NRU can add to other sources of inflationary pressure, increasing price pressures and potentially making them stickier if a wage-price spiral sets in. This is why central banks pay close attention to labour and wage data. The NRU theory is not completely uncontroversial, but most macroeconomists hold some version of it to be true.

In recent decades, economists have estimated the NRU as being in the region of 5-6%, although some argue that the rise of the gig economy has weakened workers’ effective bargaining power in a way that makes the NRU lower, closer to 4%. Regardless of which of these levels one considers, our first chart this week shows that US unemployment remains remarkably low by the standards of recent history, running at 3.5%. If one sets aside the anomalous spike caused by the Covid pandemic, it would be overdue for a cyclical upturn round about now, but this has not become clearly evident yet, so the Fed may view the tight labour market as an evidence point in favour of one more rate rise.

Our second chart shows real GDP growth running at 2.6% currently. This is not unusually strong by historical standards, but what matters is that it is a continuation of a similar trend rate of growth that dates back to recovery from the 2008-2011 banking crisis (again setting aside the anomalous crash and recovery caused by the Covid pandemic). In economic theory, if unemployment is below the NRU, then real GDP is above potential GDP (the maximum rate at which the economy can produce output without triggering inflation, given current stocks of equipment, know-how etc.).?The fact that growth is continuing at such a pace after expansionary conditions dating back over a decade suggests that we are indeed into the territory of over-production and so is another evidence point in favour of another rate hike by the Fed.

Our third chart this week looks at wage growth, which we can see running at 4.8%, as compared to a recent trend level closer to 2.5%, although the data series for this indicator does not have an available history as long as the preceding charts. This suggests that labour markets remain tight and is another evidence point in favour of the Fed hiking interest rates at least once more.

Our fourth chart looks at inflation itself, now running at a rate of 3.3%, as compared to a peak above 9% in summer 2022, a level that was similar to the inflationary shocks of the 1970s, and with a similar cause – an energy and commodity price shock driven by geopolitics coming on the back of pre-existing supply/demand imbalances. Inflation movements have some degree of momentum, and this data suggests that the current disinflation has not run its course, which is an evidence point against the Fed hiking rates further.

This leads us on to our final chart, the federal funds rate itself, the benchmark interest rate targeted by the Federal Reserve. In this chart, we zoom-in on the past ten years, rather than looking at the full long run of history, in order to consider the dynamics of the current rate-hiking cycle. Economists estimate that an increase in a basic policy interest rate like this takes 12-18 months to fully feed through the financial system and economy, because it takes that long for a whole range of other contractual and market interest rates that are built on top of this to all re-set and for this to alter the economic behaviour of various kinds of actors. This implies that the only interest rate rises we can be confident have fully fed through the system are those in early 2022, a time when the federal funds rate was still below 1%. All rate increases since then have, as yet, fed through either mostly, or halfway, or only partially. This is a strong evidence point in favour of the Fed pausing: waiting to see what are the effects of rate rises to date, before altering its policy settings further.

PERFORMANCES AGAINST US DOLLAR

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THE WEEK AHEAD

Monday, Aug 21st

• Germany Producer Price Index

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Tuesday, Aug 22nd

• US Existing Home Sales

·??????US Manufacturing Index

Wednesday, Aug 23rd ?

• Eurozone Manufacturing and Services Purchasing Managers Index (PMI) data
• UK Manufacturing and Services PMI data
• Canada Retail Sales
• US Manufacturing and Services PMI data
• US New Home Sales

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Thursday, Aug 24th

• US Durable Goods Orders
• US Initial Jobless Claims

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Friday, Aug 25th

• Germany GDP Growth Rate Q2
• French Employment
• US Jackson Hole Symposium with Fed Chair Powell Speech

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