That was the week that was – Sunday 31th January 2016

Markets
The equity markets continued their modest recovery triggered the previous week by European central bankers. It gathered pace on Friday with a potentially end-of-the-month technical rally. Short-covering? Probably. What was clear is that the great “China is causing global turmoil story” proved a bit of a head-fake. The Chinese stock markets fell heavily but the rest of the world ignored them.

The trickiest potential hurdle for equities was the FOMC meeting. It proved a damp squib: target rate held at 0.50% The Fed showed enough of a reaction to Fed-induced market turmoil to prevent further Fed-induced turmoil. Well done.

The more interesting action was in the rates market. The short end was flat over the week, showing little reaction to the FOMC, but not recovering from the move down the week before that took away expectations for an upward rate move over the next year. So 12 month USTs were stable at a 0.45% yield. Two year Treasuries fell further back to yield just 0.75%, maybe implying one 0.25% rise over the next two years. This expectation is well short of the four 0.25% moves up confidently forecast by the FOMC itself in December and repeated by Stanley Fischer in a speech on 3rd January.

In the medium to long term rates space yields fell back to 2015 lows as the impact of the continued tightening bias on nominal growth really began to hit home, and flattening the yield curve as 10 year USTs moved to yield 1.92%. All things are relative and US money policy is still seen as tight vs the rest of the world. The US$ strengthens and international money drives down longer term US yields, now much higher than other developed nations yields. If the tightening bias remains this trade could have a long way to travel. Swiss 10 year yields are negative, German ones are below 50bps and Japanese 10 year yields dropped from to just 10bps last week. Our own forecasts are for stability in US yields, but forecasting the behaviour of the FOMC remains as tricky as ever.

Topic of the Week: Central banks – can’t live with ’em, can’t live without ’em

Central banks should be irrelevant. If they’re doing their jobs properly and maintaining a stable path for nominal growth expectations we should hear little from them. Unfortunately, their already too narrow focus on inflation targets rather than growth in Nominal GDP/Aggregate Demand has morphed into an even narrower focus on inflation ceilings. So we get huge QE programmes, mostly offset by passive or even active tightening whenever inflation threatens to start rising, or worse, when central bankers expect to see inflation start rising towards 2%. Note that does not mean when inflation is over 2% or expected to rise from over 2% to 3% or more, but when falling, sub-2% inflation is expected to pick up. That is some phobia and some pall to cast over expectations.

While the FOMC meeting in mid-week was supposed to be the main event, up popped the Japanese central bank to steal the show. Things aren’t happy in Tokyo. Inflation expectations are refusing to rise despite huge QE. In our view this is because Bank of Japan chief Kuroda refuses to change the inflation ceiling. Despite battling hard to start a QE programme he remains far too cautious about inflation itself. And markets just don’t believe he wants higher inflation enough. He has to be bolder.

He became a little bolder by moving to negative interest rates for any new excess reserves held at his central bank. How much this move was encouraged by Prime Minister Abe is unclear, but he was under pressure to act due to his key ally, Economy Minister Akira Amari, resigning over a corruption accusation. Still, the modest bout of monetary activism led to both a rise in Japanese stocks and an encouraging drop in the currency.The Yen had been rising relative to a weakening Chinese Yuan, and nicely reversed course. Remember, there are only winners in a currency war.

The staggering thing with the FOMC is its apparent lack of self-awareness. Its continuing claim to see itself as exogenous, aka “it’s nothing to do with us”, is remarkable. It precipitated the bout of market turmoil in the summer of 2014 by clearly signalling it would tighten, and then again by actually tightening in late 2015. It is so frustrating of them to piously claim that external events will be closely be monitored.

It’s good, of course, that it pays attention to markets and all the turmoil, but it would be better if members could learn the lesson, and let market expectations of NGDP Growth actually steer monetary policy. We’d then hear a lot less from the FOMC, and that would make it a largely irrelevant body – a good thing.

US Data

The big macro data point was the first estimate of 4Q15 RGDP. It is pretty out of date by the time it is released and will usually be a non-event. The Atlanta Fed GDPNow remains an easily accessible and high quality forecast for the figure, based on two and half month’s worth of regular economic releases that all feed into compiling the BEA’s official RGDP figure. The estimated GDPNow actually moved up to 1% QoQ annualised growth in the days leading up the release, so that the it was a bit above the actual 0.7% official figure that came out on Friday. However, the gap was well within the average +/-0.5% expected error.

A strong recovery in monthly existing home sales for December had led to a recovery in the real residential investment growth estimate and further boosted by an adjustment to inventory estimates. The very poor durable goods report, reflective of the manufacturing, especially energy-related, recession, shaved off half-percent from the GDPNow growth forecast.

Real Personal Consumer Expenditure will always remain the main driver of RGDP. December’s PCE figure is released next week and will be closely watched as it will help set the trend for 2016. It is already included in the 4q15 RGDP number. Markets will, as ever, be looking forward, continuing to pick over historic 4Q15 corporate earnings and the mostly gloomy 2016 guidance

The historic trend in Real PCE is what gives consensus forecasts so much confidence in US real economic growth. The figure has been trending at over 3% for at least a year. A couple of weaker sub-3% YoY growth rates have worried the markets, and even the FOMC. Real retail sales have also been very weak. As Market Monetarists naturally we focus on the nominal numbers, these drag the real numbers around, deflators being very hard to calculate of course.

And here we see nominal PCE trending down since the passive tightening began in mid-2014 and nominal retail sales have also been trending weaker despite being a naturally more volatile data set. Consumer confidence has held up well for now as jobs market, always a lagging indicator, plus lower gas prices have kept spirits up. We think that the weaker nominal growth and poorer corporate outlook will eventually take their toll. Confidence has shown some big, unexpected falls around turning points in the economy, we now expect the unexpected.

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It is possible that current lowflation and the switchover from bricks and mortar sales to online sales is messing with the adjustments to get from nominal retail sales to real PCE. Nominal GDP growth remains low and going lower. So we get a puzzle of these gloomy corporate earnings versus a confident consumer. The Fed remains key. If it takes each bout of market stability as an invitation to tighten then consumers will eventually get punished as corporates adjust their expectations towards further gloom.

Base Watch

We won’t look at base money every week, or at least we won’t once it goes back to being dull. However, when it is showing figures away from the zero per cent trend of recent years we will monitor it more closely. YoY growth remains firmly negative at just over -4% pa. This is not good news, fitting better with corporate and market expectations than those of consumers.

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