Three events stand out next week. Preliminary PMI readings for many high-income countries and Federal Reserve and Bank of Canada policy meetings. The geopolitical backdrop remains high against the buildup of Russian troops and armaments seemingly poised to invade Ukraine. No new discussions between Russia and the United States are planned (yet?). Meanwhile, the surge in Covid cases appears to be slowing in parts of Europe and the United States, while Japan has imposed near-emergency rules in Tokyo and thirteen prefectures until mid-February . China appears to be stepping up its zero Covid efforts ahead of the Olympics.
The collapse of retail sales in the United States in December (-1.9%) and the unexpected drop in industrial production are giving little impetus to the world’s largest economy. Last week’s indications showed that the new year was off to a bad start. The Empire State’s January manufacturing survey slumped to -0.7 from nearly 32 in December. Economists have understood that activity is slowing down. The median forecast was 25.0 in the Bloomberg survey, warning that the slowdown could be much steeper than economists understood. The evaporation of new orders (-5.0 against 27.1 in December) is particularly troublesome. While the Philadelphia Fed’s January survey looked better, the details were disappointing.
The slowdown also seems to be happening in the Eurozone. The German statistics office warned that the economy contracted between 0.5% and 1.0% in Q4-21. Market rates are rising. The German 2-year rate rose by around 20bp since the end of November last year to reach its highest level since April 2019 (~-0.55%), before falling in the second half of last week. The 10-year yield briefly turned positive for the first time since May 2019. January’s ZEW survey found the Current Situation Assessment fell to -10.2, the lowest since last May, and worse than predicted by economists.
January’s preliminary PMI will be subject to expected weakness. However, this is not new. The eurozone composite PMI was at 53.3, the lowest since March. It has fallen in four of the past five months. The trend in the UK has been similar. The composite PMI has fallen in five of the past seven months and, at 53.6, is the weakest since last February.
The US composite PMI held up better. At 57.0 in December, it was the lowest since September. But here too, the recent trend is clear. December was the sixth month of slowdown in the last seven months of 2021.
Japan parades to the rhythm of a different drummer. It recovered from the long Covid crisis in September, but remember it was below the 50 boom/bust level in Q4-19. The composite PMI rose above 50 last October, although it retreated slightly in December. Conditions that lead to the imposition of further restrictions may weigh on the PMI.
Due to its July-September Covid surge, Australia’s composite PMI profile looks a bit like Japan’s with a rally before softening in December. The composite spent the third quarter below 50. It bottomed in August at 43.3 and improved to 55.7 in November before falling back to 54.9 at the end of the year. Lockdowns can weigh on business.
Most notable are the meetings of the Bank of Canada and the Federal Reserve. The Bank of Canada meeting ends at the start of the January 26 North American session and the FOMC meeting ends later the same day. Rather than rehash how we got here, let’s just acknowledge that both central banks are about to launch a series of rate hikes. The markets have anticipated an aggressive move in the coming months.
The overnight index swap (OIS) curve has about 160 basis points of tightening for the Bank of Canada this year and another 30 basis points in 2023. Indeed, compared to the end of last year, the market has decided to discount another rate hike this year. The two-way yield jumped 30 basis points in the first three weeks of the year. At the end of 2021, the market was tilting slightly in favor of a rate hike in January (~55%). It is now a little above 70%.
The Bank of Canada ended its bond purchases last October. In addition to raising rates, the Bank of Canada can also provide forward guidance on its balance sheet strategy. The most aggressive would be to stop the product from recycling maturation almost immediately, say next month. However, officials are more likely to inform investors more. The next meeting will be on March 2. The fact is that, like the Bank of England and the Federal Reserve, the Bank of Canada is likely to allow its balance sheet to unwind much sooner than after the Great Financial Crisis.
Even though most real sector data eased in December, the market’s reaction to the FOMC minutes and official comments is to price in a more aggressive Fed policy trajectory. Consider that on New Year’s Eve, the futures market was pricing in a roughly 63% chance of a 25 basis point hike in March and almost three hikes this year. Now the market is pretty much pricing in the March upside and a small 50bp chance. Moreover, the market is 100% confident on four bulls this year. At its peak, before stocks slumped, fed funds futures had about a one-in-three chance of a fifth price increase. The swap market has 102 bps of discounted tightening for this year and around 50 bps next year.
During his confirmation hearings, Fed Chairman Powell suggested officials had begun discussing his balance sheet strategy. It may take two to four meetings to reach an agreement. It would also allow the Fed’s balance sheet to start unwinding at the end of Q2 or Q3. Indeed, many observers seemed split between June and July. When the balance sheet starts to unravel is one problem, the pace is another. Last time it started at a rate of $10 billion per month and a year later it reached $50 billion per month. The Atlanta Fed’s Bostic has hinted that he favors a balance sheet reduction of $100 billion a month.
Also, unlike the previous episode, Fed officials seem to be talking about balance sheet unwinding to complement or even supplant rate hikes. The December FOMC minutes said “some participants” argued that balance sheet tightening more than rate hikes “could help limit yield curve flattening.” Price pressures were considerably stronger today than they were during the 2017-2018 period.
There is still a lot of uncertainty about quantitative easing and its opposite. Bernanke once joked with great amusement that EQ works in practice but not in theory. While most of the discussion is about quantities and prices, we find that the signaling channel is often underestimated. Consider Japan. It discreetly reduced its asset purchases and indicated that there was no impact on monetary policy, which would remain very accommodating. Indeed, the market reaction was muted. The ECB has also fluctuated its purchases of sovereign bonds but seems to have little perceptible impact on the markets.
Finally, note that the day after the close of the FOMC meeting, the United States will announce its first estimate of GDP for the fourth quarter. The advanced merchandise trade balance on the day of the FOMC meeting gives economists fodder for last-minute adjustments. Unfortunately, Personal Consumption Expenditure (PCE), a key input to GDP, comes out at the end of the week. However, the 1.9% decline in retail sales in December has already weighed on the outlook for PCE. The median forecast (Bloomberg) is for a contraction of 0.4%. Bloomberg’s median forecast for fourth-quarter GDP recently fell 6% to 5.3%. The Atlanta Fed’s GDP tracker fell to 5.1% from 7.3% at the end of last year.
With inflation in mind, the PCE deflator will attract attention. It may have stabilized in December. It may not be the top, but it’s close. The 0.3% increase in the headline rate in January and February 2020 (0.2% and 0.1% of the base rate, respectively) may facilitate comparisons. One implication is that in the short run, the core may converge with the title rather than the other way around. However, year-over-year inflation may start to ease later in the first or second quarter. Polls show inflation being held against Biden and help explain why Democrats are still expected to lose both houses of Congress in November.
Politics is still boiling near the surface of the forex market. Next week the focus will be on the Italian presidential selection process. A possible scenario that might be best received by the market would involve the current president (Mattarella) agreeing to stay on for a bit longer, as an interim like Napolitano did in 2013. This would allow Draghi to lead his coalition government until the end of the legislative. meeting next year. This would provide a steady hand at what is arguably an inflection point. Italian bonds would likely rally to such a move and this could provide support for the euro. Meanwhile, in the UK, Gray’s internal inquiry into government parties during social restrictions is awaited. It may not reveal hard evidence, but it may do little to bolster the PM’s backing, while other reports speak of a handful of Tory MPs considering defecting to the party labor. There is a growing sense that Johnson is fighting for his political life.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.