The economic impact of the King Dollar in the summer of 2018

One of the problems of currency analysis is the way that when you are in the melee it is hard to tell the short-term fluctuation from the longer-term trend. It gets worse should you run into a crisis as Argentina found earlier this year as it raised interest-rates to 40% and still found itself calling for help from the International Monetary Fund. The reality was that it found itself caught out by a change in trend as the US Dollar stopped falling and began to rally. If we switch to the DXY index we see that the 88.6 of the middle of February has been replaced by 95.38 as I type this. At first it mostly trod water but since the middle of April it has been on the up.

Why?

If we ask the same question as Carly Simon did some years back then a partial answer comes from this from the testimony of Federal Reserve Chair Jerome Powell yesterday.

Over the first half of 2018 the FOMC has continued to gradually reduce monetary policy accommodation. In other words, we have continued to dial back the extra boost that was needed to help the economy recover from the financial crisis and recession. Specifically, we raised the target range for the federal funds rate by 1/4 percentage point at both our March and June meetings, bringing the target to its current range of 1-3/4 to 2 percent.

So the heat is on and looks set to be turned up a notch or two further.

 the FOMC believes that–for now–the best way forward is to keep gradually raising the federal funds rate.

One nuance of this is the way that it has impacted at the shorter end of the US yield curve. For example the two-year Treasury Bond yield has more than doubled since early last September and is now 2.61%. This means two things. Firstly if we stay in the US it is approaching the ten-year Treasury Note yield which is 2.89%. If you read about a flat yield curve that is what is meant although not yet literally as the word relatively is invariably omitted. Also that there is now a very wide gap at this maturity with other nations with Japan at -0.13% and Germany at -0.64% for example.

At this point you may be wondering why two-year yields matter so much? I think that the financial media is still reflecting a consequence of the policies of the ECB which pushed things in that direction as the impact of the Securities Markets Programme for example and negative interest-rates.

QT

QT or quantitative tightening is also likely to be a factor in the renewed Dollar strength but it represents something unusual. What I mean by that is we lack any sort of benchmark here for a quantity rather than a price change. Also attempts in the past were invariably implicit rather than explicit as interest-rates were raised to get banks to lend less to reduce the supply of Dollars or more realistically reduce the rate of growth of the supply. Now we have an explicit reduction and it has shifted to narrow ( the central banks balance sheet) money from broad money.

 In addition, last October we started gradually reducing the Federal Reserve’s holdings of Treasury and mortgage-backed securities. That process has been running smoothly.  ( Jerome Powell).

You can’t always get what you want

It may also be true that you can’t get what you need either which brings us to my article from March the 22nd on the apparent shortage of US Dollars. This is an awkward one as of course market liquidity in the US Dollar is very high but it is not stretching things to say that it is not enough for this.

Non-US banks collectively hold $12.6 trillion of dollar-denominated assets – almost as much as US banks…….Dollar funding stress of non-US banks was at the center of the GFC. ( GFC= Global Financial Crisis). ( BIS)

The issue faded for a bit but seems to be on the rise again as the Libor-OIS spread dipped but more recently has risen to 0.52 according to Morgan Stanley. What measure you use is a moving target especially as the Federal Reserve shifts the way it operates in interest-rate markets but they kept these for a reason.

In October 2013, the Federal Reserve and these central banks announced that their liquidity swap arrangements would be converted to standing arrangements that will remain in place until further notice.

Impact on the US economy

The situation here was explained by Federal Reserve Vice-Chair Stanley Fischer back in November 2015.

To gauge the quantitative effects on exports, the thick blue line in figure 2 shows the response of U.S. real exports to a 10 percent dollar appreciation that is derived from a large econometric model of U.S. trade maintained by the Federal Reserve Board staff. Real exports fall about 3 percent after a year and more than 7 percent after three years.

Imports are affected but by less.

The low exchange rate pass-through helps account for the more modest estimated response of U.S. real imports to a 10 percent exchange rate appreciation shown by the thin red line in figure 2, which indicates that real imports rise only about 3-3/4 percent after three years.

And via both routes GDP

The staff’s model indicates that the direct effects on GDP through net exports are large, with GDP falling over 1-1/2 percent below baseline after three years.

The impact is slow to arrive meaning we are likely to be seeing the impact of a currency fall when it is rising and vice versa raising the danger of tripping over our own feet in analysis terms.

What happens to everyone else?

As the US Dollar remains the reserve currency if it rises everyone else will fall and so they will experience inflation in the price of commodities and oil. This is likely to have a recessionary effect via for example the impact on real wages especially as nominal wage growth seems to be even more sticky than it used to be.

Comment

Responses to the situation above will vary for example the Bank of Japan will no doubt be saying the equivalent of “Party on” as it will welcome the weakening of the Yen to around 113 to the US Dollar. The ECB is probably neutral as a weakening for the Euro offsets some of its past rise as it celebrates actually hitting its 2% inflation target which will send it off for its summer break in good spirits. The unreliable boyfriend at the Bank of England is however rather typically likely to be unsure. Whilst all Governors seem to morph into lower Pound mode of course it also means that people do not believe his interest-rate hints and promises. Meanwhile many emerging economies have been hit hard such as Argentina and Turkey.

In terms of headlines the UK Pound £ is generating some as it gyrates around US $1.30 which it dipped below earlier. In some ways it is remarkably stable as we observe all the political shenanigans. I think a human emotion is at play and foreign exchange markets have got bored with it all.

Another factor here is that events can happen before the reasons for them. What I mean by that was that the main US Dollar rise was in late 2014 which anticipated I think a shift in US monetary policy that of course was yet to come. As adjustments to that view have developed we have seen all sorts of phases and we need to remember it was only on January 25th we were noting this.

The recent peak was at just over 103 as 2016 ended so we have seen a fall of a bit under 14%

Back then the status quo was

Down down deeper and down

Whereas the summer song so far is from Aloe Blacc

I need a dollar, dollar
Dollar that’s what I need
Well I need a dollar, dollar
Dollar that’s what I need

Me on Core Finance

 

 

 

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What is driving bond yields these days?

Yesterday brought us an example of how the military dictum of the best place to hide something is to put it in full view has seeped into economics. Let me show you what I mean with this from @LiveSquawk.

HSBC Cuts German 10-Year Bond Yield Forecast To 0.40% By End-2018 From 0.75% Previously, Cites Growth Worries, German Political Tensions Among Reasons – RTRS

Apart from the obvious humour element as these forecasts come and go like tumbleweed on a windy day there is the issue of how low this is. Actually if we move from fantasy forecasts to reality we find an even lower number as the ten-year yield is in fact 0.34% as I type this. This poses an issue to me on a basic level as we have gone through a period of extreme instability and yet this yield implies exactly the reverse.

Another way of looking at this is to apply the metrics that in my past have been used to measure such matters. For example you could look at economic growth.

Economic Growth

The German economy continued to grow also at the beginning of the year, though at a slower pace……. the gross domestic product (GDP) increased 0.3% – upon price, seasonal and calendar adjustment – in the first quarter of 2018 compared with the fourth quarter of 2017. This is the 15th quarter-on-quarter growth in a row, contributing to the longest upswing phase since 1991. Last year, GDP growth rates were higher (+0.7% in the third quarter and +0.6% in the fourth quarter of 2017). ( Destatis)

If we look at the situation we see that the economy is growing so that is not the issue and furthermore it has been growing for a sustained period so that drops out as a cause too. Yes economic growth has slowed but even if you assume that for the year you get ~1.2% and it has been 2.3% over the past year. Thus if you could you would invest any funds you had in an economic growth feature which no doubt the Ivory Towers are packed with! Of course it is not so easy in the real world.

So we move on with an uncomfortable feeling and not just be cause we are abandoning and old metric. There is the issue that we may be missing something. Was the credit crunch such a shock that we have yet to recover? Putting it another way if Forbin’s Rule is right and 2% recorded growth is in fact 0% for the ordinary person things fall back towards being in line.

Inflation

Another route is to use inflation to give us a real yield. This is much more difficult in practice than theory but let us set off.

 The inflation rate in Germany as measured by the consumer price index is expected to be 2.1% in June 2018. ( Destatis)

So on a basic look we have a negative real yield of the order of -1.7% which again implies an expectation of bad news and frankly more than just a recession. Much more awkward is trying to figure out what inflation will be for the next ten years.

This assessment is also broadly reflected in the June 2018 Eurosystem staff macroeconomic projections for the euro area, which foresee annual HICP inflation at 1.7% in 2018, 2019 and 2020.  ( ECB President Draghi)

That still leaves us quite a few years short and after its poor track record who has any faith that the ECB forecast above will be correct? The credit crunch era has been unpredictable in this area too with the exception of asset prices. But barring an oil price shock or the like real yields look set to be heavily negative for some time to come. This was sort of confirmed by Peter Praet of the ECB on Tuesday although central bankers always tell us this right up to and sometimes including the point at which it is obviously ridiculous.

well-anchored, longer-term inflation expectations,

 

The sum of short-term interest-rates

In many ways this seems too good to be true as an explanation as what will short-term interest-rates be in 2024 for example? But actually maybe it is the best answer of all. If like me you believe that President Draghi has no intention at all of raising interest-rates on his watch then we are looking at a -0.4% deposit rate until the autumn of 2019 as a minimum. Here we get a drag on bond yields for the forseeable future and what if there was a recession and another cut?

QE

This has been a large player and with all the recent rumours or as they are called now “sauces” about a European Operation Twist it will continue. For newer readers this involves the ECB slowing and then stopping new purchases but maintaining the existing stock of bonds. As the stock of German Bunds is just under 492 billion Euros that is a tidy sum especially if we note that Germany has been running a fiscal surplus reducing the potential supply. But as Bunds mature the ECB will be along to roll its share of the maturity into new bonds. Whilst it is far from the only  player I do wonder if markets are happy to let it pay an inflated price for its purchases.

Exchange Rate

This is a factor that usually applies to foreign investors. They mostly buy foreign bonds because they think the exchange rate will rise and in the past the wheels were oiled by the yield from the bond. Of course the latter is a moot point in the German bond market as for quite a few years out you pay rather than receive and even ten-years out you get very little.

Another category is where investors pile into perceived safe havens and like London property the German bond market has been one of this. If you are running from a perceived calamity then security really matters and in this instance getting a piece of paper from the German Treasury can be seen as supplying that need. In an irony considering the security aspect this is rather unstable to say the least but in practice it has worked at least so far.

Comment

We find that expectations of short-term interest-rates seem to be the main and at times the only player in town. An example of this has been provided in my country the UK only 30 minutes or so ago.

Britain’s economic strength shows a need for higher interest rates, Mark Carney says. ( Bloomberg)

Mark Carney prepares ground for August interest rate hike from Bank of England with ‘confident’ economic view ( The Independent).

The problem for the unreliable boyfriend who cried wolf is that he was at this game as recently as May and has been consistently doing so since June 2014. Thus we find that with the UK Gilt future unchanged on the day that such jawboning is treated with a yawn and the ten-year yield is 1.28%. If you look at the UK inflation trajectory and performance than remains solidly in negative territory. So the view here is that even if he does do something which would be quite a change after 4 years of hot air he would be as likely to reverse it as do any more.

The theory has some success in the US as well. We have seen rises in the official interest-rate and more seem to be on the way. The intriguing part of the response is that US yields seem to be giving us a cap of around 3% for all of this. Even the reality of the Trump tax cuts and fiscal expansionism does not seem to have changed this.

Is everything based on the short-term now?

As to why this all matters well they are what drive the cost of fixed-rate mortgages and longer term business lending as well as what is costs governments to borrow.

 

 

Trade Wars what are they good for?

This week trade is in the news mostly because of the Donald and his policy of America First. This has involved looking to take jobs back to America which is interesting when apparently the jobs situation is so good.

Our economy is perhaps BETTER than it has ever been. Companies doing really well, and moving back to America, and jobs numbers are the best in 44 years. ( @realDonaldTrump )

This has involved various threats over trade such as the NAFTA agreement primarily with Canada and Mexico and of course who can think of Mexico without mulling the plan to put a bit more than another brick in the wall? Back in March there was the Trans Pacific Partnership or TPP. From Politico.

While President Donald Trump announced steel and aluminum tariffs Thursday, officials from several of the United States’ closest allies were 5,000 miles away in Santiago, Chile, signing a major free-trade deal that the U.S. had negotiated — and then walked away from.

The steel and aluminium tariffs were an attempt to deal with China a subject to which President Trump has returned only recently. From the Financial Times.

Equities sold off and havens firmed on Tuesday after Donald Trump ordered officials to draft plans for tariffs on a further $200bn in Chinese imports should Beijing not abandon plans to retaliate against $50bn in US duties on imports announced last week.

According to the Peterson Institute there has been a shift in the composition of the original US tariff plan for China.

 Overall, 95 percent of the products are intermediate inputs or capital equipment. Relative to the initial list proposed by the Office of the US Trade Representative on April 3, 2018, coverage of intermediate inputs has been expanded considerably ……….Top added products are semiconductors ($3.6 billion) and plastics ($2.2 billion), as well as other intermediate inputs and capital equipment. Semiconductors are found in consumer products used in everyday life such as televisions, personal computers, smartphones, and automobiles.

The reason this is significant is that the world has moved on from even the “just in time” manufacturing model with so many parts be in sourced abroad even in what you might think are domestic products. This means that supply chains are often complex and what seems minor can turn out to be a big deal. After all what use are brakes without brake pads?

Thinking ahead

Whilst currently China is in the sights of President Trump this mornings news from the ECB seems likely to eventually get his attention.

In April 2018 the euro area current account recorded a surplus of €28.4 billion.

Which means this.

The 12-month cumulated current account for the period ending in April 2018 recorded a surplus of €413.7 billion (3.7% of euro area GDP), compared with €361.3 billion (3.3% of euro area GDP) in the 12 months to April 2017.

 

 

So the Euro area has a big current account surplus and it is growing.

This development was due to increases in the surpluses for services (from €46.1 billion to €106.1 billion) and goods (from €347.2 billion to €353.9 billion

There is plenty for the Donald to get his teeth into there and let’s face it the main player here is Germany with its trade surpluses.

Trade what is it good for?

International trade brings a variety of gains. At the simplest level it is access to goods and resources that are unavailable in a particular country. Perhaps the clearest example of that is Japan which has few natural resources and would be able to have little economic activity if it could not import them. That leads to the next part which is the ability to buy better goods and services which if we stick with the Japanese theme was illustrated by the way the UK bought so many of their cars. Of course this has moved on with Japanese manufacturers now making cars in the UK which shows how complex these issues can be.

Also the provision of larger markets will allow some producers to exist at all and will put pressure on them in terms of price and quality. Thus in a nutshell we end up with more and better goods and services. It is on these roads that trade boosts world economic activity and it is generally true that world trade growth exceeds world economic activity of GDP (Gross Domestic Product) growth.

Since the Second World War, the
volume of world merchandise trade
has tended to grow about 1.5 times
faster than world GDP, although in the
1990s it grew more than twice as fast. ( World Trade Organisation)

Although like in so many other areas things are not what they were.

However, in the aftermath of the global
financial crisis the ratio of trade growth
to GDP growth has fallen to around 1:1.

Although last year was a good year for trade according to the WTO.

World merchandise trade
volume grew by 4.7 per
cent in 2017 after just
1.8 per cent growth
in 2016.

How Much?

Trying to specify the gains above is far from easy. In March there was a paper from the NBER which had a go.

About 8 cents out of every dollar spent in the United States is spent on imports………..The estimates of gains from trade for the US economy that we review range from 2 to 8 percent of GDP.

Actually there were further gains too.

When the researchers adjust by the fact that domestic production also uses imported intermediate goods — say, German-made transmissions incorporated into U.S.-made cars — based on data in the World Input-Output Database, they conclude that the U.S. import share is 11.4 percent.

So we move on not enormously the wiser as we note that we know much less than we might wish or like. Along the way we are reminded that whilst the US is an enormous factor in world trade in percentage terms it is a relatively insular economy although that is to some extent driven by how large its economy is in the first place.

Any mention of numbers needs to come with a warning as trade statistics are unreliable and pretty universally wrong. Countries disagree with each other regularly about bilateral trade and the numbers for the growing services sector are woeful.

Comment

This is one of the few economic sectors where theory is on a sound footing when it meets reality. We all benefit in myriad ways from trade as so much in modern life is dependent on it. It has enriched us all. But the story is also nuanced as we do not live in a few trade nirvana, For example countries intervene as highlighted by the World Trade Organisation in its annual report.

Other issues raised by members
included China’s lack of timely and
complete notifications on subsidies
and state-trading enterprises,

That is pretty neutral if we consider the way China has driven prices down in some areas to wipe out much competition leading to control of such markets and higher prices down the road. There were plenty of tariffs and trade barriers long before the Donald became US President. Also Germany locked in a comparative trade advantage for itself when it joined the Euro especially if we use the Swiss Franc as a proxy for how a Deutschmark would have traded ( soared) post credit crunch.

Also there is the issue of where the trade benefits go? As this from NBC highlights there were questions all along about the Trans Pacific Partnership.

These included labor rights rules unions said were toothless, rules that could have delayed generics and lead to higher drug prices, and expanded international copyright protection.

This leads us back to the issue of labour struggling (wages) but capital doing rather well in the QE era. Or in another form how Ireland has had economic success but also grotesquely distorted some forms of economic activity via its membership of the European Union and low and in some cases no corporate taxes. Who would have thought a country would not want to levy taxes on Apple? After all with cash reserves of US $285.1 billion and rising it can pay.

So the rhetoric and actions of the Donald does raise fears of trade wars and if it goes further the competitive devaluations of the 1920s. But it is also true that there are genuine issues at play which get hidden in the melee a bit like Harry Kane after his first goal last night.

 

 

 

 

 

 

Rising inflation trends are putting a squeeze on central banks

Sometimes events have their own natural flow and after noting yesterday that the winds of change in UK inflation are reversing we have been reminded twice already today that the heat is on. First from a land down under where inflation expectations have done this according to Trading Economics.

Inflation Expectations in Australia increased to 4.20 percent in June from 3.70 percent in May of 2018.

This is significant in several respects. Firstly the message is expect higher inflation and if we look at the Reserve Bank of Australia this is the highest number in the series ( since March 2013). Next  if we stay with the RBA it poses clear questions as inflation at 1.9% is below target ( 2.5%) but f these expectations are any guide then an interest-rate of 1.5% seems well behind the curve.

Indeed the RBA is between a rock and a hard place as we observe this from Reuters.

Australia’s central bank governor said on Wednesday the current slowdown in the housing market isn’t a cause for concern but flagged the need for policy to remain at record lows for the foreseeable future with wage growth and inflation still weak.

Home prices across Australia’s major cities have fallen for successive months since late last year as tighter lending standards at banks cooled demand in Sydney and Melbourne – the two biggest markets.

You know something is bad when we are told it is not a concern!

If we move to much cooler Sweden I note this from its statistics authority.

The inflation rate according to the CPI with a fixed interest rate (CPIF) was 2.1 percent in May 2018, up from 1.9 percent in April 2018. The CPIF increased by 0.3 percent from April to May.

So Mission Accomplished!

The Riksbank’s target is to hold inflation in terms of the CPIF around 2 per cent a year.

Yet we find that having hit it and via higher oil prices the pressure being upwards it is doing this.

The Executive Board has therefore decided to hold the repo rate unchanged at −0.50 per cent and assesses that the rate will begin to be raised towards the end of the year, which is somewhat later than previously forecast.

Care is needed here as you see the Riksbank has been forecasting an interest-rate rise for some years now but like the Unreliable Boyfriend somehow it keeps forgetting to actually do it.

I keep forgettin’ things will never be the same again
I keep forgettin’ how you made that so clear
I keep forgettin’ ( Michael McDonald )

Anyway it is a case of watch this space as even they have real food for thought right now as they face the situation below with negative interest-rates.

Economic activity in Sweden is still strong and inflation has been close to the target for the past year.

US Inflation

The situation here is part of an increasingly familiar trend.

The all items index rose 2.8 percent for the 12 months ending May, continuing its upward trend since the beginning of the year. The index for all items less food and
energy rose 2.2 percent for the 12 months ending May. The food index increased 1.2 percent, and the energy index rose 11.7 percent.

This was repeated at an earlier stage in the inflation cycle as we found out yesterday.

On an unadjusted basis, the final demand index moved up
3.1 percent for the 12 months ended in May, the largest 12-month increase since climbing 3.1 percent in January 2012.

In May, 60 percent of the rise in the index for final demand is attributable to a 1.0-percent advance in prices for final demand goods.

A little care is needed as the US Federal Reserve targets inflation based on PCE or Personal Consumption Expenditures which you may not be surprised to read is usually lower ( circa 0.4%) than CPI. We do not know what it was for May yet but using my rule of thumb it will be on its way from the 2% in April to maybe 2.4%.

What does the Federal Reserve make of this?

Well this best from yesterday evening is clear.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1-3/4 to 2 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.

If we start with that let me give you a different definition of accommodative which is an interest-rate below the expected inflation rate. Of course that is off the scale in Sweden and perhaps Australia. Next we see a reference to “strong labo(u)r market conditions” which only adds to this. Putting it another way “strong” replaced “moderate” as its view on economic activity.

This is how the New York Times viewed matters.

The Federal Reserve raised interest rates on Wednesday and signaled that two additional increases were on the way this year, as officials expressed confidence that the United States economy was strong enough for borrowing costs to rise without choking off economic growth.

Care is needed about borrowing costs as bond yields ignored the move but of course some may pay more. Also we have seen a sort of lost decade in interest-rate terms.

The last time the rate topped 2 percent was in late summer 2008, when the economy was contracting and the Fed was cutting rates toward zero, where they would remain for years after the financial crisis.

Yet there is a clear gap between rhetoric and reality on one area at least as here is the Fed Chair.

The decision you see today is another sign that the U.S. economy is in great shape,” Mr. Powell said after the Fed’s two-day policy meeting. “Most people who want to find jobs are finding them.”

Yet I note this too.

At a comparable time of low unemployment, in 2000, “wages were growing at near 4 percent year over year and the Fed’s preferred measure of inflation was 2.5 percent,” both above today’s levels, Tara Sinclair, a senior fellow at the Indeed Hiring Lab, said in a research note.

So inflation is either there or near but can anyone realistically say that about wages?

Mr. Powell played down concerns about slow wage growth, acknowledging it is “a bit of a puzzle” but suggesting that it would normalize as the economy continued to strengthen.

What is normal now please Mr.Powell?

Comment

One of my earliest themes was that central banks would struggle when it comes to reducing all the stimulus because they would be terrified if it caused a slow down. A bit like the ECB moved around 2011 then did a U-Turn. What I did not know then was that the scale of their operations would increase dramatically exacerbating the problem. To be fair to the US Federal Reserve it is attempting the move albeit it would be better to take larger earlier steps in my opinion as opposed to this drip-feed of minor ones.

In some ways the US Federal Reserve is the worlds central bank ( via the role of the US Dollar as the reserve currency) and takes the world with it. But there have been changes here as for example the Bank of England used to move in concert with it in terms of trends if not exact amounts. But these days the Unreliable Boyfriend who is Governor of the Bank of England thinks he knows better than that and continues to dangle future rises like a carrot in front of the reality of a 0.5% Bank Rate.

This afternoon will maybe tell us a little more about Euro area monetary policy. Mario Draghi and the ECB have given Forward Guidance about the end of monthly QE via various hints. But that now faces the reality of a Euro area fading of economic growth. So Mario may be yet another central bank Governor who cannot wait for his term of office to end.

 

 

Are interest-rates on the rise now?

As we find ourselves heading into the second decade of the credit crunch era we find ourselves observing an interest-rate environment that few expected when it began. At the time the interest-rate cuts ( for example circa 4% in the UK) were considered extraordinary but the Ivory Towers would have been confident. After all they had been busy telling us that the lower bound for interest-rates was 0% and many were nearly there. Sadly for the Ivory Towers the walls then came tumbling down as Denmark, the Euro area , Sweden, Switzerland and Japan all entered the world of negative official interest-rates.

Even that was not enough for some and central banks also entered into sovereign and then other bond purchases to basically reduce the other interest-rates or yields they could find. Such QE ( Quantitative Easing) purchases reduced sovereign bond yields and debt costs which made politicians very happy especially when they like some official interest-rates went negative. When that did not work either we saw what became called credit easing where direct efforts went into reducing specific interest-rates, In the UK this was called the Funding for Lending Scheme which was supposed to reduce the cost of business lending but somehow found that  instead in the manner of the Infinite Improbability Drive in the Hitchhikers Guide to the Galaxy  it reduced mortgage interest-rates initially by around 1% when I checked them and later the Bank of England claimed that some fell by 2%.

What next?

Yesterday brought a reminder that not everywhere is like this so let me hand you over to the Reserve Bank of India.

On the basis of an assessment of the current and evolving macroeconomic situation at its
meeting today, the Monetary Policy Committee (MPC) decided to:
• increase the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis
points to 6.25 per cent.
Consequently, the reverse repo rate under the LAF stands adjusted to 6.0 per cent, and the
marginal standing facility (MSF) rate and the Bank Rate to 6.50 per cent.

There are two clear differences with life in Europe and the first is a rise in interest-rates with the second being that interest-rates are at or above 6% in India. It feels like another universe rather than being on the sub-continent but it does cover some 1.3 billion people. Sometimes we over emphasise the importance of Europe. As to why it raised interest-rates the RBI feels that the economy is going well and that inflation expectations are rising as domestic inflation ( official rents) has risen as well as the oil price.

The US

This has moved away from zero interest-rates and now we face this.

to maintain the federal funds rate in a target range of
1½ to 1¾ percent

It seems set to raise interest-rates again next week by another 0.25% which has provoked Reuters to tell us this.

With inflation still tame, policymakers are aiming for a “neutral” rate that neither slows nor speeds economic growth. But estimates of neutral are imprecise, and as interest rates top inflation and enter positive “real” territory, analysts feel the Fed is at higher risk of going too far and actually crimping the recovery.

Personally I think that they do not understand real interest-rates which are forwards looking. So rather than last months print you should look forwards and if you do then there are factors which look likely to drive it higher. The most obvious is the price of crude oil which if we look at the West Texas Intermediate benchmark is at US $65 per barrel around 35% higher than a year ago. But last month housing or what the US callers shelter inflation was strong too so there seems to be upwards pressure that might make you use more like 2.5% as your inflation forecast for real interest-rates. So on that basis there is scope for several more 0.25% rises before real interest-rates become positive.

One point to make clear is that the US has two different measures of inflation you might use. I have used the one that has the widest publicity or CPI Urban ( yep if you live in the country you get ignored…) but the US Federal Reserve uses one based on Personal Consumption Expenditures or PCE. The latter does not have a fixed relationship with the former but it usually around 0.4% lower. Please do not shoot the piano player as Elton John reminded us.

If we move to bond yields the picture is a little different. The ten-year seems to have settled around 3% or so ( 2.99% as I type this) giving us an estimated cap for official interest-rates. Of course the picture is made more complex by the advent of Quantitative Tightening albeit it is so far on a relatively minor scale.

The Euro area

Here we are finding that the official line has changed as we await next week’s ECB meeting. From Reuters.

Money market investors are now pricing in a roughly 90 percent chance that the European Central Bank will raise interest rates in July 2019, following hawkish comments from the bank’s chief economist on Wednesday.

In terms of language markets are responding to this from Peter Praet yesterday.

Signals showing the convergence of inflation towards our aim have been improving, and both the underlying strength in the euro area economy and the fact that such strength is increasingly affecting wage formation supports our confidence that inflation will reach a level of below, but close to, 2% over the medium term.

For newer readers he is saying that in ECB terms nirvana is near and so it will then reduce policy accommodation which is taken to mean ending monthly QE and then after a delay raising interest-rates.

So it could be a present from Mario Draghi to his successor or of course if he fails to find the switch a job he could pass on without ever raising interest-rates in his eight years as President.

Comment

Before I give my opinion let me give you a deeper perspective on what has been in some cases all in others some of our lives.

Since 1980, long-term interest rates have declined by about 860 basis points in the United States, 790 basis points in Germany and more than 1,200 basis points in France. ( Peter Praet yesterday)

On this scale even the interest-rate rises likely in the United States seem rather small potatoes. But to answer the question in my title I am expecting them to reach 2% and probably pass it. Once we move to Europe the picture gets more complex as I note this from the speech of Peter Praet.

the underlying strength in the euro area economy

This is not what it was as we observe the 0.4% quarterly growth rate in Euro area GDP confirmed this morning or the monthly and annual fall in manufacturing orders for Germany in April. Looking ahead we know that narrow money growth has also been weakening. Thus the forecasts for an interest-rate rise next June seem to be a bit like the ones for the UK this May to me.

Looking at the UK I expect that whilst Mark Carney is Bank of England Governor we will be always expecting rises which turn out to be a mirage. Unless of course something happens to force his hand.

On a longer perspective I do think the winds of change are blowing in favour of higher interest-rates but it will take time as central bankers have really over committed the other way and are terrified of raising and then seeing an economic slow down. That would run the risk of looking like an Emperor or Empress with no clothes.

 

 

 

 

Is there a shortage of US Dollars and if so why?

At the moment we are seeing quite a few trends combined which look as though they are returning us to a position where there is a shortage of US Dollars. This is troubling as this was an issue in the genesis of the credit crunch as back then it affected banks and particularly European and Japanese ones. It seems odd as the foreign exchange market is very liquid but maybe it is not liquid enough or at least at the right price. Back in March Pictet Bank provided something of an explainer.

The problem is a spike in the differential between LIBOR and the Overnight Index Swap, or the premium over the risk-free rate non-US banks pay to borrow dollars outside of the US.

The spread has risen to 42 basis points, the highest since February 2012, and up from 25 basis points at the start of last month and just 10 basis points in November.

While the rise does not pose a systemic risk, it has nevertheless raised the cost, and reduced the availability, of dollar-denominated loans for non-US banks by a considerable margin and in short space of time.

It is pretty much back to that level (43) after going above 60 and just for clarity that is 0.6%. Here is the first lesson  of this saga in that in our present world some interest-rates do not seem to have much impact at all as for example I did warn on the third of this month that a rise in Argentinian ones would backfire. Some 9.75% higher later I guess my point has been made for me. However here we have a 0.6% or so at the peak looks in terms of Carly Rae Jepson that it “really,really,really,really” matters. This appears to be driven by two factors the first is that it affects the “precious” otherwise known as the banks and is in US Dollars. Of course the official story is rather different as the excerpt below from the May Inflation Report of the Bank of England shows.

In the years following the crisis, funding spreads narrowed as banks repaired their balance sheets and became more resilient.

I am resilient, we are resilient , it has unexpectedly collapsed ….

US Dollar

This has been a factor as we note that recently the US Dollar has been what we might call King Dollar again. If we use the US Dollar Index or DXY for this we see that it has rallied four points since mid April from over 89 to over 93 now. The bigger turn came at the opening of June 2014 when it has dipped below 80. So the price of the US Dollar has risen too over this phase. Whilst the DXY is now out of date in trade terms as for example the Chinese Yuan is missing it does a job for this sort of analysis as the Yen and Euro are there.

US Interest-Rates and Yields

This has been a case of singing along with Jackie Wilson.

You know your love (your love keeps lifting me)
Keep on lifting (love keeps lifting me)
Higher (lifting me)
Higher and higher (higher

The US Federal Reserve has increased its official interest-rate to between 1.5% and 1.75% and nearly as importantly has been raising the rhetoric about there being more (3/4) increases this year. I am not convinced by this but if we look around markets seem to be accepting it perhaps on the grounds that unlike other central banks the Fed has at least been reasonably consistent.

Also there have been rises in bond yields with the media concentrating on 3% for the ten-year Treasury Note and then 3.1%. But for this purpose more significant is what has taken place at the shorter maturities. The chart below gives us a handle on what has been taking place there.

Let me be clear here this is a financial markets thing rather than a real economy thing but these do have a way of leaking across and tripping up the unwary. Adding to this we are seeing real world effects too as I note this from Reuters.

Interest rates on U.S. 30-year fixed-rate mortgages rose to the highest in seven years as a bond market selloff this week propelled 10-year yields to the highest since July 2011, Freddie Mac said on Thursday………Thirty-year mortgage rates averaged 4.61 percent in the week ended May 17, matching the level last seen in May 2011.

Of course they affect the banks from another route.

Quantitative Tightening

One way that the supply of US Dollars is being reduced is quite basic as the US Federal Reserve has set out to do that explicitly. From a balance sheet which just passed US $ 4.5 Trillion we now see that it has fallen to US $4.36 trillion which put like that may not seem a lot but that is US $140 billion or so. The pace is also picking up a bit so in terms of narrow money or what central bankers have loved to call “high-powered money” there is less of it to go around from this source at any rate.

Crude Oil

This too seems to have been a factor in the recent moves and there is some logic to this as of course the vast majority of oil business is settled in US Dollars. Not all of it anymore but a large proportion. Thus the rise in the price exemplified by the fact that the price of a barrel of Brent Crude Oil is now just below US $80 or some 52% over the past year has also sucked US Dollars out of the system. This is my view is of course mostly a timing thing as the oil producers will then spend them as for example one of the ways the money gets recycled is by the Gulf States buying weapons but we know that timing matters in the credit crunch era. Supposedly because we are more resilient as I look up that particular page in my financial lexicon for these times.

There are many views on this but here is one from a social media exchange I was involved in.

My thesis is the $/oil correlation is a consequence of oil market design/paradigm shift. This began 1st July 2017 & completed a couple of months ago. ie the dollar is now on an If I’m right, when (not if) oil falls the $ will fall with it ( @cjenscook )

Comment

Let us now look at it the other way from the point of view of the central bankers. Let me take you to the US Federal Reserve website where with something of a fanfare it declared this back in the day.

In May 2010, the FOMC announced that in response to the re-emergence of strains in short-term U.S. dollar funding markets it had authorized dollar liquidity swap lines with the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank.

They had been gone for all of three months and were supposed to go as my emphasis below returns us again to my financial lexicon for these times.

 In October 2013, the Federal Reserve and these central banks announced that their existing temporary liquidity swap arrangements–including the dollar liquidity swap lines–would be converted to standing arrangements that will remain in place until further notice.

Very little is being used right now as one European bank has taken 80 million US Dollars worth in revolving 6 day credit or there are more than one. But this reminds me of the old wartime analogy of President FD. Roosevelt and loaning your neighbour a hose in case he has a fire. Meanwhile the emerging markets have started to be called the submerging ones.

What are the prospects for the US economy?

As we progress through 2018 we find eyes as ever turning regularly to the US economy. Not only to see what the world’s largest economy is up to but also to note any changes. The economic growth news for the first quarter was pretty solid. From the Bureau of Economic Analysis or BEA.

Real gross domestic product (GDP) increased at an annual rate of 2.3 percent in the first quarter of 2018
according to the “advance” estimate released by the Bureau of Economic Analysis. In the
fourth quarter, real GDP increased 2.9 percent.

So whilst we see a slowing it is exacerbated in feel by the way the numbers are annualised and is much lower than that seen in the UK and much of Europe. Also the US has developed something of a pattern of weak first quarter numbers so we need to remind ourselves that the number is better than that seen in both 2016 and 2017. As to the detail the slowing was fairly general. If we were looking for an estimate of the recovery since the credit crunch hit then we get it from noting that if we use 2009 as out 100 benchmark then the latest quarter was at 120.58.

Let us move on with a reminder of the size of the US economy.

Current-dollar GDP increased 4.3 percent, or $211.2 billion, in the first quarter to a level of $19.97
trillion.

Looking ahead

There was something potentially rather positive tucked away in the Income report that was released with the GDP data.

Disposable personal income increased $222.1 billion, or 6.2 percent, in the first quarter, compared with
an increase of $136.3 billion, or 3.8 percent, in the fourth quarter. Real disposable personal income
increased 3.4 percent, compared with an increase of 1.1 percent.

At a time of weak wages growth considering the economic situation that was a strong reading which may feed forwards into future consumption numbers. I wondered what drove it but in fact it was pretty broad-based across the different sectors with the only fall being in farm income. As an aside the personal income from farming was surprisingly small considering the size of the US farming sector at US $27.9 billion.

Moving onto the Nowcasts of GDP the news has also been good. From the Atlanta Federal Reserve.

The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2018 is 4.0 percent on May 3, down from 4.1 percent on May 1.

They start the series in optimistic fashion so let us say that around 3% may well be where they end up unless something fundamental changes.

Moving onto the business surveys we saw this yesterday.

April survey data indicated a strong expansion in
business activity across the U.S. service sector.
However, although the rate of growth accelerated, it
remained below the series’ long-run average.
Meanwhile, the upturn in new business quickened
to a sharp rate that was the fastest since March
2015. ( Markit PMI ).

Which added to this from May Day.

April survey data signalled a steep improvement in
operating conditions across the U.S. manufacturing
sector. The latest PMI reading was the highest since
September 2014, supported by stronger expansions
in output and new orders. Moreover, new business
rose at the sharpest pace in over three-and-a-half
years. ( Markit PMI)

Thus the summary for the start of the second quarter is so far so good which again means the US is in better shape than elsewhere at least for now.

Inflation

Earlier this week I note that the US Federal Reserve was for once on target. What I mean by that was that the PCE ( Personal Consumption Expenditure) inflation rate rose by 2% in March compared to a year before. Expectations of this are what caused the addition of the word I have highlighted in Wednesday’s Fed statement.

The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.

There has been a lot of debate over this much of it misinformed. Firstly central bankers virtually never mean it and secondly they are hinting at a possible run higher after a long period when it has been below the 2% target.

Such a likelihood was reinforced by the Markit PMI surveys.

On the price front, input cost inflation picked up in
April. The rate of increase was strong overall and
the second-quickest since June 2015. (services)

Meanwhile, average prices charged rose at the
quickest pace since June 2011, with the rate of
inflation accelerating for the fourth successive
month. Survey respondents commonly noted that
higher charges were due to increased costs being
passed on to clients. (Manufacturing)

Of course having begun the process of raising interest-rates without the most common cause of it these days ( a currency collapse) the US Fed is not in that bad a place at least in its own mind should inflation overshoot the target in the summer. Although of course as I have pointed out before in terms of logic it should have been more decisive rather than dribbling out increases along the lines expected for the rest of 2018 by Reuters.

While the Fed left interest rates unchanged on Wednesday, it is possibly set to raise them by a total of 75 basis points this year.

King Dollar

This was summarised by Reuters thus.

In just two weeks the dollar has surged nearly four percent against a basket of the most traded currencies, erasing all the losses it had suffered since the start of 2018 .DXY.

Against a broader group of currencies, including those from emerging markets, the greenback is now in positive territory against half of them.

This brings us back to the topic of yesterday where the US Dollar rebound has hit the weaker currencies such as the Turkish Lira and the Argentine Peso hard. Following on from the change of heart of the unreliable boyfriend in the UK it has seen the UK Pound £ dip below US $1.36 and the Euro is below US $1.20.

Is this a return to the interest-rate differentials that had up to then been ignored? Maybe a bit but perhaps the reality is more that the modern currency trade seems to be to follow the economic growth and as we have observed above at the moment the US economy looks relatively strong.

Comment

So in terms of conventional economic analysis things look pretty good for the US economy as we stand. The danger might be highlighted this afternoon from the wages data in the non farm payrolls release. This is because rising inflation will chip away at real wages if the rate of wages increase stays at 2.7%. Of course that reminds us of the issue of the fact that wages growth is only at that level with an unemployment rate at 4% leading many economists to scrabble through Google searches trying to redact references to full employment at a higher rate.

Elsewhere there are potential concerns of which one is debt. Should growth continue on its current path then it will help the national debt withstand the pressure placed on it by the Trump tax plan. On the private-sector side though familiar fears are on the scene.

 

Yahoo Finance helpfully updates us with this.

They’re also safer than junk bonds, at least in theory, with lenders getting repaid before creditors when firms get into trouble

What could go wrong?

Finally in spite of the recent dollar strength the Yen has pushed its way back to 109 leaving me with this from Carly Simon.

Why does your love hurt so much?
Don’t know why