Highlights in the Week Ahead

Three events that will capture the market's attention next week:  The consequences of the Japanese election, the first look at US Q1 GDP, and the ECB meeting.  The central banks of Turkey and Russia also meet. Both are expected to cut interest rates, following rate cuts in the middle of last week by South Korea, Indonesia, and South Africa.  

Japan goes to the polls on July 21 to elect the upper chamber of the Diet.  There is little doubt that the LDP-Komeito coalition will retain its majority.  The real issue is whether it keeps its 2/3 super-majority, which allows it to pursue constitutional changes.  The economy itself is struggling, and the sales tax increase in October is unpopular.  In addition, news of a (~JPY20 mln or $185k) gap between pension payouts and the cost of a 30-year retirement is seen as due to longevity more than low returns savings but does not sit well in either case.  The opposition is weak and divided, and there is much pride attached to hosting the Rugby World Cup in September and the Olympics next year.  

The recent Tankan Survey showed sentiment among large manufacturers stood at three-year lows at the end of June.  The government reported a larger than expected year-over-year decline in exports--for the seventh consecutive month. The Bank of Japan has reduced its bond purchases with little fanfare, while its equity purchases dominate the ETF space.  There is no exit strategy in sight.  Indeed, it seems more likely that it steps up its JGB purchases again if the government debt finances a supplemental budget to blunt the effect of the sales tax increase.  Before the weekend, Japan reported that its core measure of CPI, which excludes fresh food, fell to 0.5% in June, a two-year low.  

Regardless of the results of the election, just getting it over will impact the agenda.  The US-Japanese trade talks will turn more serious.  At first, the US seemed to want a comprehensive agreement, but now it appears it wants to show positive results.   Due to Japanese trade agreements under the TPP and the EU, US farmers are at a commercial disadvantage.  It has not been clear what Japan wants in exchange, but some have suggested reduced tariffs on auto parts.  Abe interest is projecting Japan's power dovetails with Trump's push that greater burden-sharing, including protecting oil tankers in the Gulf.  

Perhaps with the election behind him, Prime Minister Abe will be in a better position to have a rapprochement with South Korea.  The issue has been escalating since Moon Jae-in took office in 2017 and distanced his administration from the 2015 agreement about Japan's apology and compensation.  At the start of this year, Korea's high court allowed the seizure of the assets of a Japanese corporation for compensation for forced labor.   

The shape of Abe's response, a licensing process for South Korea companies who buy semiconductor and display materials from Japan on national security grounds, may have been influenced by the US precedent.  In fact, it was likely that the US was notified beforehand.  Although the US helped broker earlier agreements between its two allies, like one in 1965, the US has shown little interest in mediating.  Abe could still ratchet the pressure up a notch as early as next month by removing South Korea from its list of countries with privileged access to Japan's exports.  This would broaden Japan's impact and notably include auto parts.  

II

The ECB meets on July 25.  The debate about the need to ease policy has been settled.  The ECB will ease, and the main issue is when.  The indicative pricing in the derivatives market suggests the market is nearly evenly divided on whether rates will be cut this week or the next meeting in September.  Either way, the outcome will surprise the market, and headline risk runs high.  

The difference between now and two months is a tactical issue, the strategic decision has been made.  Procedurally, the ECB can use some word cues in its forward guidance.  It could, for example, re-insert the phrase around its commitment to "keep rates low or lower."   Investors would recognize it as a tell that a rate cut would be delivered in September when updated staff forecasts are delivered.   

On the other hand, in the past, the ECB has been criticized for being slow out the gate. The ECB chief economist Lane made the case recently a move sooner rather than a later and for more than less.  When the ECB does move, it is likely to be on several fronts:  forward guidance, rates, and a resumption of asset purchases.  A modification of its self-imposed position limits may be necessary, which also could justify a delay until September.  

Some have raised the prospect that if the euro sells off in response to the ECB meeting, the US could intervene in the foreign exchange market.  Although the media and analysts continue to talk about it, and Treasury Secretary Mnuchin's comments that the dollar policy is unchanged "for now" stir the pot, the risk of intervention is negligible.  It is a step that is much higher up the escalation ladder.  When Trump threatens the use of military might or ostentatiously displays the US military might it does not make war more or less likely.  The same is true of a currency war, which some believe Trump has threatened with tweets earlier this month.

To be sure, it seems most likely that tensions between the US and Europe rise in the coming months.  There are many potential flashpoints:  trade, defense spending, the German gas pipeline with Russia, and Macron's proposed tax on large digital companies (read American).  The Atlantic Alliance also seems split over Iran, how to regard Huawei, and more broadly, how to relate with China.  Half of the EU countries have signed memorandums of understanding with China and its Belt Road Initiative. 

The ECB is also aware of another exogenous risk, a disorderly Brexit.  Even though Parliament is throwing some legislative hurdles in the way, the market continues to perceive the risk of "prorogation,"" or the dissolution of parliament, which the Prime Minister formally asks the Queen to grant.  The UK will have a new Prime Minister shortly (July 23).  The confrontation between the UK and EC has enjoyed a bit of a hiatus as the UK Tories worked out this family squabble.  The EC may have held back some inducements with May. EC negotiator Barnier is open to redrafting the political declaration on future ties. However, an escalation of tensions with the new government seems unavoidable. At the same time, the clash of wills between the Prime Minister and Parliament will continue, and a new UK election seems more likely than a no-deal Brexit at this juncture.

III

The US reports its first estimate of Q2 GDP on July 26.  Most economists anticipate that an annualized pace of 1.5%-1.8% after 3.1% in Q1.  The Federal Reserve collectively sees trend growth, or the non-inflationary pace to be around 1.9%.  At the beginning of the expansion, it has estimated the central tendency to be near 2.65%.  The price deflator may have doubled to 1.8%, and the core measure is likely to have risen from 1.2% rate seen in the first part of the year.

The market impact may be minor and primarily limited to the headline effect.  What the Fed decides to do at the July 30-31 meeting is not so much a function of Q2 GDP.  It is not really based on the current data, and as the Fed's Clarida explained, one needs to move before the data turns down.  NY Fed's Williams call for swift, preemptive action when necessary also helped depress the implied yield of the August fed funds futures to a new contract low below 2% before rebounding a bit ahead of the weekend and after the NY Fed suggested Williams comments were misinterpreted.

The market was eager to believe the Fed was going to cut 50 bp in one move that it seemed to willfully confuse the seeming assurances of the timing with the magnitude of the move.  At one point, the fed funds futures market was pricing in around a 70% chance of a 50 bp cut.  The pendulum of sentiment began swinging back, but it still finished the week better than a one-in-five chance of a 50 bp cut.

The position that the non-voter Minneapolis Fed President advocated a couple weeks ago, to cut rates by 50 bp was a minority view then and remains so now. The only voting member to favor a rate cut in June, St. Loius Fed Bullard has articulated a clear preference for two quarter-point moves.  By leaning over its skis, so to speak, the market showed its bias--it wants to believe in lower rates, higher stocks, higher gold, and a weaker dollar.

Judging from the June job creation, core retail sales, and manufacturing, the economy ended the quarter upbeat.  The early survey data for July have shown the momentum has picked up.  The Empire State manufacturing index rose twice as much as expected, and the Philadelphia Fed survey jumped to 21.8 from 0.3.  It was the biggest rise in a decade and four times more than expected.  

The Fed has identified the problem as one of uncertainty.  We remain unpersuaded that a 25 or even a 50 bp move offsets the uncertainty stemming from US trade policy, the partly related slowing of the world economy, Brexit, or the approaching debt ceiling.  We are not convinced that a rate cut will be transmitted to the household sector via lower debt servicing costs.  The main obstacle to stronger business investment does not appear to be high-interest rates, so it seems a bit dubious that a rate cut now would boost it.

However, the channel in which a rate cut could be important is as a signal of a lower neutral reading.  The Fed's forecast of the long-term rate of fed funds has gradually been reduced but 2.5% the median dot is still too high.  The implication is that the monetary setting may be tighter than commonly understood.  Officials may be reluctant for practical and ideological reasons to put the equilibrium level below the current inflation target but in the world of surplus capital that we argue characterizes the modern era, that is where it might ultimately lie.  That said, the Fed is reviewing its policy framework and its findings are expected in the first part of next year.

IV

South Korea, Indonesia, and South Africa cut rates last week.  Among emerging markets, the focus shifts to Turkey (July 25) and Russia (July 26).  Colombia and Hungary central banks also meet but are not likely to move.

It is the first meeting of the Turkish central bank since the governor was dismissed.  There is no doubt that a rate cut will be delivered.  The issue is the magnitude.  The median forecast in the Bloomberg survey, with 27 respondents is for a 200 bp cut in the one-week repo rate to 22%.  The average estimate was for a deeper cut to 21.6%.  Turkey's inflation has fallen much quicker than rates, and this does appear to give the central bank scope to cut.  The year-over-year increase in consumer prices peaked last October near 25.25%.  In June it stood at 15.72%.   Before the weekend, the central bank's survey of inflation expectations over the next 12 months fell to 13.90% from nearly 16.5% at the end of last year.

Russia's central bank meets and is also poised to cut the key rate, which stands at 7.50%.  Real rates are a headwind on the economy, and in June, both the manufacturing and service PMI readings were below the 50 boom/bust level.  Price pressures appear to have peaked in the spring near 5.3% and in June stood at 4.7% year-over-year.  Rates were cut by 25 bp in June.   Another one or two more rate cuts this year are possible barring new shocks.

Three emerging market central banks (South Korea, Indonesia, and South Africa) cut rates on July 18 and all three currencies rose, even before the dollar was sold on Clarida and Williams comments. Turkey and Russia may not be as fortunate.  The dollar is near three-month lows against the lira (~TRY5.60) with aggressive Fed easing priced in as well.  The dollar has traded above TRY5.80 once this month, and that provides proximate cap.

The dollar recorded the lows for the year in June against the Rusian rouble near RUB62.50, and the recovery bounce took it back to RUB64.00, which is now acting likely resistance.  The greenback spent most of the mid- March-mid-June period between RUB64-RUB65.70.  Note that the correlation between the percent change in the exchange rate and the percent change in the price of oil is most inversely correlated (-0.61) on a rolling 60-day basis.  It is the most in three years.