USD supported by robust growth and hawkish Fed, but damaged by trade war

Outlook:

The finance and central bank chiefs are holding their G7 meeting in Canada ahead of the head of state meeting on June 8-9. French Pres Macron is already there. Canada has a really nice G7 website this time So far it’s avoiding any mention of the trade war, but pity US TreasSec Mnuchin, who is being assaulted from all sides over the US tariffs. The rest of G7 is really very angry and starting to punch.

On the whole, G7 can be counted on for bland statements of support for motherhood and apple pie, but every once in a while, G7 delivers a bombshell. One was the Japanese FinMin interruption his trip home in Guam to deliver an apology after saying at G7 that the US should watch out for treating Japan so badly over auto exports—Japan could pull its reserves from the dollar. That was in the 1990’s. Another incident was then TreasSec Snow demanding China stop manipulating its currency to remain export-friendly. And China acted a few months later to move from a fixed rate to a dirty float.

At G7 last year, the members reluctantly went along with the US demand that reference to support for free trade be removed. They may not be so craven this time. A big, fat explosion would be nice, and useful. The problem is that Trump doesn’t care what people say about him as long as they are talking about Him. This is going to get worse before it gets better.

On the domestic economy front, everyone awaits payrolls this morning, forecast at 190,000 but whispers of a shortfall. We have already reached full employment, at least the way the Fed counts it, so jobs really should be taking the back seat. The important component is wage growth, and again nothing special is expected, probably the same 2.6% as last month.

More important to the rate outlook is inflation. It’s amazing how quickly the PCE deflator left the headlines. Economists tell us that’s what the Fed watches, so we should, too. And yet the data doesn’t make the front page of the Wall Street Journal… The data do, in fact, support an aggressive Fed stance. The headline deflator is at a 2.1% pace and core PCE at 2.3% over the past three months, beating the 2% target.

Here’s the important thing: consumer spending rose 3.4% in Q2 from 3.2% in Q1. The Atlanta Fed takes that bit, plus the inventory adjustments and other data, to come up with a Q2 GDP forecast of 4.7%. Great balls of fire! See the chart. Most forecasts are looking at 2-3% and the Atlanta Fed is getting near 5% (as the Trumpies like Kudlow are predicting)? This is shocking, and if the Atlanta Fed is right, pushes the number of Fed rate hikes this year to four, despite relatively dovish-seeming comments from Fed Brainerd.  

The FX market can change sentiment like lightening—witness the CAD over the past two days. The dollar is supported by the prospect of robust growth and a hawkish Fed, but gets knocked down by thoughts of how damaging the trade war can turn out to be for the economy and negative knock-on effects seeping into every nook and cranny. For the moment, the Fed feels more immediate and likely to remain the key driver. In other words, we see a dollar recovery, a terrible thing to say when the US is the source of turmoil.

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