- Leading indicators are still showing that the pressure on core inflation in the US remains firm for the next 12 to 24 months to come.
- Hence, US policymakers focused on the labour market and inflation should consider either keeping rates steady or continuing their tightening cycle.
- However, two other main factors are suggesting a different story, which are the persistence of global uncertainty and the dynamics of the Fed Funds rate.
- We think that a 25bps cut at the July meeting remains the favourable scenario.
- USD, gold and Japanese yen are the assets to hold ahead of the FOMC meeting on July 31st.
Even though market measures of inflation expectations such as the 5Y5Y inflation swap have been dropping in recent months, suggesting that the US is experiencing a disinflationary phase and pushing the Fed to act as soon as possible, leading indicators are still showing that the pressure on core inflation remains firm for the next 12 to 24 months to come. For instance, figure 1 shows that the NY Fed's underlying inflation gauge (UIG) measure and the NFIB surveys are pricing in a higher core inflation within the next 12 to 16 months.
Two other popular indicators we like to watch are the annual change in the unit labour costs and the M2 velocity, which are also showing firm pressure on prices within the next two years. The velocity of money, which is defined as the frequency at which one unit of currency is used to purchased domestically produced goods and services within a given time period, bottomed in the middle of 2017 and has started to increase again in recent quarters.
In addition, the labour shortage in low-skill workers, which is about to migrate to high-skill workers in the quarters to come, will add wage growth pressure in more industries. At the moment, more than 30% of industries are experiencing a wage inflation higher than 5% according to intertemporal economics; a trend that could persist in the medium term. Hence, US policymakers focused on the labour market and inflation should consider either keeping rates steady or continuing their tightening cycle.
However, two other main factors are suggesting a different story, which are the persistence of global uncertainty and the dynamics of the Fed Funds rate.
1. Global uncertainty is hurting growth
First, we have noticed the strong divergence between price volatility (VIX) and uncertainty, also known as fundamental volatility, in recent years. Figure 3 (left frame) shows that the Economic Policy Uncertainty (EPU) index, a measure of uncertainty based on newspaper coverage frequency developed byBaker, Bloom and Davis (2016), has been pricing in higher volatility. We can notice that the EPU index has been on the rise in the past two months, almost back to new all-time highs. Figure 3 (right frame) shows another interesting relationship between the VIX and the Japanese yen/Korean won (JPYKRW) exchange rate. As Russell Clark from Horseman pointed out in a recent note; in a bull market, Japanese investors are often attracted to South Korean assets as they offer higher rates, which tends to gradually strengthen the KRW. However, when risk-off rises, the yen appreciates drastically as Japanese investors bring capital home. As the EPU index, the JPYKRW exchange rate is currently pricing in higher volatility.
We saw previously that higher uncertainty matters as it can have significant consequences for the economy. For instance, rising uncertainty tend to reduce business investment as companies delay projects and prefer to "wait and see". Figure 4 shows the negative relationship between uncertainty and business investment in the UK using a firm-specific approach (Melolinna et al. (2018), left frame) and using a macroeconomic approach (Smietanka et al. (2018), right frame).
In a recent study,Ahir et al. (2019) found that the increase in uncertainty observed in the first quarter could be enough to "knock up" to 0.5% of global growth in 2019. Uncertainty is rising around the world, either in advanced economies (i.e. Brexit) or emerging and low-income countries (i.e. key policies in South Africa), affecting a variety of sectors in the economy. Figure 5 shows the World Uncertainty Index times series since 1996; we can notice the sudden rise in the past few quarters mostly related to Brexit and US trade policy. We are now standing very close to the 2012 levels, when the Euro area was hit by the sovereign debt crisis. Hence, in reaction to the elevated uncertainty which is constantly lowering growth expectations, US policymakers should cut rates to counter that negative force.
Source: Ahir et al. (2019)
2. Oversupply of US Treasuries?
It is important to know that in the past couple of years, the main buyers of US Treasuries have switched from the global public sector (central banks, non-FX-hedged) to the global private sector (usually FX hedged). At the same time, the supply of Treasuries has dramatically increased as the US has embarked on a (long) period of fiscal expansion. The first problem for international private buyers of Treasuries is that if you include the hedging costs, the 2% yield that you would get for a 10Y US bond becomes negative for European and Japanese investors. Even though the 10Y yield on the German bund stands at a record low of -35bps, a FX-hedged European investor would get -80bps on a US Treasury (figure 6, left frame). Secondly, there is not enough balance sheet in the US private sector to fund the US deficit, which could one of the main reasons we have seen the persistence divergence between the Fed Funds rate and the interest on excess reserves IOER (figure 6, right frame). Luke Gromen from FFTT recently mentioned that the Fed is actually being forced to cut deficits to help fund the US government, and at some point, will start QE in order to participate as a main buyer of US Treasuries.
Source: Bloomberg, FRED, RR
Fed and USD outlook
Hence, despite leading indicators showing that pressure on inflation in the US remains firm, suggesting that the Fed should continue hiking, we think that a 25bps cut at the July meeting remains the favourable scenario. Even though long-term inflation expectations have slightly been reviewed to the downside in recent months, a 50bps cut as Evans recently suggested seems to be a bit aggressive. As the Fed is now ready to cut, it was interesting to see the reaction of the ECB, BoJ and BoE, which are all also "ready to act" and use unconventional tools to limit the slowdown in the global economic activity. We think that the ECB or the BoJ are also closely watching the exchange rate as one of the main drivers of the US dollar in recent years has been the rise in the real interest rate differential (figure 7, left frame). Hence, as the Fed has got more room to cut faster than expected, undervalued currencies such as the euro or the yen may start to appreciate dramatically, raising concerns for the European and Japanese economies. For instance, Eurostat-OECD PPP measure is pricing a "fair" value at 1.3660, implying that the euro is undervalued by approximately 18%.
We are still bullish on the US dollar in the short run as we think that the greenback will remain the preferred currency in the current environment. We would stay away from equities as a 50bps cut in the July meeting could actually send a negative message for stocks as it would imply that the situation is actually worse than previously expected. We also think that it could be interesting to hold some safe havens such as gold or Japanese yen ahead of this meeting.
Source: Eurostat-OECD, Eikon Reuters, RR
This article was written by
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