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GLOBAL MACRO VIEWPOINTWEEKLY REPORT

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InterviewNeil MacKinnonKit Juckes

In this issue:

Page

1 The US Non-Farm Payroll

4 The Markets

7 Europe

9 The UK General Election

10 The Global Economy

Weekly ReportMay 06 2015 The Fed’s

Next Move: Waiting for Yellen

The US non-farm payroll report on Friday is the key to the Fed’s next move

There are increasing concerns that the Fed is “falling behind the curve”

Bottom line: Fed to hike this year; ECB QE and euro on track; GBP at risk

1 The US Non-Farm Payroll Report

Q Andrew Rozanov

With respect to potentially market-moving events this week, all the attention seems to be focusing on the US non-farm payroll (NFP) report due on Friday. Neil, last time we spoke, I recall you were putting quite a lot of weight on this data point, in the sense that it could potentially bring forward the date of the first rate hike to June. Can you give us an update on your thinking?

A Neil MacKinnon

Indeed, the US jobs report on Friday is crucial. It is always closely watched since labour market developments clearly play such a key role in the Fed’s decisions on monetary policy. And although it has to be said that the April activity data was mixed, which I’m sure will make the doves even more confident that the Fed will remain ultra-easy, it could also be argued that in fact the Fed has been way too accommodative, given that the unemployment rate has fallen

Contributors:Neil MacKinnon Global Macro Strategy Adviser

Kit Juckes FX & Fixed Income Adviser

Andrew Rozanov Head of Institutions





quite sharply and jobs growth has been quite robust. The weekly initial jobless claims data, for example, is at its lowest level since 2000. Just how far do labour conditions have to tighten before the Fed decides to end its zero rate policy? And, on a broader note, why is a zero rate policy, along with a central bank balance sheet that amounts to USD 4.5 trillion – both of which were explicitly implemented to address an emergency situation – still required when the economy and the financial system are clearly not in an emergency?

Now, the Fed has consistently argued that the US economy still needs monetary policy support, pointing to historical examples where premature tightening derailed the economy. It would also highlight concerns about disinflation, and we also know that members are mindful of the risk of a ‘super taper tantrum’ in emerging economies, especially where there has been a surge in dollar-denominated corporate debt.

But consider this: the Fed’s ultra-easy monetary policy has pushed US equity markets to record highs and compressed bond yields, resulting in US corporate debt issuance running at a record rate this year (USD 609 billion) – after three previous record years! The net leverage ratio for highly rated US non-financial companies was 1.88 at the end of 2014, compared with 1.63 back in 2007, just prior to the global financial crisis. And stock market margin debt is at a 50-year high!

So I must say that I found myself in agreement with Professor Martin Feldstein when he said last week that the Fed was “behind the curve”. My guess is that the Fed itself is increasingly getting worried that it may have been too easy for way too long, and their recent comments seem to suggest a growing consensus for an early increase in the target range for the Fed Funds rate. So June is still on the cards, in my opinion.

“... members are mindful of the risk of a ‘super taper tantrum’ in emerging economies ...”

US Non-Farm Payrolls

Source: The ECU Group, DataStream Source: The ECU Group, DataStream

‐1000

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0

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105,000

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Jan.90

Jan.92

Jan.94

Jan.96

Jan.98

Jan.00

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Mon

th/M

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nge (100

0s)

Total (Th

ousand

person)

US Nonfarm PayrollsTotal and monthly change

Month on month change (RHS)US Employed Nonfarm Industries Total (Payroll Survey)





Q Andrew Rozanov

Kit, what’s your analysis of the Fed’s choices and how they might react to the NFP report?

A Kit Juckes

Clearly, the Fed’s tentative progress towards the start of a rate-hiking cycle has been interrupted by a lack of growth that is down to either the time of year, or something more sinister. But think about it: Q1 GDP growth has averaged just 0.6% in the years since the recession, whereas Q2 has averaged 3%. Of course, that’s a tiny sample, so we shouldn’t read too much into it, but even so, it’s too early to rule out the economic recovery or the interest rate cycle.

Two days after the poor Q1 GDP reading of 0.2% at a quarterly annualised rate (which, by the way, would have been reported as 0.05% growth anywhere else), weekly jobless claims data that Neil has already mentioned came in at their second lowest level since the early 1970s! And, as we all know, jobless claims consistently lead the cycle in the unemployment rate, so as the US economy continues to generate employment at a healthy rate (over 2% per annum), with real wages growing at a decent clip too, there is plenty of ‘ammunition’ for the Americans to head to the stores now that the snow has melted.

Because GDP fell sharply in the first quarter of last year, the year-over-year growth rate is actually higher, at 3% for real GDP and 3.9% for nominal GDP. Perhaps not fast enough for the current FOMC to pull the trigger on the first rate hike, but not that bad either! Last Friday, we also saw the release of the manufacturing ISM data, which showed signs of a slowdown too, though a forward-looking indicator, measuring new orders minus inventories, has turned up and tends to lead the overall index.

US Unemployment Rate and Initial Jobless Claims

Source: The ECU Group, DataStream

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US Unemployment Rate and Initial Jobless Claims

US Initial Jobless Claims (LHS) US Unemployment Rate (RHS)





My conclusion from all this is that the US economy continues to grow at a steady underlying rate, but without living up to the hopes of those who expect to see the kind of recovery that was more typical in the past.

This week we shall see the monthly employment report, and we should also be in a position to form a better view of how the month of April is shaping up, but 2015 so far looks like a repeat of the recent trend: forecasters start the year looking for growth above 3%, then they become increasingly depressed through the first half of the year, only to be encouraged by growth recovering a bit in the second half. Three years of growth averaging just under 2.5% pretty accurately reflects what’s going on. And since that growth is managed with the help of a steady fall in unemployment, the longer-term outlook, in my view, is for slower growth once full employment, however defined, has been reached.

2 The Markets

Q Andrew Rozanov

Let us now turn to markets: what is currently priced in and how might this change depending on the NFP print? And what are the implications for the US Treasury market and the dollar?

A Neil MacKinnon

The market is discounting an increase of 230,000 in NFP employment and a further decline in the unemployment rate to 5.4%. Market participants will also be watching the average earnings data for signs of any inflationary pressure. Admittedly, some form of wage inflation might be welcome in underpinning the growth in consumer spending. However, the recent increase in oil prices, with Brent at its highest level for the year, will bite into disposable incomes and moderate

“...the longer-term outlook, in my view, is for slower growth once full employment ... has been reached”

US ISM Manufacturing and New Order minus Inventories


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US ISM Manufacturing and New Order minus Inventories

US ISM Manufacturing (LHS)

US ISM Manufacuring New Orders minus Inventories (RHS)





the decline in inflation expectations. As I already mentioned, economic activity in April has been mixed, with strength in the economy located in consumer spending which advanced at a 2% pace in the first quarter. The negative contributions came from exports, non-residential fixed investment, and state and local government spending. The Atlanta Fed’s GDP nowcast model, which proved to be an accurate indicator of the 0.2% advance in US real GDP in the first quarter, is currently tracking GDP growth at just 0.8%. The main culprit is non-residential structures investment, which is declining at a 20% rate.

Clearly, if the jobs report on Friday fails to meet market expectations, then a lift-off in the target range for the Fed funds rate is out of the question. The US dollar would weaken and the recent increase in the 10-year US Treasury yield to above 2.00% would reverse. Markets might even question whether a September move by the Fed is still on the agenda. But I am sympathetic to the notion being propounded by the veteran bond manager, Bill Gross, that the secular bull market in government bonds is ending. In particular, he remarks that “bond yields, credit spreads and stock prices have brought financial wealth forward to the point of exhaustion.” So barring a disastrously low NFP print this Friday, I do expect the underlying trend for monetary tightening and a stronger US dollar to persist. By the way, with respect to EUR/USD, last week I advised that it was due a period of short covering given the scale of extreme short positions. So it proved. Looking at the technicals, I think 1.1300 is the top in this move and the upward trend in the dollar should return.

A Kit Juckes

Market developments last week were noteworthy. Usually, it’s the news which makes financial markets react, but last week was one of those occasions when it is the market which became the news, as blood was spilled by those who were long dollars or long of government bonds, both in Europe and the United States. German bund yields jumped, partly on better data as money supply and credit growth recovered, partly on hope of agreement in the Greek debt crisis. But mostly, it was driven by a combination of illiquid markets, the month-end, and a loss of momentum, which caused the rise in yields and in the euro.

“... I do expect the underlying trend for monetary tightening and a stronger US dollar to persist”

30 Year Government Bonds


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30 Year Government Bonds Redemption Yields (Percent)

Germany United States Japan United Kingdom





By the way, speaking of momentum – and I’m afraid the point I’m about to make is perhaps a bit too technical – I personally find the RSI, or relative strength indicator, a particularly useful tool for showing momentum in a trade. For both bond yields and the EUR/USD exchange rate, the 9-day RSI had reached exceptionally stretched levels a couple of weeks ago. That indicated trends that were going too fast. Typically, the RSI can’t maintain very low or very high levels for long, and what follows is either a consolidation or a correction.

10 Year German Bund


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10 Year German BundYield

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1.01.11.11.21.21.31.31.41.41.5


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Relative Strength Index

EUR/USD





What is interesting is that from very low levels, the RSI for bond yields and for EUR/USD have now flipped to exceptionally high levels, in very short order. Therefore, it’s unlikely that we will see the speed of the recent move maintained for more than a few days. And the risk that this snap higher is soon followed by a snap lower can’t be dismissed. Or, to put it simply, market positioning is now very stretched and the market is unstable. I wonder if this perhaps might be a foretaste of the kind of volatility we may have to get used to when the end of the cycle in the US dollar and in yields is finally reached…

But going back to possible market reactions to the jobs data, the really big question is when (or whether) the gradually tightening labour market will spark a pick-up in wage growth sufficient to prompt the Fed to start raising rates, and then how far the Fed will go. I’d still bet on a rate hike this year, because the recent pattern of a strong rebound in GDP in Q2 has every chance of being repeated, and there is now so little tightening priced in for 2016 (with rates expected to reach the dizzy heights of 1% in early 2017), that any hike will likely be dollar-friendly and disruptive for global capital flows. But for now, don’t expect Fed-watchers to do more than wait, nervously, for each new piece of economic data. The focus in the weeks ahead will be firmly on April data and whether it supports the idea that the Q1 slowdown was temporary.

3 Europe

Q Andrew Rozanov

Let us now look at Europe. There seems to be this never-ending tug-of-war between gradually improving economic performance in different parts of the euro area on the one hand, and the ongoing ‘Greek drama’, with its increasing tail risk of default and / or euro exit, on the other. How do you see things developing there?

A Neil MacKinnon

With respect to Greece, with the government debt at 177% of GDP, its ability to refinance becomes pressing. Indeed, an impending ‘cash-crunch’ is looking very likely, with a EUR 770 million payment to the IMF scheduled for 12 May, a day after the next Eurogroup meeting. There are also press reports that the Greek government is not able to pay pensions or pay employees in the public sector.

The ECB meets this Wednesday to discuss further liquidity provision to the Greek banking system (nearly 30% of Greek bank assets are funded by the ECB). Deposit outflows amounted to EUR 30 billion from last November to March. New forecasts from the European Commission today show that the Greek government will fail to meet its target of a primary budget surplus, and the Commission sees a headline budget deficit of 2.1% of GDP this year, with the debt-to-GDP ratio at 180.2%. Greek GDP growth is estimated to be just 0.5%, compared with the 2.5% prediction made in February. The problem is that imposing further fiscal austerity will make it more difficult to meet fiscal targets. However, the IMF also seems to be of the opinion that Greek finances are badly off-track.

“... any hike will likely be dollar-friendly and disruptive for global capital flows.”





All of this, in my view, increases the risk of a Greek debt default and eventual exit from the monetary union. As Charles Wyplosz, a renowned French economist, points out, avoiding an exit requires ample funding from the EU: first in the form of refinancing the debt largely held by the ECB, and then in the form of unconditional last-resort lending to the Greek banks by the ECB. Much depends on the haircut that the ECB would require the Bank of Greece to apply after a sovereign default. There is also ‘redenomination risk’ arising from a default and exit that could affect other countries still inside the monetary union. If there is a failure to conclude a last-minute deal between the Greek government and its official creditors, then Greek markets will tumble sharply, the EUR/USD would slide below parity, and markets might not share the EU/IMF view that contagion is containable. As Gillian Tett in the FT pointed out in warning, the Greek crisis has the potential to trigger a Lehman-style crisis and EU policy-makers should not assume an orderly resolution to a default.

A Kit Juckes

The Greek tail risks which Neil mentions are all too real and need to be monitored closely. But if they do not materialise, I expect that at some point in the next few months, someone will publish a forecast of 2015 euro area growth close to 2%. The data were already improving a bit even before the ECB started buying bonds as part of its QE programme, and continued to do so ever since. Throw in some kind of resolution to the Greek crisis, and we may actually see an outburst of optimism all across the continent. Miserably pessimistic economists, especially the Anglo-Saxon ones, are likely to be roundly booed. But in that scenario, rather than get too excited about the recovery in the euro area, I would be more optimistic about what a little bit of growth in Europe can do on its borders. Sweden, Norway, Poland, Hungary and the Czech Republic will all benefit. Indeed, even the UK can get a bit of a lift. But for the euro, and for European bonds, continued QE matters more, and I just can’t see the ECB giving those talking of a premature exit any help.

Greek 3 Year Government Bond Yield

Source: The ECU Group plc, Bank of Greece

Source: The ECU Group, Bank of Greece

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Percen

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Greek 3 Year Government Bond YieldPercent

Greek 3 year government bond yield

Break in trading

“If there is a failure to conclude a last-minute deal between the Greek government and its official creditors, then Greek markets will tumble sharply”





4 The UK General Election

Q Andrew Rozanov

Speaking of countries on euro area’s borders, we are now in the final stretch of the general election campaign here in the UK, quickly approaching the voting date on Thursday 7 May. While the market is understandably focused on the upcoming US jobs report, on Friday we will also see the contours of the newly elected British Parliament. I know we’ve touched on this in the past, and I’m sure we’ll spend quite a bit of time analysing the results next week, but what are your current thoughts?

A Neil MacKinnon

Well, the opinion polls continue to point to a tight result with no clear majority for the two leading contenders, Conservative or Labour. So far, the markets have been reasonably relaxed about an uncertain outcome, although traditionally political uncertainty is bad for markets. For what it’s worth, I think the conservatives will edge it in the end, but without a clear majority. UKIP will probably do better than people think, which will put pressure on David Cameron for an early EU referendum. The SNP are a wild card, as the polls suggest a landslide for the nationalists, giving them 59 seats in Parliament. Having been in Scotland the last few days, I can testify to the breadth of their support. This means that another independence referendum is probably inevitable. But I do think the SNP’s economic policies of “tax and spend”, which the nationalists seem to expect will be financed out of oil revenues or by the English, inevitably point to economic ruination.

A Kit Juckes

I would echo Neil’s comments in that the election has had less impact than some had expected on the gilts market, and it has taken until the last few days to see any signs of jitters in the currency market too. For choice, if I were long of either the pound or gilts and faced by policy uncertainty – of which there will be plenty in the days after the election – I’d be more worried about the pound. There are bigger differences in policies on spending and taxation between the major parties than there were in 2010, and these will be important even after the horse-trading needed to form a coalition government. But there isn’t nearly as much difference in plans for the overall impact of fiscal policy on the public finances. Even if both sides’ arithmetic is optimistic, the outlook is for some degree of austerity which will act as a drag on growth, anchoring interest rates and leaving sterling with little protection should global investors become skittish in the face of the budget deficit, the current account deficit, and the risk that there may be another election within 18 months.

“ industrial production dropped to its slowest pace since 2009”

“Having been in Scotland the last few days, I can testify to the breadth of ... support [for the SNP].”





5 The Global Economy

Q Andrew Rozanov

Before we conclude, let me ask one final question to ‘zoom out’ and take us back to the ‘big picture’ view of the global economy. Kit, you mentioned in one of our earlier conversations that you discerned three broad themes driving financial markets: the US interest rate cycle, the ECB’s QE programme, and the major drop in global commodity prices which you explicitly linked to the downturn in emerging market growth rates. Have your views on any of these broad trends changed during the last couple of weeks?

A Kit Juckes

Well, in all three cases doubts are creeping in, and these doubts are driving markets. When will the Fed finally start hiking rates? Indeed, will it ever start? Could the ECB’s QE programme actually be ‘working’ so well that it ends up boosting the European economy sufficiently quickly for the ECB to consider terminating bond purchases much earlier than originally planned? And finally, as prices of oil, copper and other commodities more generally bounce back, are we seeing a ‘correction’ or a turn in the longer term trend?

On the first two trends, as I argued earlier, the pause we are seeing is probably temporary, but the jury is still out on exactly when and how fast they might reassert themselves. For me, it is the third trend – the decline in commodity prices with all the resulting implications for emerging market economies – which has the most chance of being restored quickly. Think about it: oil prices fell so sharply from US$ 100 to US$ 50 per barrel, that a bounce-back doesn’t really tell us much.

“... doubts are creeping in, and these doubts are driving markets.”

UK Current Account Deficit

Source: The ECU Group plc, Datastream

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UK Current Account DeficitPercent of GDP

UK Current Account Balance Percent of GDP

Source: The ECU Group, Datastream





Is there enough global demand growth for a lasting commodity upturn? Granted, there is a bit more growth in Europe, but the softness in the US and in China matters more, and the Japanese economy hasn’t exactly been punching the lights out either. As a result, against this backdrop, I’m a seller of the bounce in commodities, and I’m also a seller of the consequent bounce in commodity exporters’ currencies.

Andrew Rozanov

Thank you both for your time and your analysis.

US GDP and Fed Fund Target Rate


Commodities and Brent Crude Oil


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US GDP and Fed Fund Target Rate

US Real GDP Percent Change Year/YearFederal Funds RateUS Nominal GDP Percent Change Year/Year

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CRB Commodities (LHS) European Brent Crude Oil (RHS)





Kit Juckes is a long-standing and independent member of ECU’s Global Macro Team and Head of FX Strategy at Société Générale.

Kit has over 25 years’ experience having commenced his career in 1985 with Money Market Services International (which became part of Standard & Poor’s).

His former roles include Chief Economist at ECU, Global Head of Research at RBS Global Banking & Markets and Head of Bond and FX Strategy at NatWest Markets.

Neil MacKinnon is a long-standing and independent member of ECU’s Global Macro Team and Global Macro Strategist at VTB Capital, having been ECU’s Chief Currency Strategist for six years.

Previous roles include Chief Currency Strategist at both Citibank and Merrill Lynch. From 1982 to 1986, Neil was an economist with HM Treasury, where he worked for the Chancellor of the Exchequer and other UK Treasury ministers.

Neil sits on the Advisory Council of Business for Britain.

BiographyKit Juckes

FX & Fixed Income Adviser

BiographyNeil MacKinnon

Global Macro Strategy Adviser

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