Bank of England Governor Carney’s hawkish comment spurred sterling’s advance late yesterday that has carried into today’s activity. Sterling is within spitting distance of the $1.70 barrier and has pushed the euro below GBP0.8000. Short-sterling interest rate futures have sold off sharply. The implied rate of the March 2015 futures contract has jumped 18 bp to 1.13%.
ECB officials have been highlighting the divergence between its monetary stance and the UK and US stances. Carney’s confirmation of what we have been arguing, namely that the first rate hike is likely prior to when the BOE has been signaling, drives home the ECB’s point, at least in part. Next week’s FOMC meeting is unlikely to signal that the Federal Reserve is prepared to match the BOE.
Chancellor of the Exchequer Osborne also had some surprises in his Mansion House speech. He gave the BOE, through the Financial Policy Committee which meets next week, direct authority, as opposed to consultative powers regarding macroprudential steps involving curbs on loan-to-value and loan-to-income. Recall former Governor King refused such powers because of the political nature of such judgments.
In fairness, Carney made other comments that mitigated in part his hawkishness, such as his assessment of the economic slack and the headwinds posed by sterling’s strength. Recent data, including today’s construction spending report (April 1.2% vs. consensus of 1.5%) does not show the UK economy accelerating, but rather maintaining a robust expansion. Nevertheless, his warning that the first hike could take place sooner than the markets had expected is being understood as the main message and likely signals that the minutes of this month’s BOE meeting, out next week, may show a more heated discussion.
After sliding lower in the first half of the week, the euro found bids in front of $1.35 and has extended yesterday’s recovery today. It poked (barely) into an important band of resistance seen in the $1.3575-$1.3620 range before running out of steam in the European morning. The softer than expected US retail sales report followed by a strong 30-year Treasury auction that saw US 10-year yields tumble back below 2.6%, sparked the euro’s recovery.
The Bank of Japan’s two-day meeting ended and, as widely expected, there was no change in policy or economic assessment. The policy signal that did emanate from Tokyo was the confirmation that the government will move to begin cutting corporate taxes starting next year. At 35%, Japan’s corporate tax schedule rate is among the highest in the OECD.
While this may seem like a laudable goal, it is more complicated. First, the tax schedule is not the same as the effective tax rate. Second, the famed Japanese savings is not in the household sector any longer, but in the corporate sector. That is to say, that a corporate tax cut is unlikely to boost investment, especially in the context of overcapacity in many industries and the slow growth prospects given the demographic considerations. Third, a corporate tax cut is a poor substitute for the structural reforms of Abe’s third arrow, which seems evident to many only by its absence.
Ironically, the lower US yields have not pushed the dollar lower against the yen. The dollar has been confined to yesterday’s ranges against the yen and important resistance is seen just in the JPY102.00-20 area. Yen sales against euro and sterling may accounted for the yen’s weakness against the greenback.
Sterling has powered ahead to straddle the JPY173 area. This area has held back sterling since the start of the year. A pullback to the JPY172.50 area may be seen as a new buying opportunity. After all, if monetary policy between the UK and Euro area is stark, the divergence is just as pronounced between the UK and Japan. For its part, the euro has built a base since the start of the week in the JPY137.75-85 area. The easing of the downside momentum appears to have spurred a bout of short covering.
The Chinese yuan has recorded its biggest weekly advance since 2011. This week’s data, beginning with the larger than expected trade surplus and running through the higher CPI figures, yesterday’s loan data, and today’s industrial output, investment and retail sales, lend support to our assessment that the Chinese economy is stabilizing. Targeted but limited government measures have helped. Chinese officials are trying to maintain a delicate balance between reducing economic and financial excesses, on the one hand, and maintaining a sufficiently strong growth rate as to make the adjustment easier.
The yuan strengthened by 0.65% this week and is the strongest Asian currency, edging out the yen by about 0.1%. The 2% rally of the Shanghai Composite this week is also the most in Asia. Roughly half of those gains were registered today, led by the financial sector and consumer goods.
The main economic data in the North American session will be the May PPI report. The headline and core rates may rise by the 0.1% of the consensus forecast, though the risk is on the upside. More importantly, because of base effects, the year-over-year increase will likely accelerate to its fastest in two years. Next week’s CPI is also expected to firm. We suspect that the cyclical low of US inflation is in place, though the increase is unlikely to be rapid. Recall that key Fed officials have indicated their willingness to tolerate somewhat greater price pressures in the near-term.
Yesterday, the US Senate did confirm S.Fischer as Vice Chair, Brainard as Governor and renewed Powell’s appointment. The Board of Governors still has two vacancies, which means that it is at parity with the five rotating regional presidents, while the design of the institution is to give the Board a majority. The sharp downward revision in US Q1 GDP, with more to come, likely means that the Fed’s baseline GDP forecast for 2014 will likely be cut at next week’s meeting.