Awaiting the Fed

Chris Scicluna

While it hardly came out of the blue, dovish talk from Draghi yesterday gave a major boost to euro area govvies, with yields on 10Y Bunds down to a new record low of sub -0.32%, yields on 10Y OATS down to zero, and 10Y BTPs rallying almost 20bps. The later announcement that Trump had a “very good” phone call with Xi Jinping and that the pair agreed to hold an “extended meeting” at next week’s G20 Summit gave a further boost to risk appetite. So, a gain of about 2% in the Euro Stoxx index was followed by a rise of 1.0% in the S&P500. And inevitably, Asian markets followed suit today.

In particular, buoyed by the news on trade discussions, China’s CSI300 closed up 1.3% and Hong Kong’s Hang Seng is currently up almost twice as much. And despite a (predictably) very weak Japanese trade report and a modest appreciation of the yen, the Topix closed up 1.7%. Meanwhile, having fallen sharply in the wake of Draghi’s speech but reversed swiftly following Trump’s announcement, yields on USTs edged up further, with 2Y yields back above their level this time yesterday, just over 1.87%.

Moving to Europe, government bonds have also opened a touch lower this morning, while equities are little changed. Looking ahead, UK inflation data are due this morning and should show an easing in both headline and core rates. But all eyes today will obviously be on the Fed, with the FOMC set to make pivotal announcements that will either validate or call strongly into question the market moves of the past couple of months.

Ahead of tomorrow’s BoJ policy announcement, the latest trade report out of Japan provided grim reading. Compared to a year earlier, the value of exports was down for a sixth successive month and by a hefty 7.8%Y/Y. In contrast, imports on the same basis were down a modest 1.5%Y/Y. So, the headline trade balance plunged from a small surplus of ¥57bn in April to a deficit of ¥967bn last month. On a seasonally adjusted basis, the value of exports fell 5.3%M/M, the sharpest decline since January, while imports rose 1.3%M/M. So, the adjusted trade deficit plunged from ¥170bn previously to a hefty ¥609bn, the biggest in more than four years.

By destination, exports to China remained a significant drag, down on a year-on-year basis for a third month and by a hefty 9.7%Y/Y, with exports of general machinery down a marked 17.1%Y/Y as appetite for capital goods remained soft. And weighed particularly by declines in exports to Korea and South East Asia as the global tech cycle remained in reverse, shipments to Asia overall fell a steeper 12.1%Y/Y with capital goods again a notable area of weakness (indeed, exports of semiconductor manufacturing machinery were down more than 40%Y/Y). Exports to Western Europe were down too, falling 9.5%Y/Y. In contrast, benefiting from a near-10%Y/Y rise in exports of autos and growth of 7.7%Y/Y in exports of general machinery, shipments to the US rose 3.3%Y/Y in the year to May. And with imports from the US down, Japan’s trade surplus with the States was up almost 15%Y/Y and for a third month to ¥395bn, the kind of figure that will not go down well with Trump.

Adjusting for price shifts, the picture in May was no more encouraging. According to the BoJ’s data, export volumes fell 4.4%M/M, the most since February 2015, to be down 4.7%Y/Y. In contrast, import volumes rose 4.0%M/M, the most in seven months, to be up 2.5%Y/Y. And looking at the first two months of Q2 together, the volume of exports was down 0.4% on the Q1 average, while the volume of imports was up 3.9% on a similar basis. So, while exports in May were undeniably hampered by the extended Golden Week holiday and should be expected to rebound somewhat in June, it seems inconceivable that net trade will be anything other than a significant drag on GDP growth in Q2. Indeed, with the surprisingly strong economic growth of 0.6%Q/Q in Q1 having been principally related to the drop in imports that quarter, the drag from net trade looks set to be a key driver of what will likely be a contraction in GDP in Q2.

Of course, these downbeat trade data will provide food for thought for the BoJ when its Policy Board meeting concludes tomorrow. However, any change in its overall assessment of conditions, which currently judges that the economy is “expanding moderately as a trend”, seems unlikely to come until next month’s meeting, when the Board will take stock of the BoJ’s forthcoming quarterly Tankan survey as well as the implications of any shift in message from the Fed.

Ahead of tomorrow’s MPC announcements, today will bring May’s inflation data. We expect the headline CPI rate to fall 0.2ppt to 2.0%Y/Y as the impact of Easter-related boost to services inflation wears off and energy inflation eases somewhat, with the risks to that view skewed to the downside. We also expect core CPI inflation to take a further small step down, by 0.1ppt to 1.7%Y/Y, which would be the lowest rate since the start of 2017. Other releases due include the latest ONS house price index and CBI industrial trends survey for June.

Politics-wise, yesterday evening’s unedifying televised debate confirmed (if such proof was needed) that no candidate in the Conservative party leadership contest has a workable Brexit plan capable of being both agreed with the EU and passed by Parliament. A further (but still likely inconclusive) vote among MPs will be held later today. With former Brexit Secretary – and no-deal advocate – Dominic Raab excluded yesterday evening, former Home Secretary Sajid Javid looks most vulnerable of the five names to go on today’s ballot paper. But, whichever candidate is eliminated at this stage, in the absence of a major new scandal, the shameless populist Boris Johnson, who topped yesterday’s poll with 126 out of the 313 votes cast, still seems highly likely to become Prime Minister next month.

Euro area:
After yesterday’s market-moving comments from Mario Draghi, the ECB’s Sintra Forum on Central Banking will conclude today with further sessions on the future of EMU, including a panel discussion to be chaired by Executive Board member Benoît Cœuré, as well as closing remarks from the ECB President. Data-wise, the news will be relatively prosaic, with figures on construction output and balance of payments data for April. With production in the sector up 0.2%M/M in Germany but down 2.3%M/M in France, a second successive monthly decline in overall euro area construction output seems highly likely. Meanwhile, in the bond market, Germany will sell 30Y Bunds.

From a market perspective, of course, everything else today pales into insignificance compared to the announcements from the Fed, which should either lend credence to – or provoke strong doubts about – current market pricing, which suggests the likelihood of a 25bp rate cut as soon as next month and further easing of up to 50bps by year-end. So, while the Fed Funds Rate target range seems bound to be left unchanged at 2.25-2.50%, the updated forecasts, dot-plots (which previously showed that six FOMC members expected further policy tightening this year), statement and press conference will be closely scrutinised for clues as to the likelihood of a near-term rate cut.

Contrary to last time around, the updated dot-plots seem likely to show that no member now expects to raise interest rates this year, and some are possibly looking to ease policy. However, Daiwa America’s Chief Economist Mike Moran expects nearly all officials to be looking for a federal funds rate of 2.375% at the end of the year – i.e. steady policy rather than aggressive easing.

Meanwhile, in the statement, the status of previous language stating that the FOMC intends to be “patient as it determines what future adjustments…may be appropriate” will be key. But while that wording might well be changed to open a door to a possible easing of policy in due course, the updated language might also fall shy of suggesting that a rate cut is imminent. Indeed, it’s notable that the more dovish tone of many FOMC members came in the aftermath of Trump’s threats of tariffs on imports from Mexico. With those proposals now supposedly shelved indefinitely, and a Trump-Xi bilateral in the diary for the end of next week, the Fed’s fears on trade might have alleviated somewhat.



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