Wednesday, June 5, 2013

June-July 2013 Outlook: Goldilocks and the Three Central Banks  June-July 2013 Outlook: Goldilocks and the Three Central Banks 

So far in 2013, markets have convincingly broken the pattern seen in recent years. Supportive monetary policies helped markets shake off the "spring swoon" that characterized the last two years, and stocks are up double digit percentages in the US, Japan, and across most of Europe. Anticipating better economic times ahead, treasury yields are starting to move too -- as speculation grows that the Fed quantitative easing program could be tapered, the key US 10-year treasury yield jumped 46 basis points in May, the largest one-month rise since December 2010. European bond yields have benefited from contraction caused in no small part by Japanese investors searching for yield after the Bank of Japan implemented its extraordinary new monetary easing program.

The central banks of the three largest developed economies - the Fed, ECB, and BOJ - continue to pour on the stimulus to the extent that their policies appear to have generated an artificial Goldilocks market for the "new normal" economy, an environment with little inflation and middling growth. Inflation has not reared its head to spoil the stimulus party (indeed Japan's entire focus is on breaking out of deflation) and economic growth has improved to respectable levels in the US and Japan, yet there is no threat that global growth will edge toward overheating while Europe's economic picture remains stagnant. In the last few months the thesis became that bad news is good news, as it implies the quantitative easing will continue for longer, while good news means that monetary policy is working. Its unclear how long this "Goldilocks" mentality can last, but the latter days of May showed some signs that it may be deteriorating.

Rather than "sell in May and go away," stocks have stayed aloft in recent weeks as traders rotated among sectors, mostly noticeable in the pull back in the overcrowded dividend plays such as utility stocks in favor of growth sectors like tech. The strength in the stock market has revitalized the interest in new issues -- IPOs are already on track to have their biggest year since 2007, signaling the return of a thirst for risk not seen since before the financial crisis. Most global stock markets have hit multi-year or all-time highs as equities appear to be the best value among risk assets given the ever inflating cushion of central bank accommodation, most recently the BOJ's unprecedented stimulus plan that has led to the Nikkei nearly doubling over the last six months. Japanese stocks have corrected sharply in the last few days and other markets have seen some profit taking on speculation about how committed the central banks are, but most analysts are labeling this as a healthy pause to refresh.

Other markets, like commodities, have been less predictable than steadily rising stocks. The cries of Goldbugs who see the precious metal as the only safe haven in a world of compressed bond yields have gone unheeded, and gold has not been able to retrace any of its losses this year. Energy prices have been a little steadier, with WTI crude holding between $85-100 barrel for the last year and OPEC content to keep production steady as long as Brent crude stays above $100. Any surprise in oil prices this summer is likely to be to the upside. Middle East tensions could send oil higher as the Syrian civil war threatens to spill over its borders into a wider Sunni-Shiite conflict and nuclear negotiations with Iran continue to go nowhere fast. The Atlantic hurricane season, starting June 1, may set off some speculation of another oil "super spike" like the one in 2008 that rocketed WTI to over $140/barrel. Forecasters at NOAA have predicted an extremely active hurricane season this year: 13-20 named storms, 7-11 strengthening to hurricanes, of which 3-6 will be major hurricanes. The record hurricane season of 2005 was the last year that Gulf of Mexico production was severely disrupted by storms, so another bad season may be "due," much to the chagrin of the oil and insurance industries. Such acts of god are one sort of development that central banks can't remedy with their policy.

Papa Bear-nanke Talks Taper

Market watchers are starting to make the case that the best thing for markets will be the Fed starting to taper off QE (encapsulated in remarks by market guru David Tepper on May 14). The confidence to begin tapering will mean the Fed is all but certain that the economic recovery is starting to be become self-sustaining. Still the market may take the first signs of tapering badly with a knee jerk reaction sell off after becoming accustomed to so much stimulus for so long. But as long as inflation stays near the 2% target level, the Fed will have the leeway to continue QE3 indefinitely, and appears to be in no rush to end it.

In an apparent effort to ward off the spring swoon after a disappointing payrolls number in early April, and to give some assurance the Fed will not end its ultra-easy policy prematurely, the committee took pains to stress in its May 1 statement that QE could be increased just as easily as it could be decreased. In the weeks since then, Bernanke and other Fed members have turned the focus back towards tapering, communicating that they could start considering trimming down QE in a few months time.

Thus, along with the data, the FOMC schedule now plays into forecasting the potential for tapering QE. The June 19 FOMC meeting includes a press conference with Bernanke, but that is almost certainly too soon to start the taper. A more likely option would be for the Fed to foreshadow tapering with some revisions to the statement at the July 31 meeting of the committee which could be built upon at the Jackson Hole conference in late August. If the economic data cooperates, this could lay the groundwork for tapering at the mid-September or mid-December FOMC meetings, the last two that include regularly scheduled press conferences. In the next two months Fed officials may float more upbeat commentary to signal they are preparing to taper off QE, as long as the data cooperates.

Economic data in the US has been swinging in the right direction, especially various indicators of consumer confidence which have largely returned to pre-crisis levels. Housing and PMI readings have improved this year too, and unemployment figures have edged lower, though there are some concerns about the underlying quality of the decline in the unemployment data. Part of the fall in joblessness earlier in the year was due to a drop in labor force participation, particularly the two-tenths decline in the March jobs report. Another concern is that some of the decline is due to the chronically unemployed exhausting their emergency unemployment benefits, leading them to accept part time jobs that previously would have reduced their benefits. If these phenomena are the main drivers of the drop in unemployment, the Fed may be very hesitant to take their foot off the gas even if joblessness gets near their 6.5% threshold. Several members have indicated that they want to see payrolls rise at a pace of 200K or more consistently for several months before they can comfortably considering tapering QE.

Later this year the focus may turn to one job in particular-Bernanke's. With his term set to end in early 2014, the chairman has been coy about his future, but in response to questions about seeing through his policy decisions to the end, Bernanke stated in March that he is not the only person who can successfully manage the eventual unwinding. His most likely successors, Vice Chair Janet Yellen or former Treasury Secretary Larry Summers, would likely stick close to the Bernanke playbook, though a new face in such a key post always creates some uncertainty. If nothing else, Bernanke has developed a more transparent institution and a strong ability to communicate the exact words the markets want to hear, and his replacement could suffer some rookie mistakes.

Cold Porridge for Europe

Over in Europe, despite the signs of greater stability in the financial sector and confidence in sovereigns, the economy is still wobbly. The era of one crisis after another appears to be over, but it has taken its toll on confidence. The most recent incident, the initial mishandling of the Cyprus bailout, has left a climate where the slightest whiff of a peripheral nation needing a new aid package could trigger bank runs as depositors scramble to protect their money from a "bail-in" confiscation.

In recent months, European leaders have been on their best behavior, trying to show that the Euro Zone and EU are making progress toward greater integration and finding ways to settle differences over key unity issues. To that end, some nations like France and Spain, have been granted additional time to meet the debt to GDP strictures of the EMU (which, after all, only Finland was able to abide by throughout the recent crisis years).

Crushing unemployment levels are still a millstone around the neck of the European economy. Across the euro zone unemployment has topped 12%, and stands at more than twice that in the hardest hit peripheral nations like Spain and Greece. With a new focus on programs to alleviate youth unemployment, leaders are making noises that joblessness could finally see a noticeable reversal by the end of the year. Programs targeting youth unemployment are being crafted, which may include novel measures such as the Bank of Spain's proposal to suspend the minimum wage to boost entry level employment. Any drop in unemployment readings would be a welcome sign on a continent that has not seen much promising data of any kind this year.

As governments continue to tinker with getting their fiscal consolidation and growth policies balanced, it has been the ECB's steady hand that has kept the Euro Zone from spinning apart. After adding a fresh cut to the main repo rate at its May meeting, ECB council members continue to discuss the potential for further cuts, stating the bank is technically ready for negative rates, though they still have misgivings about the potential for unforeseen consequences. Another hot topic for the central bank has been working to restart the ABS market to boost small business, though the usual hawks have registered opposition to the ECB executing an outright asset purchase program. A recent press report indicated that ECB officials have been publically jawboning the idea of negative rates primarily to show that the bank still has some firepower, but they are not eager to provide more accommodation until euro zone governments make stronger efforts to match monetary policy efforts with fiscal reforms.

Goldilocks and the Three Arrows

In Japan, PM Abe has promised major new fiscal programs and reforms to compliment the BOJ's massive new stimulus efforts as they attempt to tackle the stubborn deflation problem and restore Japan's economy to its former glory. The Prime Minister's economic plan, dubbed 'Abenonics,' has been distilled for public consumption using the Japanese parable of the three arrows (a single arrow can be snapped in half but three held together will not break). The three arrows of Abe's plan are massive monetary stimulus to beat deflation and weaken the yen, greatly enhanced fiscal stimulus via larger deficit-financed public works spending, and a growth program to boost the nation's economic competitiveness. Together they are meant to snap the economy out of a two decade long funk, but the boldness of the program is also causing some significant rebalancing.

The first market test of Abenomics may be underway, with the near 20% correction in Japanese stocks, the yen testing back below 100, and the recent one day blip in JGB yields. Senior Japanese officials have stated that they are monitoring markets and that any excessive volatility is undesirable. The BOJ has suggested that it could adjust its bond auction schedule to smooth volatility in the JGB market, while government economic advisors have said that the current Yen level is not far from competitive, and the stock market retracement is normal. Reports also indicate the government is promoting more flexibility for pension funds so they can shift holdings out of JGBs and into domestic stocks and overseas assets. Abe is expected to detail the third arrow, the growth program, in a major speech on June 5. If the outline of the plan fails to impress markets, it could lead to more volatility across all asset classes.

This Currency is Too Hot

Since the launch of the new BOJ policy effort and the latest ECB easing, a spate of rate cuts at other central bank has ensued. In the last month, central banks in Australia, South Korea, Israel, and Poland have all taken surprise rate cut decisions, while Turkey cut by more than expected. Others central banks like Sweden's Riksbank have indicated that they will maintain ultra-easy rate policy for an extended period of time. All the banks cited slower growth and an uncertain global outlook as concerns, while giving assurances that inflation is well contained and may allow scope for additional cuts if needed. After global leaders gave the BOJ's extraordinary new monetary policy action a pass on the grounds that its "domestically focused," they won't be able to raise objections to other central banks following suit, allowing the forex market to slide toward the currency war leaders said they didn't want.

A new front in the war could soon open up in England. Bringing in fresh blood, the UK Treasury tapped current Bank of Canada governor Mark Carney to take the helm of the Bank of England at a critical time. The UK economy has been anemic and unable to gain traction under the government's austerity regime, and some observers expect Carney will tacitly look to depreciate the pound and boost inflation to ease the UK's woes. The pound has already weakened about 7% against the dollar so far this year ahead of Carney's installation on July 1, and many analysts predict that he will try to weaken the currency another 10-15%. Carney might also push for an increase in the BOE asset purchase program from the current £375B, but its still unclear if more monetary policy will be able to overcome the headwinds of government austerity.

The fresh round of monetary easing could be troublesome for China, which has taken much criticism for taking its time to strengthen its currency. The Chinese may change tactics if outside policies chip away at its already ebbing economic growth, which Premier Li recently warned could slip to 7% next year. In March a senior PBOC official warned that China is "fully prepared" for currency war and will include QE policies in its calculus, but would rather see nations abide by G20 conventions that monetary policy should primarily serve as a domestically focused tool. This warning appears to have gone unheeded, and the massive easing efforts globally could import inflation into China and force it to tighten policy (the last time China had to raise its key rate was in July 2011, when CPI peaked at 6.5%).

Political Bear Baiting

With virtually infinite central bank monetary policy in place keeping economies alive, there is now growing pressure on governments to get their fiscal policy balance right. Progress has been slow almost everywhere, and this summer could see some old political battles being refought.

European tensions have subsided but could flare up again along the fault line between Germany and the Mediterranean states. On June 11 and 12 the German constitutional court will hear a complaint challenging the legality of the extraordinary policies used to hold the euro zone together during the crisis, including the formation of the European Stability Mechanism (ESM) and the ECB's bond buying program, which has not yet been activated but has promised to buy unlimited amounts of bonds from troubled euro zone nations to reduce their borrowing costs, provided they agree to strict reform programs set by the ESM. Most experts believe the constitutional court will follow its track record of not challenging government decisions on European policy issues, but it may reaffirm the veto authority of the German parliament as it did in a preliminary ruling on the ESM last autumn. The court is not expected to render its verdict before German federal elections this September, but the litigation of the budgetary sovereignty of the Bundestag in the face of ESM and ECB policies may make it difficult for Chancellor Merkel to keep the temperature cool while she seeks to secure reelection to a third four-year term.

Its also election season in Iran, and on June 14, Iranians will go to the polls to choose the successor for Mahmoud Ahmadinejad, who is prevented by term limits from standing for a third term. The country's ruling Guardian Council has blocked the more "moderate" candidates from running, including former President Rafsanjani and Ahmadinejad protege Mashaei. The eight remaining approved candidates are all closely aligned with the ruling clerical regime, raising the likelihood that the next president of Iran will be a more hard line leader attuned to the Supreme Leader. It appears 'the fix is in,' and the outcome may be a strong signal to the major powers that Iran will continue to be recalcitrant on the nuclear issue.

In Japan, where the frequency of elections has contributed to a series of short lived governments over the last decade, upper house elections in July will serve as a referendum on Abenomics. The Prime Minister is determined not to suffer the fate many recent leaders who have been forced out within a year of taking office after suffering losses in parliamentary elections. To avoid getting pushed out the revolving door like his predecessors, Abe has set a goal of capturing two-thirds of the upper house for his coalition, which would be a decisive margin. So far Abe's plans appear to have strong public support with approval ratings riding above 70 percent. The fickle electorate could be swayed by a sudden event or unexpected side effect of Abe's program (the sudden spike in Japan government bond yields comes to mind), but the early positive results of Abenomics appear to have enough political momentum to carry the PM comfortably through the July election.

Mr. Abe and other G8 leaders will meet in Northern Ireland in mid-June. Last year's leadership meeting was focused on the acute situation in Greece, but with no urgent developing crisis this spring, the June G8 may be rather quiet. Aside from reaffirming the usual goals of promoting self-sustaining global growth and working on credible fiscal plans, leaders may announce some trade initiatives at the conclave. The EU and Canada have been working on a trans-Atlantic trade agreement ahead of expected talks between the EU and the US later this summer.

Leaders will give some time to discussing the fiscal situation in the US. After much hand wringing in the early part of the year, it appears the US economy has absorbed the impact of payroll tax increases and the wide ranging sequester budget cuts, though they may have clipped a few tenths of a percent off of GDP. Some of that lost potential will be compensated for in July when a revamp of economic growth calculations that seeks to reflect the modern economy by capturing intangible assets such as film royalties and R&D spending will add billions of dollars to GDP figures, on the order of 3% of total economic output.

Washington partisans have been relatively quiet on budget issues lately, instead focusing on a series of mini-scandals (IRS, AP, and the Benghazi saga). This, along with his lame duck status, may weaken President Obama's hand as another fight over the debt ceiling starts brewing this summer. The two parties have not made any progress on a compromise budget and tax reform deal (the elusive "grand bargain"), but instead have continued to bog down in petty posturing. Since this political dysfunction was the main reason the US lost its AAA rating at S&P in August 2011, a reprise of those antics this summer may make the bond market jittery, and could even bring the bond vigilantes out of hibernation.

Hot, Cold, or Just Right?

Despite the potential headwinds that have been discussed, markets have avoided another spring swoon, though the typical summer doldrums may still be in store. What might help fuel an additional rally? A deal in Washington to replace the sequester with more sensible targeted budget cuts for one. Second quarter European data brightening up would also help, especially if the continent can shake off recession and finally get unemployment readings going in the right direction. Another positive factor would be the Japanese government following through on Abenomics with fearless conviction and flawless execution.

The downside risks are less pronounced under the camouflage of the Goldilocks environment, but could emerge quickly if data sours. The recent volatility in some assets may test whether markets are priced to perfection. Companies need to put up solid numbers in the July earnings season to help justify stocks reaching for more record highs. Weaker currency is a relief for Japan and EU exporters, but the concomitant strengthening of the dollar will eventually hit US businesses. Bond yields may rise further off of historic lows, luring more money out of stock dividend havens, and driving mortgage rates higher. This in turn might draw a flurry of homebuyers in to grab a low rate while they can, but ultimately may dampen the recent improvement in the housing market that has been key to the US recovery.

The Fed has the opportunity to be the first major central bank to test taking its foot off the accelerator, and press reports indicate the Fed has crafted a plan for tapering with an emphasis on managing market expectations toward the simple message that tapering means things are really better. But any such move is predicated on a string of improving data hitting the tape. In the US that means months of strong payroll data, and in Europe it means reversing shrinking growth and growing unemployment. In Japan the economic data may not take the lead as much as political conviction - Abe has to show the will to put the second and third arrows in the bullseye and not leave the BOJ's single, breakable arrow by itself for too long.

If, after all of this stimulus, those political commitments and economic improvements don't materialize, accommodation may have to be rethought, tipping the delicate balance of the monetary policy honey pot. So far, the three central banks have lured in Goldilocks with their house full of comforts, but they may ultimately end up finding her still lazing in bed and chase her out of the house as the bears did in the fable.



2: China HSBC final manufacturing PMI
3: European manufacturing PMI readings; US ISM manufacturing PMI
4: US trade balance
5: Japan PM Abe's "third arrow" speech; European services PMI readings; US ISM non-manufacturing PMI
6: BOE policy statement; ECB policy statement
7: US payrolls and unemployment
8: China CPI and trade balance

9: Japan current account and final GDP; China industrial production
10: BOJ policy statement
11-12: German constitutional court hearings ECB and ESM bailout programs
13: US retail sales
14: US PPI; Michigan prelim sentiment

17: German ZEW sentiment; 2-day G8 leadership meeting in Northern Ireland begins
18: UK CPI and BOE inflation letter; US CPI; US housing starts and building permits
19: BOE minutes; Fed policy statement, projections, and press conference
20: UK retail sales; US existing home sales; Philly Fed index; China HSBC flash manufacturing PMI
21: European flash manufacturing PMI readings

24: German Ifo business climate
25: US durable goods orders; US consumer confidence; US new home sales
26: US final GDP
27: US pending home sales
28: EU CPI

30: China manufacturing PMI and HSBC final manufacturing PMI

TBA: Japan upper house election
1: EU unemployment; US ISM manufacturing PMI
3: US trade balance and ISM non-manufacturing PMI
4: BOE policy statement; ECB policy statement
5: US payrolls and unemployment

7: China CPI and GDP
8: China industrial production; German industrial production
9: BOJ policy statement and Japan current account
10: China trade balance; FOMC minutes
12: US PPI; Michigan prelim consumer sentiment

15: US retail sales
16: US CPI
17: BOE minutes; US housing starts and building permits
18: UK retail sales; Philly Fed index
19: German ZEW sentiment

22: US existing home sales and China HSBC flash manufacturing PMI
23: European manufacturing PMI readings
24: US new home sales
25: German Ifo business climate; UK prelim GDP; US durable goods orders

29: US pending home sales
30: US consumer confidence
31: EU unemployment; US advance Q2 GDP; Fed policy statement; China manufacturing PMI and HSBC final manufacturing PMI

1: BOE policy statement; ECB policy statement; US ISM manufacturing PMI
2: US payrolls and unemployment