FX: "Transitioning to a New Phase"

From Marc to Market, Aug. 20:

The US dollar sold off for the first seven months of 2017 and then spent most of the past month consolidating those losses. The Federal Reserve's Jackson Hole Symposium likely marks the end of the market's summer, and the consolidation phase. The next several weeks may prove to be more challenging for investors than the past several weeks.

It is the confluence of events more than economic data that will shape the investment climate. The Jackson Hole confab takes place at the end of the week. At the end of the following week is the EMU's flash August CPI and the US jobs report, then Norway's national election, followed by the ECB meeting. The Fed and BOJ hold policy-making meetings two weeks later, which is days before the German election. When the US Congress comes back from its summer holiday, it will have a short window to lift the debt ceiling and approve new spending or risk missing debt servicing payments and government shutdown.

Except for Japan's CPI and the flash eurozone PMI, the economic data in the week ahead are unlikely to attract more than passing attention. Headline CPI in Japan has firmed in recent months, but even if it ticks up to 0.5%, matching a two-year high, it is nothing about which to get excited. The GDP deflator, despite the strong growth (1.0% in Q2 quarter-over-quarter, to lead the G7) remains negative and the targeted core CPI measure (~0.4-0.5%) is well below not only well below the BOJ's target, but lags behind targeted measures in the US (core PCE deflator 1.4% and the ECB's headline rate of 1.3%). In the mishmash of policies, the central banks have more or less the same quantitative target for inflation, but the quantities they measure are quite different (dare one say incomparable?).

The eurozone economy continues to expand at a sufficient rate to absorb some of the spare capacity, and the output gap is closing. While the regional economy appears to be continuing to operate at strong levels, the momentum has waned. A small gain or a small rise in the composite PMI will be consistent with this assessment and may not be much of a market factor. If it were just the real economy, one wag, noted, the ECB would be ending its extraordinary policies. And if it were just the acting, Mrs. Lincoln would have enjoyed the theater.

The vast majority of the ECB still appears to believe that the economy still needs extensive monetary support. Draghi has a fine line to walk, which is even more of a reason why the Jackson Hole forum is a proper venue to talk about the need for structural reform, an important hobby horse of his, but not the nuances of ECB monetary policy. In September, the ECB is likely to announce an extension of its asset purchases into next year at a slower pace (we suspect 30 bln euros a month down from 60 bln presently and 80 bln initially). However, as the record of the July meeting showed, officials are sensitive to the market prematurely tightening financial conditions.

The Fed's challenge lies in the other direction. Financial conditions have eased despite its efforts to systematically, but gradually, remove accommodation by lifting the Fed funds target, now four times during this cycle that began in December 2015. The market is pricing in a little more than a one-in-three chance of another hike this year.

The market may be under-appreciating the Fed's resolve, and the weaker dollar and easier financial condition add to the pressure for it to act....MORE