Is USD the new GBP?
• US housing market momentum slows
• UK wage growth stays static
• UK rate normalisation process expected in Q4
By Neil Staines
On Tuesday, we suggested that the risk of a hawkish surprise from the US Federal Reserve is rising and, while the semi-annual "Humphrey-Hawkins"’ testimony of the Fed chairman Janet Yellen could not be categorised as hawkish, it wasn’t doveish either. In fact, we view the subtle optimism that Yellen expressed in the statement as the start of the Fed's transition to monetary normalisation.
Momentum in the US housing market has slowed. Photo: Hans Hansen
There are some areas of the economy where some concerns remain, not least the slower-than- expected momentum of the housing market. The fact that the recent moderation in housing momentum coincided with rising long-term rates will only strengthen the Fed’s "forward guidance" in relation to a lower equilibrium interest rate. However, the statement over the Q2 growth rebound ie "bears watching closely" only reinforces our view that the GDP print is key to the progression of rates and the USD. While the revisions played a significant role in the Q1 data, our expectations remain that the "rebound" generates a 4 percent annualised rate of growth in Q2.
“Only in our dreams are we free, the rest of the time we need wages” - Terry Pratchett
Yesterday’s UK employment report was again very strong in all but the "last piece" of the puzzle ie wage growth, which continues to disappoint at just 0.3 percent and is being driven by sharply lower bonus payments. Apart from that, the path to normalisation is becoming increasingly clear.
The detail of the employment report is perhaps more encouraging, where most of the gains in employment in the last quarter (254k), were in the "full-time employee" category (216K). Added to this, the rise in average working time also rose alongside a significant rise in vacancies, providing a backdrop of more jobs and more people working longer hours. Furthermore, the single month ILO unemployment rate for June fell to just 6.2 percent, from 6.4 percent in May which suggest further significant unemployment declines (reduced slack) over the coming months.
As executive bonuses continue to fall, wage inflation remains absent. Base effects suggest that wage growth is unlikely to bounce next month. Beyond July we anticipate that wages will start to rise.
Those market participants who have recently begun to raise the case for an August rate hike from the Bank of England will be disappointed by the continuing lack of wage price pressure. However, we maintain our (now very) long-held view that the rate normalisation process will begin in Q4 in the UK. In relation to wages, we would echo the sentiment of the president of the Federal Reserve Bank of Philadelphia, Charles Plosser, who commented on Friday that “wage growth is a lagging indicator of inflation, not leading”, particularly in light of the recent bounce back in UK headline (and core) consumer prices.
"Those who don’t know history are destined to repeat it" - Edmund Burke
As we look at the USD, and its potential for a significant rise, it may be worth considering the dynamics of GBP before and during its recent ascent. On reflection, the core instigator of GBP strength was likely to have been the transition of the Bank of England governor and the removal of the inclination to verbally depress GBP to foster economic rebalancing towards manufacturing and exports. The ambivalent acceptance was that as the economy recovered GBP was likely to rise. This fostered a path of lower inflation, a narrowing of the decline in real wages, and ultimately, a consumer-led recovery, in the first instance. Obviously, the removal of the existential threat of the Eurozone (and the advent of OMT) was also a significant factor, as was the cumulative effect of interest rate cuts and QE.
“The Fed are not behind the curve… They are the curve!” - Fatih Yilmaz
In the US, the situation is perhaps a little more complicated. We have discussed previously that we view the US economic momentum as being stronger than the (most significantly Q1) data suggests and we maintain our view that the US will follow the BoE rate rise in Q4 and start tightening (probably at a slightly faster pace than the UK) in Q1 2015.
Yields will continue to play a significant part in the puzzle also. While the 2-year forward points for EURUSD are currently at cyclical highs, 10-year Treasury yields – often the key barometer of US prosperity – are struggling to maintain much above 2.50 percent. Herein lies a significant issue. Yellen, in what seems like a deliberate plan to stay as far behind the curve as possible to ensure that the strength of the US (and global) economy can withstand the modest tightening, is running many risks. We believe that her subtle change in rhetoric is the start of a move to a less doveish bias. However, this turn is likely to have the turning circle of the QE2, at least as far as the implications for 10-year yields are concerned, as she uses forward guidance to emphasise the new equilibrium level of rates (2.5?). This uncertainty is likely to continue even into the onset of the tightening cycle in the US.
USD higher? Watch this space
We have argued over recent months that the economic (and ultimately monetary) divergence of the US and UK in relation to the Eurozone is growing and that this divergence should induce a (potentially) sharply lower EUR against USD and GBP. While US 10-year yields have frustrated the short duration bias of the market, we can envisage a situation over the coming months in which the USD rises significantly, even if yields continue to frustrate. As Yellen shifts from uber-dove, to data-watcher, watch this space!
-- Edited by Kevin McIndoe