FIRST QUARTILE ECONOMICS |
With interest rates not a threat in the period ahead there is no reason the economy cannot continue to advance at a pace consistent with reasonable profitability -- or so the market seems to be saying. This is perhaps a bit aggressive given the still worsening situation in Asia while the more recent turmoil in Russia may still represent the beginnings of a more pervasive negative impact on the European financial system and economy.
COMMODITY PRICES: Gold prices fell by some $3/oz this past week to the $290.60 level. It appears the U.S. dollar will not post much of a reversal from recent highs and may indeed go on to new highs. The European Central Bank also indicated a target of 15 percent for its reserves in gold which verifies the probability there are lots of individual European Central Bank holdings of gold that will leak into the market in future years.
Oil prices also continue to languish in relatively low territory despite an enormous announced cutback in OPEC production in June. It seems very doubtful OPEC will agree to further cutbacks that might bring the price of WTC above $15/brl and there is nothing to rule out a renewed move to the $13 range as the summer unfolds.
In aggregate, commodity prices generally relapsed sharply during the past week as the CRB Index fell by almost 4 points or 1.8 percent. The CRB Index is now back to within 1 percent of its multi-year low set in mid-June and has given up about 75 percent of its recent rally. This kind of action begs a test of the 200 level on the CRB Index during the summer which would match the cycle lows set in 1985 and 1992. For bonds, this environment is a terrific backdrop over the next several months.
U.S. BONDS: The Treasury market has settled into a state of calm in recent days as there was little net change in the yield curve during the past week. Most of the movement in yields has been tied to fluctuations in the Yen. Recent data has been bond friendly (NAPM, unemployment rate and PPI) but the workout of the Asian economic uncertainty remains far from clear. As long as there is reasonable economic weakness in Japan and Asia, the market is prepared to believe the Fed will stay on hold indefinitely.
As a result, the flat yield curve from to 2 to 10 years leaves 30-year yields out of synch since they are some 20 basis points higher. At a minimum, it appears the 30-year yield should settle towards equality with the 2 to 10 year slope and this is expected to be the next “meaningful” move in yields. Beyond such a development, one probably has to paint a picture of future Fed easing to justify the sustainability of the entire Treasury curve below the current 5.50% Fed Funds rate. By definition, the yield curve is suggesting either very slow economic growth ahead which implies eventual Fed easing, or sustainably low inflation such that long yields still offer significant value on a real return basis.
It seems doubtful the U.S. economy will slow enough to force the Fed to lower interest rates over the next year or so but the economy can grow slowly enough to result in a core inflation rate below 2 percent. After “worrying out loud” about tight labor markets and the risks of higher inflation during the past few years the Fed has nevertheless taken its chances that inflation would remain at bay. If there is a slowdown of sorts it will likely be most welcome by the Fed and is unlikely to be quickly met with an easing cycle.
Several quarters of 2 to 3 percent economic growth is actually just where the Fed would like to see the economy settle for the long haul. So, there is no necessary inconsistency between an inverted yield curve and continued steady Fed policy. I think the underlying inflation rate in the U.S. will stay around 2 percent and probably settle lower for the next several years. This is consistent with a 30-year Treasury yield no higher than about 5 percent and a Fed Funds rate in the vicinity of 4.5 percent.
U.S. DOLLAR: The dollar gained a little versus the Yen this past week, closing at 140.50 versus 139.42 the prior week. Japanese government commitment to fiscal measures that will convincingly contribute to economic recovery remains ambiguous and this has tended to push the dollar back and forth lately. Moreover, there is always the threat of Fed or Bank of Japan intervention that has tended to limit weakness in the Yen.
It seems foreign exchange market players continue to give too much credibility to Japanese resolve to turn the economy around with any haste. Everything announced so far seems to have an impact sometime in 1999 which leaves the rest of 1998 as a total write-off as far as economic growth and corporate profits are concerned. Further, to the extent that nothing currently contemplated will do more than gradually pull Japan out of recession (no “V” shaped recovery is in the cards) the Asian economic malaise will get no support from Japan for many months yet.
The DM continues to suffer in response to perceived exposure to a collapsing Russian economy and financial system. While many analysts argue the risks to the German banking system are overstated, foreign exchange market players are skeptical about such reassurances in the wake of global economic difficulties during the past year. The bottom line appears to call for general U.S. dollar firmness over the next several months.
CANADIAN BONDS: In days gone by, new record lows for the Canadian dollar would have guaranteed some relative weakness versus the U.S. Treasury market but this holds true no more. Canada outperformed the U.S. during the past week albeit slightly. Ultimately, the domestic yield curve is not implicitly wary of a meaningful further rise in short term interest rates in response to CAD weakness. This also suggests a lack of concern that the currency has much further to decline in general. This makes sense because the next Bank Rate hike will essentially equalize Canada/U.S. money market spreads and remove one of the underlying causes of the currency’s slow but steady disintegration. The other key factor which is much further away from resolution is Canada’s still substantial Current Account Deficit. Canada is still viewed as a relatively healthy economy and as demonstrated by the developments in Japan, a Current Account Surplus of itself is no guarantee of currency strength.
Generally, the broader moves in the domestic yield curve remain contingent on U.S. market developments. Other things being equal, my anticipation of a potentially significant further decline in long Treasury yields translates into a comparable decline of long Canada yields. If as I think likely, the Bank Rate is on the verge of another increase, the short end of the domestic yield curve will also tend to rise as well. This brings Canada closer to a generally flatter or inverted yield curve scenario than the U.S. Given Canada’s superior inflation readings of late such a yield curve is quite appropriate.
CANADIAN DOLLAR: After a couple of weeks of consolidation following marginal new lows versus the U.S. currency in mid-June, the CAD has resumed its downward bias and set new record lows during the past week. This week’s trading range was 1.4678 to 1.4795 with a close of 1.4780.
The preceding chart now suggests the potential for the type of CAD weakness that will finally force the Bank of Canada to raise the Bank Rate by at least 25 basis points. Until now, the mid-June low of the currency remained within the confines of a bearish trading channel that could possibly have contained the currency for several months. This week’s significant breach of the upper channel line and failure to rally back to close within the channel will most likely fuel a renewed bout of speculative selling of CAD.
With 1.4800 having been tested before an unimpressive rally, it is totally within reason for the market to focus on 1.5000 as the next target. Yet another way of anticipating potential market targets for CAD is thinking in terms of U.S. 65 cents which equates to 1.5385. In turn, these levels suggest meaningful enough new lows versus the January low of 1.4686 that helped trigger the last Bank Rate increase, that the Bank will be forced to react with an interest rate hike.
Accordingly, the upcoming week will likely see a trading range of 1.4750 to 1.4900. Foreign exchange market participants are no doubt cognizant of the threat of an interest rate increase and are likely to test the Bank with a degree of caution that is atypical of periods of currency decline. As a result, when the Bank finally does raise rates, the currency will likely rebound more slowly than has often been the case.
July 13, 1998.
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