Saturday 21 April 2018

Daily Market Update: Strong US retail sales report bolsters case for tightening at this week’s eagerly‐awaited Fed meeting; we expect a dovish hike

Photo: Dominic Lipinski/PA Wire
Photo: Dominic Lipinski/PA Wire

Friday’s US retail sales report was stronger than expected, with various measures of core sales surprising positively in November.

So called “control group” sales (a measure that strips out a variety of erratic and non‐core items including autos, gasoline and building materials) jumped by 0.6% last month – its best month since May to leave annual growth at 2.9%, broadly in line with its average growth rate over the past few years. With consumer spending accounting for over 70% of the US economy, these figures offer important evidence of ongoing healthy expansion in a key area of the economy.

Friday’s report was the last piece of top‐tier economic news to be released ahead of Wednesday’s eagerly‐awaited policy update from the Fed. Confirmation of the healthy pace of consumer spending in our view seals the deal for the 25bps hike that is nearly universally anticipated by market observers, with just 3 out of 98 analysts surveyed by Bloomberg not expecting rates to be raised this week. As for interest rate markets themselves, current pricing this morning has a 25bps hike nearly but not quite fully priced for Wednesday.

That implies scope for the delivery of the expected hike to generate some modest market movements, including potentially some upside for US market interest rates and bond yields as well as for the dollar. But we expect a dovish hike on Wednesday, and would be surprised if Chair Yellen doesn’t strongly emphasise the Fed’s intention to proceed gradually and cautiously as it embarks on the process of normalising US interest rate settings. Ongoing declines in the price of oil (Brent crude has fallen a further 5.5% since Friday morning to trade below $37.50pb for the first time since late 2008), and some mild downward drift in both market and survey measures of inflation expectations suggest that some important inflation drivers remain contained. Given this backdrop, there’s little need, incentive or desire on the part of the Fed to sound particularly hawkish, or to be the source of major market volatility, at this point.

The last set of Fed projections from September revealed a median view within the Committee that rates would likely rise by about 25bps per quarter next year – about half the pace of tightening seen on average in the first year of the past three cycles. With markets priced for only about two such hikes next year, there will be particular focus on Yellen’s guidance and accompanying commentary on the 2016 policy outlook. We continue to think that markets will, over time, have further dollar‐positive adjusting to do to get closer to Fed guidance on this front. But we think that that’s a process that will likely take both time and further evidence on how the economy as well as the risks thereto is evolving. Ahead of what will be the first US rate hike in 9 years, Eur/USD opens the week’s trading at $1.0959 – little changed from where it was on Friday morning.

In other US news, CPI inflation is released for November tomorrow. Expectations are for the headline measure to accelerate from 0.2% to 0.4% y/y (linked mainly to favourable base effects due to the decline in oil prices during the back end of 2014) and more importantly, for core inflation (ex. food & energy) to advance from 1.9% to 2.0% y/y. While this is not the Fed’s favoured measure of inflation, the expected further signs of incremental emergence of upward price pressure should provide some boost to the Fed’s confidence that conditions are evolving in a manner that will allow inflation to return to target levels in the medium term. Manufacturing production figures for November on Wednesday will provide some flavour for how the international backdrop is affecting the American economy and expectations are for production to remain flat on the month at 0.0% m/m after 0.4% in October.

PMI numbers have been suggesting acceleration in Eurozone activity lately (to levels consistent with 0.4‐0.5% q/q GDP growth, in line with ECB forecasts) and the provisional December figures are announced on Wednesday. Expectations are for the services PMI to decline from 54.2 to 54.0 and for the manufacturing PMI to remain unchanged at 52.8, which would result in the composite PMI remaining at 54.2 in December.

The Eurozone composite PMI has published above expectations for two consecutive months, so there will be some interest regarding whether the release can continue this trend. Employment increased at 0.8% y/y in in Q2 and the results for Q3 are announced on Tuesday. Two business surveys in the form of the German ZEW survey expectations on Tuesday and the German IFO business climate on Thursday are announced. ZEW survey expectations are expected to rise from 10.4 in November to 15.0 in December, while expectations are for the IFO business climate to remain at 109 in December.

The Bank of England noted that wage growth could undershoot relative to their November Inflation 2015 Q4 forecast of 2.5% y/y. Three month average headline average weekly earnings are expected to decelerate on Wednesday, from 3.0% in September to 2.5% y/y in October, while expectations are for three month average weekly earnings ex. bonuses to drop from 2.5% to 2.3%.

The MPC also reflected that upward price pressures have been weaker than they projected, due in particular to a further decline in oil prices. However, due mainly to the aforementioned supportive base effects, headline CPI is expected to advance from ‐0.1% to 0.1% y/y. Core (ex. energy, food, alcohol & tobacco) CPI is also expected to improve to 1.2% y/y following 1.1% in October. With earnings growth starting to level off, retail sales have also been moderating, albeit to quite solid levels. Headline sales are expected to drop from 3.8% to 3.0% y/y and expectations are for core (ex. auto fuel) retail sales to decline from 3.0% to 2.3% y/y.

Finally, ECB president Mario Draghi and Bank of England Deputy Governor Shafik speak later today.

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