Last week was an interesting week from a macro perspective related to the global economy. European economies announced weaker than expected purchasing manager numbers showing further contraction of their manufacturing base. With this negative news, the markets were expecting a reduction in the ECB policy rate deeper into negative territory at last week’s ECB meeting but instead received a no policy change, with Mario Draghi indicating at the ECB press conference a likely reduction in their policy rate at their next meeting along with implementing further QE related actions. Their non-action last week led to a repricing of European rates cross the curve (chart 1).
Chart 1 – German Sovereign Yield Curve Differential from June 26th to July 26th
Contrast this to what happened in the US. The GDP number for Q2 came out well ahead of expectations, at +2.1% vs expected 1.8%. US consumer spending, accounting for 70% of US economic activity, accelerated in Q2 helping to more than offset the decline in Q2 business investments. These numbers are clearly reflected in the current crop of earnings releases. Of the more than 40% of S&P 500 companies which have reported Q2 earnings to date, 76.4% have posted stronger than forecasted earnings.
The great debate over the past few weeks for this week’s Federal Reserve meeting has been: will they cut by 50 bps or 25 bps? As of Friday close, the market expectations for a 25 bps cut in July stood at a 76.5% probability down from 81.2% the previous day, while a 50 bps cut stood at 23.5% up from 18.8%, according to the CME Group’s FedWatch tool (chart 2). With regards to the Sep 18th Fed meeting, the market is still in favour of a 25 bps cut but the probability has been steadily declining. A 50 bps cut at this week’s meeting would be quite surprising, and would dramatically reduce the probability of an additional 25 bps cut in Sep, placing the Fed firmly in the “wait-and-see” camp. The shift in expectations towards a more aggressive move at this week’s meeting reflects the concerns about business investment slowdown spreading to consumer spending over time, along with the continued uncertainty brought on by the current trade battle between the US and China. Europe and US trade issues could also boil over soon adding more uncertainty to the global economy.
Chart 2 – Target Rate Probabilities For July 31st, 2019 Fed Meeting
On the currency front, there has been much talk by the current administration about the strength of the USD and its impact on trade. There were confirmed talks in the White House last week about using currency intervention as a tool to help weaken the USD which was apparently shot down by President Trump during the meeting with his economic and trade advisors. Trump’s stance on intervention could change in the future if the current path of the USD does not change in order to achieve the positive trade outcome they are looking for. The matter of the effectiveness of using intervention as a tool for changing the general trend of a currency is questionable unless done right and is a topic for another day. In the meantime, given the current technical outlook for the USD (chart 3), we expect the USD to remain attractive for those looking for positive carry. This confidence will likely continue to spill over into EM currencies providing support to those on the hunt for yield.
Chart 3 – Dollar Index (DXY)
In our view, the market may have gotten ahead of itself in its expectations of aggressive rate cuts as the Federal Reserve may want to see if the fears of an economic slowdown start showing up in the data. Rates may stay higher for longer in the US if consumer confidence is not impacted in the near term as the Fed continues to watch its favourite confidence gauge, the stock market, make new highs while companies benefit from the persistent consumer spending strength. This will maintain the status quo of the US having the highest interest rates out of all developed economies for at least the remainder of this year.