Next Week's Alphabet Soup: FOMC, BOJ, GDP, CPI

The week ahead is important from a macro perspective. The Bank of Japan and the Federal Reserve meet. The US and the eurozone provide the first estimates of Q1 21 GDP, and the preliminary April EMU CPI will be reported.

The data will be interesting even if not market moving. The divergence meme that helped the US dollar trade broadly higher in Q1 has failed to help the greenback this month, even though a string of important data, including jobs, retail sales, auto sales, and housing starts, were well above expectations. Bloomberg's survey median forecast for 6.6% annualized growth in Q1 may be on the low side, which is consistent with the pattern seen in the high-frequency data where economists generally do not appreciate the economy's strength.

All three Federal Reserve banks that have GDP trackers project stronger growth than the private sector, mostly from bank economists surveyed. The NY Fed is the closest at 6.9%. The Atlanta Fed's model sees it at 8.3%, and the St Louis model puts Q1 growth at almost 10.2%. Even if it comes out a bit lower than the median market forecast, the US economy would have produced more goods and services than in Q4 19 before the pandemic stuck and represents a new record.

There is more good news. Growth has not peaked. The economy is still accelerating. Growth is likely to peak in the middle two quarters of the year before gradually slowing as the fiscal stimulus, and the income effect of people returning to their jobs run their course. Indeed, in Q3, some of the fiscal support winds down. But, in the meantime, the US economy is digesting $2.8 trillion stimuli agreed in the December-March period, like a python swallowing a doe.

The market is skeptical that the economic conditions will allow the Fed to wait until 2024 to lift interest rates, which is what 11 of 18 officials thought last month. The leadership, which includes the NY Fed President, and the Board of Governors, are likely in the majority. At the end of last year, the December 2022 Eurodollar futures contract ($1 mln notional contract for a three-month deposit) implied a 25 bp rate. It trended higher and peaked in early April near 57.5 bp. It dovetailed nicely with the dollar's recovery from the November-December slide.

However, since early April, and despite one strong economic report after another, the implied yield has fallen back to almost 40 bp. The market is less aggressive now, and the risk is that the re-adjustment process is not complete. Despite recognizing that the economy is taking off, the Fed will not succor to a ideas of a hike as early as next year. On the other hand, the more pressing issue is what constitutes “substantial further progress” toward the Fed's targets of maximum employment and the average inflation target. This is the bar for tapering, which is assumed to proceed a change in rates.

Fed Chair Powell has secured maximum flexibility by leaving the conditionality vaguely defined, just like he has not specified the period that the “average” rate of inflation will apply. That vagueness, the Deus ex Machina, the X-Factor, maybe the market itself and its reaction function. With more than half of US adults with at least one vax in their arms, the normalization process will likely accelerate. Talk is still about a million people returning to their jobs this month, and the decline in the weekly initial jobless claims has been greater than economists projected. Various surveys and corporate earnings reports point to rising input costs, not just a base effect, arising from bottlenecks and shortages.

By the next FOMC meeting (June 16), it will be likely evident to most observers that “substantial further progress” has been achieved; perhaps something around two million people would have returned to their jobs between March and June FOMC meetings. Weekly initial and continuing jobless claims will continue to trend lower. Officials could find it increasingly difficult to justify buying $120 bln of long-term securities a month in July 2021 than it did in, say, September 2020. Tapering is not tightening. It is slowing the pace of additional monetary accommodation. Moreover, if the Fed does not begin this process in a timely fashion, it will have to do so as the economy slows, making for poor optics. The market and the Fed see the economy returning to trend growth in 2023, which is closer to 2% than 3%. Tapering this year would seem to be consistent with preserving its tactical flexibility.

There is little for the Bank of Japan to say or do. At its last meeting, it clarified that under yield curve control, it allows the 10-year yield to trade +/- 25 bp on either side of zero. Market participants were under the impression previously that the band was 20 bp. It made for a nice headline or two, but it is not really material. Since the late February spike, that to 18 bp, Japan's 10-year yield has traded with a five-basis point range on either side of 10 bp.

The BOJ also reduced the amount of frequency of its bond purchases. It may look like tapering, but it is not. Tapering has come to mean a gradual reduction as opposed to a quick stop. What the BOJ is doing is not the first step in a sequence that will lead it to a full stop and end its quantitative easing. Instead, it is probably best to accept that it is a recalibration to allow it to be continued indefinitely. The 1-year–Japan 3-year maturity segment will be the largest bucket it buys.

The central bank owns more than 40% of the government's bonds. Its purchases and holdings have already impacted trading, to depress it. That is also one of the reasons that the BOJ has reduced its bond purchases. To be sure, it is still buying roughly the equivalent of about $54 bln of JGBs a month, down from closer to $60 bln. The BOJ has also reduced the frequency of its ETF purchases. Its balance sheet has expanded by about 2% so far this year, which is slightly faster than the Fed's.

In January, the BOJ tweaked its forecast for growth from 3.6% to 3.9% this fiscal year and from 1.6% to 1.8% next year. Its projection of core CPI stood at 0.5% (from 0.4%) and maintained the 0.7% forecast for FY22. The BOJ seems more optimistic for this year's growth. The OECD, for example, sees the world's third-largest economy expanding at less than a 3% pace this year. Given the contagion wave that appears to be forcing several large areas, including Tokyo and Osaka, back into formal emergencies and the slow rollout of the vaccine (less than 1%), a domestic economic recovery may have to be pushed out.

Foreign demand is critical to Japan's growth, and China's capex cycle, especially semiconductor fabrication equipment, is an important driver. China is absorbing a fifth of Japan's exports and is its largest trading partner. The Regional Comprehensive Economic Partnership (RCEP) managed to do something that the US could not achieve: Bring Japan and South Korea into a free trade pact. Historical issues have not been fully resolved, and Seoul has been vocal in its criticism of Japan's plan to dump radioactive water from the Fukushima nuclear accident into the ocean. However, the economic and security ties are growing. China is the destination of more than a quarter of South Korea's exports. Australia, which is also a member of the RCEP, sends more than a third of its exports to China, which has not stopped China from using trade to punish Australia for its pro-American foreign policy. Tensions may increase further following Canberra's cancellation of two projects in Victoria under the Belt and Road Initiative.

Foreign investors took advantage of the yen's decline at the end of March to its lowest level in a year to scoop up Japanese bonds. In fact, over the past three weeks, they bought the most since last February (~JPY2.1 trillion, or $19.9 bln). Remember, some financial strategies involve buying the JGB and selling the yen and making, at times, more from the currency swap than from the bond.

Japanese investors bought about JPY3 trillion of foreign bonds over the same period and are on track for their largest bond-buying spree since August 2019. That said, some reports seem to exaggerate the calendar effect and the beginning of the new fiscal year. Counting this year, Japanese investors have been net buyers of foreign bonds in 11 of the past 20 Aprils. Since early last November (US election and vaccine announcement), the US 10-year premium over JGBs doubled through the end of March to over 160 bp before pulling back to about 145 bp recently.

The eurozone will report its preliminary estimate of April inflation and Q1 GDP. While there may be some reaction to the headline, it is likely to have little, if any, policy implication. As ECB President Lagarde made clear, any rise in inflation is likely technical (base effect, shifting basket-weights, pandemic-induced charges to seasonal sale) and transitory, and that officials will look through it. After rebounding in Q3 20 after the H1 20 contraction, the eurozone economy contracted by 0.7% in Q4 20. It is likely to have contracted in Q1 21 as the social restrictions in the face of the virus surge take a toll. However, the 0.8% contraction that is being projected could be a bit pessimistic. Adjustments have been made, and many national economies seem more resilient than expected.

Both the US and eurozone economy are likely to accelerate in Q2 and Q3. Yet, it is likely that the growth differential does not begin narrowing until Q4. In some European countries, social and travel restrictions will extend into May, and the much-anticipated EU Recovery Fund may not begin disbursing funds until well into Q3. Although the German high court will not overrule parliament, which has approved the measures, while the case claiming violations of the constitution is heard, nearly a third of the EU members have yet to ratify the agreement. A small coalition partner in the Polish government is balking, making it unlikely to meet the end of April goal.

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