Sive Morten
Special Consultant to the FPA
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Fundamentals
This week we've got many important statistics and it was right in time before the Fed meeting on next week. But, to be honest, I was a bit surprised with the numbers. Well, slowdown of PCE is not surprising to anybody, but 3+% GDP growth was really something. And the major point - it is absolutely unclear where it has come from. In general if we take a look at outstanding challenges that the US has met in recent 3-4 years, including Covid pandemic, exceptional inflation spiral, multiple geopolitical issues, restructure of a global economy. The US was able to show outstanding numbers - 2023 year US GDP growth was 3.1%, for two years – 3.8%, and from the pre-shaped 4Q19, GDP grew by 8.2%, which corresponds to the historical 10-year trend of 2010-2019. The major question still remains - what the source of this growth and whether this growth has any relation to reality?
Market overview
The U.S. dollar rose on Thursday after data showed the world's largest economy grew at a faster pace than expected in the fourth quarter, suggesting the Federal Reserve would be in no rush to cut interest rates. The euro, on the other hand, fell to a new six-week low against the dollar of $1.08215 after mixed comments from European Central Bank President Christine Lagarde. She said it was "premature to discuss rate cuts" for the euro zone economy, but noted that the risks to economic growth remain "tilted to the downside."
In the United States, the Bureau of Economic Analysis' advance GDP estimate showed gross domestic product in the last quarter increased at a 3.3% annualized rate, compared with the consensus forecast of 2% growth rate.
Post-data, U.S. rate futures market priced in a roughly 51% chance of easing at the March meeting, up from late Wednesday's 40% probability but down from the 80% chance factored in two weeks ago, according to LSEG's rate probability app. The market is fully pricing in the first rate cut to occur at the May meeting, with a roughly 94% probability.
The Fed will likely wait until the second quarter before cutting interest rates, according to a majority of economists polled by Reuters. June is seen as the more likely month economists expect the Fed to ease. Next week, the Fed is widely expected to stand pat but comments from Chair Jerome Powell will be intensely scrutinized for clues as to when the U.S. central bank will start cutting rates.
A separate report from the Labor Department showed initial claims for state unemployment benefits increased 25,000 to a seasonally adjusted 214,000 for the week ended Jan. 20. Economists had forecast 200,000 claims in the latest week.
With the comments ECB made on inflation and wages, the bank was seen as appearing less concerned about inflation than before. It was noted that the ECB had removed a mention that "domestic price pressures remain elevated, primarily owing to strong growth in unit labour costs," from its decision, for instance. Markets took that as a sign the bank is becoming more convinced that wage growth, which it has flagged as the biggest risk to inflation, is slowing, analysts said.
Interest-rate sensitive two-year bond yields fell sharply as traders doubled down on rate cut bets. They now expect more than an 80% chance of a first 25 basis-point (bps) rate cut in April, up from around 60% before the meeting. They also fully factored in 50 bps of cuts by June.
Lagarde reiterated that the ECB would remain data-dependent and said she stood by her comments last week pointing to a summer rate cut. She has also previously said she expects enough wage data by "late spring" and chief economist Philip Lane has wanted to see data due in April, which would rule out easing before June.
ABN AMRO and Danske Bank stuck to their call for a June cut on Thursday. Another risk is the January euro zone inflation print due next Thursday, which could set the tone for how price pressures evolve this year.
Investors cautioned that waiting too long to cut rates risked a policy error where the ECB keeps policy too tight for an economy that is weakening. German business morale unexpectedly worsened in January, declining for the second month in a row as Europe's largest economy struggles to shake off a recession. ECB projections have long signalled higher inflation than markets. The ECB forecasts 2.7% inflation this year, versus 2.4% expected by a Reuters poll. Similarly, it has expected higher growth than analysts, seeing the economy expanding 0.8% this year. A Reuters poll puts economic growth at just 0.5%.
The U.S. dollar inched lower on Friday, after data showed inflation rose modestly in December but was trending lower, which should keep the Federal Reserve on track to cut interest rates by the middle of the year. Data showed the personal consumption expenditures (PCE) price index increased 0.2% last month after an unrevised 0.1% drop in November. In the 12 months through December, the PCE price index increased 2.6%, matching November's unrevised gain. Those numbers were in line with consensus expectations. The annual inflation rate was under 3% for the third straight month. The Fed tracks the PCE price measure for its 2% inflation target.
Jonathan Petersen, senior markets economist at Capital Economics wrote in a research note that despite recent solid economic data, growing disinflationary pressures have kept a lid on Treasury yields and the dollar. Much like the Fed, he noted that other central banks such as the European Central Bank, have pushed back against market expectations of rates cuts in the next couple of months.
OUR VIEW ON RECENT DATA
Somehow, many people that are so exciting about recent GDP data absolutely do not think about the sources of this growth and totally forget about budget deficit. We already have given the hint on this subject. The nuance is that we need to compare it with the growth rates that we observed before and how the economy was stimulated from the state budget.
In Q2 2023, growth was 2.1%. At the same time, during the quarter, public debt increased by 0.9 trillion. dollars, and the cache in the accounts of the Ministry of Finance increased by 200 billion dollars. That is, the net injection amounted to 700 billion dollars. But we must understand that the government debt ceiling was raised only in early June, so the effect of deficit spending of the budget was insignificant.
But it was significant in the 3rd quarter of 2023, when the public debt increased by $800 billion, cash increased by $270 billion, that is, net injections due to the budget deficit amounted to $530 billion, plus the deferred effect from the end of 2 sq. 2023. GDP grew by as much as 4.9%.
In the 4th quarter, with GDP growth of 3.3%, the increase in public debt amounted to more than 800 billion dollars, and the increase in cash was only 60 billion dollars. That is, a net amount of 740 billion dollars was injected. That is, the state has made the net-borrowing and created by this amount additional demand in the economy. Demand should be significantly less. Because budget expenditures to achieve it stands around 8.6% of GDP.
It follows from these figures that without the current budget deficit, GDP would have fallen by more than 5.3%. There is not a 1:1 ratio, a multiplier effect exists, because taxes are also collected from those incomes in the economy made by budget spending. In 2022, the budget deficit was 1.4 trillion. dollars (5.6% of GDP), while GDP grew by 2.1%. Now, in annual terms, the deficit is 8.6%, and GDP is growing by 3.3%. That is, in 2022, without stimulation, the fall in GDP would have been more than 3.7%, and in 2023 it would have been more than 5.3%.
Moreover, in order to maintain economic growth, and not slide it into a multi-year depression, the budget deficit and borrowing will need to continue to increase. Without incentives, the economy no longer works. Bank credit in the economy is not growing. Economy is dying and is already connected to a ventilator.
It means that any talk about reducing the budget deficit is already profanation. They cannot stop increasing the national debt. Moreover, if they suddenly do this and the economy slides into recession, then bank credit will continue to decline and deflationary processes will overwhelm the economy, which will not just deflate by a certain amount, but will slide further and further down. But this, of course, will not be allowed. True, there is no elegant and problem-free solution to this situation. Only through inflation. A separate question is how exactly it will manifest itself. So, now this chart becomes clear as it indicates how GDP is financed by raising of the budget deficit:
But the budget deficit component is not the "only" trick of statisticians. There are other mismatches exist. GDP growth in reality is an accounting technology for converting emission dollars into formal value added, especially when you consider that the real sector is not growing at all. Unemployment is at a fairly high level (we just won't believe Yellen here, because there are a lot of unemployment data and you can always choose positive ones among them) - here is
U-6 Unemployment Rate:
As we've shown above, initial claims suddenly jumps in December for 25 thousands, up to 214K level. While the average length of the working week has fallen to values not seen since covid quarantine:
There is nothing to even comment on, against the background of economic growth, the length of the working week cannot fall! And in the fourth quarter of 2023, it was the lowest in several post-quarantine years!
OTHER ISSUES TO CONSIDER
First is, BTFP programme. The Fed indeed intends to close it on 11th March, 2024, as it is suggested by programme conditions. Now we see strong acceleration of borrowing with this programme, and this is logical. Banks that have no other source of liquidity are hurry up to get funds while it is possible to do. In Feb-March we think that the pace will be even steeper. The Fed finally has recognized the arbitrage and hike the BTFP borrowing rate to avoid it. But hardly it will decrease demand for borrowing. Once the programme will be closed, the only source of liquidity for banks will be the Fed discount window. But it has no sense because funds are provided against market value of collateral. Banks with the same effect could sell bonds rather than borrow against them.
So, in a case of liquidity problems the US banking sector now doesn't have the tool that could resolve the problem. It means that once again we have to keep an eye on few liquidity data, such as DRPO level, US Treasury deposit, Banking reserves accounts with the Fed and see for dynamic. Now, DRPO remains the last source where banks could get the cash and it is dropping fast:
Then, theoretically US Treasury should start spending accumulated cash on accounts which stands around $800 Bln to support spending:
With fast money supply drop, liquidity shows first signs of problems. The spread between SOFR and RRP demonstrates a shortage or structural imbalance of liquidity in the dollar financial system. SOFR rate - used, among other things, for settlements of margin positions worth trillions of dollars in derivatives and swap transactions, and is involved in interbank lending. It is a benchmark for determining the cost of corporate lending. The RRP is what the Fed pays for placing excess liquidity of banks and funds in Fed accounts. Typically the spread between SOFR and RRP is 1-2 points, but at the beginning of 2024 it rose to 8 or even 10 points
As we will see that RRP hits ~ 200 Bln level, BTFP will be closed and US Treasury cash balance start dropping - QE is near. The Fed could even keep rates at high levels. It doesn't matter. We're not occasionally mentioned The U.S. Treasury's quarterly refunding announcements, with overall funding totals due on Jan. 29 and maturity breakdowns on Jan. 31. It is important to see whether the Fed will shift borrowing in favor of long term securities or not. If it will, then everything will go with our plan - long-term yields will start raising, normalizing the yield curve. This will be last preliminary step before recession at the end of 2024- 2025 and another inflation spiral. But in nearest 3-6 months this should be supportive to the US dollar.
Concerning EUR, that the turmoil in Red Sea should lead to jump in inflation, so EUR will have higher inflation for longer and keep high rates longer than the US. I see two objections here. First is political one - the US never let EU to grab financial flows, especially in current situation. That's why, most probable that logistics problems will trigger more degradation and destruction of EU industry sector, that leads to producer deflation rather than inflation. In fact, last J. Biden initiatives, concerning LNG limits just confirm this. Apparently, Europe is too well prepared for winter to have to take such measures. They accumulated record reserves, reduced consumption, and as a result the price went down, dragging inflation with it. It shouldn't be this way. The US economy should be the best of the worst in this crisis.
It means that degradation of EU economy due to recent decisions should accelerate, pressing on ECB to cut rate. This should make EUR even weaker.
Conclusion:
It seems that now the USD rate is determined not by rate differential but just amount of US Dollar in the system. Liquidity is becoming thinner, and if EU would have two times greater rate than US - USD probably still keeps raising anyway, just because this is not comparable size of EUR and USD in float and demand for USD. But, as EU economy is falling into recession faster, raising political instability, unrests and strikes - this will echo in GDP very soon. We suggest that as the US efforts as EU own situation in economy will make ECB to cut rates earlier than the Fed. These two factors should support USD performance in nearest few months.
This week we've got many important statistics and it was right in time before the Fed meeting on next week. But, to be honest, I was a bit surprised with the numbers. Well, slowdown of PCE is not surprising to anybody, but 3+% GDP growth was really something. And the major point - it is absolutely unclear where it has come from. In general if we take a look at outstanding challenges that the US has met in recent 3-4 years, including Covid pandemic, exceptional inflation spiral, multiple geopolitical issues, restructure of a global economy. The US was able to show outstanding numbers - 2023 year US GDP growth was 3.1%, for two years – 3.8%, and from the pre-shaped 4Q19, GDP grew by 8.2%, which corresponds to the historical 10-year trend of 2010-2019. The major question still remains - what the source of this growth and whether this growth has any relation to reality?
Market overview
The U.S. dollar rose on Thursday after data showed the world's largest economy grew at a faster pace than expected in the fourth quarter, suggesting the Federal Reserve would be in no rush to cut interest rates. The euro, on the other hand, fell to a new six-week low against the dollar of $1.08215 after mixed comments from European Central Bank President Christine Lagarde. She said it was "premature to discuss rate cuts" for the euro zone economy, but noted that the risks to economic growth remain "tilted to the downside."
In the United States, the Bureau of Economic Analysis' advance GDP estimate showed gross domestic product in the last quarter increased at a 3.3% annualized rate, compared with the consensus forecast of 2% growth rate.
Post-data, U.S. rate futures market priced in a roughly 51% chance of easing at the March meeting, up from late Wednesday's 40% probability but down from the 80% chance factored in two weeks ago, according to LSEG's rate probability app. The market is fully pricing in the first rate cut to occur at the May meeting, with a roughly 94% probability.
The Fed will likely wait until the second quarter before cutting interest rates, according to a majority of economists polled by Reuters. June is seen as the more likely month economists expect the Fed to ease. Next week, the Fed is widely expected to stand pat but comments from Chair Jerome Powell will be intensely scrutinized for clues as to when the U.S. central bank will start cutting rates.
A separate report from the Labor Department showed initial claims for state unemployment benefits increased 25,000 to a seasonally adjusted 214,000 for the week ended Jan. 20. Economists had forecast 200,000 claims in the latest week.
With the comments ECB made on inflation and wages, the bank was seen as appearing less concerned about inflation than before. It was noted that the ECB had removed a mention that "domestic price pressures remain elevated, primarily owing to strong growth in unit labour costs," from its decision, for instance. Markets took that as a sign the bank is becoming more convinced that wage growth, which it has flagged as the biggest risk to inflation, is slowing, analysts said.
Interest-rate sensitive two-year bond yields fell sharply as traders doubled down on rate cut bets. They now expect more than an 80% chance of a first 25 basis-point (bps) rate cut in April, up from around 60% before the meeting. They also fully factored in 50 bps of cuts by June.
Lagarde reiterated that the ECB would remain data-dependent and said she stood by her comments last week pointing to a summer rate cut. She has also previously said she expects enough wage data by "late spring" and chief economist Philip Lane has wanted to see data due in April, which would rule out easing before June.
ABN AMRO and Danske Bank stuck to their call for a June cut on Thursday. Another risk is the January euro zone inflation print due next Thursday, which could set the tone for how price pressures evolve this year.
Investors cautioned that waiting too long to cut rates risked a policy error where the ECB keeps policy too tight for an economy that is weakening. German business morale unexpectedly worsened in January, declining for the second month in a row as Europe's largest economy struggles to shake off a recession. ECB projections have long signalled higher inflation than markets. The ECB forecasts 2.7% inflation this year, versus 2.4% expected by a Reuters poll. Similarly, it has expected higher growth than analysts, seeing the economy expanding 0.8% this year. A Reuters poll puts economic growth at just 0.5%.
The U.S. dollar inched lower on Friday, after data showed inflation rose modestly in December but was trending lower, which should keep the Federal Reserve on track to cut interest rates by the middle of the year. Data showed the personal consumption expenditures (PCE) price index increased 0.2% last month after an unrevised 0.1% drop in November. In the 12 months through December, the PCE price index increased 2.6%, matching November's unrevised gain. Those numbers were in line with consensus expectations. The annual inflation rate was under 3% for the third straight month. The Fed tracks the PCE price measure for its 2% inflation target.
Jonathan Petersen, senior markets economist at Capital Economics wrote in a research note that despite recent solid economic data, growing disinflationary pressures have kept a lid on Treasury yields and the dollar. Much like the Fed, he noted that other central banks such as the European Central Bank, have pushed back against market expectations of rates cuts in the next couple of months.
OUR VIEW ON RECENT DATA
Somehow, many people that are so exciting about recent GDP data absolutely do not think about the sources of this growth and totally forget about budget deficit. We already have given the hint on this subject. The nuance is that we need to compare it with the growth rates that we observed before and how the economy was stimulated from the state budget.
In Q2 2023, growth was 2.1%. At the same time, during the quarter, public debt increased by 0.9 trillion. dollars, and the cache in the accounts of the Ministry of Finance increased by 200 billion dollars. That is, the net injection amounted to 700 billion dollars. But we must understand that the government debt ceiling was raised only in early June, so the effect of deficit spending of the budget was insignificant.
But it was significant in the 3rd quarter of 2023, when the public debt increased by $800 billion, cash increased by $270 billion, that is, net injections due to the budget deficit amounted to $530 billion, plus the deferred effect from the end of 2 sq. 2023. GDP grew by as much as 4.9%.
In the 4th quarter, with GDP growth of 3.3%, the increase in public debt amounted to more than 800 billion dollars, and the increase in cash was only 60 billion dollars. That is, a net amount of 740 billion dollars was injected. That is, the state has made the net-borrowing and created by this amount additional demand in the economy. Demand should be significantly less. Because budget expenditures to achieve it stands around 8.6% of GDP.
It follows from these figures that without the current budget deficit, GDP would have fallen by more than 5.3%. There is not a 1:1 ratio, a multiplier effect exists, because taxes are also collected from those incomes in the economy made by budget spending. In 2022, the budget deficit was 1.4 trillion. dollars (5.6% of GDP), while GDP grew by 2.1%. Now, in annual terms, the deficit is 8.6%, and GDP is growing by 3.3%. That is, in 2022, without stimulation, the fall in GDP would have been more than 3.7%, and in 2023 it would have been more than 5.3%.
Moreover, in order to maintain economic growth, and not slide it into a multi-year depression, the budget deficit and borrowing will need to continue to increase. Without incentives, the economy no longer works. Bank credit in the economy is not growing. Economy is dying and is already connected to a ventilator.
It means that any talk about reducing the budget deficit is already profanation. They cannot stop increasing the national debt. Moreover, if they suddenly do this and the economy slides into recession, then bank credit will continue to decline and deflationary processes will overwhelm the economy, which will not just deflate by a certain amount, but will slide further and further down. But this, of course, will not be allowed. True, there is no elegant and problem-free solution to this situation. Only through inflation. A separate question is how exactly it will manifest itself. So, now this chart becomes clear as it indicates how GDP is financed by raising of the budget deficit:
But the budget deficit component is not the "only" trick of statisticians. There are other mismatches exist. GDP growth in reality is an accounting technology for converting emission dollars into formal value added, especially when you consider that the real sector is not growing at all. Unemployment is at a fairly high level (we just won't believe Yellen here, because there are a lot of unemployment data and you can always choose positive ones among them) - here is
U-6 Unemployment Rate:
As we've shown above, initial claims suddenly jumps in December for 25 thousands, up to 214K level. While the average length of the working week has fallen to values not seen since covid quarantine:
There is nothing to even comment on, against the background of economic growth, the length of the working week cannot fall! And in the fourth quarter of 2023, it was the lowest in several post-quarantine years!
OTHER ISSUES TO CONSIDER
First is, BTFP programme. The Fed indeed intends to close it on 11th March, 2024, as it is suggested by programme conditions. Now we see strong acceleration of borrowing with this programme, and this is logical. Banks that have no other source of liquidity are hurry up to get funds while it is possible to do. In Feb-March we think that the pace will be even steeper. The Fed finally has recognized the arbitrage and hike the BTFP borrowing rate to avoid it. But hardly it will decrease demand for borrowing. Once the programme will be closed, the only source of liquidity for banks will be the Fed discount window. But it has no sense because funds are provided against market value of collateral. Banks with the same effect could sell bonds rather than borrow against them.
So, in a case of liquidity problems the US banking sector now doesn't have the tool that could resolve the problem. It means that once again we have to keep an eye on few liquidity data, such as DRPO level, US Treasury deposit, Banking reserves accounts with the Fed and see for dynamic. Now, DRPO remains the last source where banks could get the cash and it is dropping fast:
Then, theoretically US Treasury should start spending accumulated cash on accounts which stands around $800 Bln to support spending:
With fast money supply drop, liquidity shows first signs of problems. The spread between SOFR and RRP demonstrates a shortage or structural imbalance of liquidity in the dollar financial system. SOFR rate - used, among other things, for settlements of margin positions worth trillions of dollars in derivatives and swap transactions, and is involved in interbank lending. It is a benchmark for determining the cost of corporate lending. The RRP is what the Fed pays for placing excess liquidity of banks and funds in Fed accounts. Typically the spread between SOFR and RRP is 1-2 points, but at the beginning of 2024 it rose to 8 or even 10 points
As we will see that RRP hits ~ 200 Bln level, BTFP will be closed and US Treasury cash balance start dropping - QE is near. The Fed could even keep rates at high levels. It doesn't matter. We're not occasionally mentioned The U.S. Treasury's quarterly refunding announcements, with overall funding totals due on Jan. 29 and maturity breakdowns on Jan. 31. It is important to see whether the Fed will shift borrowing in favor of long term securities or not. If it will, then everything will go with our plan - long-term yields will start raising, normalizing the yield curve. This will be last preliminary step before recession at the end of 2024- 2025 and another inflation spiral. But in nearest 3-6 months this should be supportive to the US dollar.
Concerning EUR, that the turmoil in Red Sea should lead to jump in inflation, so EUR will have higher inflation for longer and keep high rates longer than the US. I see two objections here. First is political one - the US never let EU to grab financial flows, especially in current situation. That's why, most probable that logistics problems will trigger more degradation and destruction of EU industry sector, that leads to producer deflation rather than inflation. In fact, last J. Biden initiatives, concerning LNG limits just confirm this. Apparently, Europe is too well prepared for winter to have to take such measures. They accumulated record reserves, reduced consumption, and as a result the price went down, dragging inflation with it. It shouldn't be this way. The US economy should be the best of the worst in this crisis.
It means that degradation of EU economy due to recent decisions should accelerate, pressing on ECB to cut rate. This should make EUR even weaker.
Conclusion:
It seems that now the USD rate is determined not by rate differential but just amount of US Dollar in the system. Liquidity is becoming thinner, and if EU would have two times greater rate than US - USD probably still keeps raising anyway, just because this is not comparable size of EUR and USD in float and demand for USD. But, as EU economy is falling into recession faster, raising political instability, unrests and strikes - this will echo in GDP very soon. We suggest that as the US efforts as EU own situation in economy will make ECB to cut rates earlier than the Fed. These two factors should support USD performance in nearest few months.
