FX Daily: US Q1 GDP highlights Fed’s inability to fight adverse shocks

26th June 2014

  • Large dealers could face losses of $2.5 bln to $4.5 bln from their $13 bln revenues generated last year from global interest rate markets due to new reforms being implemented to the US swap market. (The FT)
  • More Japanese corporations are making acquisitions a key part of their growth strategies and adding spending targets to their business plans as they seek to use their cash reserves more efficiently. (The Nikkei)
  • China’s Premier Li said the transfer of some industries from east China to the middle and central parts could ensure employment inland and ease rising labour costs along the east coast. (MNI)
  • China has accelerated plans to set up a property registration system and could meet the deadline requested by the State Council to launch the system’s regulations by end of June. (Chinanews.com)
  • Wang Shi, Chairman of a leading property developer, said the property market downturn and adjustment would take two to four years and perhaps longer. Wang said the market needs to adjust or the property bubble will burst and that could leave China worse off than Japan was, when its bubble went at the end of the 1980’s. (China Business News)
  • The PBoC will from Friday remove the deposit rate ceiling on small amounts of foreign currency in Shanghai beyond the city’s free trade zone. (Shanghai Securities News)
  • It’s been nearly 20 years in the making, but China’s government may finally be getting ready to announce a deposit insurance mechanism, marking a key step on the road to fully liberalised interest rates. (MNI)
  • Investors are reducing their exposure to iron ore, driven by fears of oversupply which has driven iron ore prices close to two year low. (WSJ)
  • Despite shaky consumer sentiment, leading indicators of demand for larger renovation jobs suggest contemporary market conditions are improving. (Housing Research Association)
  • Australian Job Vacancies rose 2.5% on the month in May, following a previous 2.8% gain.

An annualised 2.9% contraction in first quarter growth is not just the result of “weather effects”. The largest downgrade came from personal consumption, the only main component of the US economy to grow in the three months. The temporary boost the introduction of Obamacare was initial through to have given the US economy was revised away. US Personal Consumption was revised to just 1.0% from initial estimates of 3.0% growth and to add to the irony personal healthcare spending declined on the quarter. International trade subtracted a massive -1.53% from GDP growth in the quarter, squeezed on both sides by a sharper drop in exports and an increase in imports. The shale gas boom may have helped to reduce the US’s liabilities to the global economy, but not enough to offset its propensity to spend which will only pick-up further with any recovery. Considering a large part of the overall contraction in GDP was the result of a rundown in inventories and generally lower investment, May’s disappointing durable orders report suggest the outlook isn’t looking too bright either.

The result raises a number of issues. The US will be hard pressed to scrap 2% growth this year. While the economy may be experiencing a rebound in housing, flat lining capital investment and slow retail sales growth means it will be hard to pull anything above 3% growth out of this quarter. The second issue is what policymakers can actually do about it? Capitol Hill is tied up in political bureaucracy at the best of times. In the middle of mid-terms, it’s closed to business. The real problem is with the Federal Funds rate stuck at zero and a stretched balanced that is still increasing, the Fed can’t react to any adverse shocks that hit the economy. This is a key reason why central banks need to normalise policy as right now the developed world economy is completely defenceless. The Fed could slow or stop tapering but this risks the financial instability that rocked markets through 2013. There is also another conclusion to be had. The US is further along the recovery cycle than the UK so effectively it’s an example of the post financial crisis, “new normal” world. Is this what it looks like? Trend growth of around 2% that is susceptible to changes in the weather? The US needs structural reform, which includes increasing innovation, changing the tax system and implementing an immigration policy.

The weak Q1 GDP release reaffirms our call for a mid-2015 US rate hike. The US narrative has recently shifted to inflation, most evident in the surge in gold prices and thus today’s PCE release will be a market focus. However in response to a question about the inflation risk at the recent Fed meeting, Yellen confirmed that she would look through temporary effects to reclaim more lost output. Higher inflation won’t cause the Fed to bring forward rate hikes. The dollar will remain soft in the medium term giving USD crosses a boost.

The Financial Policy Committee will meet today under a weight of pressure to take control of the bubbling UK housing market. At his recent Mansion House speech, Mark Carney announced new weapons for the committee to tackle the risk of financial instability emanating from the housing market. George Osborne outright said that the FPC should not hesitate to use the new measures if they thought it was necessary. This may not quite be the government influencing the independent central bank but it can’t get much closer. The Bank’s Monetary Policy Committee has heavily hinted that higher interest rates may come this year and while this will take considerable steam out of the sector, the MPC maintains that financial instability in the housing market is the FPC’s problem and drew particular attention to its June meeting.

The question is, what can the FPC actually do in June to tame a runaway housing market that is largely localised to the London market? The Chancellor gave the FPC powers to introduce loan-to-income ratios on all mortgages along with the more severe measure of loan-to-value. Practically in the same breath, the Chancellor mentioned that detailed consultation between the Committee and the Treasury would be needed and that the legislation is yet to be passed, ruling this option out for the time being. The FPC could make a recommendation to end the Help to Buy scheme, but the scope of this scheme is relatively limited and largely helps lower income households outside of London, where house price growth is much more subdued.

The most likely option for the FPC to take is to increase the reserve requirement for banks on mortgage lending. At present the capital requirement on mortgage loans is a fifth of the requirement for corporate lending. This explains banks’ eagerness to lend to home-buyers and their reluctance to extend credit to businesses. This measure could ease the UK’s risky housing market and help to redirect lending to the heavily neglected SME sector. While an increase in the reserve requirement ratio will lead to further declines in mortgage approvals, they are already in decline while annual house prices continue to rise.

The real problem in the UK housing market is its status as a global safe haven for investment, and the FPC simply has no power to solve this. The FPC taking action in June will protect UK citizens from taking out mortgages they can’t afford, but it won’t stop rising house prices. FPC action buys the Bank time to keep the interest rate at a record low. However the Committee long passed on the responsibility of the housing sector to the FPC and were still surprised by the low probability attached to hikes this year at the June meeting.