After weeks of summer lethargy, markets have two seismic changes to digest over the weekend, and into next week. The Fed has broken with much of the theoretical framework that has underpinned policymaking since the 1980s for a structurally more dovish approach, and Japan must consider the departure of Shinzo Abe, its longest serving Prime Minister in history.
So far, the upshot of the week’s price action in FX has been more dollar weakness. Developments in fixed income markets were mixed, with the treasury yield curve steepening, while there was a notably sharp rise in breakeven inflation rates, particularly over the widely followed 5 year forward horizon.
This suggests investors may be expecting loose Fed policy to persist, and a more sanguine approach from the central bank on labour market tightness and upside inflation risk. This is exactly the message we believe Powell was trying to get across – in this sense, yesterday’s historic speech was a success.
The Fed made two major changes to its Statement on Longer-Run Goals and Monetary Policy Strategy, which together add up to a significantly more dovish outlook for rates. Under the new framework, the FOMC will respond to “shortfalls” as opposed to “deviations” from its theoretical maximum level. Powell explained the significance of this subtle change in his speech. Previously, the FOMC hiked rates in anticipation of inflation increasing as employment rose and approached estimates of its maximum sustainable level – a theoretical level that most economists now believe is difficult or impossible to measure reliably, if it exists at all. Instead, Powell said that “employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation”. The other major change was a formal promise to target an average level of inflation, as opposed to a flat 2% target. In practice, this means the FOMC will be less concerned about an inflationary overshoot if it comes after a long period of low inflation, of the sort that has been common over the last decade. The two changes add up to a significantly more dovish outlook for Fed policy. Importantly, the Fed is now less likely to pre-emptively raise interest rates in anticipation of an inflationary spike during an economic upswing – giving the dollar less impetus to rally than in past economic expansions. The changes to the Fed’s strategic approach are largely consistent with our expectations, as outlined in our recent USD Outlook.
THE WEEK’S CALENDAR:
Monday 31st Inflation data in the Eurozone is released throughout the morning, as the prospect of a faster-than-expected economic recovery remains front-of-mind amid sustained euro appreciation. Even though the latest inflation prints remain in negative territory for major economies in the area, market-implied inflation expectations in the medium run have fully recovered from the pandemic-driven collapse in March. As price growth returns to above-zero levels, markets could maintain their current optimistic tone on the euro despite the relatively poor figures. CPI prints for August will dominate the calendar next week, with German, Spanish and Italian readings on Monday. The Eurozone estimate will be released a day after. Chinese Purchasing Managers’ Indexes for August are also likely to show the economy continued to make progress albeit at a more moderate pace. The official and Caixin PMI readings (to be released later in the week) are expected to remain comfortably above the 50-threshold, although expansion over the July readings might lose stem as per the sour sentiment amid resurging infection cases worldwide.
Tuesday 1st will likely mark a renewed vigor in currency markets as investors return from the summer holidays and price action corrects from month-end trading. Investors are likely focus on US hard data through the week, starting with the ISM manufacturing print for August, released at 15:00 BST. Consensus expectations points to a barely improving indicator, adding to the weak state of the US economy recently outlined by the Fed. In the Eurozone unemployment data in August be released at 10:00 BST amid a debate over eurozone furlough extensions, discussed further below. The second readings of August PMIs across the euro area, along with fresh prints for Italy and Spain, are also scheduled on the day.
Wednesday 2nd at 13:15 BST the US ADP unemployment figure will set the tone for non-farm payrolls on Friday. Even though ADP is a flawed guide to the official data, it nonetheless remains a relevant gauge of the labour market that is released two days earlier. ADP is expected show a net 900k jobs added to the labour market in August, far below the 1518k change in official non-farm payrolls expected on Friday. Further US labour market data will be available on Thursday 3rd as initial and continuing jobless claims for the last week of August are released.
Friday 4th will top the weekly calendar with the release of the change in non-farm payrolls – we expand on the topic in the following section of this report. Elsewhere, German factory orders in July will also see the light on the day at 07:00 BST, with the unexpected jump seen in June set to cool off on the back of resurging concerns about the coronavirus pandemic. Canada labour market data will also grab investor’s attention, with the net change in employment likely printing a positive, but at a slower pace.
Broad dollar falls to lowest since 2018 after Powell
EXTENSIONS OF FURLOUGH PROGRAMMES IN EUROPE MAY LARGEN GAP BETWEEN DATA AND REAL UNEMPLOYMENT
On Tuesday, August’s German unemployment rate is expected to print at 6.4%, similar to July’s reading, according to the median forecast submitted to Bloomberg. 15,000 jobs are expected to have been added to the labour market in August, compared to 18,000 in July. Last Tuesday, Germany extended its Kurzarbeit job preserving programme – a job scheme under which the government covers as much as 87% of net wages for employees whose work is disrupted due to the pandemic. The programme was extended to the end of 2021, which will cost the government an extra €10bn ($11.8bn). Germany’s compensation programme was already significant in size compared to other European countries before the announcement of the extension. For perspective, UK Chancellor Rishi Sunak is insisting his furlough programme will be phased out this year. Spain and the Netherlands have prolonged their furlough programmes until the end of September, and will hold meetings this week to discuss a potential further extension and any changes to the current conditions. France has a new long-term furlough system designed to provide more targeted aid for up to two years on a case-by-case basis from October onwards. The programme will be less generous than the current emergency mechanism, which covered around 9 million workers during the peak of the crisis.
Tuesday’s labour market data also includes the eurozone unemployment rate for July, which is set to print at 8% up from June’s 7.8%, and July’s unemployment for Italy and Belgium. Spain’s August unemployment is expected on Wednesday. It is important to note that the figures for July and August are likely to understate the actual unemployment numbers, as the workers who are included in the furlough schemes are not registered as unemployed. Many may become unemployed once these schemes end or become less generous. In the Netherlands, for example, the first furlough programme (NOW 1.0) was launched between March and June 30, and was extended through September 30. Changes in details of the conditions between the first launch (NOW 1.0) and the extension (NOW 2.0) already shaved off a fraction of the employment numbers. If the current NOW 2.0 is extended for another 3 months, the third NOW programme is likely to be even less generous than the NOW 2.0, making unemployment vulnerable to a rise in Q4 2020, even without taking into account that the real unemployment number may be a lot higher after the furlough programme is no longer operative.
This week’s labour market data may not be representative of the real unemployment situation, but the euro may still take clues from the release of the figures.
The unemployment rates from the current quarter may be seen as calm before the storm. If the numbers print higher than forecasted, indicating a worse than expected situation in the eurozone labour market, this may weaken market sentiment towards the single currency.
Spain and Italy record large jumps in unemployment rate in last releases
LABOUR MARKET DATA FROM US AND CANADA
July’s non-farms report in the US was better than expected, showing a sustained bounce in employment as well as a slowdown in the rate of permanent job losses – both very optimistic developments. However, a third of the 1.8m jobs created on net were from leisure and hospitality sectors – where restrictions remain in place across many states. August’s report, released on Friday 4th, will be something of a wild card for markets. Forecasts submitted to Bloomberg are very widely distributed around a median of 1.5 million, while weekly initial jobless claims continued to run above 1 million a week in August. One encouraging aspect of the labour market in the US remains the high proportion of unemployed workers reporting being only temporarily laid off – currently running at more than 50% of unemployed workers. If permanent job losses remain low in August, this would be a sign that the labour market recovery has the potential to be faster than from 2009 onwards. As usual, Canada’s jobs data will play second fiddle to the US, but considering the loonie’s persistent rally, will also be of high relevance to the currency.
Ranko Berich, Head of Market Analysis
Olivia Alvarez Mendez, FX Market Analyst
Ima Sammani, FX Market Analyst