The May US employment report changes the landscape for the Fed



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Rising oil prices and deteriorating US fundamentals vie for influence over euro-dollar exchange rates

After losing virtually all influence over the euro-dollar exchange rate since the beginning of last year, interest rate differences seem to be making a comeback, in the wake of rising oil prices. If renewed sensitivity continues, it could have a profound impact on exchange rates. If the euro-dollar exchange rate pair normalized with respect to its long-term reaction function, the economic conditions currently prevailing in the United States and Europe would imply a euro below parity with the dollar.

Until recently, however, the reaction function did not hold sway. It was weakened by structural deterioration in the outlook for the US economy, and many economists who believed in these models were caught unawares all through last year. With this in mind, let’s examine whether rising oil prices could normalize the situation and push the dollar higher, and as a corollary, the euro lower.

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The devil is in the details of the US employment report

Too much job creation risked putting more upward pressure on interest rates; too little risked undermining confidence in US growth. In either case, the risk that US stock markets would react negatively to this month’s employment report were significant. With stock market indices just barely above their end-March low points and with 10-year interest rate seemingly ready to break through the 3% barrier, the importance of this month’s employment report was greater than usual.

As usually happens in this type of situation, everyone sees what he or she wants to see. One or two additional data points, such as April inflation or oil prices, are probably needed to tip the scales in one direction or the other over the next few days. But one thing is certain: it’s getting complicated.

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Temporary slowdown or break in the trend? Our autopsy of initial first-quarter growth figures in developed countries

The slowdown in growth in the first few months of 2018 has surprised many observers, who were optimistic about the outlook for this year and next after economies had ended 2017 strongly. Looking at recently released first-quarter GDP estimates, the analysis work mainly involves trying to separate temporary drivers of the slowdown from potentially longer-lasting ones. The results will determine how sensitive consensus forecasts are to these first-quarter data, whether central banks will change their outlooks, and how observers expect interest rates and corporate earnings to develop. At this stage, there are three key takeaways from recently released figures:

–     a widespread slowdown in consumer spending,

–     weaker growth in business investment,

–     a halt in foreign trade growth.

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Would higher oil_prices steepen the yield_curve and help the banks?

Ideally, a rise in the price of oil, resulting from improvement in worldwide economic conditions, would increase inflation expectations and also pull up long-term interest rates. This could steepen the yield curve, or at least displace it upwards. All other things being equal, bank shares would benefit and their poor performance of the last few weeks would turn around. Even though higher interest rates would penalize a certain number of sensitive sectors, the breath of fresh air for the banking sector would restore some appetite for risk which has recently been lacking.

More realistically, i.e. with an economy well into the expansion phase, there is little chance this series of events would last. It is not even sure they would have the time to develop in the first place, despite some indications to the contrary over the past few days.

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The oil threat

The increased tension surrounding Syria caused the oil price to surge beyond $72 per barrel last week, and there is a significant risk of escalation that could drive prices much higher than their current levels, at least temporarily. This scenario is worrying in many respects.

Movements in oil prices have been key movers of the global economy and financial markets for the last four years, and have usually exacerbated any existing fragilities. Their collapse in 2014 was partly responsible for the increase in deflationary pressure and the subsequent monetary response from the ECB and BoJ. Then, the rebound from their January 2016 low deprived consumers of what little increase in real incomes they had seen in 2015, but without being sufficient to drive any real improvement in the situation of emerging-market exporters, which were also seeing increasing competition from the USA. The run-up in prices over the last few days could be more effective in this respect, unless, on the contrary, it sparks a crisis by causing more pain for consumers while also triggering an excessively radical jump in interest rates, which could happen quickly given the barely concealed impatience of central bank officials to escape from today’s low-interest-rate situation. That combination clearly does not bode well, since it could quickly turn into a major threat for global growth and the financial markets.

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The benefits tax_reform was supposed to give to US_employment and wages are evaporating

Last month’s employment report opened the way to optimism, but the March report swept it away. Job creations were very low, at 103,000, vs. an expected level of nearly 200,000, and new jobs in the first two months were revised down by 50,000 on average. Not only this, but wage increases are showing fewer and fewer signs of recovery. With the exception of finance, wage increases were down in most cases compared with last year or stationary at levels below the national average, which, as a result, is showing no sign of improvement. At 1.7% year-on-year in March, hourly wages in manufacturing increased at half their rate of mid-2016. The leisure and hotel sector, the nation’s third-largest employer segment with more than 10% of all positions, wages are now rising by less than 3% vs. 4.5% in the middle of last year. Although these results remain difficult to explain, they are certainly far removed from expectations, and neither the markets nor an administration tempted by protectionism can long ignore them.

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Protectionism does not necessarily go hand-in-hand with inflation

The aggressive protectionist measures announced by the US president over the past few days have generally been perceived as a prime inflationary threat. The reasoning is rather logical. An increase in import tariffs on non-substitutable goods that enter the production processes of key economic sectors or are purchased directly by US consumers will cause the price of those goods to rise. In addition, (i) the US balance of payments is likely to deteriorate and push down the dollar, and this might be exacerbated by potential difficulties in external financing, and (ii) the rest of the world might retaliate against the announced US measures, creating a domino effect. In theory, this combination is the perfect inflationary cocktail. How then can we explain that the markets have not shown greater expectations of inflation?

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