What Does it Mean?

Last week was full of updated economic data points and with each new report that hit the wire. But there was only one question: Does this data increase or decrease the likelihood of a September rate hike?

To reiterate my view, if the Fed’s decision is based solely on the US economy, then it will raise rates. But the recent instability in financial markets is obviously the wild card and is a harbinger of serious volatility until the Fed says something 17 September.

Here's where we stand going into this week:

United States

There were a number of important data points last week and at the top of the list is the latest monthly labor reports.

The headline number of both the ADP and the non-farm payrolls disappointed in comparison to what the markets were expecting but as usual, the devil is in the details. Despite coming in below expectations, the ADP report maintained its 2% annual growth rate, which is quite healthy in the context of its 14-year history. The non-farm payroll report showed that the pace of job creation slowed but so far, there's been minimal impact on the yearly rate of job growth.

The reality is that the yearly growth rate is a more reliable measure because it smooths out the noise of the monthly data. The yearly growth rate has been sliding, but the 2.4% rate in August is quite healthy and historically, August jobs number get revised higher by approximately 90K jobs, which is double the average revision of every other month. 

What matters most in economics occurs at the margins. So, it's important to watch for a decelerating yearly growth rate. But at this point, it's not clear if the deceleration is a warning sign for the business cycle or just a normal process of fluctuation.

Generally speaking, economic recessions don't begin with 2% yearly labor growth. Keep in mind that the labor market is a lagging indicator, so there are limits to analyzing the state of the economy in real time.

The worst you can say by looking at August’s labor data is that job growth has slowed. In addition to the labor market, there’s also weakness in US manufacturing. But again, it seems to be an issue of slowing growth and not outright contraction.

It's important to track manufacturing, even in a service-based economy like the US, because it helps us monitor the business cycle. Manufacturing could slide into outright contraction and still not push the US into a recession.

The more pressing question is whether or not the weakness in manufacturing is spilling over into other areas of the economy. At this point, that does not seem to be the case.

In fact, last week’s auto sales report gained 3% year over year, which is the highest growth rate in a decade and a sign that consumer spending seems to be very firm. Given that most US economic data points are signaling moderate growth ahead, it would be premature to interpret last week’s data as a sign of trouble. And I think that the hawkish response of the markets last week backs up that last statement.

Very few people are looking at the US data and saying that the Fed should hold off. The argument for holding off is based on the continuing evidence that the world outside of the US borders is in trouble.

 

China

The only economic report of note last week was the latest round of manufacturing data, which reported at the lowest level in 3 years and is now solidly in contraction. The output and new orders component of the manufacturing sector both contracted for the first time in two years.

Clearly not a good sign of things to come.

The biggest development was a change in FX policy. Starting in October, banks will have to hold the equivalent of 20% of their clients’ FX forward positions with the PBOC for a minimum of 1 year at a 0% interest rate. This requirement will cost banks money, which means the cost of trading for clients will rise and that, the PBOC is hoping, will reduce volatility, lessen the pressure on the Yuan and the slow the pace of decline in FX reserves.

The currency market isn’t the only place the PBOC is intervening. The last 4 trading days before the Chinese holiday saw interesting price action in the SSE 50 Index, China’s equivalent of the S&P 500.

In the last 45 minutes of trading each day, the average gain in the index was 6.4%! Can you imagine that type of movement on the S&P?  Government-backed funds buying shares to stabilize the market anyone? The SSE still closed down 2.2% on the week despite the PBOC’s best effort.

These kinds of “policies” should give China bears great comfort and scare the hell out of anyone who thinks China’s economics, bad as they are, come close to what is actually brewing beneath the surface. Central banks do not intervene to the magnitude and duration that the PBOC has over the last year unless they're attempting to keep the wheels from coming off.

 

Eurozone

The only real development last week came from Thursday’s ECB meeting, where, in addition to keeping rates unchanged, there were a couple of key takeaways from Draghi’s press conference. The ECB raised the ceiling of sovereign bond ownership from 25% up to 33%.

This eases a self-imposed constraint on purchases and gives them greater flexibility to increase the size and duration of the current round of QE. The other key takeaway was that the ECB cut growth forecasts for both GDP and inflation.

This year's GDP growth rate was cut by 10 basis points down to 1.4% and next year’s growth was cut down to 1.7% from 1.9%. Inflation this year is only expected to rise by 0.1% rather than June’s estimate of 0.3%.

This is further evidence that global growth is continuing to slow and inflation is non-existent. It also highlights that the US divergence trade is firmly in place as every central bank in the world, outside the US, is contemplating all possible monetary action besides tightening.

 

Elsewhere

It’s not just the world’s larger economies that are struggling.

I’ve outlined the woes of emerging market s before and that story continues to play out with no upside in sight. Japan hasn’t reported a decent economic data point this entire year.

Our neighbor to the north, Canada, just officially entered a recession, albeit a mild one, with its second straight quarterly contraction in GDP growth.

The Reserve Bank of Australia announced this week that it was leaving rates unchanged. This wasn’t surprising given the fact that a declining Aussie Dollar helps cushion the impact that lower commodity prices and a slowing China have had on the economy.

Finally, 28 global regions have reported manufacturing PMIs. 18 of those regions have posted PMIs over 50, indicating expansion. The problem is that 2/3 of those regions, or 19 of the 28, showed a deterioration in the data from July to August. This could become a real issue if these PMIs continue to slide into contraction.

 

The Takeaway

The market interpreted all of these developments across the globe as generally hawkish. This resulted in the probability of a September hike increasing from 20% to 32% by the end of the week and the likelihood of a December rate hike increased to 60%.

The problem is that no one knows how much, if any, weight the Fed will give to declining global growth and increased market volatility.

Whether the Fed will hike in September is anyone’s guess and you can see that confusion displayed prominently in key markets across the globe.