US growth in 2-3% range is dollar bullish but EM bearish

As Q2 continued along, it became ever more evident that private forecasts above 3% annualized were overly optimistic and that the Atlanta Fed’s GDPNow forecast below 1% would get revised up. We met in the middle at 2.3%. What’s more is Q1 data got revised up to 0.6% from -0.2%. With jobless claims at 267,000, the data continue to support Fed action in September. I have a few brief thoughts below.

Fist, let me just repeat verbatim what I told you last month when talking about the US:

I am basically in the camp that says real wage growth is high enough to support a continued middling upswing, with deviations due to inventories, trade and capital investment taking these numbers sometimes into negative territory. The Q1 numbers may actually be revised up slightly in June and July. So as bad as they were, they are neither representative of the pace of US growth nor will they necessarily stay negative when the final print comes through.

Add to this a year-over-year decline in oil prices has shifted income to those with a greater marginal propensity to consume, and we should expect personal consumption expenditures in the 2 to 3% real growth range.

As expected, Q1 has now been revised up to a positive number and Q2 is in the 2 to 3% range, though on the lower end of expectations and below the 2.5-2.6% median forecast by economists. This is middling growth. It isn’t spectacular but it isn’t poor either.

In my view the large upward revision to Q1 is the data point that gives the Fed the most cover for hiking rates in September. What we have seen in this recovery is an uneven path with wild swings up and down, sometimes taking us into negative territory for quarterly GDP prints. But the fact tha the most recent negative has been revised away gives support to the Fed’s optimistic tone and will make the FOMC lean heavily in the direction of hawks, despite the lower inflation numbers we should anticipate.

Yesterday, Jon Hilsenrath at the Wall Street Journal put the Fed’s dilemma well, writing:

Fed Chairwoman Janet Yellen said in testimony to Congress earlier this month that the economy is “demonstrably closer” to reaching the Fed’s full employment goal. Since the Fed last met in June, the jobless rate has notched down further from 5.5% to 5.3%, its lowest level since April 2008, hiring appears to have returned to a path of steady gains in excess of 200,000 per month after stumbling in March and wages show tentative signs of moving higher. Fed officials will need to acknowledge these advances in their post-meeting policy statement, a sign that a rate increase is approaching.

Still it is hard to see how officials derive great confidence that inflation is surely returning to their 2% goal. Oil prices and commodities more broadly have resumed their march down and the dollar its movement higher, factors that have weighed on inflation all year. The Fed has described these developments as transitory before, but slow growth in China could give them some pause about that conclusion. Broad measures of inflation show little sign of breaking out of the sub-2% trend which has been in place for more than three years. Meantime, inflation compensation in bond markets has notched lower after stabilizing earlier this year. And though wages show signs of picking up, a breakout isn’t yet obvious and the links between wages and broader inflation are tentative.

It potentially sets up the Fed and markets for a cliffhanger policy meeting in September. The jobs part of their mandate – so important to Ms. Yellen – is signaling a rate increase is due. But the inflation part of the mandate signals continued patience. Officials won’t want to lock themselves in until they see more data on the economy’s performance.

I see the Fed looking through the inflation data, using the fact that oil prices are declining and that this should aid consumers as a reason to hike in September. So at this point I see a September hike to a firm 0.25% as likely. This is only a 0.10% rise, by the way since today’s number is officially between 0 and 0.25% and presently sits at 0.15%. The Fed’s forecast leak sees 35 basis points by year end, meaning 10 basis points now to 0.25% and another 25 basis points in December. That’s baseline, in my view. And we will have to see job numbers deteriorate from here to forestall this second hike. Right now, with jobless claims below 270,000, we will need to see a big uptick.

Basically the Fed has accepted that wage growth, labor participation rates and inflation all remain weak. And they are comfortable enough to say, “look, we’ve been on zero for seven years. The supply side is permanently weak. Monetary policy has done all it can. We need to normalize policy.”

Will 25 basis points make much of a difference in market psychology? I say no. At this point in the cycle, the market internals are more attuned to economic growth than rates or even earnings. But a second rate hike already in 2015 could have an impact, especially if it has an impact on the real economy. So we need to watch the path of hikes.Let’s also remember that the Fed has always been unlikely to reverse course on a dime once rate hikes have begun. So they will likely be off the zero bound for some time to come, until the economy weakens considerably.

Where we need to look for signs of distress are in the shale and energy sector where we saw two big announcements today, with Royal Dutch Shell slashing jobs and capital expenditure and BG Group also slashing jobs. In the US, we should expect market death to begin this year already such that high yield energy bonds become increasingly distressed. And we should also expect emerging markets to come under pressure, especially if the second rate hike does occur in 2015 – as this would signal more is potentially coming in 2016 and beyond and would be dollar bullish, EM and commodity bearish.

This is also bullish for New Zealand, Australian and Canadian fixed income as they have the most runway to cut toward zero.

Overall, the U.S. economy’s baseline is still in the 2 to 3% range because of consumption growth that is underpinned by both decent personal income growth and jobs data. Policy divergence is set to continue and strengthen.