News of the week summary - 05/26/2024
Dollar falls after inflation report
The rally in the US dollar has reversed, driven by investor expectations that declining inflation will allow the Federal Reserve to cut interest rates. Earlier this year, the dollar had appreciated by up to 5%. However, after consumer price inflation dropped to 3.4% (aligned with forecasts) last Wednesday, the dollar is set for its first negative month of 2024.
Inflation is a critical factor in determining the Federal Reserve's monetary policy. Higher inflation often leads to higher interest rates as the Fed tries to cool down the economy and control price growth. Conversely, falling inflation can give the Fed room to lower rates to stimulate economic activity.
Earlier in the year, unexpected inflation increases in February and March led investors to believe the Fed might not cut rates soon, driving up the dollar. However, with the recent inflation decline, traders now expect the Fed to implement two quarter-point rate cuts this year. This change in expectations caused the dollar to experience its worst day of the year last Wednesday and has led to a 1.4% decline for the month.
The dollar's weakening has been accompanied by a fall in US government borrowing costs, notably the 10-year Treasury yield, which influences asset prices globally. As the yield dropped from 4.7% to 4.4%, stock markets in the US, Germany, and the UK have reached record highs. Lower yields generally indicate higher bond prices, reflecting increased demand as investors anticipate lower future interest rates. Hedge funds, which had been betting on a stronger dollar, have shifted their positions, now heavily shorting the currency. Meanwhile, asset managers have maintained their positive stance on the dollar.
A weaker dollar is favorable for central banks worldwide, especially in countries like Japan, which has been struggling with a declining yen. Japan's Ministry of Finance has sold about $60 billion in dollars to support its currency.
The European Central Bank (ECB) also benefits from the dollar's decline. ECB President Christine Lagarde indicated that the ECB could lower rates ahead of the Fed without significant concerns about euro weakness.
Yellen asks EU to curb Chinese exports
US Treasury Secretary Janet Yellen has called on the European Union to support American efforts to curb exports of Chinese green technology. Speaking in Germany, Yellen warned that an influx of cheap Chinese goods could threaten manufacturing industries globally. The US recently increased tariffs on Chinese cleantech products, including a significant hike on electric vehicles, to protect domestic industries in key states.
Yellen stressed the importance of a unified response from the US and its allies to counter China's growing manufacturing capabilities. She dismissed criticisms that US tax breaks and subsidies for green manufacturing constitute protectionism, arguing instead that these measures aim to bolster global clean energy technology by driving down costs.
In contrast, the European Commission, led by Ursula von der Leyen, has opted not to join the US in imposing blanket tariffs on Chinese goods. Instead, Europe has chosen to address the issue through investigations and regulatory measures compliant with World Trade Organization rules. Despite this divergence, European leaders, including German Chancellor Olaf Scholz and French President Emmanuel Macron, have echoed Yellen’s concerns about China’s aggressive industrial policies.
Yellen also refuted claims that the US Inflation Reduction Act, which incentivizes domestic green manufacturing, has adversely impacted European industry. Instead, she pointed out that US-EU trade in green energy products has been mutually beneficial, and increased US production is expected to reduce global costs for clean energy technologies.
Despite concerns about cheap Chinese imports, the EU’s trade deficit with China has decreased to its lowest level in nearly three years, to €62 billion in the first quarter of 2024. This improvement is attributed to weak domestic demand in Europe and a shift back from goods to services spending post-pandemic.
The EU has also seen a boost in trade with the U.S., with a record trade surplus of €44 billion in the first quarter. European exports to the US have increased, while imports from the US have declined.
Low consumer confidence in the OECD
The OECD's consumer confidence index reveals that in April, the proportion of people feeling optimistic was 1.6% lower than in the same month in 2019. The US saw a 2.3% decline, while the Eurozone experienced a 2.2% drop. During the pandemic, consumer confidence plummeted but recovered strongly as economies reopened. However, it fell again when inflation soared to multi-decade highs in many countries.
Economists attribute the persistently low confidence to the lingering pressure on households despite economic growth. The loss of purchasing power and increased tensions globally have compounded the issue, with governments having limited funds to alleviate the situation.
While inflation is decreasing in most large economies, prices remain significantly higher than a few years ago. In the UK and Eurozone, prices are about 20% above January 2021 levels. Wages have not kept pace with inflation, remaining below 2019 levels in the third quarter of 2023 in 20 of the 35 OECD countries, including Germany, Italy, and Spain.
The low consumer confidence presents challenges for politicians in upcoming elections worldwide, including the EU parliament elections, the UK general election, and the US presidential election, where economic health is a central issue.
Strong wage growth in Germany
German wages have increased at the fastest rate in nearly a decade, suggesting a broader rise in Eurozone wages and raising questions about the European Central Bank's (ECB) plans for interest rate cuts. In the first three months of the year, collectively agreed wages in Germany rose by 6.2%, up from 3.6% in the previous quarter. This, with data from other countries, implies that Eurozone annual wage growth increased to 4.7% in the first quarter, up from 4.5% in the previous quarter.
The acceleration in wages presents a challenge for investors who were expecting consecutive rate cuts from the ECB, which is anticipated to be the first major central bank to reduce rates on June 6. The ECB has stated that the timing of rate cuts depends on whether workers receive lower pay rises this year and if companies absorb these extra costs by cutting profit margins rather than increasing prices.
The stronger-than-expected wage growth in the first quarter suggests that policymakers are unlikely to agree on a second consecutive rate cut in July, with a more likely scenario being a delay until September. Following this news, Germany’s rate-sensitive two-year bond yield rose above 3% for the first time in three weeks, as investors adjusted their rate cut expectations.
Despite these developments, Eurozone inflation remained steady at 2.4% in April, down from its peak of over 10% in 2022. ECB President Christine Lagarde has indicated that inflation is "under control".