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Western economies risk overheating

Today’s news headlines:

  • ‘Carney to extend stay as Bank of England Governor until end-January 2020’. (Bloomberg)
  • ‘Canada ready to allow US diary access in NAFTA talks: source’. Canadian Foreign Minister Chrystia Freeland said a US-Canada trade deal is ‘imminently possible’. (Reuters)
  • ‘Trade wars: China fears an emerging united front’. Beijing welcomed American disputes with Tokyo and Brussels but now faces isolation as G7 allies begin to co-ordinate policy. (The Financial Times)
  • ‘Brexiteers discuss leadership challenge’. About 50 members of the Eurosceptic European Research Group openly discussed ‘how best you game the leadership rules.’ (BBC)
  • ‘French and German advisors call for Eurozone budget rule overhaul’. Economists call for more enforceable debt and deficit regime in break with crisis era. (The Financial Times)

Tuesday’s UK employment report confirmed survey evidence of labour shortages and rising wages; vacancies rose to a series high. However, the biggest headline of the report was pay growth; basic pay rose 3.1% on the year in July, the most since July 2015. The UK economy is finally achieving real wage growth after years of inflation undercutting nominal wage gains. However, wage gains without a recovery in UK productivity translates into price rises and inflation.

The Bank of England (BoE) will take centre stage on Thursday. The market is pricing in only a 0.9% probability of a rate hike this week, betting that Brexit will hinder the Bank’s natural instinct to raise interest rates. Our base case is for an orderly and soft Brexit, which could mean the rates market needs to come to terms with reality. An economy reaching its supply capacity limit with inflation in the pipeline suggests at least two rate hikes in 2019. The rates market repricing would be GBP supportive.

An ageing expansion is not a UK-specific problem. Yesterday’s US NFIB Small Business Optimism Index achieved multiple records. The overall index, hiring plans and measure of skill shortages hit a historical high. In total, six out of nine sub-indices reached all-time highs. The US economy is overheating, as President Trump’s fiscal stimulus extended an already aged expansion. The hiring plans index is one of the best predictors of the following months US Non-Farm Payrolls, setting us up for a strong September print. However, we are at the limit of what the market can price in for near-term US Fed rate hikes, in the absence of a substantial revision to the Fed’s rate outlook. The Dollar should remain supported, but its upside is limited. 

In the day ahead, the week through September 7th’s US MBA Mortgage Application data will continue to show signs of a housing market slowdown, as the sector grapples with higher interest rates and a lack of affordable homes for sale. US August PPI will provide the latest word on whether trade tariffs and the robust US expansions risks stoking inflationary pressures. The index surged from the first half of 2016 on a recovery in food and energy prices. Ultra-dove James Bullard will speak of the US economy and monetary policy. He recently warned that more hiking could unnecessarily raise recession risk and is concerned about unconventional shifts in the US Treasury market. Later in the session, Fed’s Lael Brainard will provide a more centrist view.