Dollar Mixed, Equities Higher in ECB’s Wake

Dollar Mixed, Equities Higher in ECB's Wake

  • ECB President Draghi sent an unambiguous signal to investors yesterday
  • This supports our emphasis on the divergence of monetary policy as the key macro force driving the capital markets and what we argue is the third significant dollar rally since the end of Bretton Woods
  • Comments from Japanese policymakers overnight support our view that markets might be overestimating the odds of imminent action by the BOJ
  • The political situation in Portugal remains fluid
  • The flash Eurozone PMIs were released earlier
  • Korea GDP was stronger than expected, but the JPY/KRW cross is likely to be a growing concern
  • Brazil reports current account and FDI data for September

Price action:  The dollar is mixed against the majors, but is still trading mostly within narrow ranges.  The Aussie and the yen are outperforming, while the Swiss franc and the Swedish krona are underperforming.  The euro is trading flat near $1.11 after a brief dip below that level.  Sterling is also trading flat near $1.54, but yesterday’s outperformance has driven the EUR/GBP cross down near .7200.  Dollar/yen is down slightly after earlier testing the 200-day MA near 121, with official comments suggesting no BOJ action next week.  EM currencies are mostly firmer in the wake of the ECB meeting.  KRW, MYR, and RUB are outperforming while PLN, TRY and ZAR are underperforming.  Poland and Argentina hold elections this weekend, with both likely to have market-unfriendly outcomes.  MSCI Asia Pacific rose 1.7%, with the Nikkei up 2.1%.  China markets were higher, with the Shanghai Composite up 1.3% and the Shenzen Composite up nearly 3%.  The Dow Jones Euro Stoxx 600 is up 1.6% near midday, while S&P futures are pointing to a higher open.  The 10-year UST yield is up 2 bp to 2.05%, while European bond markets are mostly softer.  Commodity prices are mixed, with oil up modestly.

  • ECB President Draghi sent an unambiguous signal to investors.  Although the economic data from the region has been largely stable, the downside risks have grown, and the ECB will take action at its next meeting, which is in early December.  In the past, Draghi has indicated that the -20 bp deposit rate exhausted the scope for rate cuts.  However, he did reveal that the possibility of another cut in the deposit rate was discussed.  He also noted that some members wanted to take action immediately.  Still, even if the ECB announces its intention to provide more monetary stimulus in December, the launching of the new effort is unlikely to start until early 2016.  In addition, it would not be surprising if in the coming days, the less dovish ECB members, like the Bundesbank’s Weidmann, resist the push.
  • Most observers have been focused on extending the length of the asset purchases.  We have been skeptical of the effectiveness of extending a program that is not even half complete.  It essentially concedes that the current purchases are insufficient.  Increasing the size of the current operations seems to be the more logical course.  That is what the Bank of Japan did last October.  However, there is a concern that it might exacerbate a shortage of some instruments, like German bunds.  This has been a concern since the asset purchases plan was announced, but thus far there is only marginal evidence of this.  Consider that 10-year German bund yield has risen 33 bp over the past six months.
  • Still, under the ECB’s program, instruments yielding less than the (minus 20 bp) deposit rate cannot be included in the official purchases.  After yesterday’s rally, German yields from one through four years are lower than -20 bp.  The two-year yield set new record lows near -32 bp.  Reducing the deposit rate further would free up more instruments that can be bought, theoretically.  The ECB can also tweak the composition of the assets it is buying.  The Bank of Japan has shown that a wide range of instruments, including ETFs, REITS, corporate bonds, commercial paper can be bought.  The focus in Europe is on increasing the agency bonds that are bought.
  • This supports our emphasis on the divergence of monetary policy as the key macro force driving the capital markets and what we argue is the third significant dollar rally since the end of Bretton Woods.  Divergence was not just about the Fed tightening, but what made this force so potent is that others are still moving in the other direction.  The first phase of divergence is precisely that: other countries are easing policy while the Fed prepares to begin normalizing monetary policy.  The second phase begins with the Fed’s lift-off.  Like many in the market, we have struggled to time the transition from phase one to phase two.  Yet, with the 4-week moving average of US weekly jobless claims making new cyclical lows, we continue to believe that the second phase will materialize.
  • The dramatic euro drop in response to Draghi’s dovishness saw the single currency test the seven-month uptrend drawn from the year’s low set in March near $1.0460.  The trend line connecting April, July, and August lows comes in near $1.1075 now.  That area ~$1.1085 also corresponds to a 50% retracement of the euro’s rise off that March low.  The 61.8% retracement level is found near $1.0940.  Below there is the $1.08 level that held in May and July.  Given the magnitude of yesterday’s move, which pushed the euro to its lower Bollinger Band (a little below $1.11), players may be reluctant to be aggressive ahead of the weekend.
  • EM and risk assets reacted well to Draghi’s comments.  Yet we have to question how far such a bounce can go, especially if accompanied by a stronger dollar.  Yes, the ECB is likely to widen its QE program, but it is doing so because of downside risks to growth.  The same twisted logic can be used to discuss Fed lift-off.  Yes, the delayed lift-off will keep US rates at current levels, but the Fed is delaying lift-off because of downside risks to growth.
  • The political situation in Portugal remains fluid.  The Socialist leader, Antonio Costa, continues to search for an agreement with the Left Bloc and the Communist Party in the hopes of forming a stable coalition.  Costa said he would work to prevent Prime Minister Coelho and his Social Democratic coalition to form the next government.  Coelho’s party won the most seats but fell short of a majority and needs to rule in a coalition.  Still, President Silva invited him to form the new government, which helped cheer markets.  Portuguese bonds are outperforming today, falling 3 bp in the back end while yields in most other countries are slightly higher.
  • The flash Eurozone PMIs were on the strong side.  The composite reading was unchanged at 54.0 vs. 53.4 consensus.   Looking at the country breakdown, German composite came in at 54.5 vs. 53.7 consensus, with the manufacturing component a bit weaker than expected and the services a bit stronger.  The French composite came in at 52.3 vs. 51.6 consensus, with both the manufacturing and services components surprising on the up side.
  • In the past, China flash PMI from Caixin (formerly HSBC) was released on the same day as the Eurozone flash readings.  That has been discontinued.  Instead, both Caixin and official PMIs will be reported next weekend.  For now, China seems to be neutral for global market sentiment, with risk of some positive spillover if and when the PBOC eases again (which we expect).
  • During the North American session, the US data calendar is very light.  The only report scheduled is preliminary October Markit manufacturing PMI, and is expected at 52.7 vs. 53.1 in September.  There are no Fed speakers due to the pre-FOMC embargo.
  • Canada reports September CPI.  Headline is expected to rise 1.1% y/y vs. 1.3% in August, while core is expected to rise 2.2% y/y vs. 2.1% in August.  Canada reported stronger than expected retail sales yesterday, which helped CAD recoup some of its post-BOC meeting losses.  A clean break of the 1.3145 area and then the 1.3220 area is needed to set up a test of the September 29 high near 1.3455.
  • Comments from Japanese policymakers overnight support our view that markets might be overestimating the odds of imminent action by the BOJ.  An advisor to Prime Minister Shinzo Abe, Etsuro Honda, noted that immediate additional easing by Bank of Japan is not necessary. He also added that if the BOJ carried out additional easing, it could increase annual JGB purchases to JPY100 trln from JPY80 trln currently, and added that the “next additional easing would be last one.”  While Honda is probably not the most influential voice in this decision process, it still serves as another indicator of how little consensus there is about taking action in the near term.
  • Similarly, Deputy Finance Minister Abe continued to play down the effectiveness and the trade-offs of more easing in the near term.  He said, for example, that it would be hard for inflation to reach 2% even if the BOJ eased now, and that there are limits to how much monetary policy can push up prices.  Still, a recent survey showed that some 40% of market participants expect the BOJ to ease in December, and this number is probably higher now after Draghi’s comments.
  • Some observers have argued that the dovishness of the ECB make a BOJ move next week more likely.  We are less convinced.  We link the yen’s weakness to 1) the broad dollar strength, 2) the rally in equities, and perhaps to a lesser extent, 3) firm US yields.  The reasons why many economists look for BOJ action next week is the specter of deflation and the risk of a second contracting quarter.  In our conversations with Japanese officials, they seemed to play down such concerns.  They want to look past the sharp drop in energy prices.  They recognize that given the low growth potential, normal GDP variance can produce negative growth from time to time.  Officials seem willing to do more if necessary.  They are not yet convinced it is necessary.
  • Dollar/yen was at the lower end of its range last week when it tested the JPY118 area on October 15.  With yesterday’s gains and the bit of follow through in early Asia, the dollar is approaching the upper end of its current narrow range, which we see as JPY121.25-JPY121.35 area.  However, it takes a move above JPY122 to signal anything of significance.
  • Korea Q3 GDP came in on the strong side at 2.6% y/y against expectations for 2.4% y/y vs. 2.2% in Q2.  The Bank of Korea just cut its 2015 and 2016 growth forecasts to 2.7% and 3.2%, respectively.  Despite the recent number, this still seems a bit optimistic.  Inflation of 0.6% y/y in September is well below the 2.5-3.5% target range, and BOK forecasts it at 0.7% this year and 1.7% next year.  We think downside risks will move the BOK to a more dovish stance in 2016, and the next move becomes even more likely if the JPY/KRW continues to strengthen.  After poking above 10 in August and September, that key cross is moving back towards 9.  It is currently testing its 200-day MA near 9.32 via a combination of a strong won and weak yen.
  • Brazil reports current account and FDI data for September.  The current account is expected at -$2.3 bln, which would see the 12-month total fall to around -4% of GDP.  But while the external accounts are improving, the fiscal accounts are deteriorating.  The government’s chief of staff Wagner warned yesterday that Brazil will miss its fiscal targets this year and is likely post the widest primary deficit on record.  He also warned that the deficit could be even wider if the federal government is forced to pay back money owed to state banks.  September fiscal data will be reported October 29 (central government) and 30 (consolidated).