- With risk-on sentiment still in full force, we acknowledge that the dollar may remain under pressure near-term
- Recent developments take some pressure off the Fed to cut rates again this month, which is ultimately dollar-positive
- US data highlight this week will be September retail sales Wednesday
- UK Parliament reconvenes Monday; EU summit October 17-18 is seen as the last opportunity to submit workable Brexit deal
- China September data deluge comes this week; MAS and BOK meet and both are expected to ease
A partial US-China trade deal in principle was confirmed late Friday. Both sides note that final negotiation are ongoing but the outline so far is as expected. China committed to buying more US farm goods and agreed to some sort of currency pact. In return, the US will suspend tariffs planned for mid-October and possibly mid-December. China reportedly invited the US team to continue talks in Beijing later this month but no date was set yet. While the devil is in the details, markets are simply relieved that both sides took a step back from the brink.
With risk-on sentiment still in full force, we acknowledge that the dollar may remain under pressure near-term. EM and the growth-sensitive majors (Scandies and dollar bloc) are likely to outperform this week. That said, it’s worth noting that the existing tariff structure remains in place and so there are still risks to the global economic outlook. And the medium-term outlook for the dollar might not be so bad. Why?
We believe these recent developments take some pressure off the Fed to cut rates again this month. With the improved market mood, Fed Funds futures are pricing in less Fed easing now. The implied yield on the January 2021 contract is around 1.25%, which is only slightly more than two cuts priced in for the rest of this easing cycle vs. nearly four earlier this month. Elsewhere, the positively sloped yield curve removes significant recession risk, while rallying equities will help sustain positive sentiment and consumption. WIRP suggests 73% odds of a cut October 30, down from the 85% peak earlier in the month. We think this overstates the case for a cut. As markets continue to adjust their Fed easing expectations lower, we believe the dollar will get more traction.
The US data highlight this week will be September retail sales Wednesday. Headline sales are expected to rise 0.3% m/m, ex-autos 0.2%, and the so-called control group 0.3%. With manufacturing weakness starting to spread to the wider economy, strong consumption is vital to avoiding a recession. The next slug of tariffs planned for October 15 have been suspended, but that was just a five percentage point increase. The 25% tariffs already in place will remain in place and that remains a big risk to consumption still.
Believe it or not, the US economic outlook still remains solid. The Atlanta Fed’s GDPNow model is tracking 1.7% SAAR growth in Q3 vs. 1.8% previously, which is still near trend (~2%) with some drop-off from 2.0% in Q2. Elsewhere, the NY Fed’s Nowcast model is tracking 2.0% SAAR growth in Q3 while its forecast for Q4 growth is tracking 1.3% SAAR, both steady from last week.
The US 3-month to 10-year curve now at +7 bp, the highest since May 3. If sustained, this move to positive slope will significantly push down perceived recession risk. It’s not just the long end that’s moving as the aggressive Fed purchases of T-bills announced Friday (see below) is pushing the short end down, with 3-month yields at a cycle low 1.66%. That has helped the US curve steepen.
The NY Fed has a recession probability model that’s based on the US yield curve. It is updated monthly and the latest reading for September fell back to 34.80% from the high of 37.93% in August. That was the highest since March 2008 and so the subsequent drop is welcome. Curve inversion has averaged -9 bp so far in October but should move into positive territory if the current trend into positive territory is sustained. If so, this would lead to a further reduction in recession probability for this month.
The Fed Beige Book for the upcoming October 30 FOMC meeting will also be released Wednesday. There is also a full slate of Fed speakers. Bullard, Bostic, George, and Daly speak Tuesday. Evans and Brainard speak Wednesday. Evans, Bowman, and Williams speak Thursday. Kaplan, George, and Clarida speak Friday.
The Fed announced Friday it will expand its balance sheet by buying $60 bln of T-bills monthly starting October 15. It added that the purchases will continue at least into Q2. Basically, that is close to six months of outright purchases, so the total would be around $360 bln. This is a bit larger than market estimates that were centered around $250 bln total. The Fed has stressed this is not QE but it sure feels like it. The good news is that this aggressive liquidity add should eliminate the spikes in short-term lending rates. By our calculations, this would take the Fed’s balance sheet up to $4.22 trln from $3.86 trln at the end of September. It was last that large back in August 2018.
October Fed manufacturing surveys kick off with Empire manufacturing. A reading of 0.5 is expected vs. 2.0 in September. Philly Fed will be reported and a reading of 7.8 is expected vs. 12.0 in September. These first Q4 readings will be watched closely for signs of further weakness.
EUROPE, MIDDLE EAST, AFRICA
UK Parliament reconvenes Monday for the Queen’s Speech. It has little time to waste, as it must approve Johnson’s Brexit deal ahead of the EU summit this Thursday and Friday. This summit is widely seen as the last opportunity to submit a workable deal. In terms of negotiations, the UK and EU have entered what they call “the tunnel” where drafts of legal text will be negotiated in secret. That suggests the divide has narrowed. Yet even as market optimism picked up, EU negotiators warned over he weekend that Johnson’s proposals are not yet good enough to be the basis for an agreement. Our base case remains that enough progress towards a deal will allow for yet another extension. Perhaps the EU can unilaterally grant one to save Johnson the embarrassment of having to ask for one.
The big unknown for investors is how much of this sterling rally is pure short-covering. Obviously, the market was structurally short GBP ahead of October 31. Is there enough meat in this story to warrant going long? Not yet, in our view. However, we think the reintroduction of 2-way risk for sterling will make for some more volatile price action in the coming weeks. Sterling rally ran out of steam last week right at the 200-day moving average near $1.2715. That level also corresponds with the 62% retracement objective of the May-September drop. Break above it would target the May 6 high near $1.3185.
China September data deluge comes this week. Money and new loan data will be reported but no date has been set. Trade data will be reported Monday, with exports expected to contract -2.8% y/y and imports by -6.0% y/y. CPI and PPI will be reported Tuesday. CPI is expected to rise 2.9% y/y and WPI is expected to fall -1.2% y/y. IP and retail sales will be reported Friday. The former is expected to rise 5.0% y/y and the latter by 7.8% y/y, both accelerating modestly from August. Q3 GDP will also be reported Friday, with growth expected to slow a tick to 6.1% y/y. The economy is likely to continue slowing even if there is a partial trade deal. If so, we see more stimulus ahead but believe the PBOC will refrain from outright rate cuts for the time being.
News out of Japan will be very light this week. BOJ Governor Kuroda speaks Tuesday. September national CPI will be reported Friday. Headline inflation is expected to fall a tick to 0.2% y/y, while ex-fresh food is expected to fall two ticks to 0.3% y/y. WIRP suggests 90% odds of a cut October 31. USD/JPY is on track to test the August 1 high near 109.30. Break above that level would set up a test of the May 21 high near 110.65.
Monetary Authority of Singapore and Bank of Korea meet and both are expected to ease. All the regional economies are suffering from the trade war and so the decision to ease should be an easy one. If MAS eases, then it joins virtually every major central bank in the region in adding stimulus this year.