– The week ahead is among the most important of the year
– The divergence in the trajectories of monetary policy has not peaked, or even come close to a peak
– While all Fed tightening events do not lead to a dollar rally, the previous two significant dollar rallies were preceded by Fed rate hikes
– We highlight seven key events for this week: China’s PMI and the IMF’s SDR decision; policy decision by the RBA, the Bank of Canada and the ECB; the US employment data; and the OPEC meeting
Price action: The dollar is mixed on the day, but moves have been relatively modest. The euro and pound are drifting lower to $1.0570 and just over $1.50, respectively. The dollar is underperforming against the Scandies and the Swedish krona, but outperforming against the yen, back at ¥123.0. EM currencies are equally mixed in narrow ranges. KRW and IDR are underperforming while TRY and RUB are outperforming. After falling over 3% earlier in the session, the Shanghai Comp managed to close with a small gain, averting a second day of sharp declines. Real estate shares led the recovery following news of a about an ambitious shanty town renovation plan for next year. The Nikkei closed 0.7% lower and the South Korean Kospi is underperforming following a large miss in the country’s October IP data. EuroStoxx is up 0.4% and US futures are flat.
The week ahead is among the most important of the year. Rarely is there such a confluence of events in a short period that will have far-reaching implications for investors that are known ahead of time and have been discussed so extensively. One implications of this is that there are expectations that have been discounted by the market. The potential for sharp price gyrations and the dictates of money management should not distract from the big picture and the durable trends. In this context, there are two important considerations long-term investors ought to keep in mind:
First, the divergence in the trajectories of monetary policy has not peaked, or even come close to a peak. If we agree this is the main driver in the foreign exchange market, then further dollar appreciation on a trend basis should be anticipated. There has been a dramatic re-build of long dollar positions since mid-October. The late momentum traders are vulnerable in the period ahead. It may occur after this week’s events, or it may be after the FOMC meeting later in December. Such a shakeout may provide long-term investors with a new opportunity to position with the underlying trend.
Second, while all Fed tightening events do not lead to a dollar rally, the previous two significant dollar rallies since the end of Bretton Woods (the Reagan dollar rally and the Clinton dollar rally) were preceded by Fed rate hikes. Recall Volcker’s hikes prior to the 1980 election helped set the stage for that dollar rally that ultimately lift the greenback more than 50% on a real trade-weighted basis before coordinated G7 intervention reversed it.
The Fed raised rates in 1994. This, combined with a new Treasury Secretary that promised not to use the dollar as a trade weapon, spurred the five-year Clinton dollar rally. It too ultimately ended with the help of coordinated intervention in October 2000.
Here is a thumbnail sketch of next week’s seven key events:
1. China’s November PMI readings: Expectations are for little change from the previous month. The manufacturing economy likely slowed while the service sector continues to expand. The economy is transitioning away from manufacturing so the traditional go-to metrics, like railroad car loadings, electrical consumption, and bank loans, were picked by Premier Li at an earlier stage of development. Market impact is likely to be minimal. The China stock and bond markets are trading on another dynamic than the macroeconomic condition. The equity market posted a dramatic loss before the weekend, but the global knock-on effect seemed minimal and the US S&P 500 eked out a small gain. Often negative economic surprises from China weigh on commodity producers including the Australian dollar.
2. IMF’s SDR decision on China: It seems like a forgone conclusion now that the IMF will include the yuan in the next configuration of the SDR, which will be implemented in September 2016. Assuming this is a reasonable surmise, then the real question is about the weighting of the yuan. This is very much unknown in part because, as the IMF is the first to admit, it is not a mechanical decision. There is a large judgment component. The literature suggests the IMF’s own approach has been evolving toward more weight on capital markets than the market for goods (exports). Also, the other currencies in the SDR are substantially more accessible and used than the yuan.
If just relying on China’s exports, the IMF staff suggested in the summer, a weighting of 14-16%. Many observers seemed to have taken this illustration out of context, and this became the rough consensus of what will be announced. We are less sanguine. From China’s point of view, the key now is getting in, not the weight. That is where there is scope for compromise with those who think that yuan is not seasoned sufficiently, and much more work has to be done to increase the role of markets in setting key elements of the price of money in China. Also, there is some discomfort with the light capital controls that China has imposed to deter capital outflows.
We expect the market impact to be minimal. We do not expect central banks to immediately begin buying yuan. Macroeconomic considerations still favor some depreciation in the yuan, though the large trade surplus and the shift away from manufacturing argue against a significant depreciation. The gap between the onshore (CNY) and offshore (CNH) yuan is widened in recent days. The IMF had indicated over the summer that this was not desired. The gap has approached levels at which officials appeared to take indirect action. The may also be arbitrage opportunities for large Chinese banks.
3. Reserve Bank of Australia policy decision: The chances of a rate cut this week are very small, but the risk that the 2.0% cash rate is the bottom of the interest rate cycle has decreased following the unexpectedly large decline in Q3 capital expenditures. The 9.2% drop was three-times larger than the Bloomberg consensus forecast, and it is more than twice the drop seen in Q2 (-4.4%). It was the fourth consecutive quarterly decline during which time capex has fallen by more than a fifth. The transition in China is helping to force a transition in Australia. The combination of low interest rates and a depreciating currency (-15.6% over the past 12 months) is facilitating the transition. Barring a surprise cut, which would likely send the currency back toward $0.7000, Governor Stevens’ statement will likely shape the market’s reaction. Before the capex data, he was clear that the RBA was on hold into Q1 16. We think the RBA likely tell investors that there is scope to cut rates again if needed. The market may see this as an increasing the likelihood of a rate in Q1 16.
4. Bank of Canada policy decision: The risk of a Bank of Canada rate cut is also low, but the two rate cuts earlier this year may need to be followed up in Q1 next year. Recall that according to the monthly GDP figures, the Canadian economy contracted from last November through May. The 0.4% expansion in June was the quickest pace that was achieved, and since then growth has been decelerating (0.3% in July and 0.1% in August. The economy is expected to have stagnated in September, which will be reported on December 4, two days after the Bank of Canada meeting. The loss of economic momentum as the quarter proceeded may be more important than the Q3 figures reported at the same time (Bloomberg consensus forecast is 2.3% annualized). Canada’s jobs data before the weekend are expected to be soft after an outsized rise in October (44k), but the fate of the Canadian dollar is likely to be driven by the next three events.
5. ECB policy decision: Even though there is great uncertainty about precisely what the ECB will do, expectations for additional action seems nearly universal. There appear to be four moving parts: the deposit rate, the pace of purchases, the instruments that can be bought, and the duration of the program. Each has been the subject of much discussion. If there is a specific consensus, it seems that it is for a six-month extension of the program until March 2017. On one hand, it may be the least significant action because the current September 2016 termination was always soft. On the other hand, it may be significant in that in confirms that the divergence of monetary policy may persist, which in turn begs the question of how much has been and can be discounted.
There had been reports that the ECB was considering buying sub-sovereign bonds and non-performing loans. We are highly skeptical of the latter and suspect that in these negotiations, having chits one can sacrifice is helpful. We doubt that sub-sovereign bonds will be included. Sufficient transparency may be lacking. However, increasing the agencies whose debt can be bought appears to be an ongoing process.
The ECB recently raised the cap on any one issue that can be bought. Although there is a limit on liquidity grounds, it shows that the ECB can revise its self-imposed rules. For example, there has been some suggestion to waive entirely the deposit rate as the floor for yields that can be bought under the asset purchase program.
The deposit rate currently sits at minus 20 bp. Previously Draghi had indicated that at this rate, monetary policy had been exhausted. However, other countries showed that where ever the limit to negative interest rates was, it was not 20 bp. More recently, Draghi (and others) have indicated that a lower deposit rate could still be helpful. The OIS market appears to be pricing in about a 5-7 bp cut in the deposit rate while surveys suggest the market is divided between 10 and 20 bp cut a slight majority at the lower end.
There has been some discussion that the ECB is considering implementing a two-tiered system similar to the one used in Denmark. At first we thought this would penalize the large banks (especially from Germany and France), but it may be construed in such a way that it allows a somewhat less “penalty” to banks with large deposits. This may help minimize the disruptive impact in the money markets.
Lastly, many expect the pace of purchases to be accelerated. A common forecast is for an increase of 20 bln euros a month to 80 bln. If this does materialize and starts in January, and the program is extended by six months, this amounts to doubling the purchases to 1.2 trillion euros. Under the present program, the ECB would buy 60 bln euros for the first nine months of next year, or 540 bln euros. This anticipation has helped drive eurozone yields down in recent weeks. It makes us more circumspect on the amount of bonds that can be freed up for purchases by a lower deposit rate.
Even though the anticipation of action this week has driven the euro lower, it may sell-off further on the news. First, it is difficult to say with any confidence precisely what has already been discounted. Second, despite the clear record of Draghi’s tenure at the helm of the ECB, the market has repeatedly underestimated him. He has repeatedly surprised on the dovish side. Note that Draghi speaks the next day at the NY Economic Club. The third reason that profit-taking on short euro positions may be limited is because of the next key event.
6. US jobs data: This month’s jobs report takes on extra special meaning. Barring a shockingly poor report, this report is seen as the last hurdle to an FOMC decision later on December 16 to deliver the much-anticipated rate hike. The most important thing to know about the employment report is that no one expects a repeat of the 271k increase in October nonfarm payrolls. It was the best of the year. The weekly jobless claims also point to some payback. The consensus is for around 200k. It would likely 30k-50k for the pendulum of market sentiment to swing very far, especially if some of the internals, like average hourly earnings, the unemployment, and under-employment (U-6) is constructive.
Separately, we note that at the start of a new month, there is a full slate of US economic reports, with the jobs report being the single most important one. Also, we would draw your attention to US auto sales. Even before the crisis, Americans rarely bought more than 18 mln vehicles (annualized pace) in a month. When they do occur, they look like one-month wonders. Not only did Americans buy 18.12 mln vehicles in September for the first time in a decade, but it looks to have repeated the feat in October.
The Fed’s Beige Book that will be released two days before the jobs data is unlikely to have much market impact. The market appears convinced that the US economy continues to grow around trend (seen ~2%) even though personal consumption in October soft (reported last week at 0.1% vs. consensus of 0.3%). The Atlanta Fed cut its GDPNowcast to 1.8% from 2.3% in Q4 following the report.
There are no fewer than nine Federal Reserve officials that will speak for the week ahead. Yellen speaks several times, including at the Economic Club in Washington, and the Joint Economic Committee of Congress. She is unlikely to break new ground. Expect her to reiterate the progress that has been made, and provide assurances that accommodation will be removed gradually. Fischer also speaks on Thursday at a conference on financial stability. No doubt timely rate hikes are integral. The regional presidents’ views are fairly well known at this juncture. The only other Governor to speak is Brainard, and her views will be interesting given that she previously was more comfortable with a later lift-off.
7. OPEC meeting: Barring a decision to cut output, we expect oil prices to continue to trend lower. The market continues to perceive a glut. US rig count has fallen 18% since the summer, and 54% since the peak in October 2014, but US output is still running about 145k barrels a day more than it did a year ago.
Many participants misunderstood the report that indicated that Saudi officials were prepared to work with OPEC and non-OPEC producers to stabilize the market. They thought this was a constructive development for prices, that the Saudis were softening their position. Hardly. Saudi Arabia was reiterating that there would be no unilateral cuts. And since many OPEC and non-OPEC producers do not want or claim inability to cut production, the prospects for an agreement seem quite remote.
There has been pressure on the Saudi riyal peg to the dollar. We expect the speculators to be proven wrong. The economic challenge has been greater than now, and the peg remained. It is an anchor of stability for Saudi Arabia and the world. Every so often someone gets a bee in their bonnet about testing the durability of one of the rare currency pegs to the dollar. To their own detriment, such participants have repeatedly underestimated the Saudi Arabia’s will.
The same may be true regarding the oil market. It must be assumed that Saudi Arabia is pursuing a long-term strategy that it realized would have near-term costs. Have the costs been substantially more than anticipated? Is there a way to evaluate the strategy and assess the probability of success? The answers, of course, are beyond the scope of this note, but the strategy is hardly a year old. Saudi Arabia’s exports to the US are at two-month highs. Saudi Arabia recently escalated its competition with Russia in Europe. Competition in Asia remains fierce. The declines in energy investment have been brutal and will impact in the medium term.
Finally, we note that if there is a change in the OPEC quota, rather than a cut, don’t be surprised if there is an increase. The increase may come as a surprise to many. The market is vulnerable to headline risk. However, the issue may not be what it seems. First, Indonesia, which had left OPEC rejoined. It produces about 880k barrels a day. This could prompt a one mln barrel increase in OPEC output, which essentially transfers from non-OPEC. By not impacting supply, theoretically it should not impact prices.
The second issue is Iran’s oil. How will OPEC manage this? If the overall quota is not adjusted, that would mean that other members’ output would have to be cut to make room for Iranian oil. Even if the political climate was less antagonistic, it is difficult to envision this taking place.