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October 26th, 2015 6:41 am | by John Jansen |

Via Marc Chandler at Brown Brothers Harriman:

Policy not Data to Drive the Dollar

– The European Central Bank and the People’s Bank of China reanimated the divergence theme just when many observers had all but given up on it
– The Sweden’s Riksbank is the most likely to ease further this week; the Reserve Bank of New Zealand is expected to stay on hold
– We are less sanguine than markets about the prospect of imminent easing by the BOJ
– There is practically no chance of the Fed raising rates this week; meanwhile there are no signs of a resolution toward a resolution of the pending debt ceiling
– Political risk remains high in EM

Price action:  The dollar is mostly softer against the majors, but is trading mostly within narrow ranges.  The Aussie and the Norwegian krone are outperforming, while the Swiss franc is underperforming.  The euro is trading flat near $1.1030 after a brief dip below the $1.10 level.  Sterling is also trading flat near $1.5330, and has so far been unable to break below $1.53.  Dollar/yen is down slightly and is testing the 200-day MA near 121 after earlier trading as high as 121.50.  EM currencies are mixed.  HUF, TRY, and SGD are outperforming while KRW, TWD, and IDR are underperforming.  EUR/PLN is trading flat after Poland’s opposition Law and Justice party won weekend elections.  In Argentina, opposition candidate Macri did better than expected, forcing a run-off election for the presidency November 22.  MSCI Asia Pacific rose 0.4%, with the Nikkei up 0.7%.  China markets were higher, with the Shanghai Composite up 0.5% and the Shenzen Composite up 0.7%.  The Dow Jones Euro Stoxx 600 is down 0.1% near midday, while S&P futures are pointing to a lower open.  The 10-year UST yield is flat near 2.08%, while European bond markets are mixed.  Commodity prices are mixed, with oil up modestly.

  • The European Central Bank and the People’s Bank of China reanimated divergence as a critical driver just when many observers had all but given up on it.  The divergence is about monetary policy, broadly understood, not about the data per se.  Of course, there is a relationship between the two but it may not be particularly tight.  The recent string of eurozone data, for example, including last week’s preliminary PMI reading, does not show the kind of deterioration that matches the urgency Draghi expressed.  The survey of loan managers reported improving supply and demand of credit.  The preliminary October CPI may show deflation at the headline level, but the core rate is expected to remain steady at 0.9% (and the risk is to the upside).  
  • Draghi’s strong hint of ECB action in December has no bearing on the setting of US monetary policy.  It does, however, set the stage for a potentially dramatic divergence in December, when it is possible that both central banks move in opposite directions.  And even with a modest expansion of the ECB’s asset purchase program, the BOJ’s QQE may be more aggressive, even if it does not increase it.  
  • The dollar appreciated sharply from mid-2014 through Q1 2015.  It has consolidated since, and for good macroeconomic reasons, including the Fed’s reluctance to shift monetary policy from extremely accommodative to very accommodative.  During the consolidation, the dollar held above key technical retracement levels that could have called the bull market into question. Now the forces of divergence are coming into play again.    
  • Four major central banks meet in the week ahead.  Sweden’s Riksbank is the most likely to ease further.  It may expand its bond purchase program to SEK40 bln while maintaining a negative 35 bp deposit rate.  The prospects of further ECB action in December would seem to increase the likelihood.
  • The Reserve Bank of New Zealand also meets.  The Bloomberg consensus looks for the central bank to stand pat at 2.75%, though a small number of banks, including two based in Australia and New Zealand, are among those looking for a rate cut.  The nearly 8% appreciation of the New Zealand dollar over the last six weeks increases the risk of a surprise move.
  • Many observers would put the Bank of Japan on the list of central bank candidates that are likely to ease policy.  A Bloomberg poll found 15 of 36 economists expect action this week.  We are less sanguine.  Here too there appears to be a gap between the data and official action, but the opposite of the ECB.  In Japan, the high frequency data seems to be deteriorating, and the Bank of Japan is still sounding optimistic.  
  • Before the BOJ meeting, some more September data will be released.  It includes industrial output, which is expected to have fallen for the third consecutive month.  It will increase the risk that the entire economy contracted in the July-September quarter, the second consecutive quarterly contraction.  The latest inflation data will also be published.  It is unlikely to have improved, meaning that the core rate (excluding fresh food) remains in negative territory, and there is risk that the October reading for Tokyo shows continued deflation as well.  
  • Officials want to say that it is mostly a measuring problem.  The dramatic drop in oil prices is rare and distorts various metrics.  There are also demographic developments that may weigh on some prices, such as rents.  A core measure of CPI that excludes food, energy and rents is rising around 1.3%.  The weakness in industrial output partly reflects a running down in inventories, and that it is a temporary soft patch.  The recent trade data confirmed that exports to the US and Europe more than offset the decline in exports to China.
  • Weak output and price data, even if the labor market remains tight, may encourage speculation of a BOJ policy response.  This could make the disappointment all the more bitter.  In this context, this would likely be expressed as a stronger yen and weaker stocks.  
  • There is practically no chance of the Fed raising rates this week.  Little has changed since the September meeting, though the global capital markets are somewhat calmer.  The statement itself may reflect this, but it is unreasonable to expect the FOMC to say anything that can be interpreted to exclude a move in December.  That would contradict what it has been saying, and it would not be consistent with the data-driven approach it claims.  
  • The Federal Reserve is out of play until the middle of December and Q3 GDP that will be released the day after this FOMC meeting is nearly irrelevant.  Policy must be forward looking.  In addition, the inventory cycle, perhaps influenced by the expectation that the Fed would have lifted rates by now, likely hampered growth.  It is also difficult to separate the role of exchange rates and the role of weak foreign demand in curbing US exports.  Consumption likely remained above 3% for the second consecutive quarter and the fifth time in the seven quarters.  
  • Income is fuelling consumption.  Over the past two years, nonfarm payrolls have increased by more than 5.5 mln.  Revolving credit (credit card use) has been very mild, meaning that debt creation is not financing consumption.  The last two nonfarm payroll reports have been disappointing.  However, other readings on the labor market have not confirmed the breakdown.  There include the ISM/PMI and ADP estimates.  The four-week average of weekly initial jobless claims is at new cyclical lows.  
  • There has yet to be a resolution or even movement toward a resolution of the pending debt ceiling in the US.  The US Treasury has been doing what it can, which included cancelling last week’s two-year note auction.  The Treasury Department now expects that it will have exhausted its resources around November 3.  Also, there is spending authorization that comes to a head in December.  
  • The debt ceiling impacts the ability to service US debt and pay for already authorized spending.  It threatens default.  The spending relates to the funding of the government’s activities.  The failure to reach an agreement here leads to closure of parts of the government.  This peculiarity of US politics is familiar to many investors.  Because of the potential disruption, including potentially on Fed policy, it is prudent to track these developments.  
  • Political risk remains high in EM.  Poland’s opposition Law and Justice won an outright majority in parliament, and threatens to pull policy towards a more populist trajectory.  In Argentina, opposition presidential candidate Macri did better than expected, forcing a second round run-off November 22.  Turkey holds elections this coming weekend, with polls suggesting another stalemate.  In Brazil, the impeachment drums continue to sound.  These developments add yet another wrinkle to an already difficult investment climate.  Despite what appears to be a more beneficial global liquidity backdrop, we remain negative on EM as an asset class.


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