Monetary Policy in Focus, but Fiscal Policy may Prove More Formidable

The Federal Reserve Open Market Committee meets on November 4th for the second to last meeting of the year. With the central banks of Australia, UK and the euro zone also convening in the coming days, the focus is squarely on the trajectory of monetary policy.

USD Stabilizing Against the Mexican Peso

Earlier this week the US dollar rallied strongly against the Mexican peso, nearing MXN13.37 and was even near MXN13.36 yesterday before staging an outside down day (traded on both sides on Wed range and then the dollar finished below the Wed low). However, the pressure on the greenback appears to be abating just below the MXN13.00 level. That said, the boom end of the 5-6 month range comes in near MXN12.80.

Canada August GDP Disappoints

Canada reported that August GDP contracted by 0.1%, whereas the consensus expected a 0.1% increase. Small change for sure, but the sign is wrong. And it likely prevents the Canadian dollar from recovering from the recent slide that has brought it to a 4 week low against the otherwise sagging US dollar. Although the US reported a 3.5% expansion in Q3 GDP yesterday on a preliminary basis, it is not clear that the Canadian economy has exited from its recession. The economy was flat in July before the 0.1% contraction in Aug. The weakness in the report was noteworthy in the oil and gas extraction sectors that contracted 2.3%. Manufacturing remains in the doldrums, contracting 0.7%. Some may attribute the weakness in manufacturing to the strength of the Canadian dollar, but the soft demand may be a bigger culprit. What strength there was in the Canadian economy stemmed from the fiscal assistance.

Fox News: Will Dollar Remain World's Reserve Currency

More Thoughts on Brazil

Brazil's 2% IOF tax comes as a wave of profit-taking weighs emerging markets in general. The MSCI EM index is off nearly 8% since Oct 20, while the Brazilian Bovespa entered "correction" territory yesterday with a cumulative decline of a little more than 11% in the same period. In the last 5 days, net-net the Brazil real has slipped about 2.4% against the dollar. From its low on Monday near BRL1.70, through yesterday's high, the dollar appreciated almost 4.7%. This underscores the point we initially made that the volatility of the Brazilian real is sufficiently high as to quickly offset the cost of the 2% tax.

IMF Regional Report

The IMF's regional report noted that the recoveries in India, China and Australia are proceeding at such a pace that the output gaps are beginning to close. As we have often highlighted, central and Eastern Europe are significant laggards. This is underscored today by Russia's central bank 50 bp cut in its key refi rate to 9.5%. It is the eighth rate cut since late April. Whereas officials in some Asian countries want to tighten lending activity, Russia seeks to boost lending activity. Russia's economy contracted 10.9% in Q2. The government forecasts a 6.8% contraction here in H2 09. Russia is the only BRIC still cutting rates. Inflation remains stubbornly high, though easing. The CPI year-over-year pace peaked in the middle of last year near 15%, but was still near 14% in Q2. It stood at 10.7% in September and the Oct reading is due out next week amid expectations of a 10.2% rate. Turning away from Russia, Hungary is seen as the next big candidate in the region to cut interest rates. The key two-week deposit rate stands at 7% and the central bank meets against on 23 November and 21 December. The market looks for a 50 bp rate cut before year-end, though we recognize the risk in the direction of more aggressive action rather than less. Separately, in a report issued today warning that widening public deficits and debt levels is undermining the outlook for the region. It now expects the region to contract 6.1% compared to a 4.6% decline anticipated in a report 4 months ago. More supportive global environment, Fitch says will help lift growth next year to 2.6% from its prior forecast of 1.5%. However, the budget deficits are expected average 4.6% of GDP (down from 5.9% this year). This means that deficits will expand faster than the economy, meaning that government debt ratios will continue to rise. Fitch estimates that the average debt to GDP will rise to 36% by the end of next year from 23% at the end of 2007.

New Fed Paper on Crisis and the Dollar--Interesting

The October issue of the NY Fed's monthly Current Issue was just released. There is an article that may prove interesting to further understand how the crisis impacted the dollar. It can be found here.

More Thoughts on Deciding What to do with the Brazil Real

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Investors continue to grapple with the best way to work around Brazil's new 2% front-end tax on foreign inflows. Understanding that in order to minimize impact, many investors would contemplate holding BRL balances received as proceeds of a sale, a dividend or coupon payment to use to make purchases of other Brazilian assets at some future time, we looked at the volatility of the BRL-USD exchange rate. The implied volatility and the actual weekly range of the BRL suggests that the risk of holding the BRL balances is that the currency movement can in a relatively short period be larger than the 2% tax.

Reduction in Risk Continues to Support US Dollar

The Japanese yen is benefiting the most from the current bout of reducing risk trades. Month-end demand by Japanese corporates may also be helping the yen recovery from roughly week lows against the dollar and two month lows against the euro. Dollar support is seen near JPY90.60 today and then JPY90.20/30. Japan's Sept retail sales were stronger than the market expected rising 0.9% on top of the 1.0% rise in Aug and 0.5% in July. The July-Sept quarter is the first since at least 2000 when retail sales rose each month. The Sept figures may have been flattered by the five-day holiday (Silver Week) this year. However on a year-over-year basis, Japan's retail sales are still off 1.4%, the smallest decline in nearly a year. Tomorrow Japan reports Sept industrial production. The strong gains that were recorded at the start of the fiscal year (5.9% in April and 5.7% in May) have not been sustained. Each month since May has been weaker and following August's 1.6% increase, the consensus looks for something closer to 1%. The year-over-year decline continues to moderate, bottoming in February with a 38% contraction. In August the pace of decline had been cut in half to 19%. The forward looking expectations for Nov may also be noteworthy. Lastly, note the BOJ meets this week, kicking off a series of major central bank meetings next week (FED, ECB, BOE, RBA). Decisions on the commercial paper and corporate bond purchases are awaited. The new government, like previous governments, may share the economic assessment of the BOJ but also seems to prefer to want to continue the supportive programs.

Chance US First Time Homeowner Tax Break is Extended

We have generally emphasized monetary factors, such as the low relative and absolute US interest rates and a global financial system awash with dollars in understanding the dollar's weakness. At the same time we recognize the concern over the trajectory of fiscal policy.

Two recent signals from Washington may be undermining confidence in the commitment to rein in fiscal policy. First, with no cost of living adjustment for Social Security recipients in 2010, the White House has floated the idea of a one-off $250 payment instead.

UK CBI Distributive Trades Keeps Sterling Bid

Sterling continues to recover from the trouncing its received at the end of last week on disappointment with a negative Q3 GDP reading. Talk today is of consistent Middle East demand against both the dollar and euro. The $1.6450 area has been approached, but good offers thought to lie in the $1.6470-$1.6500 band may encourage some intra-day position squaring. Support is seen in the $1.6380-$1.6400 area. While there are some calls for the euro to test the GBP0.9000 level, we suspect the euro can claw some ground back here today in North America, with the GBP0.9050 area holding and momentum indicators poised to reverse.

Firmer US Dollar Tone in Play

Although yesterday's dollar gains have not been extended, the underlying tone remains relatively firm. There are two fundamental currents that are aiding what appears to be largely a technically inspired move. First, there has been a modest firming of short-term US interest rates in recent days. And some observers are linking this to speculation that next week's FOMC statement may modify or drop the phrase about rates being exceptionally low for an extended period of time. The justification for the shift will ostensibly be to address inflation and boosting confidence in the Fed's commitment to price stability. This would be consistent but different than the second current, highlighted by famed Fed watcher Steve Beckner. In a report yesterday Beckner of Market News noted that last week Bernanke broached the dollar topic without being instigated. Beckner connects recent comments by Geithner and Yellen as well and suggests this is part of a new offensive that will underscore the Treasury Secretary has called a commitment "to do everything we can to sustain confidence in the dollar". The new rhetoric, Beckner suggests, will go beyond simply reiterating the strong dollar mantra. It is not so much a case of strong dollar policy on steroids, as Beckner is also clear that officials are not so concerned about the recent decline in the dollar as in the change in monetary policy to defend it; more like the strong dollar policy on antibiotics. This is consistent with the spirit of what our Washington contacts have implied and with what I advocated at the recent Bloomberg foreign exchange conference. Of course, I don't expect changed rhetoric to have immediate impact, but it is, I suspect, a necessary even if not sufficient part of a larger dollar recovery story.

Euro Reverses

The euro had made new highs for the year earlier today in response to calls to diversify Chinese reserves and after trading broadly sideways in Europe has broken down in North America. With the hitting of stops, the euro has been pushed through Friday's lows, near $1.4986. A close below there would be what technicians call a key reversal. The last time such a pattern was recorded may arguably have been on Dec 29, 2008. The session before, Friday Dec 26, the euro spent a quiet session, the day after Xmas and Boxing Day in the UK, in narrow trading ranges (at the time when volatility was quite elevated). The range was roughly $1.3989 to $1.4119. On Dec 29, the range was $1.3921 to $1.4364 and the close was near $1.3927. The euro then went on to fall about 10.6% against the dollar before bottoming in early March.

US Survey Results: Sentiment Improves, but...

The Dallas Fed factory index rose to -3.3 in October from -6.4 in Sept. The index bottomed in Feb at -565 and has risen steadily since. The best news came from the six-month ahead activity index which rose to 16.7 from 13.9. Most of the other components though suggest moderating activity. Output, new orders, shipments, employment and unfilled orders all slipped from Sept readings. Prices paid increased, but prices received fell further, which warns of pressure on profit margins.

China Inflation Fears Rising

In recent week's there has been a steady increase in "wagers" that the Chinese yuan will resume its appreciation in the coming months. There appear to be two main drivers. First, decline in exports is moderating. The 15% year-over-year decline in September is the smallest of the year. Second, last week the State Council (cabinet) signaled that inflation concerns should play a larger role in setting policy. The State Council's last statement in June did not mention inflation at all. Consumer prices rose 0.5% in Aug, the first rise in six months. Last week, the Vice Governor of the PBOC also noted that inflation pressures on gradually building.

US Treasury Supply Continues

The US Treasury will auction a record $123 bln of notes and bonds this week, adding to the $1.1 trillion net sales already this year. It is interesting to review who is buying all this paper.

Asia--the Contested Terrain

The East Asian Summit will be held this weekend in Thailand. Japan's (new) Prime Minister Hatoyama seems to be leading the call for an expanded trade bloc. Partly this is seen as a way to take some initiative and balance off not only the US, but China as well. China, as one would expect, has greeted Japan's proposals cautiously. China, India, Australia, New Zealand, and South Korea have already finalized free trade agreements with ASEAN. In addition to trade issues, officials this weekend may also discuss Myanmar, where the military regime plans to hold elections next year and may look for ways to improve the response to natural disasters.

A Review of the Trade Weighted Dollar

Companies and investors often have exposure to individual currencies, such as the euro, Japanese yen, British pound and the Brazilian real. The bilateral movement of a foreign currency against one’s base currency can be substantial and have significant financial impact. However, from a broader economic perspective, and especially to understand the impact of currency movement for a country as a whole, it is often preferable to look at a currency on a trade-weighted basis.

Worth Reading: Is Happiness Still That New Car Smell?

The New York Times published a very interesting article on America's changing relationship with the car, check it out here.

Brazilian Bonds and Stocks

Late yesterday Brazil announced it would impose a 2% tax on foreign purchases of Brazilian bond and stock transactions. This is particularly aggressive in that the new tax replaces a 1.5% tax that was scrapped last year during the crisis and only was applicable to fixed income purchases. The new tax goes into effect today. The tax may weigh on the Brazilian real in the short-run, sentiment towards Brazil is likely to remain positive. As noted the tax has been adjusted recently and it is difficult to see its impact. The bullish Brazil story, that has lifted the stock market by almost 80% this year and has made the real the best performing major currency against the dollar, up nearly 35% this year has been its high interest rates, commodity intensive economy, the global investment climate favoring high yielding high risk assets, and what appears to be a diversification of portfolios, especially by Japanese and American investors. Data from the local stock market indicates that foreign investors have bought around BRL17 bln worth of Brazilian shares this year. The dollar has been forming a base near BRL1.70 in recent sessions. The BRL1.75 area is the first area of notable resistance.

Currency Adjustments

Currency adjustments help ease global imbalances, but perhaps not so much through prices, but underlying economic activity. Press reports suggest that Honda may be considering moving production for its popular FIT hatchback form Tokyo to the U.S. to offset the strength of the yen. Currently, Honda produces 8 of 10 cars it sells in the U.S, according to reports. The weak dollar combined with high productivity of American workers translates into relatively low unit labor costs in the U.S.. In addition, the risk of protectionism also encourages locating production within the U.S. itself. The build locally-sell locally foreign direct investment strategy is superior to export oriented strategies insofar as it helps insulate companies from the vagaries of the foreign exchange market., creating offsetting currency exposures and some flexibility in reallocating production when necessary. The U.S. is one of the top exporters in the world and this year will export a little more than $1 trillion. However, the foreign affiliates of U.S. multinationals will sell something on the magnitude of $4 trillion this year. The sales by U.S. affiliates has outstripped U.S. exports since the government began tracking such data in nearly 50 years ago. The Japanese Ministry of Finance estimates affiliate sales of Japanese companies surpassed exports in the late 1990s.

What is Driving Norway

Norway is widely expected to be the next major country to hike rates. The Norges Bank meetings on Oct 27 and the following day is likely to lift the deposit rate 25 bp to 1.5%. As one of the early hikers, the krone has benefitted. In addition, relatively poorer news from Sweden has seen the krone appreciate almost 9% since Sept 23 against the krona.

Treasuries and the Dollar

At the end of Sept, the IMF COFER data showed euro and yen reserve holdings rose faster than dollar holdings, even though dollar holdings rose as well. We are reluctant to read a new trend into one quarter's report. In addition, the TIC data shows foreign investors continue to increase their Treasury holdings.

Dollar Concern Remains Low

Comments from the German Economics Minister Guttenberg has played down the significance of dollar weakness on German exports and identified a benefit of a weak dollar in that it keeps oil prices down for Europe. Given sentiment, this is a close to a green light to sell dollars as one could hope for ahead of the weekend and the euro immediately poked up to $1.49. Only the lack of participation and sliding equity prices may limit the euro gains.

TIC Data Color

The TIC data for Aug was in line with expectations. Long-term flows rose to $28.6 bln from $15.3 bln in July. Although there is much talk about demand for short-term US securities, net purchases of long-term assets has risen from about $8 bln in Q4 08 to $49 bln in Q1 09 and $82 bln in Q2. The July and Aug pace is about $45 bln, threatening to break the streak.

The Bump and Grind of Demographics

Forces of change seem to come in one of two varieties: bumps and grinds. Bumps are generally an event contained in a short term that produces profound effects. Think about 9/11 or an earthquake. Grinds are slow, almost imperceptible events, which produce significant change over longer time periods. Think climate change or the peak oil story.

Difference of Opinion BOJ and MOF

The Bank of Japan upgraded its assessment of the economy today, but Finance Minister Fujii opined that he thought that economic conditions were more severe than the BOJ appreciated. There was another are of disagreement. The BOJ suggested that the corporate bond and CP market were less dependent on the central bank. Fujii seemed much more sympathetic noting that there was still market interest.

Import Prices Show Little Problem with Weak Dollar

The channel through which a weak currency fuels inflation is through imported prices. The US reported that import prices rose 0.1% in September, but are 12% lower on a year-over-year basis. This was slightly lower than consensus expectations. Excluding energy, core import prices rose 0.6% and are off 4.1% from last Sept.

Trajectory of Policy Mix Bullish for NOK

The trajectory of the policy mix in Norway will continue to underpin the krone and may lead to some under-performance of the local bond market and underpin the equity market, which is one of the best performers in developed Europe. Although the Norwegian economy is expanding sufficiently to prompt the central bank to have considered hiking rates last month and likely will hike rates toward the end of this month, the economy is not sufficiently strong to get the politicians to withdraw their fiscal stimulus. The expanding fiscal policy while monetary policy moves in the opposite direction tends to be supportive for the currency.

Not Much Canada Can Do About Soaring Loonie

The Canadian dollar hit a low near 77 cents in early March and with today's advance, briefly moved above 97 cents. Since the March low the Canadian dollar has appreciated by more than 25%, which is nearly 3 times the yen's advance and 50% more than the euro's advance in the same period.

American Investors Playing Role in Dollar Slide

With the US deficit large and rising, the appetite of foreign investors for US securities is keenly monitored. Often the TIC data is viewed in its aggregate form, which is really on a net basis, net that is of what American investors are going. By looking at what Americans themselves are doing illustrates another source of pressure on the greenback.

Unemployment and Rate Hikes

Since 1954, the Federal Reserve has only begun raising rates after unemployment peaks. Recent comments by Fed officials reinforces this expectations. Most recently, St. Louis Fed's Bullard that he would like to see job growth and unemployment easing before hiking rates. The perennial hawk Lacker from the Richmond Fed was one of the few that suggested that rates may need to be raised before unemployment peaked.

Déjà vu All over Again

The Economist Magazine ran a story and leader noting that the U.S. dollar’s dominance is waning. There are numerous press articles about oil being denominated in something other than dollars and, more broadly, there is much discussion about the diversification of central bank reserves. That was in the first quarter of 1995.

Fed Funds Futures Adjust

The seemingly more hawkish stance taken by several Fed officials including Bernanke has helped spur the bout of dollar short covering. There is a sharp adjustment in interest rate expectations which is evident in the Fed funds futures strip. The market sees a little chance of a hike in Q1 but a higher target is fully discounted by the middle of Q2. The Dec 2010 funds contract is off 12.5 bp today to imply an effective Fed funds rate at the end of next year of 1.32% and given that the meeting is in the middle of Dec 2010, then it is implying an almost 1.5% Fed funds target by the end of next year. Although we have been in the camp that saw a risk of the first rate hike around the middle of next year, the market seems to be getting ahead of itself. At the same time, the US debt market is experiencing a sharp drop today with 2 and 10 year yields are 9-10 bp and 30-year yield up 7 bp. The long bond is experiencing its biggest drop since August after the lukewarm reception to yesterday's auction.

Sweden Disappoints

Sweden's industrial order and production data disappointed the market. August industrial production was expected to have risen almost 1%, but increased Sweden reported a 2.9% decline, which is the largest drop in the cycle. And, adding insult to injury, the July decline was revised to -0.6% from -0.5%. The year-over-year rate edged lower to -20.9% from a revised -20.6%. The consensus had expected a -18.4% year-over-year decline. Orders fell 4.2%, reversing half of the 8.4% increase in July. The year-over-year decline slumped to -18.1% from -16.9%.

Consolidative FX Session

The dollar has enjoyed a firmer bias today, but is largely in a consoldiative mode. Two main considerations lie behind the price action today. First, as we noted no one we talked with or seen quoted actually believes the press claim of a secret meeting to denominate the oil in a basket of currencies and gold. Although the report allowed participants to do what they wanted to do, which is to sell the dollar, especially in the aftermath of the G7 meeting that simply repeated their April boiler plate statement about volatility, despite some official comments suggesting a heightened level of concern.

Polish Cabinet Reshuffle, Opportunity to Add to Long Zloty

News that the Polish Prime Minister Tusk is using the alleged corruption scandal to re-jig his cabinet to attempt to rebuild support for his ruling Civic Platform Party has weighed on the zloty as a wave of profit-taking on its strong three day advance is seen. Public support for the Civic Party has declined according to polls since the the scandal story broke last week. An election will be held next year and the departure of the Deputy Prime Minister Schetyna is noteworthy as he was seen as a likely successor to Tusk. He is now tipped to head the party in parliament and replace the sports minister who resigned previously (Oct 5) and headed the Civic Party's parliamentary club. Finance Minister Rostowski has retained his portfolio but his deputy Szejnfeld did not.

Struggling with a Strong Yen

Japan's new government continues to wrestle with the strength of the yen. Although previously as a finance minister Fujii seemed more sympathetic to intervention, he now wants to break from the past. While he has back tracked from his previous apparent endorsement of a strong yen, he is still setting the bar for intervention high. News wires quote him warning of an official response if the foreign exchange market is disorderly.

East Europe Update: Zloty Extends Gain, Rouble Rallies

The rally in oil prices has given the Russian rouble a spur and reports suggest that the central bank intervened, estimates suggest $500- $700 mln worth of roubles were sold. The rouble traded at its best level for the year against the dollar. While much of the intervention is thought to have been conducted against the dollar, there is talk that some of the dollars have been or will be sold for euros. Separately, Russia reported Sept inflation eased to 10.7%, the lowest in two years, from 11.6% in August. This is supporting speculation that Russia will cut rates again this month and maybe another time before year end. The Economic Ministry expects inflation to range between 11.6%-12% this year after 13.3% last year. The risk is that inflation undershoots. The rouble appreciated almost 6% against the US dollar in Sept, its first monthly gain since May.

US Corporate Cash and the Dollar

It is widely appreciated that US corporate bond sales have been very strong this year. It begs the question what are they doing with all that cash they have been raising. There are two general answers.

Will the Euro See $1.60 and the Dollar JPY80 ?

Sentiment toward the dollar is clearly negative. Some observers cite structural factors; other cyclical. But how negative is market sentiment?

The first place to look may be surveys. News wire surveys put the consensus for the euro in Q4 09 and Q1 10 around $1.45. This is close to the forward rate of about $1.46 for both periods. However, there are a number of calls by individual forecasters for $1.50 by year-end and for a move to re-challenge the record high near $1.60 in Q2 10 or Q3 10.

Treasury Supply Weighs on Dollar Sentiment

The US Treasury sells $78 bln in notes and bonds this week and $60 bln in bills. The continued deluge of supply weighs on dollar sentiment, especially given indications from the G7 that the pain threshold to stop the dollar's decline has not been reached. The auctions begin with $7 bln 10-year inflation protected security and the bills today, followed by a record $39 bln three-year auction tomorrow, re-opened 10-year auction Wed for $20 bln and re-opened 30-year bond sales trying to raise $12 bln on Thursday.

Make Me: The State of U.S. Manufacturing

The United States has been hollowed out. It no longer manufactures goods. Once the factory of the world, the U.S. now manufactures debt. The high wage manufacturing jobs have been out-sourced to low wage economies. The demise of U.S. manufacturing is at the core of the decline of America, its chronic trade deficits and growing international indebtedness. It makes the world’s savers reluctant to be exposed to the U.S. dollar.

Euro Run Back to $1.4850

The euro broke below $1.45 support briefly in the knee jerk response to the disappointing US jobs data. However, more critical support near $1.4470 held and the euro has made new highs for the session. While the close will be important, the price action suggests the nearly 2 week and 3.5 cent correction may be over. Good buying was reported from sovereign and other long term investors on the pullback.

Zloty To Reverse

News that the zloty dividend had to a large extent been hedged by Dutch-based Eureko has helped the Polish currency recover from the 10-week lows against the euro reached earlier today near 4.30. The resolution of the PZU-Eureko dispute is seen as removing a negative. In addition, an economic advisor to Poland's president and a candidate for the central bank warned that the new board that will be in place at the start of 2010 will likely raise rates very early in it tenure: "almost at the start of its term".