Policy not Data to Drive the Dollar

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 improved 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).  

Four major central banks meet in the week ahead.   The 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, were among those looking for a rate cut.   The nearly 8% appreciation of the New Zealand dollar over the last six weeks increases the risk 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, the 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 around 1.3%. The weakness 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 policy response.  This could the disappointment all the more bitter.   In this context, this would likely be expressed as a stronger yen and weaker stocks.  

The Federal Reserve meets.  There is practically no chance of it raising rates.  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 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 the 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 fueling consumption.  Over the past two years, nonfarm payrolls have increased by more than 5.5 mln.  Revolving credit that is 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.  

While monetary policy will command attention given the FOMC meeting.  However, there has yet to be a resolution or even movement toward a resolution of the pending debt ceiling.  The US Treasury has been doing what it can, which included canceling last week's two-year note auction. The Treasury Dept now expects that it would 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.  

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.    

Disclaimer