The Week Ahead: Building Expectations

A critical driver in the foreign exchange market, and the global capital markets more generally, is the continued preparation by the Federal Reserve for a rate hike, while many other central banks, including the ECB, warn investors that more accommodative monetary policy may be necessary.  In the days ahead, the economic data and official speeches will be understood in the context of building expectations.

After Draghi's press conference following the ECB meeting last month, market expectations for more monetary stimulus is running high.  However, while many market participants view it as a done deal, it is not clear that a consensus has been forged.  The recent economic data suggests that expansion continues apace, and if not impressive, steady.  Core inflation is running at 1.0% year-over-year, which while soft, is not signaling a deflationary spiral.   Moreover, the European economic locomotive, Germany, is expected to have found better traction after a weak August, and both orders data and industrial output data is forecast to have bounced back.  

As we noted last week, the euro zone economic data does not seem consistent with the sense of urgency Draghi's expressed recently.  Either the economic data stream deteriorates, or it will be difficult to reach a consensus for new bold action.   If the economic data is in line with consensus, suggesting that the eurozone expanded by 0.4% in Q3 as it did in Q2, which is also the average quarterly growth since the middle of 2014, then the risk is that the pendulum of expectations swing back to mild action.  An increase in the duration of the purchases may be more likely than buying more, or cutting rates deeper into negative territory, as had seemed possible following Draghi.

The Federal Reserve cannot be very disappointed with Q3 GDP figures.  As it had anticipated, the largest inventory swing in four years weighed on headline growth, but final domestic sales (excludes inventories and net exports) rose 2.9%.  Although this is slower than Q2's 3.7% pace, it is better than 2014 (~2.4%) and H1 2015 (~2.3%).  It speaks to the resilience of the US economy.  Moreover, after tax income rose 3.5%, allowing consumption to add 2.2 percentage points to GDP and an increase in savings.

There are at least nine Fed officials who speak in the week ahead.  We argue that the Fed's leadership defines the hawk-dove scale at the Fed.  This is to say that several Fed officials are more dovish than the troika of Yellen, Fischer, and Dudley, and several are more hawkish. Methodologically, we suggest that policy emanates from the leadership, and emphasis should be placed on their views.   Also, we suggest investors be sensitive to changes in views.  That Brainard and Tarullo among the governors, for example, that have more dovish than the troika.  It would be more newsworthy if they softened their stance than if it was maintained.

The US reports ISM for manufacturing and services, which is the Chicago PMI offers any hint, there is upside risk to the consensus estimate of 50 and 56.5 respectively, and auto sales, which may slow slightly from the nearly 18.1 mln unit annualized pace in September.  However, the most important report of the week is the monthly nonfarm payroll report.   The deterioration of the last two job reports has not been confirmed by other labor market readings, including the weekly jobless claims, where the four-week moving average is making new cyclical lows.

The October employment report is expected to be the best in three months, with job growth picking up to 180k from 142k in September.  The three-month average is 167k.  The internals may be as important as the headline.  These include the possibility of an upward revision to the August and September reports, the potential for the unemployment rate to slip to 5.0% and the underemployment rate (U-6) to dip below 10% for the first time since 2008.  The year-over-year pace of hourly earnings increase can tick up to 2.3%, which is the upper end of the recent range.

While the eurozone data is not poor enough to suggest the need for urgent monetary action, the US data does not seem to justify the emergency setting of the Fed Funds rate.   Barring a significant surprise, this week's data should keep a December rate hike very much in play. Remember for the majority of the Federal Reserve, the continued absorption of slack in the labor market, understood as the sufficient and necessary condition to boost wages, which in turn are seen as the key to core inflation, and headline inflation converges to core inflation.  

Three central banks from high income countries meet in the coming days:  The Reserve Bank of Australia, the Bank of England and Norway's Norges Bank.   On balance, the market does not expect any to change rates, but the RBA is seen to be the closest call.  Soft inflation data with a backdrop of variable mortgage rate hikes by leading banks spurred the speculation.  The derivatives market put the odds at nearly 50/50.  However, strong domestic credit growth may have bought the RBA some time.  The Norges Bank cut rates at the last meeting and signaled a lower repo-rate path. It seems for the moment, though,  that it is content to wait and watch.  

Under the new communication regime, the Bank of England will release the minutes and the quarterly inflation report at the same time as its rate decision.  The BOE appears several months at least from raising interest rates.   There has been one dissent at the past two meetings.  There seems to be a greater risk of someone joining the dissent than McCafferty giving up his call for an immediate hike.  Even if the dissent does grow, the forecasts contained in the inflation report will illustrate why this will remain a minority for some time.   Note for example that the 5- and 10-year breakevens have fallen by about 35 bp since the end of H1.  Similarly, the implied yield on the June 2016 short-sterling futures contract has declined about 40 bp since mid-July.  

The BOE is widely expected to be the second major central bank to hike rates after the Federal Reserve.  This anticipation should help sterling outperform most other major currencies on the divergence hypothesis.   However, the perceived gap between the Fed's move and the BOE's move can be several months and therein lies sterling's vulnerability.  At the same time, growth appears to be moderating and shifting composition.  This PMI data is expected to shed more light on this. Manufacturing activity is forecast to moderate for the third consecutive month while services are expected to have quickened their expansion, snapping a three-month slowdown.  

Monetary conditions in the UK have tightened in recent weeks.  Sterling has risen near 3.0% (2.85%) on the BOE's broad trade-weighted measure since mid-October.  At the same time, 10-year gilt yields have gone up by 16 bp.   Even if blunted by the 1.5% rise in the FTSE 100, monetary conditions have become less accommodative, leaving the BOE to make a nuanced argument that it is not the right time to raise rates yet, but that day continues to approach.  

Another highlight of the week ahead is Japan's public offering of Japan Post.  It will take three forms, a holding company, a bank and an insurance company.  It will be listed as of November 4.    It is the world's largest IPO of the year and the biggest Japanese IPO since 1987.   It is largely aimed at domestic retail investors, and preliminary reports indicate strong interest.  It is unlikely to be a significant factor in pushing the yen.  

The BOJ left policy on hold last week, which disappointed many who had anticipated an expansion of its asset purchase plan.  While BOJ's Kuroda offers assurances that further easing will be delivered if necessary, investors are thinking about what will take to reach that threshold.  Current core inflation is negative and after weak output and household spending data, it is likely the economy contracted in July-September period after contracting April-June.   

Contrary to what some refer to as a "technical definition", Japanese officials do not appear to regard what Japan is experiencing as a recession.  Still continued weakness in Q4, and the risk that base effects lift headline inflation, but does nothing for measures of core inflation, will likely keep speculation running high for addition monetary easing either late this year or early next.  

China's PMIs released over the weekend are unlikely to have much lasting impact. the PBOC has on average cut rates every other month this year.  The PMI data is consistent with other data suggesting that the service sector, which the government want to grow, is doing better than the manufacturing sector which continues to slow.  Further targeted easing measures are likely this year.   With the new five-year plan agreed upon, the next important focus is the IMF's decision on the SDR, which is expected later this month.  

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