Another Week that is Not about the Data

The contours of the investment climate are unlikely to change
based on next week’s economic data from the US, Japan, or Europe.
  The state of the major economies
continues to be well understood by investors. 
Growth in the US, EU, and
Japan remains solid, and if anything above trend, as the year winds down.
  The incremental data will likely
show that the eurozone economic momentum is intact with the November flash
PMI.  Japan’s October trade balance is expected to be little changed, but
strong imports and exports are consistent with a revival of trade activity seen this year.  The US durable
goods orders, stripped of aircraft and defense orders, to get the underlying
signal, are expected to have risen around 0.6% in October, which would be
just below this year’s average (0.8%), but follows three consecutive months of
more than 1.2% increases. 
Instead of focusing on
latest iterations of high frequency data, investors will likely focus on policy
US tax reform and the minutes/record from the latest FOMC and ECB meetings
standout.  In the UK, Brexit and the budget are the focus. 
US tax reform made important
progress last week.
The House of Representative approved its version.  The Senate Finance
Committee approved its version.  The next step is a vote on the Senate
floor.  This could come after the
return from the Thanksgiving break, after which there are a dozen legislative
sessions before next month’s holiday break.   However, we are skeptical
that the bill can pass in its current form.  The regressive nature of the proposals and the divisive inclusion of the
repeal of the individual mandate for the Affordable Care Act will produce at
least three defections from the Republican Party. 
Indeed, nearly 2/3 of the
economists polled by Reuters (November 13-17) were not confident that tax
reform would pass this year.
  Many who think it might be
passed next year seem to expect a scaled-down
version that may rely on temporary cuts more than reform per se. 
If the tax bill falters on
the floor of the Senate, as we think likely, the stock market may be vulnerable
to disappointment and volatility would likely increase.
  Bond yields may ease, and with the
short-end anchored by the expected path of Fed policy, the yield curve may
flatten further. 
In the currency market, on a
purely directional basis, the yen is the most sensitive to US 10-year yields
(past 60-day correlation 0.94). 
The Swiss franc (0.86) is followed
by the Australian dollar (0.81) and the Norwegian krone (0.80).  The correlation
between the 10-year yield and euro (and Swedish krona) lag behind but is still
robust at 0.76, while the Canadian dollar’s correlation is a touch lower at 0.74. 
Sterling is the outlier with a correlation of 0.18 over the past 60

The Federal Reserve and the
ECB release the minutes/record of their most recent meetings.
  The FOMC meeting was as much of a
non-event as its meetings can be, with no forecast updates, press conference,
or new initiatives. Perhaps the most interesting thing about the November 1
FOMC meeting is that Powell knew he would be nominated to be the next Chair,
though Yellen apparently did not. 

A debate over the extent that the Fed’s reduction of the balance sheet will
tighten financial conditions has emerged.
Many argue that the $450 bln reduction of the Fed
balance sheet envisioned by the end of next year is tantamount to 100 bp hike
in the Fed funds rate.  We respectfully demur. 

The difference in views
stems from a disagreement on how the asset purchases worked. 
 Given that US Treasury yields fell
on the announcement and rose on the actual purchases underscores, in our mind,
the important of the signaling channel for impact as opposed the material
impact.  This is not so much a
resurrection of the debate over flows
(purchases) versus stock (holdings) as it is an appreciation of the
significance of official communication.  In recent speeches, central bank
officials seemed to acknowledge this and give credence to our emphasis. 

That said, where we do agree
is that investors may be underestimating the extent of Fed tightening in 2018.
is not because of the balance sheet effects, but because we expect the Fed to
raise rates two or three times in 2018, while the market has a little more than
one discount.  A Reuters survey
found that most economists it surveyed expect the Fed to hike rates twice next
year, which is somewhere in between what the market is discounting and what the
Fed’s forecasts suggest. 
The ECB’s
meeting’s October 26 meeting was more significant.
  It announced the extension of its asset purchases
through September 2018 at half the current 60 bln euro monthly pace. There are
two debates that investors may look at the record to shed light. 
First, the ECB left the end
date of its program open-ended. 
 Some officials wanted to provide a date certain that it
would end.  The position is understandable.  Growth remains above trend, and the threat of deflation has been extinguished.   However,
tactically it would be a mistake.  It would minimize the central bank’s
options.  It would likely produce an undesirable impact in the market by
increasing interest rates, and thus undermining the ongoing operation. 

One thing we do not think
has been fully taken into account is that
when the ECB meets in the June and July
next year, the balance sheet may have begun shrinking. 
 The cause of this would not be the
scarcity of securities that some are focused on, but rather starting in the middle of next year, the TLTROs
(long-term borrowings) can begin being repaid early without penalty. 

New lending is growing slowly, and negative rates still associated with dominating short-term and
intermediate-term rates, we suspect some banks will want to return the
undesired and costly liquidity. 
The ECB charges 40 bp on deposits.  The German curve is
negative through seven years, and the
French curve is negative through five.  Spain, Portugal, and Italy offer negative rates out through three

One of the reasons that the ECB shied away from calling its
announcement tapering is that its extraordinary policies have not
negative deposit rate remains.  It will continue to fully meet all demand
at its refi operations conducted at zero interest rates.  The second
may have been over linking these measures to some inflation.  This
issue can be expected to get more airtime
next year.

Political drama may be most
profound in the UK.
Two issues dominate.  The budget and Brexit.   Chancellor
of the Exchequer Hammond will make his budget statement on Wednesday. 
 Expectations are rightfully low. 
The Chancellor had to
quickly backtrack from his March initiative to raise the National Insurance
contribution of some self-employed people.
  He is likely to be particularly cautions this time.  His tenure may depend on it. The revised forecasts
of the Office of National Statistics do not give Hammond much room to maneuver
even if he was so inclined.  Growth forecasts have been revised lower, and as a consequence, the
projected deficit is larger than previously anticipated. 
Brexit continues to be
the past eight months, UK officials appear to have struggled to get their heads
around the legal fact that once Article 50 was
invoked, the power of the agenda and negotiations shifts to the
EU.  EU has clearly demanded that
progress is made on three separate issues to
move forward on the terms of the new relationship.   The three issues
are the rights of EU citizens in the UK, the Irish border, and the UK’s
willingness to make good its past financial commitment to the EU.  
EU Council President Tusk
gave the UK a two-week deadline to make progress,
or he will not endorse the beginning of the next phase of negotiations at the
December heads of state summit.  
The pressure is on
the UK to take action.  
Reports suggest a
mini-cabinet meeting of key Brexit ministers on Monday may be a potential
turning point and poses a risk for a
spike in sterling volatility. 
There are rumors that a significant cabinet shakeup also may be announced shortly.  Sterling has been in a roughly $1.30-$1.33 trading range
for the past two months.  It has been
confined to a range against the euro.  The euro has traded largely
between GBP0.8750 and GBP0.9050. 

Perhaps what Churchill once
said about Americans-that they could be
counted on to do the right thing, after the alternatives have been exhausted,
might apply to the UK here. 
 Anything that suggests the UK and/or the EU is moving away
from the brink may be seen as sterling
positive.  We think an upside break should be respected.  


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