Focus Shifts toward Europe

There were significant moves in interest rates and currencies last
 The drama was primarily spurred by the solidification of expectations of a
Fed hike in the middle of this month and the stimulus promised by
President-elect Trump.  
After years of
falling budget deficits, the prospect for
fiscal stimulus by the new President may have forced up long-term yields in any
the prospect of stimulus while the US economy enjoys trend growth and full
employment,  which as a percentage of GDP appears to rival the 2009
stimulus when the US economy was in the throes of a deep economic downturn
implies a greater demand for capital than the 1.80% yield on the US 10-year
Treasury that prevailed before the election reflected.   Part of
the increase in yields is due to an increase in the inflation premia, and partly
reflects an increase in the real cost of capital.  
At the same
time, evidence has accumulated indicating that the inventory and
manufacturing-led economic soft patch has been
  Business investment also appears to
have bottomed, and the recession in
corporate profits have eased.    There is little doubt that the Fed
will hike rates for the second time in the cycle in a couple of weeks.
 The rise in US yields at both ends
of the helped drive a sharp widening of the interest rate differentials.
developments have helped fuel a strong dollar rally. 
 The Federal Reserve’s real broad trade-weighted
index, which is the measure to be used to assess economic impact, rose by almost
2.3%, just edging out the January rise to be the biggest advance to Lehman
failed.   The yen was the weakest of the major currencies, depreciating by
8.4%.  The euro lost 3.6%.  The Canadian dollar fared better than
most, losing only 0.2%, underscoring one of our rules of thumb: in a strong US
dollar environment, the Canadian dollar typically outperforms on the crosses.
The table is set.  Fed officials will draw confidence
from the drops in the unemployment and underemployment rates, and the continued
solid even if not spectacular job growth. Average hourly earnings
disappointed, but the trend has been good, and many will expect more wage
pressure going forward.  The economic calendar turns light in the week
ahead. There are several Fed officials who speak before the cone of
silence is invoked ahead of the FOMC meeting.  Separately, with the
announcement of the Treasury and Commerce Secretary nominees, non-economic news is likely to dominate in the
days ahead.  
The absence of
new impulses from the US, and given its events, the market’s focus will turn to
 First is today’s events in Europe,
the Italian referendum, and the Austrian
presidential election.  Ironically, there seems to be much confidence in
the outcome of the former, and only slightly less so in the latter.  The
referendum is widely expected to lose,
and the Freedom Party’s Hofer is likely to become the next Austrian President.
Our key point
about Italy is that it is Italy.  
We are talking about a country that is on its 64th government since the end of WWII.  Too much commentary and analysis offers an  apocalyptic view.   A defeat of the referendum seeking
constitutional change is not the same as a populist/nationalist victory.
 Elections are not imminent elections and even if they take place before
2018, when they are current scheduled, the political rules for the election of
the lower chamber is being reviewed the
judiciary.  A referendum on EU or EMU membership is also not imminent or
particularly likely over the next 18-24 months.  
We suspect that
after the referendum very little will change.  
Win or lose;
Renzi may stay on as Prime Minister with a cabinet reshuffle. It would
not be the first time a politician changes their mind, and Renzi has
acknowledged his error.  The point is that it does not automatically
trigger a snap election.  
 If he
steps down, another member of his party, and perhaps a sitting minister will slide over a few chairs over. 
 The two big issues are the preparation for the 2018 election,
which involves electoral law, and the banks.  More important than the
referendum for Italian banks may be the administrative court ruling before the
weekend that froze part of the government’s banking reforms pending a decision
by the Constitutional Court.  
The reforms
involve turning the large mutual banks into joint stock companies. 
 The court took exception with the central bank’s
regulation that would allow the banks to limit or eliminate the cash
reimbursement to shareholders that opposed the reform and chose to exercise a
withdrawal right.  The logic of the Bank of Italy’s regulation was to
prevent the capital base of the banks from being drained by shareholder demand
for reimbursement.  
The Austrian
election is a different story. 
  If Hofer is elected, it is clearly
a victory for those nationalist and populist forces.  It is Brexit, Trump,
Hofer, not Brexit, Trump, Grillo.  If Hofer is elected Austria’s
President, nothing will change Monday.  The post is mostly ceremonial, but
the drama will be set into motion even if it takes several months to play out.
  The rise of the Freedom Party may be more about the demise of the
traditional political elite rather than support for an anti-EMU or anti-EU
From another
angle, the nationalist-populist forces first appeared in eastern and central
Europe, Hungary, Czech, Slovakia, and
 The election of Hofer sees this bloc grow within the EU. After this weekend,
many observers turns to France, where Le Pen is widely expected to make it into
the second round after no candidate gets
50% in the first round and the top two compete in a run-off. The center-right
Republicans have sent into retirement Sarkozy and Juppe again, and have gone
for self-described French Thatcher.  That is radical in France.  The
Socialists will have their primary next month.  Hollande indicated he would not seek re-election, leaving the
right-wing of the party, whose policies are not so dissimilar from some French
Republicans, to take the mantle.   
In the past,
when faced with a potent challenge from the National Front, the main two
political parties find common ground. 
seems like the most likely scenario again.   Before France, the
Dutch go to the polls.  It is considerably more likely that the
populist-nationalist forces serve, and possibly lead the next government than in France. 
The big event
next ahead of the FOMC meeting is this week’s ECB meeting. 
 This is a live
meeting in the sense that policy announcements are expected to be forthcoming.
 What is at stake is not interest rates.  The deposit rate will
remain at minus 40 bp.   Instead, decisions are needed about its asset purchases.  
First is
extending the program past the current soft end-of-March time frame.
 Most are focusing on a six-month
extension, mostly on the basis that that was the length of time of the previous
extension. The challenge here may be to do it in a way that makes it clear that
it is not an open-ended program. There
are many ways that this can be achieved,
and verbally by Draghi is one such way. There is some speculation that the ECB
could scale back the amount of monthly purchases (currently 80 bln euros).
 If this does materialize, we suspect it may be an operational tweak in
the covered bond purchases.  
Second is
adjusting the decision-making rules about the purchases. 
 The capital key, which is currently being used, is based on the relative size of
the economy so that the larger the economy,
the greater amount of bonds the Euro-system buys.  This is an important principle and one that is most unlikely to be
jettisoned as some have suggested.  Instead, we suspect the ECB can modify
some of its own rules, like the
individual issue cap.  The ECB may also apply the minus 40 bp floor on the
portfolio level rather than the individual security level, and this too would
overcome or minimize the scarcity operational challenge. 
Third is measures
relating to the securities lending program to address the stress in the repo
 The idea here is that when the ECB
buys securities, it not only removes the
securities as an investment vehicle but
also as collateral.  The ECB and the national central banks have
securities lending programs, but they are not particularly user-friendly.
 There has been some speculation that the ECB will take measures to
improve its ability to provide the securities it buys back to the market.
Turning to the
UK, its Supreme Court hears the government’s appeal of the Constitutional Court ruling that protected Parliament’s
authority to trigger Article 50. 
 A decision is not expected until the middle of next month.  Many expect
it to uphold the Constitutional Court’s decision.  This is important in the markets because Parliament involvement is associated with a soft Brexit rather than
hard.  And a soft Brexit is seen as sterling positive. Moreover, it may
delay the triggering of Article 50 by three or four months.  Still,
through the cacophony, it appears that on balance,
access to the single market is possible, at a price. 
Last month, sterling was the only major currency to
appreciate against the dollar (~2.15%).
 Sterling’s gains came despite the fact
that interest rate differentials moved dramatically against it. The US premium
on two-year month rose from 58 bp at the end of October to a little above 100
bp before the end of November.  It is the most in at least a quarter of a
Many argue that the resilience of the UK economy shows that those favoring
Brexit were right and the economic risks were exaggerated by the Remainers.
  However, the sterling’s decline was a shot in the arm, a dramatic one-off
devaluation.  Against the dollar, sterling has fallen by about 17%, and on
a broad trade-weighted index it is off by about 10%.  The currency
depreciation, coupled with the low interest rate loans by the Bank of England,
its rate cut, and the resumption of its asset purchases, mean that the UK
economy got a large dose of monetary stimulation.   
Lastly, outside
of Europe, the Reserve Bank of Australia and the Bank of Canada hold policy-making meetings. 
 Both are most likely leaving policy on hold.
 The strengthening of the US economy (the Atlanta and NY Fed models have
the economy tracking 2.7% here in Q4) and rally in oil prices buy Canada time.  And it needs that time.  It has lost fully time jobs this year
(~25k).   The 3.5% annualized growth in Q3 was largely driven by the
recovery from the disruption from the earlier fires.  

The RBA is on
hold, but many continue to look for a rate cut next year. 
 The rise in metal prices and the apparent
stabilization of the Chinese economy are helpful.  China releases a host
of data next week, including reserves, trade,
and inflation.  The broad picture is unlikely to change.  China
continues to experience capital outflows.  The trade surplus remains large
though the value imports and exports are lower than a year ago.  Its trade
surplus with the US has eased a little this year from a record last year.
 Consumer inflation continues to hover a little above 2%, while producer
prices are beginning to get traction after an extended period of deflation.   

The day after
the RBA meeting, Australia will report Q3 GDP.
  It is expected to have slowed to
0.2% in the quarter from 0.5%, while the
year-over-year pace eases to 2.5% from
3.3%.  The year-over-year pace is will likely fall to near 2.0% here in


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