Four Key Events in the Week Ahead

Of the forces driving prices in the week
ahead, events appear more important than economic reports. 
There are four such events that investors must navigate.  The Bank of
Canada and the European Central Bank meet.  The UK High Court will deliver
its ruling on the role of Parliament in Brexit.  The rating agency DBRS
updates its credit rating for Portugal.

The Bank of Canada is not going to change
interest rates.
  Still, growth has disappointed,
and price pressures appear to be ebbing.  It will take longer than the BoC
is currently anticipating to close the output gap.  It may adjust its
forecasts accordingly.  In addition,
the recent use of macro-prudential policies to address housing market activity
eases one of the inhibitions for a rate cut.  The market is currently
pricing in about a one in 20 chance
of this materializing next year.

The risk may be somewhat greater
than that 
In part, there
seems to be too much made of the trade-off between the fiscal stimulus and monetary
easing.  It is so pre-crisis. 
This week’s data is likely to show that CPI continues to moderate and,
despite the launch of a new low-income
family benefits program, retail sales
like fell in August, and the risk is on the downside of the median forecast
of -0.1%.

It does not appear that the ECB is prepared to
announce a decision about whether it will extend its asset purchases after the
current soft end date of March 2017, or about how it will address the
potential scarcity of particular securities.
  Although we thought
there was an opportunity to do so last month, it now seems more likely
that the ECB will make its decision at the December meeting.

In addition to giving it more time see
the impact of its current policy setting, it will also have new staff
forecasts, which Draghi seems to prefer.
 The updated forecasts are
helpful in stealing some thunder from his critics that often make it sound as
if Draghi’s commitment stems from his national origin rather than
“objective” economic analysis.

Draghi will likely be pulled in at least two
directions at the press conference.
  One set of questions will likely
address the tapering story.    Draghi was clear at the last
meeting, saying the issue was not discussed
More information will be sought amid suspicions
that the ECB President was disingenuous. 

However, Draghi indicated before and will
likely restate that the asset purchases should not end abruptly.
  This implies some kind of tapering process.  It does not say anything
about when the asset purchase program will end of when the tapering begins or the pace of
tapering.    At this juncture, our best guess is that one way or
the other, the ECB will be expanding its balance sheet most if not all of
next year.   

Another set of questions will likely revolve
around the capital key.
  To avoid appearances of favoritism, the
ECB  buys assets in proportion to the economic size of its members. 
There is a concern, seemingly higher among some market participants than policymakers
that shortages are emerging that could threaten the program.  Those
shortages will become more acute the
longer the purchases continue.

The less disruptive and, perhaps, the easiest
to reach an agreement on, seems to be to ease self-imposed rule of not buying a
security that yields lower than the minus 0.4% deposit rate.
The concern here is a forcing a national central bank to realize a loss. 
However, instead of a narrow security-by-security imposition of the rule, it really needs
only apply to the portfolio as a whole, or the average yield of the bonds

The UK’s decision to leave the EU remains a
high divisive issue not only in Europe but within the UK itself. 
referendum was approved with
the narrowest of margins, but a combination of hubris and naivete prevented the
establishment of a threshold for such a significant change, such as 60% or
2/3.  Also, since the decision
profoundly impacts the future of the UK, there is no compelling reason why the
franchise was not extended to 16-year olds, as Scotland did for its referendum
on independence.

Despite the proximity of the outcome, pundits
and politicos are trying to divine the will of the people, and like a
Rorschach test, people see what they want.
   There was nothing
in the referendum that indicated the role of Parliament and the Prime Minister
in devising and negotiating with the EU over the separation.  Treaty
negotiation and foreign policy is usually a remit of 10 Downing Street.

At stake how acrimonious does the divorce need
to be, and the referendum did not address this issue. 
A hard Brexit is one that denies the UK access to the
single market on the same terms as is the case currently.  A soft Brexit
preserves this access.   The dilemma turns on how hard the UK wants
to free itself from the EU principle of free movement of people, though it is
not a member of the Schengen Agreement.

The UK’s “Brexit” team, which Prime
Minister May selected, is inclined to push for hard Brexit.
  For them, limiting immigration is the number one
priority.  The former head of UKIP was
quoted in press putting the fine point on it:  less prosperity is
acceptable if it means fewer immigrants.
   On the other hand,
Parliament is coming from the other direction.  There is both a
constitutional issue of the role of parliament as well as a more moderate
approach to Brexit. 

The UK High Court is expected to announce its
ruling on Monday. 
Sterling’s near-free fall in the foreign exchange
market is a reflection of the risks of a hard exit.  The value of UK
assets is understood to be less if it is no longer has access to the single
market.  The greater the role of that the High Court insists on for
Parliament, the more hard Brexit may be tempered
In turn, this could help spur a short-covering recovery of sterling. 

However, there are two mitigating factors that
will not be lost on investors.
First, regardless of the decision, one side or the other will appeal to the UK
Supreme Court.  A decision would be
before the end of the year.  Second, in some ways, and not
to put too fine of a point on it, but
what the UK wants may not be the deciding issue (and who doesn’t want
one’s cake and eat it?).

It is not in the EU’s interest to make it easy
anyone that wants to leave or to allow any member to treat the Community as a smorgasbord where one can pick the and chose
one what is on one’s plate. 
  Benefits cannot come without
costs.    The idea that the UK can retain access to the single
market without accepting the free movement of people is a non-starter. 
Judging from comments from EU’s Tusk, any exit from the EU will be a hard
exit.  Article 50 of the Lisbon Treaty, which is to govern the exit
process, is designed to give the EU not the member state the upper hand in the negotiations. 

At the end of the week, DBRS will update its
assessment of Portugal’s sovereign credit rating.
  The ECB recognizes four rating agencies and provided that at least one rates a country as
investment grade, the country’s bonds will be including in the asset purchase
program.  A country’s rating also determines the haircut given to the
government bonds used by banks to secure funding from the ECB.  A loss of
investment grade status would make the country’s bonds no longer acceptable as
collateral (without a waiver). 


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