The Week of Digestion

The week ahead does not have nearly the event
risk of last week.
  It is difficult to compete with a BOE rate hike
that spurred the largest sterling decline in five months, the nomination of a
new Fed chair, and the unveiling of the initial tax reform proposals.  The
information set of investors’ is unlikely to change much in the coming
days. 

The event schedule is light, and the economic data is mostly from Q3, which are the estimate
of Q3 GDP is of less interest. 
The eurozone reports the service and
composite PMIs for October, but the
thunder was largely stolen by the flash readings that have already been reported

In many ways,
the broad investment climate seems healthy. 
There seems to be a
synchronized expansion underway.  The US just strung together its best two-quarters of growth since 2014.  The
eurozone and Japan are growing above trend.  The large emerging market economies and many others are participating too.  For the most part in the high
income countries price pressures continue to remain modest, and below targets, however, measured. 

Interest rates remain low in nominal and real
terms.
  Credit is available, and
lending is rising.  Unemployment rates are falling.  In a mixed
overall report, the US underemployment rate fell to 7.9%  from 8.3%, while
the unemployment rate fell to new cyclical lows.  Unemployment also
continues to trend lower in the euro area.  It stood at 8.9% in September,
down from 9.9% in September 2016, and is the lowest since early
2009.  Japan is also understood to be at full employment, while UK
employment growth remains firm and unemployment stands at 4.3%.  Labor
markets in Canada and Australia are doing well.  Canada has created 200k
full-time positions in the past two months, which, proportionately, would be as
if the US created two mln jobs
in the same (in actuality is created 279k).   Equity markets
continue to race ahead.  

Below
the surface, there is much angst.
  Central
bankers are concerned that price pressures are too low, leaving aside
the Bank of England.  This leads to
unusually low policy rates and fears of
the misallocation of capital and asset bubbles.  Although
populism-nationalism has not swept into power, the broader push against the
elites continues.  The ongoing resistance against male sexual
predators may have been re-energized by the pushback
against elite men.  The seems to be a high degree of economic
anxiety/insecurity and, while the disparity of wealth is part of the public discourse
it has intensified.   Measures
of social trust appear to be
deteriorating.  

In broad terms, we have suggested parallels
between the current period and the period immediately following the breakdown
of Bretton Woods in 1971.
  What was
going to replace that order was not clear for nearly a decade.
  Six
years later, there was still what US President Carter is said to have referred
to as “malaise in America.”  Nine years after Lehman failed, and
eight and a half years after the US economic contraction ended, there remains a
profound sense that things are not on a durable and desirable path.  The
elites in most of the high income countries have failed to deliver the goods, a
rising living standard for the vast majority of people.  Not only that,
but they seem to lack a vision and a plan.

Despite the synchronized expansion, monetary
policy divergence continues.
  Many have been tempted to consider
convergence, but this has proven premature.  The Bank of Canada assures
investors that its two hikes in Q3 were not the beginning of a sustained
monetary tightening cycle.  The hikes were taking by the accommodation
provided in 2015 in the face of the terms of trade shock.  As participants
gave up the idea of a tightening cycle, the Canadian dollar depreciated by
about 4.8% over the past two months.  The Bank of England’s rate hike last
was in this vein as well.  The rate cut provided after the 2016 referendum
as taken back.  The implied yield of the December 2018 short-sterling
interest futures fell 15 bp in the face of the 25 bp rate hike.  This illustrates that many participants viewed
the rate hike as dovish.  Is it any wonder that sterling sold off? 

Next week the Reserve Bank of Australia and
the Reserve Bank of New Zealand hold policy meetings
.  Both central
banks remain on hold.  Soft inflation and retail sales in Australia keep
the RBA on hold.  The central bank continues to expect the overtime,
continued above-trend growth and the strong labor market will boost inflation and
buffer aggregate demand.  Many market
participants are less convinced.
  Speculators in the futures market
have been paring long Aussie exposure for five consecutive weeks through
October 31.  The Australian dollar has fallen 5% since
early September and has already given up about 50% of this
year’s gains.  

 

The New Zealand dollar has also lost about 5%
over the past two months.
  The main drag is political, not economic.  Investors are worried about the new
Labour-New Zealand First government.  There two immediate concerns. 
First, is the declared effort to give the central bank a “dual
mandate” like the Fed where full-employment is given its due alongside price stability.  Second, some
government policies will be aimed to discourage foreign purchases of New
Zealand homes.  However, the macroeconomic situation seems
constructive.  Inflation is near 2% in Q3 (1.9%),
and the labor market remains strong.  While it may be a bit early to
suggest an RBNZ hike, pressures may still
mount on the RBA to cut rates. 

The New Zealand dollar was the strongest currency among
high income countries last week with a 0.4% advance.
  It had
fallen nearly 10% in the three months from late July. Last week’s upticks
fizzled out in front of the minimum retracement of the last leg down that began
on October 17.  The Kiwi finished poorly ahead of the weekend, but
additional losses into the $0.6950-$0.6970 area may offer a low-risk entry opportunity.  

In the US, the focus will remain very much on
tax reform.
  Revisions to the bill are
expected
to be unveiled early in the new week so the House Ways and
Means Committee can debate it, mark it up before voting on it.  After the
Committee votes on it and given the composition ( the majority of Republicans), the bill will
eventually pass.   Then it goes to the entire House floor.  Meanwhile, the Senate is working on their own version.  

With the passing
of the FOMC meeting, the quiet period ends and several Fed officials will be
speaking next week.
  We do not anticipate new news, and the Fed funds
futures market implies a December hike remains largely discounted.  We
estimate that the implied interest rate of the December contract of 1.295%
would be fair value assuming a rate hike and the contract settled at 1.28%
before the weekend.  We suspect the market will be most keen to hear from
the newest Fed Governor Quarles, whose views are not known, though he voted all
the other FOMC members last week.   Reports suggest Treasury
Secretary Mnuchin convinced President Trump not to re-appoint
Yellen.  Similarly, reports suggested that Quarles threatened to resign if
Warsh was picked as Chair.  

Given the light news stream, we suspect the
week ahead will be largely consolidative in
nature
.
  Although we remain favorable the dollar based on
continued divergence (peak is not a 2018 story but 2019), the technical
condition makes us suspicious that near-term dollar gains might not be sustained without stronger interest rate
support or negative developments abroad. 

Disclaimer

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