Thumbnail Sketch of the Week’s Big Events

The week ahead will be among the busiest in Q4.   In
this note, we provide a brief sketch of
the different events and data points that will shape the investment
the importance of initial conditions, we will begin with an overview of the current investment climate.
Equity markets continue to
rally, helped by strong earnings season, this is particularly true of the
developed markets.
The MSCI Emerging Markets Index eased for the past two weeks. It had snapped an
eight-month advancing streak in September.  
To say that European bonds
have outperformed the US is that same as saying that the US interest rate
premium is increasing.
It is true through the entire coupon curve.  It is as if both blades of
the scissors are moving.  US rates are rising and, for the most part,
European rates are falling.  The US 10-year yield rose through the
six-month cap around 2.40%, but finished the week, just above that threshold.  
The dollar has been tracking
US yields higher since early September.
  We argued at the time, and still believe, that the dollar’s
setback, mostly from late April through early September is best understood as a correction of the dollar’s significant run
since mid-2014.  The correction was sparked
by the easing of the political anxiety that had cast a pall over Europe after
UK referendum and Trump’s victory in the US.  There was the inflation
scare in Europe, doubts about the Fed, and adjusting to the unorthodox US
The dollar’s rebound has
caught many short-term participants wrong-footed,
and this appears to be contributing to the pace of the recovery.
   We think the market’s
judgment about the end of divergence was premature.  We do not expect the
balance sheet divergence or the monetary policy divergence to peak until well
in 2019.  

Now, we turn to the brief
description of the key events and data in the days ahead:

FOMC:  There is no
press conference following this meeting,
and no change in policy is expected.  At the end of last week, the
Fed completed the first month of its balance sheet operations.  The net
seven basis point increase in 10-year yields this month are not seen as a function of the reduction of the balance sheet. 
The FOMC statement may be shorter with minor technical changes, though its
assessment of the economy could be tweaked
Market Impact:  Headline risk
Fed Nominations:  President Trump is expected to
announce new nominations to the Board of Governors in the coming days. 
While the focus is on the Chair, the Vice Chair is also open as other two other
Governor chairs.  For a few weeks, the market has seen Powell as most
likely.  Chair Powell would not rule out a Taylor Vice Chair. 
 The appointment of Quarles, who will vote at his first meeting on
November 1,  seemed to diminish the chances of Warsh, who are personal
rivals, of getting the nod.   We suggest that barring the innovation
that is needed in a crisis, the general
policy of the Fed is unlikely to change if Yellen is no longer the Chair. 
Monetary policy is in the process of normalization, and it seems more of a technocratic function than one
of partisan politics.   
Market Impact:  Minor, though vulnerable to a
surprise.  Taylor is seen as more
hawkish than warranted, and Yellen more dovish.  
US Tax Reform:  The House Ways and Means Committee is
expected to provide the first detailed tax reform bill toward the end of the
week.  In the coming weeks, it will be debate and “marked-up” in
committee.  The committee will vote on it,
and it will pass.  It will then be debated, amended, and voted on by the
entire floor.  Officials hope to do this before the Thanksgiving break in
late November.  
Market Impact:  Even though the initial tax bill
will subject to many changes, and the situation is very fluid, there will be
winners and losers in the tax reform.  The markets will likely respond
accordingly despite the not knowing the final version.  
US Jobs Report:  The 33k jobs the US lost in September
was not a statement about the economy as the impact of the storms. 
 October’s recovery is expected to be sharp.  The median forecast in
the Bloomberg survey is for a 310k increase in non-farm payrolls.  We
suspect the risk is on the upside.  Before September, the non-farm
payrolls averaged 171k a month this year, and that was the pace over the three
months through August.  We would not be surprised to see print more than 350k.  
Market Impact:  Participants understand the skewed
nature of the jobs report.  The market is likely to continue to focus on
average hourly earnings data  
Bank of England:  The market has been more confident
of a BOE rate cut than we have been over the past several weeks. We had thought
that the combination of slowing growth, expectations that CPI is near a peak,
the continued risks associated with Brexit would allow the BOE to remain on
hold.  During his tenure, Carney has
often resorted to hawkish rhetoric without delivering.   We expect
two-three dissents from a decision to raise rates.  
Market Impact:  As the ECB delivered a dovish
tapering, the BOE can deliver a dovish hike.  Through its forecasts and
minutes, the MPC can suggest that this meant to take back the rate cut
delivered after last years referendum.  It is not the start of a
tightening cycle.  Sterling could be sold,
but it may depend on the broader dollar direction.  We suspect the
interest rate market will adjust.  It seems out of alignment that the UK
two-year Gilt is yielding almost half as much as the December 2018
short-sterling futures contract (46 bp vs.
88 bp).  The December 2019 short-sterling contract yields 108
Eurozone Flash
announcement of “less for longer” regarding
its asset purchases, while keeping all of its other unorthodox measures, steals
the thunder for this week report.  Perhaps more accurately, it raises the bar to what constitutes a surprise.
The market expects little change in CPI.  In September, the headline rose
1.5% year-over-year, while the core rate was up 1.1%.  
Market Impact:  Headline risk, but
little implication
in terms of policy.  The market may be
more sensitive to a stronger core than
headline CPI. 
BOJ Meeting:  The BOJ is not expected to change
policy.  Headline line inflation is
rising at half the pace of the eurozone.  The BOJ could shave this year’s
inflation forecast of 1.1%.  It stood at 0.7% in September.  One of
the BOJ’s innovations was the yield curve targeting, with the deposit rate set
at minus 10 bp and keeps
the 10-year yield in a 10 bp range around
zero.  Its next move could be to adjust its yield curve strategy, and
there has been some discussion of targeting the belly of the curve (5-year yields),  but that may be a 2018
decision.  Separately, the LDP recent electoral victory has bolstered the
likelihood that Kuroda gets an unusual second term, according to local
Market Impact:  Limited market reaction barring a
surprise.  The key to the dollar-yen is the US 10-year yield. 
Meanwhile, foreigners have continued to increase exposure to Japanese
equities.  There has been strong buying in the four-week period ending
October 20, according to MOF data.   
Spain:  A small window for a de-escalation
of Spain’s crisis closed largely it would seem due to the failure of vision and
imagination.  Puigdemont has played a weak hand poorly.  He fell
victim to the secessionist sentiment he fomented.  Rajoy, leading a minority
government, seemed to thrive in the application of power, without mercy. 
Puigdemont did not prepare Catalonia for independence and failed to secure
support from a clear majority of Catalans, let alone a foreign power. 
Although candidate Trump encouraged the UK to leave the EU, the US quickly
endorsed the territorial integrity of its NATO partner.  Parliament has
authorized invoking Article 155 that strips Catalonia of its autonomy.  A
new regional election is scheduled for
early December.  Even if the party representation in parliament is not significantly changed, it will likely
move away from secessionist efforts.  Spain can still move in a more
federal direction.  
Market Impact: Spanish 10-year bond yield rose more than
five basis points before the weekend, but at 1.57%, it is more than 20 bp below
the October 5 high.  If anything, political crisis will serve as a mild
economic headwind.  
Italy:  Two developments took place before
the weekend that could lift Italian asset prices at the start of the new
week.  Italy’s sovereign rating was unexpected upgraded by S&P to BBB
from BBB-.  A politically-motivated attempt not to give Bank of Italy
Governor Visco a second term was successfully
repelled.  The upgrade brings S&P to where the other two main
rating agencies put Italy.  S&P had regarded Italy’s sovereign risk
one step above junk, and the rating increase
is a positive development.  It is the first the S&P has given Italy in three decades. The reasons
it cited are also instructive:  stronger growth outlook, better employment,
and improving banking sector.  Earlier this month, the Bank of Italy
indicated that the banking system insolvent loans had fallen to three-year
Market Impact:  Italy’s 10-year bond yield has
fallen 30 bp since earlier this month through the pre-weekend low, which
approached the 1.90% area which has been
a floor since January.  However, with a roughly 60 bp premium over Spain,
there is scope for additional outperformance.    The Italian premium
over Germany, however, is already near the least of the year (~150 bp). 
Further significant outperformance may be difficult to sustain.  Italy’s
FTSE- MIB set new two-year highs before the weekend but settled poorly. 
The bank index, in particular, was weak,
losing nearly 1.7%.  There may be scope for better a better performance.
Oil:    Brent oil traded above $60 a
barrel before the weekend, a level that has not been
seen in a couple of years.  US WTI reached an eight-month high near $54.  Saudi Arabia
signaled its agreement to extend the
output restraint beyond next March, and
the supply disruption from Iraq-Kurds continues to pinch.  Strong global
growth reports (PMIs) were also
constructive.  Several large oil companies reported earnings.  Exxon
and Chevron reported lower output than expected, while Total reported its best
oil and gas earnings in a couple of years.  
Market Impact:  WTI for December delivery closed
strongly with a 4% gain on the week. It is especially impressive given the appreciating dollar.   It
is the third weekly advance and a higher
close for the eighth week of the past nine.  The pace of the move has left
the technical indicators stretched, and
near-term consolidation is likely.   However, the medium-term outlook
looks constructive, and we target $58 in
the coming weeks.  


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