Weekly outlook: “wait and see” as investors search for some resolution

There’s so little change over the last week, it’s barely worth discussing what the themes are in the market. I mean, do you really want to read 1,000 words about why EUR/USD went from 1.1051 to 1.1062? The main theme seems to be “let’s wait for something new to happen.”

Trade fatigue has set in as no one knows what Trump is thinking or is likely to do. Central banks are largely on hold. The European economy seems to be bottoming, but we can only know that for sure in retrospect. Perhaps today’s preliminary PMIs for the EU will corroborate that assumption.

Nonetheless, expectations for the Eurozone are pretty weak. The European Commission this week downgraded its forecast for Eurozone growth to 1.1% in 2019 and 1.2% for next year, a reduction of 0.1 ppt for 2019 and 0.2 ppt for 2020. Germany remains the weak point, with the commission expecting GDP to expand by only 0.4% this year, although picking up to 1.0% next year.

You can see how the market has steadily downgraded its forecast for German growth this year, far more than that for any other major country – even the UK, in the midst of Brexit turmoil.

The outlook for next year isn’t improving, either. The gloom surrounding the Eurozone economy suggests to me that the EUR/USD has limited upside potential, if any. About the only way I could see that happening is if expectations for the US economy suddenly take a steep dive – which is always possible, of course. But even then, as we’ve seen recently with the trade war, whatever causes US growth to slow seems to have an even stronger effect on Eurozone growth. So I’m not sure a downturn in the US would necessarily boost EUR/USD.

The only country where there was a notable change in the odds of a rate cut over the last week was Japan. In his testimony to the Diet on Tuesday, BoJ Governor Kuroda that “there is plenty of scope to deepen negative rates from the current -0.1%.” He also reassured the Diet that there were still plenty of Japanese government bonds left to buy. Apparently his comments increased speculation about a rate cut in the coming fiscal year. Note from the chart above though that it didn’t hurt the yen any; JPY is still moving according to “risk on, risk off” rather than any rate speculation.

How realistic are Kuroda’s comments? One headline also quoted him as saying “BoJ to normalize policy once price target is achieved.” Hah! Japan has had interest rates near zero for over 20 years and yet inflation over that time has averaged 0%, if we exclude the years immediately following hikes in the consumption tax. Kuroda is the Chiang Kai-Shek of monetary policy, promising to retake the mainland year after year but never coming anywhere near his goal. Apparently though the market expects him to try one more time next fiscal year.

But in Japan as elsewhere, central banks are approaching the “reversal rate,” the point at which negative interest rates start eating into the profits of banks and thereby make them less likely to lend, not more. A meeting in September between BoJ officials and representatives of the “Shinkin” banks, regional co-operatives, saw the bankers pressing for a rate hike to restore profitability. On the other side of the world, the minutes of the recent FOMC meeting showed that “all participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States.” We’ll hear more about this topic next Tuesday, when RBA Gov. Lowe speaks on “Unconventional Monetary Policy: Some Lessons from Overseas.”

Brexit update: a binary decision

GBP hasn’t moved much this week even as the shape of the December election comes into view. The results of the election are binary: either the Conservative Party gets a majority in Parliament, in which case the UK will leave the EU on 31 January according to the Withdrawal Agreement that PM Johnson negotiated, or it won’t get a majority, in which case there will probably be another referendum.

For all his faults, Johnson has largely accomplished his goal in calling the election. A purge of pro-EU Conservative Party candidates means that everyone standing for election has agreed to vote for Johnson’s Withdrawal Agreement. That has convinced the electorate that the Conservatives are the party that can bring about Brexit. Polls show that 71% of those who voted “Leave” now plan to vote for the Conservatives. As a result, Nigel Farage and the actual Brexit Party have been neutralized and the “Leave” votes are likely to go mostly to the Conservatives.

The problem for the “Remain” side is that there is no such unified force for them. Although 45% of the electorate identify as “Remain” vs 41% “Leave,” there is no single “Remain” party that these people can vote for. And under Britain’s “first past the post” system, where the winner in each constituency is simply the person with the most votes, the Conservatives don’t need to get a majority of the votes in any constituency — they just have to get more votes than any of the opposition parties. Compounding the problems for the “Remain” side is that the Labour Party, the largest opposition, has not taken a firm stance on Brexit and is led by someone whom many people simply don’t trust.

It therefore looks increasingly like we will get Brexit on schedule on 31 January. This idea doesn’t seem to be bothering the FX market. Looking at the risk reversals, demand for puts is actually less than it was a month ago, before the election was called. People are still worried about the long-term implications of Brexit for sterling, but the near-term fears have calmed down. Perhaps Brexit is now largely discounted in the market and Britain too has settled into a “wait and see” mode.

Three-month options have covered the Brexit date for almost a month now, and the implied volatility of GBP options has steadily declined.

Watch the Middle East

What with the impeachment proceedings and the crucial UK election occupying much of the news, readers may not be paying attention to events in the Middle East. You should. Iran, Iraq and Lebanon are all in the throes of riots so severe that they could easily be called revolutions. Reports are that there are uprisings in some 132 cities in Iran, with an estimated 200 people killed and some 3,000 wounded so far. In Iraq, more than 200,000 Iraqis across the country have gathered every day for the last five weeks to demonstrate against the government. And Lebanon is also in turmoil; it’s estimated that as much as one-quarter of the population recently demonstrated against the government. The Prime Minister resigned, but the crowds want more.

Oil almost always rises when there’s a convincing increase in instability in the Middle East. In this case, Iran and Iraq together pump almost 7mn barrels a day (b/d) of oil, accounting for 20% of OPEC’s oil and 9% of the global supply. Any disruption to their governments is bound to reduce their output, at least temporarily. Instability in the Middle East would also tend to push up the price of gold.

If we look at what happened to these two commodities during the early stages of the “Arab Spring” in 2010-2011, this is when gold hit its record high and oil prices surged around 60%. Could we see a repeat of this event? Stay tuned.


Next week’s schedule: Inflation update, Thanksgiving holiday

Next week will be a truncated week in the US. The Thanksgiving holiday is on Thursday, and many Americans leave work early on Wednesday to get home to their families (it’s the busiest day of the year for US airlines). They then take Friday off to digest the traditional turkey dinner (except in my case I’m a vegetarian, so I have a Tofurkey instead). US activity in the latter half of the week will therefore be quite thin.

The focus will be on inflation. The US releases its personal consumption expenditure (PCE) deflators on Wednesday. These are the gauges that the Fed uses to measure inflation, not the more widely watched consumer price index (CPI). The headline figure is expected to show a modest acceleration in inflation, but the more important core inflation measure is forecast to show the opposite. This will not come as any surprise to the FOMC however as it said since May that “overall inflation and inflation for items other than food and energy are running below 2 percent.” A modest decline such as is expected would not meet the FOMC’s hurdle of requiring a “material reassessment of the economic outlook.” It should therefore be neutral for the dollar.

Germany announces its inflation data on Thursday, followed by the EU-wide data on Friday. These figures are expected to show a healthy uptick in inflation, including EU-wide core inflation, which is what the ECB targets. Recently, expectations of ECB easing have receded somewhat; perhaps an uptick in inflation could cause expectations to fall further, firming up the euro somewhat. But don’t expect anything major, as the ECB seems to be more concerned with growth than inflation.

The Tokyo CPI is also expected to tick up a bit, but given that they just raised the consumption tax by 2 percentage points in the previous month, that’s pathetic. In any event it’s still so low that it won’t make much difference. JPY neutral

Outside of that, we will get a number of important US indicators crammed into the holiday-shortened week: the advance goods trade balance, Richmond Fed index, new home sales and Conference Board consumer confidence on Tuesday; and the 2nd estimate of Q3 GDP, durable goods, personal income & spending, and the Fed’s Beige Book on Wednesday. The weekly Commitments of Traders report, which usually comes out on Friday, will be delayed until the following week.

Fed Chair Powell and Gov. Brainard will both speak on Tuesday. They will be the last Fed speakers before the blackout period begins on Saturday, ahead of the next FOMC meeting. We’ve heard so much from Powell, he’s likely to repeat the usual. Gov. Brainard on the other hand will discuss the Fed’s policy framework review. That may give us more insight into any changes that the Fed might be considering. That’s particularly important given the sturm und drang in the repo market nowadays. Don’t expect any immediate changes though; in the minutes to the latest FOMC meeting, “a number of participants” expected their review of the framework to be finished by around the middle of next year.

Japan has its usual end-of-month crunch of indicators Friday morning their time, when in addition to the above-mentioned Tokyo CPI, the labor market data and industrial production come out. The jobless rate is expected to hold steady while the job-offers-to-applicants ratio is forecast to edge down one tic. It looks as if the labor market has stopped improving. If wages haven’t started moving up by now – and they haven’t – then one wonders whether they ever will. And if wages never go up, then how will further BoJ easing create inflation? I have no answer, but I suspect no one else does, either.

Other important indicators out during the week include the Ifo indices on Monday. The expectations index in particular is expected to pick up, which could lift sentiment towards the euro somewhat.







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‘The key is not to predict the future, but to prepare for it.’ Pericles, 500 BCE