Fundamental Analysis 11.10.2017 - Market Outlook

Catalan President Carles Puigdemont declared independence, as he had threatened, but immediately suspended the declaration to allow time for talks with the central government through an international mediator. The national government rejected the request as they say the referendum was illegal and therefore invalid.

In any event, the speech had little impact on the markets; EUR/USD had risen gradually during the day ahead of the speech, and aside from a small spike at the opening in Asia, it’s now trading at about the same levels as during the speech. Spanish 10-year yield spreads also barely moved during and after the speech.

The corollary to a higher EUR was of course a lower USD.

Elsewhere, market movements were subdued. AUD fell further even though the Westpac consumer confidence index was up sharply (no forecast available). My guess is that people outside the region thought the move in AUD/NZD was overdone and shorted the pair, which moved lower after the Asian day finished. The move accelerated when trading started in Asia today, suggesting locals were taking what profits were left. As I said yesterday, I think with the steel market in China cooling, Australian coal prices are likely to fall and AUD fall with it.

Oil soared as the OPEC Secretary General reiterated his claim that the market is rapidly rebalancing and predicted strong demand for oil next year. There are also reports that Saudi Arabia will reduce its output, but I question how important that is – they often increase output in the summer and then decrease it in the fall. In any event, I don’t believe the rebalancing story and think oil is likely to head back below $50 in the not-too-distant future.

Today’s market

Another relatively quiet day in terms of indicators. There’s nothing of particular interest during the European morning.

There could be some volatility as the annual IMF and World Bank meetings get under way in Washington and reporters talk to the assembled dignitaries.

There could also be news headlines as the fourth of the seven rounds of NAFTA talks begin. Nearly 700 officials are gathered to discuss overhauling the free-trade agreement between the United States, Mexico and Canada. This could be the decisive week as the US negotiating team is expected to finally reveal its position on the most contentious issues, such as “rules of origin;” how to settle disputes involving foreign investors; Mexican labor standards; and Trump’s goal of narrowing the US trade deficits.

If this round of talks also ends in failure, it will be difficult to reach an agreement in the time that’s left. But this may be exactly what Trump intends. Some analysts think he will deliberately make proposals that Mexico, which holds a presidential election next July, can’t possibly agree to. Then the talks would collapse and the US could leave the agreement. CAD and MXN will be very sensitive to these talks.

Chicago Fed President Charles Evans takes part in a moderated discussion on the economy and monetary policy. Evans, a voting member, is skeptical about whether the low inflation is transitory and said on 25 September 2017 that “we need to see clear signs of building wage and price pressures before taking the next step…” If he still thinks this way, which seems likely to me, it could be hard for Fed Chair Yellen to get enough votes to raise rates in December 2017. That would be USD-negative.

The Job Openings and Labor Turnover Survey (JOLTS) report is expected to show that job openings remained near the record-high level of the previous month. That would be good news for the US economy, because of course payrolls can increase only if there are jobs out there. Plus, a continuing high demand for labor should mean in theory that eventually employers will have to start bidding up wages in order to get employees – although there are many people around the globe wondering why this hasn’t happened yet in their country. USD-positive.

The minutes of the 20 September 2017 FOMC meeting will be closely scrutinized to get further clarification on the inflation debate. Some members (Yellen and Dudley, for example) argue that low inflation doesn’t mean there’s too much slack in the economy, and therefore the Fed should stick with its plans for gradual tightening. Other members (Brainard and Evans) want to wait to see more concrete signs that inflation is nearing their target before they hike further.

Several members have spoken on this topic since the meeting however so there might not be too much confusion left to clear up. The risk is perhaps that one or two members made dovish comments that stand out in the minutes and give an unbalanced impression of the discussions. In any event, the market sees a 77% likelihood of a hike in December 2017, so the minutes can’t do that much to increase the odds.

The minutes may also give us some insight into the surprising revisions to the FOMC’s forecasts that were made at the meeting. They were revised to show stronger growth this year, a deeper fall in the unemployment rate, and yet lower inflation this year and next and therefore a longer time to achieve the Fed’s inflation goal – seemingly contradictory developments. We may also get some insight into how the Committee members expect the hurricanes to affect the economy.

Finally, the FOMC announced at this meeting plans to begin shrinking their balance sheet starting in October 2017. That move will no doubt impact overall financial conditions regardless of what happens to rates. How do they see the impact of the balance sheet move vs rates?

Next up is ECB Chief Economist Peter Praet, who will be speaking at a conference in New York on “European Exit Strategies.” This is a tantalizing topic, because of course everyone is wondering what the ECB’s strategy for exiting its extraordinary stimulus program will be. The ECB has made it clear that it’s going to end its bond purchases long before it considers raising rates. Now the question is, do they sharply cut the amount they buy each month but continue the program a long time, or do they reduce the amount they buy by less, but end the program sooner? Volume vs duration. Praet may give us some hint as to which way he’s leaning.

If they choose the former path, it would mean rates would stay lower for longer and therefore be negative for the euro, whereas ending the program sooner means they can raise rates sooner, which would be positive for the euro. Currently, the market expects ECB rates to remain below zero for some four more years.

Overnight, Japan announces its producer price index (PPI). In theory this should be a leading index of inflation, in which case the further rise in this index should be JPY-positive. In fact as you can see from the graph CPI inflation in Japan seems to be going nowhere, but we are discussion how the market is likely to react, not how the real economy is likely to react.

Overnight, Japan announces its producer price index (PPI). In theory this should be a leading index of inflation, in which case the further rise in this index should be JPY-positive. In fact as you can see from the graph CPI inflation in Japan seems to be going nowhere, but we are discussion how the market is likely to react, not how the real economy is likely to react.

Finally, Australian home loans are seen growing at a slightly above-trend pace, even after the strong gains in the previous month. Note that this indicator measures loans to owner-occupiers. The amount of these kinds of loans may have been boosted by the macro-prudential measures put in place in March to cool demand for housing loans for investment purposes, which may have shifted demand into these kinds of loans. In any event the figures suggest that demand for housing is still robust despite those measures, and so it’s less likely the Reserve Bank of Australia will cut rates further = AUD-positive.

This article comprises the personal view and opinion of the STO Investment Research Desk and at no time should be construed as Investment Advice.

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