Fundamental Analysis 17.10.2017 - Market Outlook

USD gained on two main factors:

1) an incredible surge in the Empire State manufacturing index, and

2) Trump meeting with and being impressed by John Taylor, inventor of the eponymious Taylor Rule for calculating an appropriate level for a central bank’s main rate.

Taylor is probably the most hawkish of all the candidates for Fed chair. If his rule were applied nowadays, the Fed funds rate would be about 250 bps higher than it currently is, and indeed even higher than most of the FOMC members think is the appropriate “long term” rate where Fed funds should settle once things are back to normal (3%). Taylor thinks that long-term level should be closer to 4%, which is higher than anyone currently on the FOMC thinks (the highest estimate is 3.5%). He did say last week though that he did not think "rules should be used as a way to tie central bankers' hands,” even though that’s exactly what a lot of Republican members of Congress would like to see.

Trump is expected to interview current Fed Chair Yellen on Thursday 19th October 2017.

On the other hand, CAD was the weakest G10 currency. Over the weekend, Bank of Canada Gov. Poloz said that Canada’s economy may be entering a point in the business cycle where growth can accelerate without triggering inflation. He said investment could fuel growth while expanding production capacity at the same time, thereby preventing inflation. This view, coupled with a disappointing result from the BoC’s survey of managers Monday, pushed the odds of a rate hike this year down to 45.8% from 53.4% on Friday 13th October 2017 and caused CAD to weaken.

I think there could be further reconsideration of the Canadian interest rate story ahead of next week’s BoC meeting, which could push CAD lower still. Watch for Friday 20th October 2017’s Canadian inflation numbers, which could change the story again.

EUR was only vaguely affected by the rising tensions in Spain, while GBP was only mildly affected by further headlines about looming disaster in the Brexit talks.

Today’s market

The focus during the European day will be squarely on the UK as Bank of England Gov. Carney and two of his colleagues from the Monetary Policy Committee (MPC), Silvana Tenreyro and David Ramsden, appear before the UK Parliament’s Treasury Committee. This is the first time since the June election that Carney has spoken here. Tenreyro and Ramsden are the newest members of the MPC and this is their first appearance.

Carney appeared on CNBC on Friday 13th October 2017 and repeated his view that the BoE is “running out’ of spare capacity and it therefore may be “appropriate” to raise rates “in coming months.” He declined to say when more specifically or to be drawn on whether this would be a one-off hike or the start of a tightening cycle.

The graph below shows how the market has interpreted the MPC’s changing views. The green line shows the market’s estimate of the likelihood of a rise in rates at or before the November 2017 MPC meeting. Note how those odds fell after the August 2017 meeting, when Carney warned about the uncertainties caused by Brexit, and then soared after the last MPC meeting in September 2017, when the statement added the fateful words that “some withdrawal of monetary stimulus is likely to be appropriate over the coming months.”

At the same time as those three are elucidating their positions to the Right Honorable Members of Parliament, the UK CPI will be announced. It’s expected to show a further acceleration in inflation, which would probably seal the deal on a rate hike in November 2017. It could also propel GBP higher, at least temporarily – assuming no bad news on Brexit during the day.

Germany’s ZEW survey is expected to move ever higher. This is a survey of analysts and investors, not people who really do something, and so is more of an indicator of sentiment than of activity. Given that Germany’s DAX stock market index is at a record high, I’d say investor sentiment is pretty good, which suggests that expectations of a further rise in the index are reasonable. The current situation index is forecast to hit 88.5, not far off the record high of 91.5 set in May 2011. EUR-positive.

Then we wait until the US day begins.

The US indicators start with import prices, a second-tier index that is somewhat important for its theoretical implications for the CPI. But imported goods are only part of total goods, and in any event some 40% of the CPI is comprised of housing costs, which aren’t influenced at all by imports. Nonetheless, the index does seem to have a significant impact on EUR/USD over the 1-hour horizon. The forecast is for a modest acceleration in price increases, so it may be positive for the dollar.

However notice how much more slowly import prices excluding petroleum (the green line) are rising – only 1% yoy, vs the forecast 2.6% for overall import prices. Moreover, based on the consensus forecast for the mom change in that index, it’s expected to stay at +1.0% yoy this month, showing no acceleration. Given that the Fed targets core inflation, not headline inflation, that should be negative for the dollar. But it probably won’t be, because people don’t look that hard at this one.

US industrial production is probably more important for the market. The figure is forecast to show a month-on-month rise slightly higher than the six-month moving average, which would be excellent considering that it includes the effects of the two hurricanes during the month. I think a positive figure would show the resilience of the US economy and be positive for the dollar.

The National Association of Home Builders (NAHB) housing market index is expected to be unchanged. The index peaked in March 2017 at almost a 12-year high, so the fact that it’s stuck at a slightly lower level now is nothing to be alarmed at. USD-neutral

Overnight in Australia we get the Westpac-Melbourne Institute leading index. No forecast is available, but it does seem to affect AUD significantly in the hour following the release. The index seems to be on a downward trend; a further decline could be expected to be negative for AUD.

The main event overnight though will be President Xi’s opening speech to the 19th Conference of the Communist Party of China (CPC). These congresses take place every five years to elect the people and approve the policies for the next five years. This congress marks the start of Xi’s second and presumably final term. China experts say Xi is likely to use the event to further solidify his position. As for what he’s likely to do when he’s even more solidly in charge…well, we’ll have to wait to hear what he has to say. My guess is that he’s likely to promise wonderful things, which could give AUD and NZD a temporary boost.

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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