Fundamental Analysis 20.10.2017 - Market Outlook

USD weakened for much of the day, but then jumped in early Asian trading as Senate Republicans passed a FY 2018 budget. The move could allow Republicans to pass their proposed tax reform later this year or early next year, including a proposed $1.5tn tax cut. The next step is for the House of Representatives to take up the legislation, which could happen next week. Action instead of gridlock and the possibility of tax cuts are likely to keep US sentiment strong and US stocks underpinned, which should allow the Fed to keep hiking rates.

EUR was little affected by the crisis in Spain. First off, even if Spanish PM Rajoy does try to evict the Catalan government, it apparently will take about two weeks to get Senate approval. Secondly, the EU has sedulously avoided getting dragged into the dispute despite the regional government’s best efforts to involve international mediation. European Council President Donald Tusk yesterday said that “there’s no room, no space for any kind of mediation or international initiative or action.” As long as the crisis is confined to Spain and doesn’t trigger any other regional break-away movements or involve the EU central authorities, it’s seen as a local irritant, not systemic. We might compare it more to the IRA activity in Britain many years ago, which was seen as just a British problem, rather than the recent right-wing populist victories in several European countries, which was seen as possibly an EU-wide trend.

NZD was the big loser overnight as the opposition Labour Party took the reins of government, ending the National Party’s nine-year rule. Markets generally dislike uncertainty, and doubly so when the balance of probability lies towards policies that they don’t like. Both the Labour Party and its coalition partner, New Zealand First, are thought to be more interventionist than the National Party is. Moreover, having been out of power for nine years, Labour lacks members with Cabinet experience.

The key threat to NZD is that the party campaigned on rethinking monetary policy in ways that would tend to make it looser. It wants the central bank to add full employment to its mandate of price stability and has proposed that policy be determined by a committee that would include external members, instead of just by the governor. A looser monetary policy added to their pledges of higher spending probably means higher inflation, lower real interest rates, and a weaker currency.

GBP also fell as the ever-present Brexit fears were compounded by much weaker-than-expected retail sales figures. Weak sales make it more likely that even if the Bank of England does raise rates at its next meeting in November 2017, it won’t be the start of a steady hiking cycle.

JPY eased slightly as polls show that the ruling Liberal Democratic Party (LDP), which is neither liberal nor democratic, is likely to win Sunday 22nd October 2017’s election. Contrary to New Zealand, continuity here suggests a weaker currency, because it means the continuation of ultra-loose monetary policy.

Today’s market

The day starts off with Britain’s public sector net cash requirement (PSNCR), or as most countries would say, government deficit. The figure excludes the borrowing with respect to the banks that the government nationalized back in the global financial crisis. The data aren’t seasonally adjusted, so the actual figure doesn’t matter much to me – I’m more concerned with how the 12-month moving average goes. The market consensus forecast of £6.5bn would bring the average to £3.78bn, almost exactly the same as the previous month. The cash requirement has been on a downward trend – or, more accurately, the government deficit has been narrowing – so as long as it’s at the consensus forecast or below, it should be positive for the pound.

The press conference following the EU summit will be closely watched for whatever comments they make about the Brexit negotiations.

Canada’s CPI and retail sales will be important for the CAD. CPI is expected to accelerate, getting closer to the Bank of Canada’s 2% target. That should make it easier for the Bank of Canada to tighten policy further. Currently the market is pricing in only a 53% chance of a rate hike at the December 2017 meeting, but faster inflation could increase those odds.

Retail sales, excluding autos, are expected to do a little bit better than the previous month’s weak result. The consensus figure would be right in line with the recent trend and so probably would be neutral for the currency.

These two indicators do not always come out together. When they do, I suspect that the CPI is considered the more important one.

The pace of US existing home sales is forecast to slow a bit. I expect the market to place less weight on the housing data for the next several months on the assumption that it’s distorted from the hurricanes.

Sales of both new and existing homes peaked in March 2017 and have been trending lower, but there’s considerable debate about whether this is a sign of a weak housing market. The National Association of Realtors (NAR) says sales are low because of “inadequate levels of available inventory.”

Late in the US day, Fed Chair Janet Yellen will speak on “Monetary Policy Since the Financial Crisis.” It’s likely that she’ll say they did a pretty good job.

And in Japan, the markets are looking towards the Lower House election this Sunday 22nd October 2017. Recent polls have shown the ruling Liberal Democratic Party (LDP) doing better and the upstart Party of Hope flagging. The latest survey by the Nikkei newspaper predicted the LDP and its coalition partner could win around 300 seats, allowing it to keep its majority in the 465-seat Lower House. That’s less than it currently has, but would probably still ensure PM Abe another term, making him the longest-serving PM in the post-war era. That would mean the continuation of so-called “Abenomics” and probably the re-appointment of BoJ Gov. Kuroda when his term expires next April 2017.

The question is of course, will that be good or bad for the yen? My view is that a continuation of the same policies is subject to diminishing marginal returns. Policies that haven’t worked yet since Abe launched them in 2013 aren’t likely to work any better now, and so therefore should be negative for the yen. I think the market will consider the question differently but come up with a similar conclusion: since the result is likely to mean a continuation of the current policy, it’s to be just slightly negative for the yen – no change in personalities, no change in policies, hence no need for a big change in the currency.

Looking back at the last five Lower House elections, we can see that in general, USD/JPY has tended to rise – that is, the yen has weakened – following the election. The big exception to this was in 2009 (the red line), when the LDP lost its majority to the Democratic Party of Japan (DPJ). The DPJ didn’t perform very well however and at the next election in 2012, the LDP won a landslide and Abe became PM (purple line). We can see that the yen weakened dramatically then, probably in anticipation – correctly, as it turns out – that PM Abe would force the BoJ to loosen monetary policy.

I must point out however that the yen strengthened immediately after the last election (light blue line). It subsequently lost the gains over the next few days. This could be a guide to what’s likely to happen this time as well, since PM Abe was effectively running for re-election in that election as well.

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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