Fundamental Analysis 2017.09.29 – Trump’s New Tax Reform

Market Recap
USD slipped as the market re-evaluated the likely impact of the Trump tax breaks, or perhaps more accurately, the likelihood of them getting enacted as is. Furthermore, many bond investors rolled out their positions slightly as the end of the month approached in order to keep in line with bond indices, which also had the effect of bringing US interest rates down. Lower US rates put downward pressure on USD.

It was notable that the market ignored several indicators that should have been positive for USD: an unexpected upward revision to Q2 GDP (albeit a small one), a much narrower-than-expected US trade deficit, a much higher-than-expected rise in wholesale inventories, and an unexpected rise in the Kansas City Fed manufacturing activity index. This just shows me how the focus in the US is largely on politics and Fed policy and how the underlying sentiment towards USD is so negative.

CAD was the best-performing G10 currency as the USD weakened and some of the pessimism caused by Bank of Canada Gov. Poloz’ recent speech faded. Investors may buying ahead of today’s Canada GDP and industrial product prices, although I expect only the latter to be a reason to push CAD higher (see below). CAD’s rallyl was all the more impressive given that oil prices fell on the day.

Today’s market
Following yesterday’s German CPI figures, the focus for the indicators today remains on inflation, with the EU-wide inflation figures and the US personal consumption expenditure (PCE) deflators coming out.
There’s a lot happening over the weekend, too. If Catalonia goes ahead with its referendum on independence, that could hurt EUR. And Japan announces the results of its quarterly Tankan report, the most important Japanese economic indicator, at the start of its business day on Monday.

UK indicators will dominate during the European morning.

The European day starts with British house prices from the UK Nationwide Building Society. While the year-on-year rate of growth is expected to slow, on a month-on-month basis, prices are expected to rise slightly, compared to the slight fall in the previous month. That could be interpreted as supportive for the pound, even though it does appear that the downward trend is still in place.

German unemployment can sometimes affect EUR, but usually it’s just a minor impact.

The Bank of England data on mortgage approvals is expected to show a 2% month-on-month decline. This would be in contrast to the 0.4% mom increase in the British Bankers’ Association. While not impossible, the two indicators have moved in the same direction 85% of the time since 1999 (88% since 2010), so such divergence would be a relatively rare occurrence. I see a good possibility of an upward surprise in this indicator, which could also be positive for the pound (if it happens).

The third and final revision of UK Q2 GDP is expected to be unchanged from the 2nd revision and therefore unlikely to have much impact.

EU CPI is the crucial indicator for the Eurozone nowadays as the ECB mulls withdrawing some of its extraordinary stimulus by slowing down and eventually stopping its monthly bond purchases. Today’s CPI data is the last one before the ECB’s October meeting (26 October) and hence will set the background for the discussion then.

While the headline figure is expected to creep up a notch, core CPI (which excludes energy prices) is expected to rise at the same pace as in the previous month, well below the Bank’s target of “below, but close to, 2%”.

Nonetheless, this result is already incorporated in the ECB’s outlook and shouldn’t give the Board pause. At the Bank’s last meeting on 7 Sep, ECB President Draghi noted that core inflation has “yet to show convincing signs of a sustained upward trend.” Nonetheless, he said it “is expected to rise gradually over the medium term, supported by our monetary policy measures, the continuing economic expansion, the corresponding gradual absorption of economic slack and rising wages.” Thus so long as inflation doesn’t slow further, the report should be positive for the euro.

Yesterday’s German HICP inflation rate was unchanged from the previous month, contrary to expectations that it would accelerate slightly.

The US day starts off with US personal income and spending. Both are expected to be up from the previous month, but growth is expected to drop by 20 bps from the previous month’s month-on-month rate of growth. Both are expected to rise at a below-trend pace. Growth in incomes is expected to continue to outpace growth in spending (not in my family, unfortunately), which is healthier over the longer term but may result in some negative reaction in the dollar.

An examination of the impact of these two indicators on EUR/USD suggests that the market largely ignores the income figure and focuses on spending, at least with regards to the surprise vs expectations.

The US PCE deflators are expected to show much the same story as the EU CPI data: headline inflation accelerating slightly but core inflation remaining stubbornly below target. This is important for the US, because the core PCE deflator is the Fed’s preferred gauge of inflation. Nonetheless, again as in Europe, this prospect seems to be incorporated already in the FOMC’s thinking, as embodied in Fed Chair Janet Yellen’s recent comment that “it would be imprudent to keep monetary policy on hold until inflation is back to 2 percent.” Accordingly, so long as the PCE deflators don’t slow, I would expect this report to be positive for the dollar and to outweigh the impact of slowing incomes & spending.

An examination of all four of these four indicators – personal income, personal spending, PCE deflator and core PCE deflator – shows that the market’s reaction seems to follow the headline PCE deflator most strongly, at least in the first 30 minutes. That’s what I would expect the market to focus on if there’s any contradiction among the indicators.
Canada will also be in focus as the country announces its monthly GDP figure as well as industrial product prices, the equivalent of producer prices. These two series, which are released simultaneously, are forecast to have opposite impacts on the currency, which suggests considerable volatility following the reports as investors weigh the relative importance of each.
Canada’s GDP growth is forecast to have slowed somewhat in July. This should come as no surprise to the Bank of Canada; Gov. Poloz said in his speech on Wednesday that the 4.5% pace of growth in Q2 “is unlikely to be sustained, and recent data point clearly to a moderation in the second half of the year.” Still, in the context of his observation that monetary policy “will be particularly data dependent”, plus the market’s newfound skepticism about the pace of rate hikes in the country, the news could be negative for CAD.

On the other hand, the nation’s industrial product prices are forecast to rise sharply after two months of steep declines. This could bring the prospect of higher inflation back into the conversation and reverse some of CAD’s recent softness.

Which indicator is likely to win out? Watch for any divergence from the forecast. My guess is that since industrial product prices are most closely associated with inflation, the result here should be the key to CAD, but of course the market is not always so rational. It also depends on the size of any miss.

There will be a major hurdle for EUR over the weekend: a possible referendum on independence for the Spanish region of Catalonia. The regional government there has pledged to go ahead with the referendum, which Spain’s Constitutional Court has outlawed. If the referendum goes ahead – not certain at the time of writing – and if the vote is for independence – also not certain – it could plunge Spain into a constitutional crisis. Following the recent better-than-expected showing by the AfD in Germany, such a result could resurrect political concerns about the Eurozone, resulting in downward pressure on EUR.

Catalonia held a symbolic poll in 2014. The vote was overwhelmingly in favor of complete succession (80%), but only 32% of the electorate took part, meaning only 26% of possible voters voted in favor of succession. Thus even if the vote goes ahead on Sunday, it’s impossible to say how it will go, and even if it goes in favor of succession, it’s impossible to say what impact it will have, since the central government has already ruled it’s illegal. Nevertheless, uncertainty is bad for a currency, and such a result could be expected to be negative for the euro.

Finally, right as the market opens for business Monday morning Asian time, Japan announces the Bank of Japan’s short-term survey of economic conditions, aka Tankan, for Q3. This is the most important Japanese economic indicator. While there are almost limitless data points from this survey of 10,799 non-financial and 196 financial companies, the most important ones are probably the diffusion index (DI) for large manufacturers, plus the larger manufacturers’ forecasts for what their DI is likely to be in Q4. That gives an indication of whether they see things headed. Both are expected to improve by one point. Oddly enough, that could be negative for the yen, because the tankan often has a strong impact on the stock market, and when the stock market rallies, JPY often weakens.

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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