Fundamental Analysis 24.10.2017 - Market Outlook

A relatively quiet market overnight, with little movement in most of the major currencies.

Silver and gold were the big winners. The slightly weaker dollar helped, as did a massive trade of 18,792 gold futures contracts in five minutes (about $24.1mn). Treasury yields moved lower and Fed fund rate expectations weakened a touch as equity markets were unable to sustain their record highs.

USD peaked around 10:30 GMT and came off sharply around 1700 GMT. You can see the plunge in USD/JPY particularly sharply, but it’s also there in EUR/USD. My guess is that it was technical, caused by filling the gap caused by the election in USD/JPY. In the event, JPY was higher on the day.

News that North Korea may be developing biological weapons may have caused some risk aversion. Risk aversion and risk-on, risk-off moves have nothing to do with actual optimism or pessimism about the countries involved, but rather those countries’ investors hedging their huge amounts of overseas assets when they get nervous.

I expect the concerns to calm down quickly and for JPY to resume weakening, as is usual after an election. Furthermore, the Tokyo stock market has been up for 12 consecutive days. Usually, USD/JPY moves in tandem with Japanese stocks, i.e. the yen weakens when the stock market gains (a “risk-on” trade). USD/JPY has lagged the rally in Japanese stocks; I believe it has some catch-up to do.

On the other hand, NZD was the big loser as the risk-off sentiment encouraged investors to liquidate carry trades such as NZD/JPY and NZD/CHF. Uncertainty about the intentions of the new coalition government are also weighing on the currency.

In other news, US Congress continues to move towards passing a budget. The House of Representatives may vote as early as Thursday 26th October 2017 on the Senate’s budget resolution. If it passes, then the Senate will only need 51 votes to pass it, not the usual 60 votes – that should make it possible. If so, the Republican dreams of tax cuts will come one step closer, stock markets are likely to go even higher, and risk-on should come back. That ought to be positive for USD and negative for JPY and CHF. I think the progress of the US budget and US tax reform is probably the greatest factor moving USD for the time being.

Trump said in an interview that he would make his decision on the Fed chair “very shortly.” The short list consists of Fed Gov. Jerome Powell, academic John Taylor, and incumbent Janet Yellen. He agreed it was possible to give Powell and Taylor the Chair and vice-Chair (which is currently empty). Powell would be USD-negative and Taylor would be USD-positive; it’s hard to say what the impact giving both of them positions would be.

It may be though that the perceived differences between the candidates are greater than the actual differences. The next step would be Senate confirmation hearings, probably in late November 2017. Nominees usually emphasize continuity over sudden changes in policy. Furthermore, even Taylor has backed away from the idea (much beloved of Republicans) of mechanistically applying his or any other monetary policy rule to Fed policy, so even he is probably closer to the status quo than people think. Yellen of course would be totally status quo, but nonetheless I’d say she would also be USD-positive, not because she’s so hawkish but rather because she represents continuity and a known quantity.

Today’s market
It’s purchasing managers’ index (PMI) day today! Markit, the company that compiles these indices world-wide, puts out preliminary indices for several of the major economies.

So the action starts when Europe opens up, with France, Germany and then the EU overall index. Both the manufacturing and service-sector indices are all expected to be lower, which could prove to be negative for the euro.

The EU-wide manufacturing index basically tracks those two – they explain something like 97% of the variability of the index – so once the German indicator is out, in fact the EU-wide one is somewhat of an afterthought. And as you can see, the German index (the green line) moves more in line with the EU-wide index (the red line) than the French one does (the blue line).

Markit doesn’t divulge the weights in the EU index, but the German index has a 98% correlation with the EU-wide vs 92% for the French index, and moreover, the change in the German index has a 93% correlation with the change in the EU-wide index, vs only 58% for the French index. So I would say the game is about one-quarter over when the French index is announced and then pretty much finished when the German one comes out.

Later in the day, the US PMIs are coming out. These are significant for USD even though they are perhaps not as widely watched as the Institute of Supply Management (ISM) version, which are the original version on which everything else is based. The manufacturing index here is expected to be up a bit. The services index on the other hand is forecast to fall slightly.

The Richmond Fed index is expected to fall slightly. This would be in contrast to the already-released Empire State and Philadelphia Fed indices, which were both surprisingly strong. It may be that the southern part of the US is feeling the impact of the hurricanes more than the northeast.

Overnight, Australia announces its consumer price index (CPI) for Q3. This is the key event for AUD this week. The most widely watched measures of inflation are expected to just poke their nose into the Reserve Bank of Australia’s target range of 2%-3%, owing to higher electricity prices. This could make the market think a rate hike is more likely and therefore be bullish for AUD. (At the moment, the market thinks a rate hike any time soon is highly unlikely; only a 50% chance of a hike before next July 2017 or August 2017 is priced in.)

On the other hand, this quarter’s slight rise might be offset by the market’s awareness of next quarter’s revision to Australia’s CPI basket, which occurs every five or six years. That’s expected to depress the annual inflation rate by a more substantial 0.2 ppt to 0.4 ppt.

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

STO Review