Fundamental Analysis 25.10.2017 - Market Outlook

USD and EUR both gained yesterday. USD apparently has conflicting forces working on it. On the one hand, the announcement that Republican Senator Jeff Flake won’t seek re-election makes it more difficult for the party to pass its tax reform, because he may vote against it. The party can only afford to lose three votes before it becomes unable to pass the legislation and there are already other Republicans who seem likely to vote against it. That’s negative for the dollar.

On the other hand, Trump sounded out Republican Senators about who they’d prefer as Fed chair and found that academic John Taylor is their favored candidate. That’s positive for the dollar and turned out to be the dominant thread in the market today.

All eyes are now on the US Treasury market. The 10-year bond broke through the long-awaited 2.40% level and at the time of writing is trading at 2.4171%. That’s just a whisker away from the 2.42% level last seen back in May that’s apparently an important technical level. Break through that and Treasury yields are expected to go a lot higher, which would tend to be bullish for the dollar.

EUR gained as the manufacturing purchasing managers’ indices (PMIs) beat expectations. Disappointing service-sector PMIs and the continuing struggle in Spain didn’t hold back the currency. In fact, the spread of Spanish bonds over Bunds actually narrowed slightly and Spanish stocks were higher yesterday, suggesting that the problems there aren’t even disturbing Spain, much less Europe as a whole.

AUD plunged after the Q3 CPI turned out not only lower than expected, but actually showed a fall in the year-on-year headline rate. You can see from the graph below how that pushed out estimates of when the Reserve Bank of Australia (RBA) might start hiking rates.

GBP weakened as Bank of England Deputy Gov. Jon Cunliffe said the timing of the first rate hike is still an “open question.” Many investors have been assuming that the question would be settled at next week’s Bank of England meeting (2 November 2017), when the market sees over an 80% likelihood of a rate hike. Of course, Cunliffe used the exact same phrase last Thursday, so his comment shouldn’t have come as a surprise to anyone.

Watch Brexit Secretary Davis’ comments in Parliament today for a direction on sterling. It’s also Prime Minister’s question time, which may provide a similar opportunity for the government to put some positive spin on the downward spiral of Brexit negotiations. However, at the same time the UK GDP figures may be a drag on the currency (see below).

We’ve got a number of significant indicators out today. First let’s discuss the Bank of Canada meeting, as that’s the main feature. The market had estimated that there was about a 25% chance of a rate hike at this meeting – not great, but not negligible either. Then Friday’s Canadian CPI came out showing a slower-than-expected headline rate of inflation (although an acceleration nonetheless, just a lower-than-expected acceleration). The result was a downgrade of expectations for this meeting and the December meeting as well.

What we can see from the graph is that several times since the global financial crisis, Canadian inflation has been well above the 2% target – indeed, it’s even gone above the 1%-3% target range – without the Bank of Canada raising its overnight rate above 1%, where it currently stands. What that suggests is that the Bank needs to see a strong case for a sustained period of inflation at or near its target in order to make a case to raise rates further.

The Bank has stressed that its decision is would depend on the data, and I’m not sure the data demands an increase any time soon. Last Monday’s Bank of Canada business survey showed that business sentiment, while still positive, fell somewhat in Q3. BoC Gov. Poloz recently singled out this survey as “one of the most important vehicles” that they have for assessing crucial “soft data” about the economy that allows them to pick up hints about future trends before they show up in the data.

Retail sales fell in August 2017, both in volume and in value terms. Moreover, there have been some changes in the rules for mortgages both at the national and regional levels in an effort to cool the housing market. A hike in rates would only exacerbate the expected decline in house prices.

Before the September 2017 Bank of Canada meeting, the market was pretty sure that a rate hike was coming at this meeting. Now, it’s seen as likely at the January 2018 meeting. My feeling is that the Bank may soften its stance somewhat and the market could push the expected date of the next hike out further, thereby weakening the CAD.

In addition, the Bank’s quarterly Monetary Policy Report, which will be issued at the same time, will be important reading for clues as to their intentions. Gov. Poloz observed recently that this report will contain an updated forecast for growth and inflation. These forecasts, plus Gov. Poloz’ comments on them in the press conference, are probably the key to the medium-term direction of CAD.

As for the indicators, first up is the German Ifo index. This is a domestic version of the purchasing managers’ indices. They’re all expected to decline marginally. This would be similar to yesterday’s small (0.1-point) decline in the German manufacturing PMI for the month. In any event, the business climate and current assessment both hit record highs in July, so some small decline from that level is nothing to be concerned about.

The first estimate of Britain’s Q3 GDP is expected to show growth stagnating at the same pace as in the previous two quarters. UK growth is now the most sluggish of the G10 countries, and the discussions over Brexit aren’t likely to make it any better. Slow growth makes it less likely that the Bank of England can carry out a sustained series of rate hikes.

US durable goods orders are as expected. The headline figure (green dot) will be inflated by some airplane orders; excluding those, the index is forecast to have risen at the same pace as in the previous month (red dot). The figure could be negative for the dollar.

US new home sales are expected to be down slightly in September 2017 following two months of bigger declines. Note though that existing home sales (the purple line) actually rose during the month despite the fact that so many existing homes were destroyed. That leaves open the possibility that new home sales may have risen during the month, too, although the fact is that the monthly change in the two indicators is barely correlated at all – only about half the time do they even move in the same direction (basically random). In any event, I’d expect to see a sharp rebound in these figures once people start rebuilding their houses in Texas and Florida.

Finally, overnight New Zealand announces its trade balance for September. The figures aren’t seasonally adjusted, so the actual number gives relatively little information. The market forecast for a small narrowing in the deficit would also mean a continued narrowing in the 12-month moving average – a good sign for the economy and one that could boost the NZD.

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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