Fundamental Analysis 26.10.2017 - Market Outlook

EUR and USD were little changed. US 10-year Treasury yields did pop over the crucial 2.42% barrier that I mentioned yesterday, but buyers came in and pushed them back down. In the end, the event didn’t impact USD that strongly. Today’s ECB meeting will of course be crucial for EUR/USD. After that, tomorrow’s US Q3 GDP number is the big event for the dollar.

GBP gained as better-than-expected Q3 GDP figures made it more likely that the Bank of England would hike rates at its meeting next week. The odds in the market have increased to 89% from 82% before the figure.

The data coincided with some optimistic words about Brexit, which may also have lifted sentiment towards the pound. Brexit Secretary David Davis said that the UK expects to agree with the EU by early next year on the form of a transition arrangement that would follow Brexit. Crucially, he said that the relationship should be “very close to existing circumstances” during the transition period. This basically amounts to the UK giving in to EU demands. Signs that the UK is capitulating suggests that the impasse may eventually be solved, which would be positive for the UK and the pound.

On the other hand, CAD plunged after the Bank of Canada not only kept rates steady, but issued a more dovish statement than the market had expected. In the press conference afterwards, Bank of Canada Governor Stephen Poloz said that the Bank is “more preoccupied with the downside risks to inflation” and that the Bank would be “cautious in considering future interest rate adjustments.” Unlike what happened in Britain, the odds of a rate hike at the next BoC meeting (12 December 2017) fell to 33% from 44%. I think as the NAFTA talks drag on, CAD is likely to weaken further.

AUD/USD is quickly approaching its 200-day moving average (0.7694). A break of that might trigger the next leg down for the pair.

Today’s market

Today’s a big day for central bank meetings, with Sweden’s Riksbank, Norway’s Norges Bank, and the European Central Bank all holding their meetings today.

The ECB isn’t going to change rates either, however is expected to begin to taper down its bond purchase program. Currently it purchases €60bn of bonds each month in a program that it said will run “until the end of December 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.”

The two questions are, how much will they now purchase, and when will they stop the buying entirely? It’s hard to estimate what the “market consensus” on these crucial points is. A Reuter poll says the consensus is that the ECB will cut its bond purchases to €40bn a month and extend them from six to nine months past the end-December cut-off. Bloomberg’s survey says investors expect them to be cut in half to €30bn a month and extended for nine months.

With an announcement a virtual certainty, the market’s response depends on how the actual decision compares with expectations. The lower the bond purchases, the more EUR is likely to strengthen, because bond yields should rise more as a result.

Similarly, the longer they extend the program, the more the euro is likely to weaken, or at least the less it’s likely to gain. That’s because a longer extension would mean interest rates will be “lower for longer.” The ECB has pledged not to start raising rates until “well past the horizon of our net asset purchases.” In this vein, the Council may want to leave some flexibility around the cut-off date by saying something like it does now, e.g. “nine months, or beyond, if necessary,” rather than promising to stop purchases at a specific time. A softer ending date rather than a firm cut-off time would also tend to be negative for the euro.

The ultimate response depends on the trade-off between the volume of purchases and the duration. Duration seems to me to be more important, because of the ECB’s pledge not to start hiking rates until after they’ve stopped the purchases.

At the moment, the market isn’t expecting the ECB to change rates any time soon. The probability of a rate hike by the end of next year, which seemed almost a certainty back in July 2017, has dropped below 50% (green line).

The first rate hike is now priced in for about two years from now. According to a Bloomberg survey, economists see the ECB hiking the deposit rate in 1Q 2019 and the key refinancing, or refi, rate in 2Q 2019. The deposit rate, currently -0.40%, isn’t expected to get back to zero until four years from now – which certainly qualifies as “well past the horizon.”

There are some other technicalities that the market may pay attention to. For example, when the Council says they will buy a certain amount of bonds, is that “net purchases” – i.e., including the reinvestment of an estimated €15bn a month of maturing bonds -- or “gross purchases” not including them. Gross purchases would mean less purchases overall and would therefore be seen as more hawkish and positive for the euro.

After the ECB drama, the two US advance reports – wholesale inventories and trade – are likely to be rather minor events.

Wholesale inventories are expected to be up slightly, not as much as in recent months but about in line with the six-month average. I think this could be slightly disappointing and therefore be negative for the dollar.

At the same time, the goods trade balance is expected to widen slightly. This would also tend to be negative for the dollar (although to tell the truth, the figure is slightly narrower than the six-month trend and so should be considered good, in my humble opinion – but it probably wouldn’t be.)

So both of these figures would be dollar negative. However, that probably doesn’t matter, because they’ll come out just as ECB President Draghi starts talking, and what he says is much much more important for EUR – and therefore for EUR/USD – than what happens with wholesale inventories.

By the way, if indeed the market is paying attention to these two, the trade balance seems to be the more significant indicator for EUR/USD.

Japan announces its inflation data overnight. They have a ton of different ways of measuring inflation, and all of them show basically the same story: no inflation after some 20 years of near-zero interest rates.

This time around not only is there no acceleration in inflation forecast, but the core Tokyo CPI is forecast to remain at no annual increase in prices for the third month in a row. Maybe this is better than the previous two months, when prices actually fell year-on-year, but it’s still pretty dismal after something like 20 years of zero interest rates. The yen could weaken on the news, but frankly I don’t think anyone expects the Bank of Japan to do anything more than it already is doing.

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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