Fundamental Analysis 27.10.2017 - Market Outlook

EUR weakness – and its counterpart, USD strength – was the theme overnight in the wake of the European Central Bank (ECB) decision to reduce and extend its monthly bond purchases.

It’s true that they cut the bond purchases to €30bn a month, at the low end of expectations, but the impact of that choice was offset by a number of dovish qualifications, namely:
Their target is “net” purchases not “gross” purchases, meaning the reinvestment of maturing bonds isn’t included in the amount that they’ll be buying;
They extended the purchases by nine months, the maximum observers expected;
They left open the possibility that not only might they extend the purchase program longer, but they could even increase the amount again if it turns out to be necessary; and
They pledged to continue reinvesting maturing bonds even after the purchase program ends. This is an important point because reinvestment could be €10bn a month.

In fact, ECB President Draghi virtually promised that the program was going to be extended further when he said, “…the decision today is for an open-ended program. I may add certainly it's not going to stop suddenly.” He later added, “…this is not tapering; it’s just a downsize.”

Draghi pointed out that the ECB’s forecasts are that inflation is actually likely to slow to 1.2% yoy next year from 1.5% yoy this year and only hit 1.5% yoy in 2019, still below the ECB’s target of “close to, but below, 2%.” “So we aren’t there yet,” he said. And given that the ECB has pledged to continue to keep rates low “well past” the end of the bond purchase program, this means ECB rates are likely to stay lower for longer than the market had expected. Thus EUR weakness.

Meanwhile, the USD’s rebound was boosted when the House of Representatives passed a budget resolution, suggesting further progress on tax reform is possible. Republican leaders said that they hope to have the tax bill introduced, debated and approved in both chambers by the end of November.

Also, news reports have suggested that current Fed Chair Janet Yellen and former Fed Governor Kevin Warsh are no longer in the running for Fed Chair, meaning the decision is down to academic John Taylor and current Fed Gov. Jerome Powell. Taylor is considered the most hawkish of the candidates and so his nomination would be positive for the dollar.

Ten-year Treasury yields are at 2.46% this morning, well above the 2.42% technical level I mentioned yesterday. That suggests US rates may be headed higher, meaning the dollar is likely to get continued support from the “monetary policy divergence” with the euro.

Elsewhere, AUD weakened after the Australian High Court ruled that Deputy Prime Minister Barnaby Joyce has to leave Parliament because of his dual citizenship. This will cost the government its one-seat majority.

Today’s market

The only major indicator on today’s schedule is the first estimate of US third-quarter GDP. The market expects a slowdown in growth. Nonetheless, the forecast rate of 2.6% qoq SAAR is still above the FOMC’s forecast for this year (2.4%) and indeed well above their median estimate of the long-term rate of growth in the US, which is 1.8%. So it would still be enough to allow the Fed to keep hiking rates and could therefore be USD-bullish.

Note though that reliable sources have a wide variety of estimates. The Atlanta Fed’s GDPNow forecast estimates the figure will be 2.5%, close to the market consensus, but the New York Fed’s Nowcast estimate is far lower at 1.5%. If the number came in closer to what the New York Fed expects, I would imagine that US rates would fall and the dollar would weaken.

The other part of the GDP figure is of course the price deflators, especially the core personal consumption expenditure (PCE) deflator, which is the Fed’s preferred inflation target. Both are forecast to move higher.

With growth remaining above the economy’s long-term potential non-inflationary level and inflation rising back towards the Fed’s target level, it should be possible for the Fed to continue with its series of gradual rate hikes. The figures therefore ought to be positive for the dollar, in my view.

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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