Risk appetites returned in a big way in October, as equities, emerging markets, commodities and currencies all generally advanced and smartly so, recouping much of the ground lost in September. The events in the week ahead will likely set the tone for the month of November. They include three central bank meetings (RBA, Fed and ECB), two data points (UK Q3 GDP and US employment report) and the G20 summit.
The risk-on theme was evident prior to the somewhat improved fundamental outlook–euro zone agreement, 2.5% Q3 US GDP driven by 3.6% increase in final sales, and a rise in the HSBC PMI for China back above the 50 boom/bust level. Circumstantial evidence, including the Commitment of Traders, suggest much of the market moves have been the reduction of short positions. If new buyers are to take over the leadership, fundamental developments will likely need to not just confirm, but surpass expectations.
Reserve Bank of Australia: The outcome of the RBA meeting will be known early on November 1. There had been nearly universal opinion anticipating a cut in the 4.75% cash target rate. While a low core inflation report creates scope for a cut, some have had second thoughts given the more optimistic global backdrop. Surveys, whether of economists or Australia’s four largest banks, find 3/4 anticipate a rate cut this week still. At the IMM, the non-commercial market has been re-building a long futures position. At the end of Sept, the net speculative longs stood at 5.2k and as of last week 23.1k.
The Australian dollar has appreciated about 14.7% over the course of October. Its rally came along side the expectations for a rate cut, suggest that the general investment climate–risk-on–was a greater driver that domestic policy considerations. The technical conditions look stretched and late longs are in weak hands. If the $1.0760 resistance area can be successfully breached, the next target would be $1.10. Given the pace of the run-up, solid support is not seen until the $1.03 area.
Federal Reserve: The FOMC holds a two day meeting Nov 1-2 with a press conference after the conclusion. The Fed’s staff will update growth, employment and inflation forecasts. We do not expect new initiatives by the Federal Reserve. Its economic assessment may be tweaked slightly better. The inflation assessment is unlikely to change. Comments by the Fed’s Tarullo and Yellen have fanned speculation that the Fed is preparing the market for a new round of asset (MBS?) purchases.
We suspect that comments need to be placed in the context of options still available to the Fed not a indication of an imminent policy shift. Rather than Tarullo and Yellen, it could be the Chicago Fed’s Evans that points to the near-term direction. He has been arguing in favour of shifting the time-frame of mid-2013 with more explicit (that is numerical) thresholds for inflation and unemployment. This cannot be done in one fell swoop, so incrementalism will carry the day.
European Central Bank: Draghi chairs his first ECB meeting on Nov 3. Although there is some speculation that he could cut interest rates, we look for the ECB to stand pat. This week’s PMI readings will likely confirm last week’s flash report warning that the region is likely slipping into recession. However, Draghi’s hands are tied. Given the importance of ECB credibility in general and Draghi’s credibility in particular, it seems be a stretch to expect the first ECB president from the periphery to begin his term, with 3% headline inflation (Sept) to cut interest rates and reverse in part or whole the interest rate hikes delivered in Q2 and Q3. Instead, we continue to believe a rate cut is considerably more likely following the new staff GDP and inflation forecasts, including for the first time 2013 forecasts, which will be available at the Dec meeting.
At his press conference, we expect Draghi to defend the ECB’s independence and contrary to the demands of the German Bundestag continue to buy sovereign bonds in the secondary market under its SMP operation. Immediate resistance for the euro is seen near $1.4250 and then at the trend line drawn off the year’s high in May (~$14940) and the late-Aug high (~$1.4550), which comes in this week $1.4350-70. Talk of demand for 1-month $1.45 euro calls surfaced at the end of last week.
G20 Meeting: The focus will remain very much on Europe at the week end’s G20 meeting. More details about the special purpose vehicle it intends to set up will need to be forthcoming to entice anything but words from the deep pools of capital in the form of central bank reserves or sovereign wealth funds. One of the parts of the European agreement that has not garnered much attention is its pledge of a EU-wide scheme to guarantee bank debt issuance. This will be of international interest as well.
We do not expect euro zone calls for a financial transaction tax to get much traction. Interest in a new SDR allotment may gain ground, but an actually agreement, especially given the low usage of the previous allotment, is not imminent. Expect the international community to be relatively supportive of Europe’s agreement and the latter will promise more action if needed (and we suspect it will be before too long).
UK GDP: The UK publishes its advance Q3 GDP on November 1. The consensus is for a 0.3% quarter-over-quarter advance. UK growth has stagnated over the past three quarters and we do not think Q3 marks the end of the stagnation phase even though it is better than growth of 0.1% posted in Q2.
This week’s PMI readings will likely point to continued near stagnant conditions in Q4. Sterling has rallied about 5.8% against the dollar in Oct. Immediate resistance is seen in the $1.6150 area. Above there, the $1.6300 area is next ceiling. Support is seen near $1.60.
US Jobs: The non-farm payroll report is among the most difficult of the high frequency data to forecast. There are not many useful inputs. The market’s focus is on the private sector as the government, mostly local, continues to shed workers. The private sector is expected to have expanded payrolls by around 125k, which is essentially its average performance over the past six months (6-month ave 127k). The four week moving average of weekly initial jobless claims and the weekly report covering the period in which the monthly survey was conducted point to continued job growth. Over the past year, the private sector has created almost 1.8 mln jobs. This is insufficient to bring down the unemployment rate as it largely matches the natural growth in the workforce.
The market does not anticipate any change in the work week. Hourly earnings are likely to rise about 0.2%, which is enough to keep the year-over-year rate just below 2%. The year-over-year rate may increase with the Nov and Dec reports due to base effects. It is not clear what else monetary policy can do to address this important issue. The recent Beige Book reported that some regions have job opening, but not the required skills in their workforce. Other US economic data in the coming days, including the ISM reports and auto sales figures will likely show Q3 momentum has carried into early Q4.
Things to Watch
1. While many markets point to risk-on, several markets seem less sanguine. Three-month dollar LIBOR finished last week at its highest in more than a year and its longest rising streak since 2005. Libor-OIS also is at its highest level since 2009. These indicators should be seen as warning that the financial plumbing remains under stress.
2. The decision to avoid triggered Greek credit default swaps, despite the “voluntary” 50% haircuts by private sector holders of sovereign bonds will have far-reaching implications. It raises questions over the value of CDS insurance and analysts will have to review bank holdings and valuations in light of this. If buying a CDS no longer offers protection, it may lead to a selling of the underlying instruments, i.e., sovereign bonds, especially in the periphery. Watch the performance of financial equities, sovereign bonds and CDS market for investor reaction to the European developments.
3. Italy remains at the vortex. Prime Minister Berlusconi refutes press reports that he agreed to step down on condition that his Northern League allies support a change in the 2-year hike in the retirement age in more than a decade’s time. The Northern League rejected such a reform in recent weeks. Despite the euphoric market performance following the European agreement, 10-year Italian yields finished the week above the 6% threshold and at the highest closing yield since the ECB began its purchases near 3 months ago. The PMI readings this week will strengthen market conviction that the third largest economy in the euro zone is either in a recession or quickly headed there.
4. New European bond supply. Of particular interest both Spain and France brings bond supply to the market at the end of the week. This will be a test of the market’s appetite for European sovereign bonds in the aftermath of the agreement. Spanish 10-year yields have not risen as much as Italy’s over the past month, but are up 50 bp and still rising. Although European officials do not want banks to reach the Tier 1 9% capital requirement by selling assets, it will be hard to enforce. One of Spain’s largest banks retracted its offer to sell a 3 bln euro package of repossessed homes and land because it was not satisfied with the bids. More generally in the euro zone, privatization from governments and asset sales by banks may not raise the projected revenues.
French banks exposure to peripheral debt, especially of Italy, and the doubts over the efficacy/integrity of the sovereign CDS market, and the 50% haircut on Greek exposure, illustrates the vulnerability of the sovereign. The French premium over Germany reached a post-EMU high of 115 earlier in Oct before narrowing to 92 last week. This may very well prove to be the low before new record widening is seen.
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