The combination of the unequivocally strong US jobs report and the contrasting unexpected decline in German factory orders and industrial production reported last week, sets the broad investment framework for the period ahead.
The pendulum of market expectations has swung decidedly in favor of the long-awaited Fed hike next month. A Reuters poll found 15 of the 17 primary dealers expect a hike at the December FOMC meeting, up from 12 after the September FOMC meeting. The median probability was assessed at 80%. The US-German 2-year swap rate (interest rate differential) finished last week just shy of 118 bp, which is the largest US premium in more than nine years. The premium was near 80 bp as recently as mid-October.
Whereas the euro-dollar exchange rate seems sensitive to the 2-year differential, the dollar-yen rate appears more responsive to the 10-year differential. The US premium has risen from about 166 bp in mid-October to a little more than 200 bp at the end of last week. It is less than a quarter basis point from the year's high and the largest premium since September 2014.
The argument that the divergence meme has been long discounted never sat well with us. We understand interest rate differentials and slopes of yields curves as creating incentive structures for new investments and hedging decisions and not simply the stock of current investment. Moreover, if our macroeconomic analysis is correct, that premium the US offers should be expected to rise over the next several quarters.
This is to say that investors will be incentivized to be long dollars by an increasing amount. The opposite is also true, the cost of being short the dollar will also become more onerous. This has direct implications for the currency mismatches that still seem to exist for emerging market sovereigns and corporates that borrowed dollars to lock in low interest rates.
II
Market sentiment does not move in a smooth continuous function. It moves in lurches and is prone to exaggeration. A year ago China was "ten-feet tall." It was thought to be on its way to surpassing the US (by some estimates of purchasing power parity); its demand was setting commodity prices and its output, driving world prices. Now some wonder if it is more like the "gang that can't shoot straight," with what one wag called a "ham-fisted" response to the dramatic sell-off of Chinese shares after a breathtaking rally. Its economy is slowing, and this exposes the excess capacity that is one of the forces behind the deflation in producer prices for nearly the past four years. This brings little confidence that China can avoid the middle-income trap.
German Chancellor Merkel has often been praised for her political astuteness; her quiet, subdued, focused approach, with a rare combination of determination and flexibility, has allowed her to outmaneuver her friends and adversaries on numerous occasions. Her laurels were sung far and wide. Then the refugee/immigration challenge emerged. Now the pundits contemplate a post-Merkel Germany and post-Merkel Europe. Another dramatic reversal of fortune in a short period of time.
Here is another dramatic swing in sentiment: The yield on the US 2-Year note has risen 40 bp from the low on October 14 to the high before the weekend. The 95 bp that it touched is the highest in six years. This is important for the next set of issues that are going to confront investors now that it is widely accepted that the Fed will raise rates next month, barring, of course, a significant downside surprise. And that is over the pace and extent of the Fed's tightening cycle. To be sure, many—if not all—of the Fed officials would argue that far from tightening, the Fed is moving from a super-accommodative monetary policy to a very, very easy monetary stance.
If investors have spent time parsing the Fed's meaning of "considerable period", "patience", and "data-dependent", they will now turn their attention to the meaning of "gradual" as in the pace of normalization of monetary policy. The Fed's dot plot suggests four hikes a year through 2018. This is a rate hike essentially every other meeting. This is more gradual that Greenspan's 25 bp at every meeting.
The market is almost there for next year. The Reuters survey found that the consensus among primary dealers anticipates that Fed funds will be at 1.125% at the end of 2016. This is down 25 bp from the mid-September survey, as if the Fed's failure to raise rates then is simply removed from the forecast rather than made up for later. Assuming that the Fed lifts off in December, this implies 100% confidence of three rates hikes next year with consensus evenly divided on the prospects for the fourth hike.
Unlike past cycles, the Fed's balance sheet can be part of making monetary policy less accommodative. There are reportedly about $220 bln of US Treasuries that the Fed owns that will mature next year, for example. Fed officials have indicated a desire to stop re-investing proceeds after the normalization process has begun. The Fed may not allow the full $220 bln (~5% of the Fed's balance sheet) to roll-off, but in its understanding, the easing of QE lies more in the holding than the buying. Any significant reduction of the Fed's balance sheet needs to be understood as part of the gradual normalization process.
III
The record rise in US consumer credit ($28.9 bln) in September that was reported just before the weekend was likely lost on many investors, after a busy week and cathartic jobs data. The bulk continues to be accounted for by non-revolving credit (auto and student loans), with only $6.7 bln accounted for by revolving credit (credit cards). Still, consumer credit is running almost $500 mln a week more than last year's pace ($2 bln a month), and revolving debt is trending higher.
Credit plus wage income stemming from the two mln net new jobs created in the first ten months of 2015 has helped fuel consumption that has been fairly stable, around a 3% annual pace. The October retail sales report is the most important US economic report (due Friday) this week. The headline will be constrained by the drop in gasoline prices and the fact that the new cyclical high in auto sales sequentially was small. Overall retail sales capture about 40% of personal consumption in the US. However, for GDP purposes, items like gasoline, autos, and building materials are picked up in other time-series. This core measure that excludes them has been weak over the last couple of months and declined by 0.05% in September. Look for a snap back toward its long-term average (~0.25%).
The University of Michigan's consumer confidence report often gets passing interest by market participants. However, this week's report will deserve somewhat greater attention. Here is why: last month's report showed the long-term (5-10 years) inflation expectations, which in the past Fed officials have cited, fell to its lowest level since 2002 (2.5%). Among the most powerful arguments against the Fed from tightening is that price pressures remain modest and below target. Separately, we note that the 10-year break-even has risen 12 bp since the Fed's late-October meeting and two bp since the mid-September meeting.
The UK's data, especially the latest readings on the labor market and wages, may help investors regain their balance after being discombobulated by the dovish BOE. Recall that the August report showed a new cyclical low in the ILO measure of UK unemployment to 5.4%. However, the claimant count rose in both August and September and is expected to have risen against in October (~1.4k).
Barring a major surprise, the focus will be on the earnings, which, like ILO unemployment is reported with another month lag. Here a divergence is taking place between overall earnings and those excluding bonuses. The former may quicken and the latter slow. Although over the past three months the average pace has been the same 2.8%, the headline has risen for two consecutive months and is expected to have risen in September, while excluding bonuses, average weekly earnings fell in August and are expected to have slowed further in September.
As we have noted, there seems to be a divergence between eurozone economic data and the urgency that Draghi expresses to review the ECB's course with an eye to providing even more monetary support. The eurozone reports Q3 GDP at the end of the week. Growth is expected to have maintained the 0.4% pace posted in Q2. With little variance, this has been the pace of growth since the middle of 2014. It is more than twice the pace of the three-year quarterly average. Moreover, if one uses similar definitions of core inflation, it is roughly the same in the EMU, the UK, Japan and the US.
Swedish and Norwegian CPI reports can influence expectations of the trajectory of their respective monetary policies. Sweden's economy is doing OK. Last week, the October manufacturing PMI was reported at 53.5%, a little softer than expected, while the non-manufacturing PMI rose to 57.5, the highest since May. It also reported September industrial output rose 2.0% on the month (consensus was for a 0.5% decline) after a 1.7% increase in August.
Sweden's challenge may not be inflation but official perceptions of inflation. September headline stood at 0.1% year-over-year. It is expected to be steady in October. However, an under-appreciated source of downward pressure is coming from the sharp drop in interest rates. The central bank's underlying measure of inflation that uses fixed interest mortgage rates was at 1.0% in September and is expected to have ticked up to 1.1% in October. It is low, but how worrisome is it really?
Norway's challenge is growth, and there is no threat of deflation. The manufacturing PMI has been below 50 since May, and manufacturing output has fallen 3.5% in the first three months of this year. Headline inflation has averaged 2.1% year-over-year here in 2015, and this was the pace in September. It is thought to have quickened to 2.3% in October.
Norway's underlying rate, which excludes energy and taxes, has been accelerating. It stood at 3.1% in September and may have maintained this pace in October. It averaged 2.4% in 2014 and 2.6% in the first nine months of this year. A firm report could dampen ideas that Norges Bank could cut rates at its next meeting, which is not until the middle of December. However, the prospects of further ECB easing and data over the next month may be more important.
In explaining its decision to leave rates on hold, the Reserve Bank of Australia specifically cited the improvement in the labor market as a consideration. Australia's October labor report is out toward the end of the week ahead. September jobs report was poor. It lost a net 5.1k jobs and nearly 14k full-time positions. The October report is expected to be better. The Bloomberg consensus is for a 15k overall increase in jobs. There is no breakdown of full/part-time jobs. The three-month average is 17k. The three-month average of full-time jobs is 3.4k.
IV
When the Fed did not raise rates in September, it appeared to place emphasis on the unsettling developments in China. By numerous measures, the impulse from China does not appear as alarming. The yuan has strengthened against the dollar since late-August despite the warnings from a Nobel-prize winning economist that China had taken "only" one bite at the cherry. The dollar weakened by a little more than 2% against the yuan, although it has trended higher against most currencies during this period.
The Shanghai Composite has rallied by more than a quarter since the scary late-August lows. It finished last week with two consecutive closes above 3500, a key chart point from late August. On its way to the next major objective (4000), there may be some resistance in the 3740-3800 area. Officials signaled a collective sigh of relief by indicating that initial public offerings will resume before the end of the year.
One source of anxiety has been capital outflows from China. While we recognize that there have been outflows, we have argued that much of the talk in the market seems exaggerated because it has not taken into account three things: valuation swings, liberalization that allows corporates to hold on to foreign currency earnings, and possibly the seeding of other government arms, such as China's Development Bank.
Some of the capital outflows from China went back home to Hong Kong. These flows helped push the Hong Kong dollar to the upper end of its band. In October, the HKMA intervened by buying $11 bln, the most for any month in six years. A rate hike next month by the Fed will require the HKMA to follow suit. The HKMA may find that its work is cut out for it.
China reported its October reserve and trade figures over the weekend. Reserves rose by $11.4 bln, the first increase since April. Of what are thought to be its major exposures, the euro fell by 1.5% and the yen fell by 0.6%. Sterling rose by almost 2%, and both the Canadian and Australian dollars rose by about 1.8%. Yields rose over this period. Given the euro's decline and the rise in yields, we suspect that, if anything, valuation likely weighed on China's reserve figures.
The October trade surplus of $61.64 bln is a new record. The large surplus is one of the reasons why some economists do not think a large depreciation of the yuan is warranted, though the diverging trajectories of monetary policy suggests scope for some modest yuan depreciation, if market forces were given sway.
Ironically, the widening surplus is happening at the same time as exports and imports are falling. Exports fell 6.9% year-over-year in October, more than twice the pace that the consensus expected, and is the fourth consecutive decline. Imports fell 18.8% compared with the consensus forecast of a 16% decline. This follows the 20.4% decline in September. It is the 12th consecutive decline.
The sharp drop in commodity prices is giving China a positive terms of trade shock, which is the mirror image of the negative terms of trade shock that is hitting commodity producers. On top of that, China's domestic economy slowed, and officials are trying to transition the economy. Many developing countries are facing a double blow—the Federal Reserve is likely to raise rates and China's import appetite has faded.
China reports more data in days ahead. The inflation reports will garner much attention. Another tick down is expected. The rising specter of disinflation is likely to prompt the PBOC to cut rates and/reserve requirements if not later this year then early next.
Investors need to keep in mind the transition China is undertaking toward consumption and services when they review the new data, including retail sales, industrial output, and investment. One can get a sense that the transition is working if retail sales remain firm and industrial output and investment slow (on a trend basis). The transition also means that the Li Keqiang index, which enjoys widespread use by investors (railway cargo volume, electricity output, and loans disbursed as a better measure of China's growth) may be less revealing than it previously may have been.