Fiscal Deadlock/China data

This week kicked off with a heavy China’s Sep data slate and Q3 GDP today.  The data releases were positive, revealing yet more signs of strengthening recovery. Industrial production, retail sales, jobs and property investment all beat expectations while Q3 GDP fell short. The data supports the view that China will be one of the only major economies to record positive growth this year. This bodes well for China’s markets and will likely also filter into improving prospects for the rest of Asia.

In contrast US recovery continues to be at risk, with fiscal stimulus discussions remaining deadlocked; a 75-minute conversation between House Speaker Pelosi and Treasury Secretary Mnuchin yielded no progress at the end of last week.  Pelosi has now given a 48-hour deadline to agree on stimulus while Senate majority leader McConnell has scheduled a Senate vote on a more targeted $500bn bill tomorrow. Talks are scheduled to continue today but there still seems to be little chance of a deal this side of elections. 

On the data front, US Sep retail sales data registered broad-based gains on Friday, with headline sales up 1.9% m/m (consensus 0.8%). In contrast, industrial production fell a sharp 0.6% m/m in Sep (consensus +0.5%).  Lastly, Michigan consumer sentiment rose in the preliminary Oct report to 81.2 from 80.4 in Sep (consensus 80.5).  The lack of a fiscal deal means that the prospects of a loss of momentum in the US economy has grown, something that will become more apparent in the weeks ahead. US data is limited this week and instead focus will remain on progress or lack thereof, on fiscal stimulus as well as the Presidential debate towards the end of the week. 

Another saga that is showing little progress is EU/UK Brexit transition talks.  The stakes have risen, with UK PM Johnson warning UK businesses to prepare for a hard exit while threatening to abandon talks completely.  On a more positive note UK officials are reportedly prepared to rewrite the contentious Internal Market Bill, which may appease the EU.  Credit ratings agencies are running out patience however, with Moody’s downgrading the UK ratings by one notch to Aa3. The pound seems to be taking all of this in it stride, clinging to the 1.30 level against the US dollar, suggesting that FX markets are not yet panicking about the prospects of a no deal transition.

Several emerging markets central banks are in focus this week including in China (Tue), Hungary (Tue), Turkey (Thu), and Russia (Fri).  Of these Turkey is expected to hike by 150 basis points, but the rest are likely to stand pat.  Most central banks are taking a wait and see approach, especially ahead of US elections. Reserve Bank of Australia meeting minutes tomorrow will garner attention too, with clues sought on a potential rate cut next month.  

Euphoria fades, risk currencies weaker

The euphoria emanating from last week’s eurozone agreement will likely fade into this week as renewed doubts creep in. Details of how the EFSF bailout fund will be leveraged or how the special purpose vehicle will be utilised have yet to emerge while the firewall to protect countries such as Italy and Spain may still be insufficient given that the use of the European Central Bank (ECB) to provide unlimited support has been ruled out.

With more questions than answers markets will be hungry for further details over coming weeks and until then it is difficult to see risk appetite stretching too far. One indication of such concern was the fact that Italy’s borrowing costs climbed to euro-era highs the day after the European Union (EU) plan was agreed. The G20 meeting on 3-4 November will be eyed for further developments as well as further reaction to the EU agreement.

There are plenty of events to digest this week that could add to any market nervousness. In terms of central banks we do not expect to see any change in policy stance from the ECB, Federal Reserve or Reserve Bank of Australia (RBA) this week but the decisions may be close calls. The ECB under the helm of new President Draghi will be under pressure to ease policy as growth momentum has clearly weakened but the Bank will likely hold off for the December meeting when new growth and inflation forecasts will be released.

The RBA may also take some solace from a better global economic and market climate but the market disagrees having priced in a cut this week. The Fed will look to see how ‘Operation Twist” is faring before moving again but recent indications from some Fed officials suggest growing support for purchases of mortgage backed securities.

On the data front eurozone inflation today will be the key number in Europe while the US jobs report at the end of the week will be the main release in the US. Ahead of the payrolls data, clues will be garnered from the ISM manufacturing data and ADP jobs report. The consensus is for a 95k increase in non-farm payrolls and the unemployment to remain at 9.1% maintaining the trend of only gradual improvement in the US jobs market.

Recent data releases have turned less negative, however, and at the least have helped to alleviate renewed recessionary concerns. Overall, I suspect that markets will come back down to the reality of slow growth and unanswered questions this week, with risk assets likely to lose steam over coming days.

Euro still looks uglier than the dollar

Currency markets continue to vacillate between US debt ceiling concerns and eurozone peripheral debt worries. Despite a lack of agreement to raise the debt ceiling, with House Republicans failing to back a proposal by House speak Boehner, the USD actually strengthened towards the end of the week as eurozone peripheral issues shifted back into focus.

The resilience of the USD to the lack of progress in raising the debt ceiling is impressive and reveals that the EUR looks even uglier than the USD, in many investors’ eyes.

Much in terms of direction for the week ahead will depend on the magnitude of any increase in the debt ceiling and accompanying budget deficit reduction measures. Assuming that a deal is reached ahead of the August 2 deadline it is not obvious that the USD and risk currencies will enjoy a rally unless the debt ceiling deal is a solid and significant one.

Given the limited market follow through following the recent deal to provide Greece with a second bailout, the EUR remains wholly unable to capitalise on the USD’s woes.

A reminder that all is not rosy was the fact that Moody’s ratings agency placed Spain’s credit ratings on review for possible downgrade while reports that the Spanish parliament will be dissolved on September 26 for early elections on November 20 will hardly help sentiment for the EUR. Compounding the Spanish news doubts that the EFSF bailout fund will be ready to lend to Greece by the next tranche deadline in mid-September and whether Spain and Italy will participate, have grown.

Some key data releases and events will also likely to garner FX market attention, with attention likely to revert to central bank decisions including the Bank of Japan, European Central Bank, Bank of England, Reserve Bank of Australia and US July jobs report. None of the central banks are likely to shift policy rates, however.

The risk for the USD this week is not only that there is disappointing result to the debt ceiling discussions, but also that there is a weak outcome to the US July jobs report. An increase of around 100k in payrolls, with the unemployment rate remaining at 9.2%, will fixate market attention on weak growth and if this increases expectations for a fresh round of Fed asset purchases the USD could be left rather vulnerable.

The RBA is highly unlikely to raise interest rates but the tone of the accompanying statement is unlikely to be dovish. The RBA noted the strong emphasis on the Q2 CPI inflation data and in the event it came in higher than expected, a fact that supports my expectation that the Bank will hike policy rates at least once more by the end of this year.

Markets have largely priced out expectations of a rate cut but there is still scope for a more hawkish shift in Australian interest rate markets, which will give the AUD a boost. However, AUD remains vulnerable to developments in the US and Europe as well as overall risk aversion, and a preferable way to play a positive AUD view in the current environment is via the NZD.

EUR higher but resistance looms

EUR and risk currencies in general were buoyed by the passage of the austerity bill in the Greek parliament. The implementation bill is also likely to be passed later today opening the door for the disbursement of EUR 12 billion from the European Union / IMF from the EUR 110 bailout agreed for the country. Combined with news that German banks are progressing towards agreeing on a mechanism to roll over Greek debt alongside French banks as well as likelihood of an European Central Bank (ECB) rate hike next week, the EUR is set to remain supported over the short term.

Nonetheless, it once again looks as though a lot of good news is priced in and it would be surprising if EUR/USD could extend to above strong resistance around 1.4557 given the many uncertainties ahead, not the least of which includes the stance of ratings agencies on any Greek debt rollover.

USD/JPY is the only major currency pair that is correlated with bond yield differentials at present (2-year yields) and therefore it should not come as a surprise that USD/JPY has moved higher as the yield differential between the US and Japan has widened by around 10bps over the past week. Indeed, yesterday’s move above 81.00 was spurred by the move in yield differentials although once again the currency pair failed to build sufficient momentum to close above this level.

Further gains will require US bond yields to move even higher relative to Japan but perhaps the end of QE2 today may mark a turning point for US bond markets and currencies. The end of QE2 taken together with a jump in bond supply over coming months, will see US Treasury yields will move sharply higher, implying much more upside for USD/JPY.

AUD has bounced back smartly over recent days, with the currency eyeing resistance around 1.0775 versus USD. A general improvement in risk appetite has given the currency some support but markets will be unwilling to push the currency much higher ahead of the Reserve Bank of Australia (RBA) meeting next week. On the plus side, there are no rate hikes priced in for Australia over the remainder of the year, suggesting an asymmetric risk to next week’s meeting.

In other words, unless the RBA openly discusses rate cuts in the statement, the AUD will likely remain supported. Conversely any indication that a rate hike may be in prospect will be AUD supportive. In any case we continue to believe the AUD offers better value especially relative to NZD and maintain our trade idea to buy AUD/NZD.

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