- In Italy, as the polls had consistently shown, the referendum to reduce the size and power of the Senate was easily rejected
- The big event ahead of next week’s FOMC meeting is this week’s ECB meeting
- UK Supreme Court hears the government’s appeal of the Constitutional Court ruling that protected Parliament’s authority to trigger Article 50
- Outside of Europe, the RBA and the BOC hold policy-making meetings
- EM retains a soft tone, and country risk still matters
The dollar is mostly firmer against the majors in the wake of the Italian referendum. The Scandies are outperforming, while Kiwi and the yen are underperforming. EM currencies are mostly softer. IDR, BRL, and RUB are outperforming, while TRY, ZAR, and SGD are underperforming. MSCI Asia Pacific was down 0.8%, with the Nikkei falling 0.8%. MSCI EM is down 0.1%, with Chinese markets falling 1.7%. Euro Stoxx 600 is up 1% near midday, while S&P futures are pointing to a higher open. The 10-year UST yield is up 3 bp at 2.41%. Commodity prices are mostly higher, with Brent oil up 1.3%, copper up 1.5%, and gold down 1%.
After softening ahead of the weekend, the US dollar has begun the new week on firm note. It is gaining against most major and emerging market currencies. Outside of what appears to be a staged call between US President Elect Trump and the Taiwanese President, the developments in Europe grabbed the markets’ attention. Austria turned back the populist right Freedom Party’s bid for the presidency. The Freedom Party does not appear to have carried any districts.
In Italy, as the polls had consistently shown, the referendum to reduce the size and power of the Senate was easily rejected. Prime Minister Renzi has indicated plans to submit his resignation. Finance Minister Padoan, who canceled his plan to attend the EU finance ministers’ meeting that begins today, is seen as a potential caretaker.
Reforms for the lower chamber are pending judicial review. Parliamentary elections are slated for 2018. It may come sooner, but it is not imminent. Polls suggest that if an election were held today under the new electoral rules, the 5-Star Movement would win in the second round. At the same time, polls suggest that there is not much appetite (about one in seven) in Italy to leave the EMU. That said, we are hesitant to see the rejection of the referendum as part of an anti-establishment revolt. For sure, there was an element of that, but it does not do justice to the widespread opposition included Monti, for example, and members of Renzi’s own party.
The euro initially was marked down in early Asia to almost $1.05. It recorded a new 20-month low. By early European turnover the Europe had returned to unchanged levels near $1.0665 before consolidating. Italy’s 10-year yield is jumping nearly 10 bp. From a week ago the yield is still off 7 bp. The two-year yield is flat, while German, French, and Spain’s two-year yields are a basis point higher.
Italy’s stock market is above 0.3% higher, a laggard within Europe today. Italian bank shares are off 1.25% after gaining almost 5.2% last week. Recall that Monte Paschi is in the middle of a 5 bln euro capital raising exercise. The Dow Jones Stoxx 600 is about 1% higher in late-morning dealings. Financials are matching the market’s performance.
There were significant moves in interest rates and currencies last month. The drama was primarily spurred by the solidification of expectations of a Fed hike in the middle of this month and the stimulus promised by President-elect Trump.
After years of falling budget deficits, the prospect for fiscal stimulus by the new President may have forced up long-term yields in any event. However, the prospect of stimulus while the US economy enjoys trend growth and full employment is a different matter. The incoming president has promised a package which, as a percentage of GDP, appears to rival the 2009 stimulus when the US economy was in the throes of a deep economic downturn. This in turn implies a greater demand for capital than the 1.80% yield on the US 10-year Treasury that prevailed before the election reflected. Part of the increase in yields is due to an increase in the inflation premia, and part of it reflects an increase in the real cost of capital.
At the same time, evidence has accumulated indicating that the inventory and manufacturing-led economic soft patch has been overcome. Business investment also appears to have bottomed, and the recession in corporate profits has eased. There is little doubt that the Fed will hike rates for the second time in the cycle in a couple of weeks. The rise in US yields at both ends of the helped drive a sharp widening of the interest rate differentials.
These developments have helped fuel a strong dollar rally. The Federal Reserve’s real broad trade-weighted index, which is the best measure used to assess economic impact, rose by almost 2.3%, just edging out the January rise, to be the biggest advance to Lehman failed. The yen was the weakest of the major currencies, depreciating by 8.4%. The euro lost 3.6%. The Canadian dollar fared better than most, losing only 0.2%, underscoring one of our rules of thumb: in a strong US dollar environment, the Canadian dollar typically outperforms on the crosses.
The table is set. Fed officials will draw confidence from the drops in the unemployment and underemployment rates, and the continued solid (even if not spectacular) job growth. Average hourly earnings disappointed, but the trend has been good, and many will expect more wage pressure going forward. The economic calendar turns light in the week ahead. There are several Fed officials who speak before the cone of silence is invoked ahead of the FOMC meeting. Separately, with the announcement of the Treasury and Commerce Secretary nominees, non-economic news is likely to dominate in the days ahead.
After this weekend, many observers will turn to France. Le Pen is widely expected to make it into the second round after no candidate gets 50% in the first round and the top two compete in a run-off. The center-right Republicans have sent into retirement Sarkozy and Juppe again, and have gone for a self-described French Thatcher. That is radical in France. The Socialists will have their primary next month. Hollande indicated he would not seek re-election, leaving the right-wing of the party, whose policies are not so dissimilar from some French Republicans, to take the mantle.
In the past, when faced with a potent challenge from the National Front, the main two political parties find common ground. This seems like the most likely scenario again. Before France, the Dutch go to the polls. It is considerably more likely that the populist-nationalist forces serve, and possibly lead the next government than in France.
The big event ahead of next week’s FOMC meeting is this week’s ECB meeting. This is a live meeting in the sense that policy announcements are expected to be forthcoming. What is at stake is not interest rates. The deposit rate will likely remain at minus 40 bp. Instead, decisions are needed about its asset purchases.
First is extending the program past the current soft end-of-March time frame. Most are focusing on a six-month extension, mostly on the basis that that was the length of time of the previous extension. The challenge here may be to do it in a way that makes it clear that it is not an open-ended program. There are many ways that this can be achieved, and verbally by Draghi is one such way. There is some speculation that the ECB could scale back the amount of monthly purchases (currently 80 bln euros). If this does materialize, we suspect it may be an operational tweak in the covered bond purchases.
Second is adjusting the decision-making rules about the purchases. The capital key, which is currently being used, is based on the relative size of the economy so that the larger the economy, the greater amount of bonds the Euro-system buys. This is an important principle and one that is most unlikely to be jettisoned as some have suggested. Instead, we suspect the ECB can modify some of its own rules, like the individual issue cap. The ECB may also apply the minus 40 bp floor on the portfolio level rather than the individual security level, and this too would overcome or minimize the scarcity operational challenge.
Third is measures relating to the securities lending program to address the stress in the repo market. The idea here is that when the ECB buys securities, it not only removes the securities as an investment vehicle but also as collateral. The ECB and the national central banks have securities lending programs, but they are not particularly user-friendly. There has been some speculation that the ECB will take measures to improve its ability to provide the securities it buys back to the market.
Final Eurozone PMI readings for November were reported. The headline Eurozone services and composite PMIs came in weaker than expected and fell to 53.8 and 53.9, respectively. The country breakdown was mixed. Spain and Italy were better than expected, while France and Germany were weaker than expected.
Turning to the UK, its Supreme Court hears the government’s appeal of the Constitutional Court ruling that protected Parliament’s authority to trigger Article 50. A decision is not expected until the middle of next month. Many expect it to uphold the Constitutional Court’s decision. This is important for the markets because Parliamentary involvement is associated with a soft Brexit rather than a hard one. And a soft Brexit is seen as sterling positive. Moreover, it may delay the triggering of Article 50 by three or four months. Still, through the cacophony, it appears that on balance, access to the single market is possible, at a price.
Last month, sterling was the only major currency to appreciate against the dollar (~2.15%). Sterling’s gains came despite the fact that interest rate differentials moved dramatically against it. The US premium on 2-year paper rose from 58 bp at the end of October to a little above 100 bp before the end of November. It is the most in at least a quarter of a century. UK November services and composite PMIs came in stronger than expected and both rose to 55.2.
Many argue that the resilience of the UK economy shows that those favoring Brexit were right and the economic risks were exaggerated by the Remainers. However, the sterling’s decline was a shot in the arm, a dramatic one-off devaluation. Against the dollar, sterling has fallen by about 17%, and on a broad trade-weighted index, it is off by about 10%. The currency depreciation, coupled with the low interest rate loans by the Bank of England’s rate cut and the resumption of its asset purchases, mean that the UK economy got a large dose of monetary stimulation.
Lastly, outside of Europe, the Reserve Bank of Australia and the Bank of Canada hold policy-making meetings. Both are most likely to leave policy on hold. The strengthening of the US economy (the Atlanta and NY Fed models have the economy tracking 2.7% here in Q4) and rally in oil prices buy Canada time. And it needs that time. It has lost full time jobs this year (~25k). The 3.5% annualized growth in Q3 was largely driven by the recovery from the disruption from the earlier fires.
The RBA is on hold, but many continue to look for a rate cut next year. The rise in metal prices and the apparent stabilization of the Chinese economy are helpful. China releases a host of data this week, including reserves, trade, and inflation. The broad picture is unlikely to change. China continues to experience capital outflows. The trade surplus remains large though the value imports and exports are lower than a year ago. Its trade surplus with the US has eased a little this year from a record last year. Consumer inflation continues to hover a little above 2%, while producer prices are beginning to get traction after an extended period of deflation.
The day after the RBA meeting, Australia will report Q3 GDP. It is expected to have slowed to 0.2% in the quarter from 0.5%, while the year-over-year pace eases to 2.5% from 3.3%. The year-over-year pace is will likely fall to near 2.0% here in Q4. It’s worth noting that Kiwi is being sold on the unexpected resignation of New Zealand Prime Minister Key over the weekend.
EM is starting the week off on a soft note. Despite the negative connotations of a rising US rate environment, EM gathered an element of stability last week as the market consolidated the recent dollar gains. Rising commodity prices are also helping EM at the margin, with RUB and COP amongst the best last week on higher oil and CLP on higher copper.
Yet EM country risk still matters. BRL and TRY were amongst the worst EM performers last week due to negative political risk. On the other hand, ZAR was amongst the best due to perceived positive political developments (prospects of a Zuma exit and S&P maintaining its BBB- rating). CNY bears watching in light of potential tensions with President-elect Trump. We think divergences will continue within EM, but that the asset class as a whole is likely to remain under pressure well into next year.