Dollar Heavy into ECB

ECB European Central Bank

  • The euro’s recovery ahead of the ECB meeting seems to leave it vulnerable to a “buy the rumor, sell the fact” type of activity
  • Japan revised Q3 GDP growth unexpectedly lower
  • China reported its November trade figures
  • Italy’s political situation is far from clear; late yesterday, Moody’s cut the outlook on Italy’s credit rating to negative from stable
  • South Africa October manufacturing production came in much weaker than expected; Mexico reports November CPI

The dollar is broadly weaker against the majors ahead of the ECB decision. Kiwi and sterling are outperforming, while the Norwegian krone and the Aussie are underperforming. EM currencies are mostly firmer. KRW, TRY, and TWD are outperforming, while ZAR, PLN, and RUB are underperforming. MSCI Asia Pacific was up 1.5%, with the Nikkei rising 1.5%. MSCI EM is up 1.3%, even with Chinese markets falling 0.2%. Euro Stoxx 600 is up 0.3% near midday, while S&P futures are pointing to a lower open. The 10-year UST yield is up 3 bp at 2.37%. Commodity prices are mixed, with oil up 1%, copper down 1%, and gold up 0.2%.

The US dollar is trading lower against all the major currencies as the corrective forces continue to hold sway. The euro rose to nearly four-week highs in the European morning, briefly pushing through $1.08. With today’s gains, the euro has recouped 38.2% of the losses since the US election. Although we have suggested potential in this correction toward $1.0850, the next important retracement objective is a little above $1.09.

The euro’s recovery ahead of the ECB meeting, however, seems to leave it vulnerable to a buy the rumor, sell the fact type of activity. Perhaps the rumor is that Draghi has no important surprises to unveil. Nearly everyone is looking for an extension of the asset purchases, some operational adjustment to allow it to reduce the risks of scarcity, and some measures to make it securities lending program more user-friendly. Also fitting in with a pullback in the euro could be an increase in the US premium over Germany on two-year money for the first time in five sessions today. Initial support for the euro may be pegged in the $1.0740-$1.0760 area, with a break sending the single currency back toward $1.07.

There are three other developments that are on the radar screen of international investors today. First, Japan revised Q3 GDP growth unexpectedly lower to 0.3% rather than 0.5%, which reduces the annualized rate to 1.3% from 2.2%. Business spending and inventories drove the revisions, while the upticks in consumption were insufficient to do more than blunt some of the impacts. The GDP deflator was revised to minus 0.2% from minus 0.1%, leaving Japan as one of the few countries still experiencing deflation.

At the same time, Japan adopted the best practices in terms of GDP calculation (which other countries such as the US and many European countries have already done). Among other things, it means that research and development expenditures are counted as capital formation rather than an intermediate input. This means that at the end of last year, the Japanese economy was about 6.5% larger (JPY532.2 trillion instead of JPY500.6 trillion) than previously measured. The dollar held above its week’s low against the yen (~JPY112.90). A move now back above JPY113.60-JPY113.80 would likely help stabilize the dollar’s tone.

Second, China reported its November trade figures. The surplus was smaller than expected at $44.6 bln (compared with $49.06 bln in October). Both exports and imports rose. Exports rose for the first time in seven months on a year-over-year basis, even if just barely (0.1% in dollar terms). Imports rose 6.7%, the most in two years. Imports of copper, iron ore and coal rose. The impact on either the dollar-bloc currencies, like the Australian dollar or metal producers like the South African rand, has been muted.

Since the end of July 2015, the yuan has fallen 9.7% against the US dollar. This may help Chinese exports, especially as China continues to evolve away from simple assembly work and toward more value added. However, as many other countries have found, the linkage between currency valuation and exports is far from simple or straightforward. There is little substitute for stronger demand.

Third, Italy’s political situation is far from clear. A new government will be formed, and it still looks possible that Renzi, the head of the largest party, is a likely candidate. The state of the election law is problematic. The Constitutional Court will not review the electoral reforms for the lower chamber until January 24. There is no electoral law for the upper house. And there is no returning to the previous law, which was ruled unconstitutional.

Many are still talking about the referendum results as being anti-establishment. Some observers seem to think the Five Star Movement will be swept into power and call for an immediate referendum on EMU membership. Leave aside the fact that polls consistently show that the vast majority of Italians want the euro instead of a new lira; the Constitutional Court has ruled out referendums on international treaties.

Late yesterday, Moody’s cut the outlook on Italy’s credit rating to negative from stable. It is a Baa2 credit, according to Moody’s, which is two notches into investment grade. S&P has it lower at BBB- and Fitch has it a step higher at BBB+. A one step cut by Moody’s would have little consequence.

DBRS is the one to watch. It gives Italy an A rating. It is under review, which after postponing for the referendum, the agency will make a decision by early February. It previously was most concerned about growth but recognizes that recent developments are credit negative. The DBRS rating is important because the most optimistic rating agency is the one the ECB pays the most attention to in setting the haircut on collateral. If DBRS cuts Italy’s rating, the haircut will be larger.

The Financial Times lead story is that Italy has requested more time for Monte Paschi to complete its capital raising exercise, arguing that the referendum complicated matters. Meanwhile, Italian bank shares are gaining for the third session. It is up nearly 2% after yesterday’s almost 4.5% advance and Tuesday’s nearly 9% charge. Italy’s 10-year sovereign bond is underperforming with a six bp rise in yields. However, on two-year money, Italy is outperforming the core and other periphery countries today.

The US reports weekly initial jobless claims and Canada reports housing starts, permits, house prices and capacity utilization rates. These are not market moving reported, and the focus will be on the ECB.

South Africa October manufacturing production came in much weaker than expected, contracting -2.7% y/y. It was expected to rise 0.8% y/y after a flat reading in September. Q4 is starting off on a very soft note, and comes after a weak Q3 (when GDP grew at an annualized 0.2%). S&P maintained its BBB- rating with negative outlook last Friday, but we still expect an eventual cut to sub-investment grade by at least one of the agencies in the coming months. All the agencies have cited the lack of economic growth as a major factor behind potential downgrades.

Mexico reports November CPI, which is expected to rise 3.34% y/y vs. 3.06% in October. If so, this would be the highest since December 2014. While it is still within the 2-4% target range, we think Banco de Mexico will likely hike rates 50 bp at its next policy meeting December 15, especially if the Fed hikes December 14. The weak peso is apparently feeding into rising price pressures.