A Tale of Two Speeches

BBH CurrencyView

• Dollar continues to firm amid choppy market conditions; US futures point to modest decline
• President Obama announces bigger package than expected; fiscal stimulus may be USD supportive
• China’s CPI report shows that inflation has likely peaked; Mexico’s minutes may mark a dovish shift

A tumultuous market environment continues to support the US dollar. Equity markets remain pressured at the end of a tumultuous weak after the unchanged ECB and BoE decisions and the Obama and Bernanke speeches all confirmed a weaker global backdrop but failed short of backstopping market cyclical and structural concerns. The Euro Stoxx 50 is down 1.3%, led by a 2.8% loss in financials and a 1.9% drop in industrials. This is leading US equity futures lower into the open, with the S&P 500 down 3pts to 1177, not far from last Friday’s closing level of 1163. German 10yr yields reached a new record low of 1.81%, while peripheral bonds are trading weaker with Italian-German 10yr yield spreads widening to 354bps from 335bps ahead of the ECB’s policy meeting and Spanish 10yr yields up to 931bps from 907bps on the same basis. Meanwhile, Canada’s employment growth came in below expectations, supporting the shift in tone from the BoC.

US President Obama presented a larger jobs package than originally expected, with the core of the package relying heavily on tax cuts rather than direct government spending. Indeed, the President also indicated that the package is likely to be paid for by spending cuts recommended by the administration’s fiscal committee, which is likely in part to garner support of fiscal hawks given that the package is unlikely to alter the deficit. What’s more, the approval of this fiscal package could more than offset the expected fiscal cuts that are in the pipeline for 2012 and potentially add 2% to growth based on preliminary estimates. In terms of the dollar, this package over the medium term is likely to be more supportive of a stronger dollar than the current mix of monetary and fiscal policy. For one thing, based a theoretical macroeconomic perspective in a world of highly mobile capital the current policy mix in the US of loose monetary and (expected) restrictive fiscal is an extremely bearish mix for the currency. Arguably, in a world of highly mobile capital this policy mix is unlikely to be considered an attractive investment destination due to its low interest rate environment and weak economic output potential. In fact, loose monetary policy reduces interest rates relative to other countries, supporting investment by reserve managers and other investment managers into higher-yielding currencies, while tighter fiscal policy is expected to decrease domestic economic activity and in turn reduce the attractiveness of investments. That said, one direct implication of his package on the outlook for the dollar would be to remove some of the burden from the Federal Reserve and in time potentially reducing the need for more aggressive monetary policy actions. Notwithstanding the potential for interest rates to remain on hold until 2013, more direct fiscal support and less need for QE3 would, in theory, be more supportive of a strong USD. On balance, there are many obstacles to this package becoming law but on the face of it a potential shift in policy mix would be fundamentally more supportive for the USD and also likely to buoy demand for the growth sensitive currencies.

China’s CPI report, as expected, came in at 6.2%, while PPI was slightly higher than expectations at 7.3% (although CPI is likely to remain above the government’s 4% target for several more months). To us, the market print appears to confirm our view that Chinese inflation is likely to have peaked and looking ahead we are unlikely to see further interest hikes in 2011 from the PBOC. Indeed, PBoC adviser Li Daokui said inflation has nearly peaked, but the Bank still needs to extend its "prudent" monetary policy. In addition, the China Daily said that PBoC policy may be close to an inflection point after 11-months of tightening and it could start to pull back from aggressive policy moves. And while we expect the inflation rate to gradually decline in the coming months, we continue to believe that the tightening measures pursued by the PBOC are unlikely to trigger a hard landing. Instead, Chinese financial conditions have only tightened marginally after this recent bout of rate increases and therefore we still expect to the economy to grow at or above its potential over the coming months. What’s more, we think the PBoC will maintain its anti-inflation bias until it feels comfortable with the pace of inflation (driven in part by food prices) and thus expect the policy channel to continue to shift from interest rate to a stronger FX rate. Elsewhere, we expect the release of Mexico’s central bank policy minutes this morning to confirm a more neutral tone from the central bank, which is likely to pave the way for a rate cut down the road. In fact, the overnight OIS rate has nearly 50bps priced into the policy rate ahead of the October meeting. Thus, looking ahead we expect the Mexican central bank to shift to a more dovish posture in line with some of the other EM central banks, such as Brazil.