QE will end, GDP growth expected at 3.0%, deflator at 1.4%
Drivers for the Week Ahead
– This will be a busy week between stress tests and data releases, which markets have taken as positively
– Market expectations have settled down, and the Fed is widely expected to announce the finish of QE
– Economic news for Europe has been mixed so far, with M3 improving by German IFO disappointing
– The initial impact of the Ukrainian and Brazilian elections will be local
Price action: The dollar is trading softer against the majors, but within very narrow ranges. The yen and the antipodeans are outperforming, while the Scandies are lagging. The euro is trading just below $1.27, while sterling is trading right around $1.61. Dollar/yen is lower on the day, back below 108 after earlier pushing up to near 108.40. EM currencies are mixed, with KRW outperforming and TRY and ZAR underperforming. BRL is expected to weaken when markets open, as Rousseff has won a second term. Brazil ETFs are down sharply in pre-market trading. MSCI Asia Pacific is up 0.6%, boosted by gains in Japan, Australia, and New Zealand. Euro Stoxx 600 is down 0.5% near midday, while S&P futures are pointing to a lower open.
- The week ahead is eventful. Investors will learn of the results of review and stress test of European banks. The Federal Reserve meets, as do three other central banks (Bank of Japan, Sweden’s Riksbank and the Reserve Bank of New Zealand). Important elections were held in Ukraine and Brazil over the weekend.
- In terms of data, the highlights include the first look at Q3 US GDP, a batch of Japanese reports, including the September CPI, and the preliminary eurozone October CPI and September money supply and credit figures. UK has mostly second tier reports, but mortgage approvals, which have been trending lower, may draw attention.
- Perhaps UK politics may overshadow economic news. It is not so much the EU’s 2.1 bln euro surcharge, after this follows directly from the upward revisions to the national income accounts that are so striking. Rather it is the Prime Minister’s surprise that is remarkable. The larger public sector borrowing requirement had weakened the electoral strategy of some fiscal gifts before next spring’s election.
- After some jitters around the middle of the month, market expectations have settled down, and the Fed is widely expected to announce the finish of QE. The part of the statement that was devoted to QE could largely be eliminated, and this will make for a shorter statement that may seem terse. Given our understanding of the way the Fed operates, with key core centrists (Yellen, Fischer, and Dudley) driving policy, the statement is their organ, more so than the minutes or dot-plot.
- We expect three key phrases of forward guidance to continue to be included. First, it will likely to continue to characterize the labor market has suffering from “significant under-utilization.” To be sure, developments are in the right direction, as reflected in the new cyclical low in the four-week average of weekly initial jobless claims. Further improvement in the broader labor conditions is possible likely.
- Second, the statement will likely continue to identify a “considerable period” between the end of QE and the first rate. The phrase has lost whatever precision investors projected. However, we can agree that considerable period does not mean the next meeting. Nor does it mean the meeting two years hence either.
- Third, at the end of the statement, there is a reference to the expectation that this monetary cycle will be of smaller amplitude than past cycles. That is to say that the peak in the federal funds rate will likely be lower. The statement recognizes that even when the Fed’s mandates are approached, the federal funds target may be lower than what is regarded as its long-term equilibrium level.
- In addition to these words, investors will scrutinize how the Fed characterizes inflation. Recall that in September, the FOMC had dropped the reference to the risk of core inflation being persistently below target. It would seem awkward to simply bring it back. It could refer to the breakdown in market-based measures of inflation expectations, but could also note that it has not been confirmed in other measures.
- The US economy is expected to have expanded by a 3.0% annualized rate in Q3. The preliminary estimate is subject to statistically significant revisions. That said, we think investors should note the composition of growth. Consumption is likely to be softer while business and residential investment and foreign demand (net exports) may have improved.
- The core PCE deflator is expected to have fallen from 2.0% in Q2 to 1.4% in Q3. This is not a cause for alarm. The 2.0% print was the outlier. The average has been 1.4-1.5% for the past 4, 8 and 12 quarters.
- The BOJ issues its monetary policy statement next week amid speculation that it will use its semi-annual outlook report to acknowledge that its self-imposed 2% core inflation target, excluding the sales tax, is unlikely to be met. Some observers think this will be reflected in projections of even larger increase in the monetary base. The current pace is around JPY70 trln a year.
- The current pace is already posing some technical hurdles in the implementation. It could take the ECB’s approach, and find other assets to buy, but it is already buying a wide range of assets, including corporate bonds, ETFs, and REITs. Or it could extend the duration of the QQE. To wit: “Even after inflation has achieved its target, the QQE operations may persist for a considerable period.”
- The data points from Japan are unlikely to be helpful. With exports increasing, it ought not to be surprising if industrial output recovers. However, overall household spending is not. Inflation itself likely softened in September, while Tokyo’s October reading will suggest no turnaround this month either. Still, there is some hope that the decline in the yen will do for the BOJ what its asset purchases are struggling to do–reignite inflation.
- The EBA released the stress tests results. Disappointingly and dishearteningly, even if not totally unexpected, much of the general results of the Asset Quality Review and stress tests appear to have been leaked before the weekend. As leaked, the EBA found that 24 of the 123 banks (covering 70% of total EU banking assets) failed to maintain sufficient capital ratios under adverse conditions tested. Ten banks have already plugged the gap. That leaves 14 banks to raise about 9.5 bln euros within the next nine months. The officially preferred way is to tap the capital markets. This effectively dilutes existing shareholders and creditors. The alternative is to reduce the balance sheet. Some combination of the two is likely.
- Overall, officials will require banks to adjust the valuation of their assets by 48 bln euros. Italian banks appear to account for a quarter of this. Greek banks will adjust their valuations by 7.6 bln euros, German banks by 6.7 bln, and French banks by 5.6 bln euros. This is the result of reclassifying 136 bln euros of loans as non-performing. One of the important achieves is a standardized definition of non-performing loans, which is essential for a single regulatory system. Bad loans in the eurozone banking system are now estimated to be 829 bln euros.
- The market seems, for the most part, pleasantly disposed. Even though EU stocks are lower this morning, the banking-sector shares are holding up OK. The amount of capital that must be raised overall seems modest, and to get past the event risk with no significant surprises is also important.
- Meanwhile, on the data front, news for Europe has been mixed so far. Money supply (M3) for September improved by more than expected, growing 2.5% y/y against consensus for 2.2%. This is the highest level since mid-2013. The contraction in credit is likely to have continued to slow. At the end of the week, the ECB will report preliminary October inflation. It is expected to tick up to 0.4-0.5% from 0.3%. German IFO disappointed in all three subcategories. The business climate fell to 103.2 (exp. 104.5), the current expectations section fell to 108.3 (exp. 110.0) and the expectations component fell to 98.3 (exp. 99.2).
- Briefly turning to the two other central banks that meet, the market has largely discounted a 20 bp cut in the Swedish repo rate that would bring it to 5 bp. The Swedish krona has under-performed in the recent sessions as the markets priced it in. Last week, it lost 1% against the US dollar, which made it the second worst performing major currency behind the Japanese yen.
- The Reserve Bank of New Zealand will most likely leave rates on hold (3.5% cash rate) but may tone down its forward guidance on rates. On a trade-weighted basis, the New Zealand dollar has appreciated in October (3%) before selling off in the second half of last week. A break of $0.7800 is needed to sustain the downside momentum against the US dollar.
- The initial impact of the Ukrainian and Brazilian elections will be local. In Brazil’s case, Dilma went into the polls with some momentum and secured her victory. ETFs trading in the UK markets suggest that Bovespa will be down around 10% in the open. In Ukraine, the pro-Europe party swept the elections. But the situation is far from resolved, and there is much the new government could do to antagonize Putin. Political naiveté could be as dangerous as Machiavellian tactics. The sanctions are biting, though, of course; they offer no coup-de-grace. The drop in oil prices, which may in part be the House of Saud’s expression of displeasure with Putin’s support of Assad in Syria, is aggravating the economic pressure on Russia.