A Shift in Policy Tones

Highlights
The US dollar is retaining its new found firm tone.  Position adjusting ahead of next week’s key events continues to dominate, encouraged by the loss of the dollar’s downside momentum.  Softer Australian CPI (2.8% in Q3 from 3.1% in Q2 sent the Australian dollar down the most today, about 1.2% as rate hike ideas pulled back (scratched) or pushed out (into the future).  The Wall Street Journal story today about a more restrained QEII and the greater take down at the ECB’s 3-month refi operations (42.47 bln euros allotted vs expected of nearer 34 bln) helped support the firmer dollar tone.  Rising US yields and position-adjusting mode has seen the dollar rise to its best level against the yen since Oct 13, but offers near JPY82 seem formidable.  Initial support now is seen near JPY81.20-40.   The dollar is broadly higher against emerging market currencies today as well. 

Most Asian stocks fell, led by banks and brokerages, as the WSJ said the scale of the Fed’s asset purchases may be less than anticipated.  China’s stocks fell more than most with the Shanghai and Shenhzhen both down by more than 1%.  On the other hand, the Nikkei was up by 0.1% led by a gain in telecommunications and consumer goods.   But overall, the MSCI Asia Index was negative, falling by 1.2% in overnight trading.  In Europe stocks were little changed, albeit positive as shares gained on the news of mixed earnings and speculation of the Fed’s QEII.  The Stoxx 600 was down 0.06%, led by a nearly 1% loss in basic materials.  Meanwhile, stocks in the UK dropped, sending the FTSE 100 lower, as a fall in raw material prices weakened mining shares.

Greek bonds slid for a third day as Finance Minister George Papaconstantinou said tax revenue shortfall is stifling government’s efforts to lighten the deficit.  The declines pushed the yield on the 10-year bond up 45bp, the highest in more than three weeks.  Ahead of a report that is expected to see an uptick in CPI, German government bonds dropped with the yield on the 10-year up 6bp and the 2-year up 2bp.  Meanwhile, the rumors of lighter-than-expected QEII have pushed up the 10-year Treasury yields by 4bp, even though the 2-year is flat. 

Currency Markets

There a number of different forces at work today.  First, the Financial Times reports that there has been progress in talks between the US and China regarding current account deficits.   Since logic dictates that only a few economic variables can be targeted at a time, it is difficult to see what domestic variables would be or should be sacrificed to bring the external account, which is partly a function of growth differentials, into balance.  Color us skeptical of a real substantive quantitative agreement as opposed to some kind words about a shared objective.  Second,  WSJ reports about a lite-QEII plays into the recent heavier tone of US Treasuries, but in conjunction with the FT story, plays into pre-G20 talk of a deal between the US and China:  QEII lite in exchange for some yuan concessions, for which the external imbalance agreement might substitute.   It is noteworthy that the justification for QEII is not so much that the economy is headed for a double dip or that deflation looms.  Rather the argument is QEII is needed because the US economy is unlikely to grow above trend, which means limited progress in achieving full employment, and without greater resource use, the risks of deflation persist.  That speaks to the need for insurance (lite) not the lift support that has been discussed ($2-$4 trillion).   Third, QEII lite talk today offers contrast with the ECB’s activity.  While the ECB is still perceived to be aiming for the exit, today’s 3-month tender was (expiry Jan 27) was more than expected and this coupled with a somewhat disappointing money supply figures (M3 rose 1.0% in year-over-year in Sept after 1.1% in Aug and 1.3% consensus forecast) and slower loan growth (1.2% vs 1.4% expected) suggests more gradual process.   This saw euro rates ease. 

Another thing at work is the recent policy shift, following the weaker-than-expected Australian inflation numbers.  In fact q/q CPI rose 0.7% in Q3 versus Q2, a smaller than projected increase following the 0.6% gain in Q2. Y/Y CPI was 2.8% above the level in Q3 of 2009, also below expectations after the 3.1% y/y bit in Q2.  Moreover, core inflation measures were light and came in short of expectations.   Taken together, this is a notable slowing from the 3.1% y/y rate in Q2 and the average of the quoted figures appears to be inconsistent with the RBA’s recent CPI forecast.  In the October minutes the RBA stated that, “underlying inflation around 2.5-2.75% would be consistent with the central forecast scenario.”  Indeed, the tame total and core CPI figures for Q3 provide cover for the RBA to leave rates a steady 4.50% at next week’s meeting.  However, given the fact that global central banks have been pumping abundant liquidity, overall, it appears the RBA will most likely retain its tightening bias and we still see room for a hike next year.

Following the policy shift theme for the day, the BoE’s Bean says spare capacity within UK firms appear “relatively modest.”  This logic is in line with one of the banks more hawkish members, Sentance.  Of course, sounding less less dovish than his fellow MPC member Posen, Bean noted that indicators of capacity utilization drawn from business surveys and the limited rise in unemployment "suggest a far more modest margin of unused resources" than the output is now running almost 10% below potential. He noted, however, that "while judging the margin of spare capacity is always a problem for policy makers, it is particularly difficult at the current juncture because a banking crisis accompanied by a deep recession is likely to lead to some impairment of the economy’s supply capacity."  He feels that if demand were to pick up it would take relatively little adjustment to reinstate a higher level of production.  On the whole, this is another sign that the BoE is leaning on the hawkish side and may not be as open to continued stimulus as some had hoped, although this does not rule the possibility for stimulus next year as the inventory cycles wanes and output contracts following a the inception of the governments tough austerity measures. 

The Bank of Japan meets tomorrow.  While it is not expected to change policy after unexpectedly cutting rates earlier this month.  However, it will be in the BOJ’s new biannual outlook that the policy signal will be sent.  It is likely to lower its CPI forecast for FY11 to zero from 0.1% and more important, it may forecast a 0.5% CPI for FY2012.  The BOJ has defined price stability as 1% CPI.  If it does indeed forecast a CPI less than that for FY2012 would signal zero interest rate policy until FY2013.  Just like the SNB go more desired currency market reaction from its inflation forecasts than from its intervention, the BOJ may hoping for similar results. 

Upcoming Economic Releases

At 8:30 EST / 12:30 GMT the US reports September durable goods orders.  The market expects a favorable rise of 2% following a drop of 1.3% in August.  Next, the US reports new home sales which are expected to increase by 12k from the previous month which translates into a m/m increase of 4.2%.  Meanwhile, at 13:00 EST / 17:00 GMT Mexico’s central bank releases is 3Q inflation report.  And finally, the Fed’s Dudley speaks at 16:00 EST / 20:00 GMT.