Thoughts on Hump Day

Investors continue to wrestle with the implications of the Federal Reserve's decision last week not to taper. What is being generally overlooked is that a full third of the market, according to various polls, did not expect the Fed to taper.  

Many journalists were surprised, and this seems to be coloring their coverage. For example, just yesterday Financial Times reporters wrote, "To a man, Wall Street's best strategists were caught out by the Federal Reserve's decision not to curb its emergency asset buying." Substitute strategists with reporters and the assessment may be fairer.

While US 10-year yields have continued to move lower and are now at their lowest level since mid-August, equities have stalled, with the S&P 500, the only major stock market that is actually lower, albeit slightly (~0.4%) over the past week. The dollar itself has risen against all the major currencies since the immediate reaction to the Fed's announcement. Soft soft economic data, the drop in oil prices (a little more than 1% over the past week) and a good reception to the US 2-year auction may have helped weigh on yields. The price of gold is off nearly 3%.

The price action is also noteworthy because of the fiscal brinkmanship that is once again being played out in the US Congress and the dysfunctional fiscal process.  Traditionally, the US Congress approves 12 appropriation bills to fund the government.   However, this process has broken down in recent years and stop gap measures the resort.  Hence the continuing resolutions.  The last one was passed at the end of March and was good for six months.  

Since 1976, there have been seventeen different government shutdowns.  The longest was in 1995-1996 and lasted three weeks.  There were six shutdowns in the 1970s and all last more than a week.  The shutdown in 1982 lasted a single day.  Foreign exchange prices have many determinants and it is difficult find an overall pattern, but we do note that the dollar tended to strengthen in the 1995-1996 government closure period.  

What makes the current situation seem so intractable is that the leadership of both parties seem to have limited influence over the rank-and-file.  This makes a deal more difficult to achieve.  Various polls show that while voters may not be enthusiastic supporters of the Affordable Care Act, they do not want to see a closure of the government over its funding.   The voters' distaste for the macabre political posturing may ultimately force the belligerents to reach a deal, with an eye.  

The debt ceiling is a separate issue from the continuing resolution.   The latter is about authorizing spending, while the former is about borrowing to pay for spending that had been previously been authorized.    The debt ceiling is expected to be hit some time in mid- to late-October.  Although one would hope that the elected representative would reach an agreement that would resolve both issues, the lack of effective leadership warns that this may not be possible.  

The US reports August durable goods orders.  Given the decline in airplane orders that has already been announced, the risk to the consensus forecast of a 0.2% decline is to the downside.  August new home sales will also be reported.  Recall that July saw a sharp 13.4% decline, the largest in three years.  Rising rates was seen as the most important driver.  Mortgage rates did not peak until late August/early September, though the consensus expects that about half the July decline was recouped in August.    

The Federal Reserve cited the rise in mortgage rates as a consideration for its decision not to taper.   Some blame the Fed itself for the increase in mortgage rates with its talk about tapering.  While surely the talk played a role, we suspect the Fed was as surprised as anyone that the talk of reducing the pace of accommodation, would see mortgage rates rise from around 3.35% in early May to nearly 4.60% by late August.  

Meanwhile, the fiscal drama keeps the focus on the US.  The past weekend German election, though an impressive victory for Merkel has not yielded a majority, and the process of finding a partner has historically taken several weeks.   This, coupled with the largely second tier economic releases this week, is helping to prevent the focus shifting away from the US.  Our instinct to sell the euro after the Fed-disappointment bounce, which we had outlined, has thus far been the right call, but the satisfaction has been limited, though the single currency did make a new five day low earlier today.  In fact, a move back above the $1.3520 area now would likely point to another leg up.  

The antipodeans have been under performing in recent days and the unexpected and marked deterioration in the New Zealand August trade balance (it reported a NZ$1.19 bln deficit, roughly 50% larger than the consensus expectation of NZ$700 mln and the July shortfall of NZ$774 mln), on the back of slumping exports (and imports) has provided incentive to extend yesterday's decline.  While New Zealand is expected to hike rates in the early part of 2014, the market appeared to exaggerate the aggressiveness of the central bank, pricing in another two hikes for next year, and leaving the currency vulnerable.  The Aussie's push above $0.9500 last week seems like a distant memory.  With today's losses it has completely retraced the post-Fed's gains.  Technically, there looks to be scope for another cent decline toward $0.9250.  

The dollar is soft against the yen, perhaps reflecting the continued decline in the greenback's interest rate support.  The dollar is likely to find support ahead of the JPY97.80-JPY98.00 area.  Earlier Japan reported that August corporate service prices rose 0.8% (year-over-year), which beat expectations and the July rise of 0.4% was revised to 0.6%  The August increase is the fourth consecutive rise and reinforces the sense the deflationary forces are being beat back.   The next focus is next week's Tankan survey, which is seen as the last remain hurdle before the formal decision to implement the retail sales tax hike.  

Separately, there is increasing pressure from the US Congress to include a section on currencies in the Trans-Pacific Partnership trade agreement.  Several key US industries apparently are dissatisfied with the weakness of the yen.  That said, we note that US auto makers are profitable and Japanese companies, including the auto makers, build product in the US (and some even export).  The biggest competition the US auto makers face is not from Tokyo, but from the "transplants" in the US.    That said, we have anticipated a political push back against the weak yen leg of Abenomics and this could be only the tip as European producers have yet to weigh in.