Thursday's Drivers

The US dollar appears somewhat firmer today, but is in fact consolidating.  Against most of the major and emerging market currencies, it remains largely confined to yesterday's ranges.  The downside momentum that had threatened to build has dissipated.  

One of our thematic points was that the next leg up for the dollar might be more driven by negative developments abroad than positive developments in the US.   Yet the wrangling over the federal government's spending authorization (continuing resolution) and the debt ceiling has distracted market participants from deteriorating situation in the euro area.  

However, the percolating political developments in Italy and continued contraction in private sector lending in the euro area appears to have helped stall the euro's advance.   Specifically, Berlusconi's allies in parliament have reaffirmed their willingness to resign and trigger a political crisis, if the center-left votes next week to oust the former prime minister from the Senate.  The full Senate vote is currently set for next Friday, October 4.  A delay is possible.  

Meanwhile, recall that by October 15, Berlusconi has to decide whether to accept a one year jail term (unlikely) or do community service for being found guilty of tax evasion.  The tax evasion conviction is seen by many in Italy, judging from the local press, as a bit of a badge of honor.  Moreover, it fits into the narrative Berlusconi tells that his opponents have failed to beat him with the electorate and instead have used the courts to try to defeat him.  While he may accept community service as his penalty, the law that prevents a convicted felon of sitting in parliament was passed after the tax evasion offense and so, it is claimed unfair to have it enforced (ex post facto laws are recognized as inherently unfair). 

At the same time, the Italian economy is arguable deteriorating rather than improving.  Recall that last week the government recognized the economic contraction this year is deeper than it has previously anticipated.  It now expects the economy to contract 1.7% rather than 1.3%.  Today's July retail sales report shows a 0.3% fall, a bit more than the consensus expected and follows a 0.2% decline in June.  

The ECB reported a small tick up in August money supply (M3) growth to 2.3% from 2.2% in July, though the 3-month measures, used to smooth some of the noise, fell to 2.3% from 2.5%.   There is some speculation that the repaying of the LTRO funds may be a factor behind the sluggish growth in the money supply.  

Still, more worrisome is the continued decline in private sector lending.  Such loan growth fell 2.0% a new record, after a 1.9% decline in July.  This is the sixteenth consecutive monthly contraction in lending.   Lending to non-financial businesses  fell 3.8%, while consumer credit growth contracted by 2.6%.   Note that next week's ECB meeting will be held in Paris on October 2 as Germany celebrates (re-)unification on October 3.   The data today provides additional fodder for Draghi to reiterate his dovish forward guidance.  

For several months there have been reports that Japan's government pension funds would diversify away from the JGB market and toward higher risk assets, such as stocks, real estate, infrastructure projects.  Another panel earlier today urged this and was seized upon to drive the Nikkei higher.   Japanese shares had initially opened lower, perhaps in response to the yen's gains, but recovered and closed above Wednesday's high, led by telecom and consumer services.  Basic materials slumped by a little more than 2% and was the only losing sector in today's activity.  

There is a compelling logic for Japanese pension funds to diversify away from JGBs.  However, if this were to be a significant development, it would bring forward the day that the government cannot depend on domestics to fund its budget deficit.    We still think that day is a few years in the future, though have been hearing more about this issue from concerned clients.  

Talk continues to circulate about a corporate tax cut, which is thought to help blunt the impact of the retail sales tax hike, which is as much of a done deal as these things get before the formal announcement, expected shortly after next week's Tankan survey.     Japanese corporations are flush with cash and it is in the corporate sector when Japan's famous savings are to be found--not in the household sector, where the savings have been drawn down.  It is not clear, precisely how a corporate tax cut offset the retail sales tax hike and instead can only aggravate the distributional issues in Japan. 

We also note that the US-Japanese 10-year interest rate spread has narrowed considerably in the wake of the Fed's decision not to taper last week.  The US premium has narrowed to almost 193 bp today from a high of 221 bp two weeks ago and 212 bp on the eve of last week's FOMC decision.  Today's premium is the lowest in a month and may help explain why the dollar has made lower lows against the yen each day this week.  

US Treasuries continue to trade firmly.   A Bloomberg survey found 59% of the respondents expect the Fed to taper in December at the earliest.  While we recognize the possibility, we suspect it is really a 2014 move.  For now, let us just summarize our three top reasons:  1) we do not expect a significant pick up in economic activity before then or a substantial increase in measured inflation; 2) while the Federal Reserve cut its economic forecasts last week, we suspect they did not go far enough and in December may shave them again; 3) it is better for the institution and its communication credibility to let the next chairperson initiate the tapering.  

While we have long thought Yellen is the most qualified candidate, we have been concerned by a couple of a factors.  First, President Obama clearly preferred Summers, and nearly all the important economic appointments have been given to the Rubin-wing of the party.    Obama was out-maneuvered by his own party.  If he reverts back to Yellen now, it may  display his lame duck status, which would necessarily weaken his negotiating ability on other issues.  

Second, Yellen is seen as a continuity of the current policy and would be seen as a third term for Bernanke.    If the message the White House wants to give, especially ahead of the 2014 congressional elections, is that the economy is on the mend and that the extraordinary policies were successful, but not longer needed, then a cleaner break from the past may be signaled by another candidate besides Yellen.    While Summers candidacy was objected to by Democrats, Yellen may run into stiffer Republican opposition.  

That said, we note that Yellen's scheduled talk next week to the NY Economics Club has been canceled and this understood by many as a precautionary move to avoid controversy ahead of her rumored nomination.  

Three Fed officials speak today, of which Governor Stein will be the most important.  George who continues with her hawkish dissents is a known quantity and clearly she does not reflect the consensus at the FOMC.  Kocherlakota is a non-voting member.  There is noise and there is a signal and we continue to urge our clients to focus on the signal from the Fed and that is generally embodied in comments from the Fed's Troika--Bernanke, Yellen and Dudley.  

US economic data today is unlikely to have much market impact.  There are revisions to Q2 GDP. These are two historic to matter much.  Estimates for Q3 GDP are around 2% and not much more for Q4.  Weekly initial jobless claims are due out, but the time series has been particularly noisy lately and the interest is really on next week's monthly non-farm payroll report, where another sub-200k net job growth is expected.  Weakness in August pending home sales is expected, but the FOMC decision appears to have taken that on board already.  The Kansas City Fed report is not a market mover, even in the best of times.  

We note that the S&P 500 has been down for five consecutive sessions coming into today.  It is trading higher on the electronic platforms.  The key will be whether it can sustain the gains.  At yesterday's lows, which is settled on, it had retraced 38.2% of the gains since the August 30 low.  The 50% retracement is found near 1679, which is also approximately the 20-day moving average.