Developments Cast Pall Over Dollar

The near-term fundamental considerations for the dollar have turned more negative.  Two developments last week that had bolstered the dollar are being rethought.  

First, the Bloomberg report that cited to unidentified people close to the ECB playing up the risk of a negative deposit rate, has not been confirmed or replicated by other news agencies, despite the apparent copy-cat reporting that seem so pervasive in the business news space.  Indeed, several key official, including ECB President Draghi himself, played down developments in this direction.  

While it is naive to expect an official to deny itself options, a move to a negative deposit rate could be highly disruptive for the financial market and banks, who the ECB is supporting with the other hand, without a high probability of boosting lending or deteriorating financial conditions.   Moreover, ECB officials have also downplayed the deflationary threat that many pundits have discussed.  

An adoption of such an unprecedented policy requires a significant threat, which policy makers do not perceive.  In fact, the preliminary Nov CPI due at the end of the week ahead is expected to tick up.  This will support the official recognition of disinflation rather than deflation.  

Second, the pendulum of market sentiment swung from Yellen's confirmation hearing, where many took away a ultra-dovish signal, to the FOMC minutes that many read as bringing forward Fed tapering to possibly next month.    Yet the key officials (Bernanke, Yellen and Dudley) have made it clear that the decision to taper requires more economic progress.  And such progress is lacking.  

While Q3 US GDP appears set to be revised up to a little more than 3%, the composition, especially the inventory build, may detract from Q4 growth.  The regional Fed surveys for November also point to some softening of the economy.  The Chicago PMI will be released at the end  of next week and it likely to pullback sharply from the heady reading near 66 in Oct.  

Our confidence that some compromise on the continuing spending resolution and the debt ceiling that would prevent a new crisis has been shaken by last week's parliamentary maneuvers, which will likely aggravate the partisan (not necessarily ideological) strife.  

The Republicans in the Senate have used their minority status to block not only legislation, but also presidential nominations to an unprecedented extent. Since the country was founded, the Senate has blocked through delay 168 nominees.  Half of these have taken place in Obama's 5 1/2 years in office.  On Oct 31, the Republicans in the Senate blocked North Carolina Representative Watt from heading the agency that will oversee Fannie Mae and Freddie Mac.  This was the first time in 170 years that a sitting member of Congress was denied a confirmation to an executive branch post.  

After threatening to do so earlier this year, Senate leader Reid used his majority to change rules that reduce the obstructionist powers of the minority by requiring executive appointments (not legislation) to pass with a simply majority rather than 60 votes.  The 60-vote requirement has been the case since 1975, when it was reduced from 67.  

Reid's move will allow for some more of the 93 judicial vacancies, including the three on the Federal Court of Appeals for Washington DC, which often rules on challenges to government regulation and presently has a Republican majority,  to be filled in the coming months.  This is important for Obama's agenda, if he is not to be a lame duck.  It may also expedite the changes at the Federal Reserve Board of Governors, which currently has 2 vacancies and with Bernanke set to step down a third seat open.  Reid's move may also prevent delay tactics over Yellen's nomination on the floor of the Senate, which were threatened.   

Our analysis suggests that there will likely be a few more vacancies in the period ahead.  These large changes on the seven-member Board of Governors is another reason we argued that from an institutional point of view, it makes more sense to let the new Fed take the next policy initiatives.   

The Republicans are incensed by the parliamentary maneuver, though three Democrats voted against Reid's move.  Relations between the two parties were strained in any event, but Reid's move may lead an immediate freezing of whatever cooperative efforts may have been taking place.  In particular, this is a new obstacle to a fiscal agreement.  

Government spending is authorized until Jan 15 and the debt ceiling is Fed 7.  As will be recalled it is the spending that can lead to a government shutdown and the debt ceiling can produce a default.   While this may still be avoided, the risks that it is not has risen by the internecine conflict.   The Federal Reserve cannot ignore this when it meets in the middle of next month.  

Separately, there were two other developments over the weekend that may influence the investment climate. The deal struck over the Iranian nuclear development may prompted some reduction of the risk premium for some oil, including Brent.  Israel's Prime Minister responded negatively to the news, which may be seen as negative for the shekel.  

If the Iranian deal reduces the threat of hostilities, China's new East China Sea Air Defense Identification Zone threatens to escalate tensions.  China's initiative is a unilateral attempt to impose new rules on the airspace of the islands who's ownership is disputed, especially with Japan.  China threatened to take "defensive emergency measures" against aircraft that fail to identify themselves in that airspace.  

There was modus vivendi (an agreement to disagree) about the islands until last year, when the DPJ-led government was forced to buy the islands so the Governor of Tokyo acting for the metropolitan government would not.  This in effect nationalized them and drew the ire of Chinese officials, who are particularly sensitive to its territorial integrity for a number of historical and political reasons.  

Up until now, the nationalist objectives that Japan's Prime Minister Abe is believed to harbor, have not been given as much attention as expected.  The economic challenges and political considerations may have kept this part of the Abenomics agenda under wraps, but what understood as provocation by China is likely to stir the pot.  

Outside of the advanced euro area inflation report, the economic calendar for the euro area is light in the week ahead.  There are though two political issues to note.  First, the new German coalition government may be announced.  Realpolitik has been at play.  The SPD lost the election handily, but the necessity of its participation meant that it could demand a lot.  Of twelve broad areas, Merkel's CDU appears to acquiesced to at least ten.  There are some policy difference between Germany's two main parties, but as we suggest is the case in the US, such differences are not so ideological and the ability to have a grand coalition seems further evidence of this observation.  

Second, the Italian Senate is likely to vote to eject Berlusconi.  A few months ago, such an event would have threatened to topple the fragile Letta government.  A split in the center-right in Italy, over personality rather than ideology, indicates the Letta government will survive.  The real challenge for Letta may come from his own party (a leadership election early next month) rather than from Berlusconi, who may be subject to more legal action when he loses the immunity his Senate seat confers. 

We note that at the end of the week, Japan  will report a host of economic data, including the Nov CPI reading (expected to tick up to 0.2% from flat on the core, which is the BOJ preferred measure). Despite widespread skepticism that the BOJ can achieve its 2% target, the BOJ does not seem to be in any hurry to provide more stimulus.   Meanwhile, the Oct Industrial production is expected to have accelerated to 2% from 1.3% in Sept and a 0.9% decline in Aug. Offsetting the economic impact of this will likely be slower household consumption after the out-sized 3.7% increase in Sept.  

Finally, the central bank of Brazil is likely to hike the overnight Selic rate by 50 bp to 10%. Although its first hike in April was 25 bp, since then central bank has delivered four 50 bp hikes.  This week will be the fifth. The central bank of Hungary is likely to cut is base rate by 20 bp.  It has cut the base rate 20 bp in each of the past three months.  It has cut the base rate by 25 bp per month in April through July.