The Week Ahead and Beyond

There are three main events in the days ahead that will set the stage of the immediate post-holiday period:  The FOMC meeting, the flash euro area PMIs and the European summit. 

The recent string of data has convinced many observers that the US economic expansion has accelerated to the point where the Fed could begin to slow its assets purchases as at this week’s meeting.  

Although we had initially favored a Dec tapering over a Sept move, we have become less convinced.  The key to argument is two-fold:   core PCE inflation is low and is likely to fall sharply over the next few months, and the credibility of  forward guidance, which is to replace the asset purchases, is enhanced by letting the post-Bernanke Fed announce and implement.

The core PCE deflator, the Fed’s preferred inflation measure rose 1.1% in October from a year ago.  Consider the base effect when Nov 2012 monthly increase of 0.8% and Dec 2012 monthly increase of 0.5% drops out of the comparison.     It is more prudent to taper at least when inflation is not falling especially from so such low levels. 

There will be significant changes in the composition of the Federal Reserve Board of Governors, which extend beyond the chairmanship itself.  The credibility of forward guidance dictates that the new Fed, under Yellen’s leadership, articulates a new forward guidance that will coincide with the tapering decision. 

There are other, less compelling reasons for the Fed not to taper, like avoiding unsettling money markets over the sensitive year-end period, or that more data is needed to confirm the economy has turned a corner.  The point is that many observers seem to have simply extrapolated from some arguably strengthening of economic activity to conclude Fed tapering, without adequately taking into account the low and falling inflation and the need to maximize the credibility of forward guidance to ensure the market continues to recognize the difference between tapering and tightening. 

The euro area reports the flash Dec PMI on Monday.   While the PMIs generally do a good job tracking real sector activity, we note that they appear to be running ahead now.  The weakness in the Nov industrial production figures, for example, was not anticipated by the survey data.  More broadly, the contraction in the euro area as a whole has ended, but in its place is stagnation.  In the euro area, a recovery has yet to begin.  In the US, the issue is the strength of the expansion. 

The divergence between the economic performance of France and Germany has been more evident in the PMI data than the performance of the asset markets.  In part, due to robust Asian investment flows, France appears to have retained investor confidence.  A continued poor performance of the French economy may become a greater market force next year. 

At the end of the week, the last European Council, of the heads of state, will hold their last summit of the year.  The most important issue will be the formal decision on the single resolution mechanism.  The ECB will be the supervisor, working with the European Banking Authority.  The debate over the mechanism itself has been fierce.  The compromise seems to be that national authorities retain much control and responsibility for the process.   It is not so much a banking union, especially in the first several years, as an agreed upon extension of the status quo. 

Nevertheless, the pieces will be in place that will allow the Asset Quality Review and the stress test to proceed as planned for 2014.  In the next phase of the construction of a banking union, the focus will be on the creation of a Single Resolution Fund.   The way the resolution mechanism was worked out will shape the fund, especially before it can be adequately funded by the banks.  Essentially, the bank and its investors are the first line of defense.   The German desire for a banking union is limited by its wiliness to 1) let Brussels make decisions about the landesbanks, and 2) willingness to fund a resolution mechanism. 

    

Outside of the US and euro area, there are several more events that investors will be monitoring.  The UK has three events that will be noteworthy:  inflation report, the latest reading on the labor markets and minutes from the recent BOE meeting. 

Inflation expectations remain anchored, but price pressures remain sticky in the UK.  Of particular interest will be the effect of the previously announced increase in utility prices.  The BOE’s forward guidance, like the Fed’s, has provided an unemployment threshold (7.0% vs 6.5% for the Fed).  The unemployment rate is likely to tick down to 7.5%.  The UK’s participation rate has held up better than in the US (and Australia) by contrast, but the price has been lower productivity.

As BOE Governor Carney pointed out in NY last week, the atrophy of skills is taking place in the UK on the job (labor shifted form high productivity to lower productivity positions) as opposed to among the long-term unemployed, as seems to be the case elsewhere. Finally, the BOE’s minutes will be studied for clues to how forward guidance may evolve next year, especially in terms of labor market dynamics. 

Sweden’s Riksbank meets.  It is a close call.  Important real sector data has deteriorated and disinflationary conditions threatened to morph into deflation.  Interest rates policy is recognized (by at least some board members) as an inefficient tool to address the elevated household debt levels.  If a cut is not delivered, the krona may be subject to a short-covering bounce, but expectations for a cut will simply shift to early next year. 

The Bank of Canada meets.  It had previously distanced itself from the forward guidance that was inherited from Carney that indicated the “removal of accommodation” (i.e. a rate hike) would be delivered soon (though it repeatedly pushed out in time what that would be necessary).    

Canada is experiencing disinflation and the impact on the real economy is likely to be a 2014 story.  Headline inflation is running at 1.0% year-over-year, while the core rate at 1.2% is essentially the same as the US rate.   However, a key difference is that Canada’s housing prices and consumer debt are at record levels.  

Although some Canadian banks have tried to play down the extent of the over-valuation in the housing market, it is clearly on the central bank’s radar screen. Last week Governor Poloz recognized the housing market as the single biggest domestic economic threat.   Mortgage borrowing increased another 1.8% in Q3, bringing household debt to 163.7% of disposable income. 

Comments by the Governor of the Reserve Bank of Australia that provided a specific bilateral exchange rate target of $0.8500 for the Australian dollar violate the spirit of G20 agreements.  He is unlikely to repeat this faux pas.  It is well understood and appreciated that the Australian dollar is over-valued by almost any metric one wants to use.  However, a nominal bilateral exchange rate is a poor proxy for the competitiveness of the currency.

Moreover, macro-economic variables do not appear very sensitive to a few percentage point move that Steven’s target entails.   The new government will provide new economic forecasts and a fiscal update.  Australia debt is rising and this issue will likely become more significant next year. 

We note that of all forces that impact foreign exchange prices, the wishes of policy makers, unless a signal of action, tend not to be very salient.  The largely speculative market seized on Steven’s comments to push against the bottom pickers who were arguably poised to take a stand. 

The Bank of Japan holds its final meeting for 2013.   It is most unlikely to take any fresh initiatives.  There seems to be a general expectation that the BOJ will take additional action, but there is much debate over when.  We think it does not come before officials have greater visibility on the impact of the retail sales tax increase on April 1. 

The Tankan report first thing Monday in Tokyo is expected to confirm a gradual increase in business sentiment in Japan.  However, we note that businesses are not the most ardent supporters of Abenomics in deed, regardless of their support for the LDP.  This is especially true in two important areas in which Abenomics has been disappointing:  capital expenditures and sharing the windfall profits generated by a weaker yen in the form of base wage increases.

Turning to emerging markets, five central banks meet.  India is expected to hikes for the third consecutive time.  A 25 bp increase will take the key overnight rate to 8%.  Hungary is expected to deliver another 20 bp rate cut that would put its key rate at 3%.  The central banks of the Czech Republic, Colombia and Turkey meet, but no action is expected. 

Lastly, China seems to be on the move.  Tensions over the disputed islands, airspace, and sea lanes have intensified and the risk of an international incident has increased markedly.  China does not appear to be afraid of a confrontation, but, to the contrary, appears to be looking for one. 

 With the successfully landing and deployment of the Jade Rabbit rover, China became the third country and the first in almost four decades to have an unmanned moon landing.  Neither of these developments appears to be having a particular impact on financial assets.  However, many will be scrutinizing the bilateral trade flows, especially with Japan and South Korea, to see if China is linking the political dispute with trade, which it has done previously. 

While the moon landing is a great feat from an engineering point of view, one can’t help but wonder about the price for what appears to be an expensive way to bolster status and prestige.  Recall that despite China being the second largest economy in the world; it is still a poor country, where GDP per capita is about $6500 a year.    The Chinese economy is a little more than half the size of the US, its GDP per capita is roughly a fifth the size.  

The soft moon landing may say more about China’s desire to be seen as a great power, the egos of the key decision makers (individually or collectively) and the surplus accumulated by the state, than it does about China’s space prowess.  The terrestrial implications are more significant.