Eventful Week Ahead

The week ahead is eventful.  Investors will learn of the results of review and stress test of European banks.  The Federal Reserve meets, as do three other central banks (Bank of Japan, Sweden's Riksbank and the Reserve Bank of New Zealand.  Important elections were held in Ukraine and Brazil over the weekend.

In terms of data, the highlights include the first look at Q3 US GDP,  a batch of Japanese reports, including the September CPI, and the preliminary eurozone Oct CPI and September money supply and credit figures.   UK has mostly second tier report, but mortgage approvals, which have been trending lower, may draw attention.

Perhaps, UK politics, may overshadow economic news.  It is not so much the EU's 2.1 bln euro surcharge, after this follows directly from the upward revisions to the national income accounts that are so striking.  Rather it is Prime Minister's surprise that is remarkable.  The larger public sector borrowing requirement had weakened the electoral strategy of some fiscal gifts before next spring's election.

After some jitters around the middle of the month, market expectations have settled down, and the Fed is widely expected to announce the finishing of QE.  The part of the statement that was devoted to QE could largely be eliminated, and this will make for a shorter statement that may seem terse. Given our understanding of the way the Fed operates, with key core centrists (Yellen, Fischer and Dudley) driving policy, the statement is their organ, more so than the minutes or dot-plot.  

We expect three key phrases of forward guidance to continue to be included.  First, it will likely to continue to characterize the labor market has suffering from "significant under-utilization".  To be sure developments are in the right direction, as reflected in the new cyclical low in the four-week average of weekly initial jobless claims.  Further improvement in the broader labor conditions is possible likely.

Second, the statement will likely continue to identify a "considerable period" between the end of QE and the first rate.  The word has lost whatever precision investors projected.  However, we can agree that considerable period does not mean the next meeting.  Nor does in mean the meeting two years hence either.

Third, at the end of the statement, there is a reference to the expectation that this monetary cycle will be of a smaller amplitude than past cycles.  That is to say that the peak in the Fed funds rate will likely be lower.  The statement recognizes that even when the Fed's mandates are approached, the Fed funds target may be lower than what is regarded as its long-term equilibrium level.

In addition to these words, investors will scrutinize how the Fed characterizes inflation.  Recall that in September, the FOMC had dropped the reference to the risk of core inflation being persistently below target.  It would seem awkward to simply bring it back.  It could refer to the breakdown in market-based measures of inflation expectations, but also note that it has not been confirmed in other measures.

The US economy is expected to have expanded by 3.0% at an annualized rate in Q3.  The preliminary estimate is subject to statistically significant revisions.  That said, we think investor should note the composition of growth.  The consumption is likely to be softer while business and residential investment and foreign demand (net exports) may have improved.

The core PCE deflator is expected to have fallen from 2.0% in Q2 to 1.4% in Q3.  This is not a cause for alarm. The 2.0% print was the outlier.   The average has been 1.4%-1.5% for the past 4, 8 and 12 quarters.

The BOJ issues is monetary policy statement next week amid speculation that it will use it semi-annual outlook report to acknowledge that its self-imposed 2% core inflation target, excluding the sales tax, is unlikely to be met.  Some observers think this will be reflected  in projections of even larger increased in the monetary base.   The current pace is around JPY70 trillion a year.

The current pace is already posing some technical hurdles in the implementation.  It could take the ECB's approach, and find other assets to buy, but it is already buying a wide range of assets, including corporate bonds, ETFs, and REITs.    Or it could extend the duration of the QQE.  To wit:  "Even after inflation has achieved its target, the QQE operations may persist for a considerable period."

The data will are unlikely to be helpful.  With exports increasing, it ought not to be surprising if industrial output recovers.  However, overall household spending is not.  Inflation itself likely softened in September, while Tokyo's October reading is will suggest no turn around this month either.  Still, there is some hope that the decline in the yen will do for the BOJ what its asset purchases are struggling to do--reignite inflation.

Disappointingly and dishearteningly, even if not totally unexpected, much of the general results of the Asset Quality Review and stress tests appeared to have been leaked before the weekend. The market seems pleasantly disposed.  The ETF, EUFN that tracks the MSCI European Financial Index rose about 5% last week and has recovered 15% since the October 15 climactic sell-off.  It appears poised for further recovery.   The amount of capital that must be raised overall seems modest, and to get past the event risk with no significant surprises is also important.

As leaked, 25 of the 130 euro area banks failed the overall assessment. A dozen has  already covered their capital needs.  The remaining 13 will have to raise 25 bln euros.   They will have between six and nine months to raise the capital.  The officially preferred way is to tap the capital markets.  This effectively dilutes existing shareholders and creditors.  The alternative is to reduce the balance sheet. Some combination of the two is likely.

Overall, officials will require banks to adjust the valuation of their assets by 48 bln euros. Italian banks appear to account for a quarter of this.  Greek banks will adjust their valuations by 7.6 bln euros, German banks by 6.7 bln, and French banks by 5.6 bln euros.  This is the result of re-classifying 136 bln euros of loans as non-performing.  One of the important achieves is a standardized definition of non-performing loans, which is essential for a single regulatory system. Bad loans in the eurozone banking system are now estimated to be 829 bln euros.

The EBA conducted the stress tests.  It found that 24 of the 123 banks (covering 70% of total EU banking assets) failed to maintain sufficient capital ratios under adverse conditions tested.   Ten banks  have already plugged the gap.  That leaves 14 banks to raise about 9.5 bln euros within the next nine months.  

Meanwhile, on the data front, the news for the ECB will likely be constructive. Money supply (M3) will be reported at the start of the week and is expected to continue to improve. The consensus expectation for 2.2% year-over-year in September, after 2.0% in August, would be the strongest pace since August 2013. The contraction in credit is likely to have continued to slow. At the end of the week, the ECB will report preliminary October inflation. It is expected to tick up to 0.4-0.5% from 0.3%.

Briefly turning to the two other central banks that meet, the market has largely discounted a 20 bp cut in the Swedish repo rate that would bring it to 5 bp. The Swedish krona has under-performed in the recent sessions as the market priced it in. Last week, it lost 1% against the US dollar, which made it the second worst performing major currency behind the Japanese yen.

The Reserve Bank of New Zealand will most likely leave rates on hold (3.5% cash rate) but may tone down its forward guidance on rates. On a trade-weighted basis, the New Zealand dollar has appreciated in October (3%) before selling off in the second half of last week. A break of $0.7800 is needed to sustain the downside momentum against the US dollar.

The initial impact of the Ukrainian and Brazilian elections will be local. In Brazil's case, Dilma went into the polls with some momentum. As she was in the first round, so too now she has been under-estimated. The Bovespa and the real have generally under-performed (though the Bovespa staged an impressive rally before the weekend, rising 2.4% on Friday, after having lost nearly 9% in the previous five sessions). While it may appear ripe for a "sell the rumor, buy the fact" type of activity, we caution against the counter-trend trade in what could be an emotional market.

Ukraine is expected to elect a pro-Europe parliament. Reports suggest there is not much in the way of campaigns in the south and east. The situation is far from resolved, and there is much the new government could do to antagonize Putin. Politically naivete could be as dangerous as Machiavellian tactics. The sanctions are biting, though, of course; they offer no coup-de-grace. The drop in oil prices, which may be in part the House of Saud's expression of displeasure with Putin's support of Assad in Syria, is aggravating the economic pressure on Russia.