Drivers in the Week Ahead

The continued partial shutdown of the US government and the risk of default remains the overriding consideration in the global capital markets. There appears to have been limited progress over the weekend.  

This could spark some disappointment and weigh on US dollar and equities on Monday.  Activity will be lighter than usual, as Japan, Hong Kong, Canada markets are closed, while the US Columbus day holiday will likely reduce participation.  

That said, because of the stakes involved, most investors expect that a default will be avoided, even if at the last minute.  And that last minute does not appear carved in stone.  Many observers have emphasized the October 17 time frame as date certain, but in reality, is likely some time after that. Moreover, the power of the executive branch should not be under-estimated to find the means  to prevent missing a T-bill or coupon payment.  

The underlying sense that what is happening in Washington is theater and that some resolution is likely.  This may help prevent a sharper market reaction.  At the same time, there are a number of reports suggesting several institutional investors are avoiding the short-term bills.  The plumbing of the international financial system relies to some extent on the use of T-bills for collateral for trading and repos.  

Despite the ink spilled about the decline of the US, and what some have dubbed the G-zero world, the US dollar and the Treasury market remain the essential feature. It is clear that even the threat of default is disrupting the functioning of the global capital markets.  The threat of a US default has replaced the exit of euro zone member as the number one concern for risk managers.  

News over the weekend that China's exports in September fell on a year-over-year basis may increase concerns that the world's second largest economy is not finding much traction.  Exports fell 0.3%, the first contraction since June, and contrasts with expectations for a 5.5% increase. Imports held up significantly better, rising by 7.4% year-over-year in September and surpassing expectations for a 7.0% increase.   Some of the imports may be going into inventory or, as in the past, used to conceal portfolio flows.

The net effect was to reduce the trade surplus to $15.21 bln, the smallest since a deficit was recorded this part March.  The consensus expected a surplus near $26.25 bln.  The news may temper expectations for the Q3 GDP figures expected at the end of the week.  

Separately, while new yuan loans may have slowed, aggregate financing is expected to remain strong and fixed asset investment is expected to continue to grow faster than 20%.  The Chinese model of debt financed investment remains intact.   

Rather than deal with the issue directly, officials are likely to address the moral hazard implicit in the widespread belief that there are guaranteed returns.  Specifically, in the coming days China's Banking Regulatory Commission will allow eleven banks to sell asset management plans directly to customers.  In this pilot program, banks will not be allowed to assign an expected return to the plans.  Participating banks will also be required to publish net asset value, which is understood as reinforcing the concept that returns are a function of the asset performance not on the creditworthiness of the bank.  

The highlights from the euro area include the industrial production figures on Monday, the German ZEW survey on Tuesday and the inflation and trade figures Wednesday.  Although German industrial output increased more than expected (1.4% rather than 1.0%), several other countries disappointed (despite the improvement in the manufacturing PMI).  

On other hand, Germany reported a smaller than expected trade balance (13.1 bln euros rather than 15.0 bln) and this may serve to drag the aggregate series.  However, real take away point is that many countries in the area have seen improvement in external imbalances (which is generally leading to smaller Target2 imbalances).  The improvement is a function of a compression in domestic demand, but also several countries are seeing improved exports.  

The euro area finance ministers are meeting at the start of the week, but the difficult issues are unlikely to be addressed until the heads of state meet and a new German government is in place.  In the week ahead Merkel's CDU/CSU will talk again with both the SPD and Greens.  The SPD have dropped reference to joint European bonds, but negotiations look likely to last a couple more weeks, at least. 

The market is awaiting the ECB's announcement of the framework for the asset quality review, which is the beginning of the process by which the ECB takes on supervisory functions, and it tun is part of the drive for a banking union.  Initially, there was talk of announcement on Oct 15.  More recently Draghi has suggested a vaguer "second half of October" time frame.  

Meanwhile, industry reports and anecdotal evidence suggests foreign investors continue to see investment opportunities in European periphery, and especially Spain and Italy.  We continue to anticipate renewed strains in the region, likely emanating from the financial sector.  The ECB appears to be facing few effective options.  

If banks will get penalized for LTRO borrowings next year in the stress tests, which only seems reasonable if the stress tests are to be taken seriously,  it argues against a new one, or suggests participation will be disappointingly limited.  The ECB could cut the repo rate if the declining in excess liquidity pushes up EURONIA, but the key is really the deposit rate and the ECB is very reluctant to set it below zero.  The ECB continues to sterilize the funds associated with the previous bond purchase program (SMP).  If ceased its sterilization program it would add extra liquidity to the system, but would run into opposition for turning Trichet's bond purchase program into a money printing exercise.   

It is big week for UK economic reports.  Inflation measures will be released Tuesday, employment data on Wednesday and retail sales on Thursday.  Base effects suggest the year-over-year pace of CPI is expected to ease.  In Q3 '12, consumer inflation rose by 1% (sum of the monthly changes), in the following quarter it rose 1.2%.  In Q1 '13, the CPI rose 0.5% and in Q2 0.2%.  The consensus forecast of a 0.3% monthly increase in September will put the Q3 increase at the same pace as Q1 and Q2 put together.    Unlike the US and the euro area, UK inflation has proved much stickier.  

The UK labor market has, on the other hand, fared better than the euro area and the US and this is likely to be evident with by another decline in the claimant count.  There is some risk of a decline in the unemployment rate, though the consensus leans against it.  Finally, while headline retail sales should recover from the declines August.  The risk though is on the downside, based on the BRC figures and fact purchasing power is being sapped by a decline in real earnings.  

Japan reports final August industrial production data on Tuesday.  Market participants will be closely the weekly MOF portfolio after Japanese investors sold a record amount of foreign bonds the previous week.  Most likely, we suspect, this was a function of reducing T-bills given Washington's drama.  It may not then be repeated in the new report.  

Separately, but related, we note that indirect bidders, which includes central banks, participated more than they have at recent auctions at last week's Treasury auctions.  The Fed's Treasury holdings for foreign officials rose by about $5 bln in the week through last Wednesday/  The settlement of last week's auction will likely see the custody holdings rise again.  

Interestingly, the Japanese government will submit a bill to the Diet next week that removes the ban on outsourcing reserve management.  At $1.273 trillion, Japan has amassed the second largest reserves.   The vast majority are believed to be held in dollar-denominated instruments.   The outsourcing is likely to be limited and will provide clear investment guidelines and evaluation process.  

Some may speculate that this will entail diversification from the dollar.  We are less convinced of this and instead suspect that, initially at least, it will seek to maximize returns of the asset class, such as giving a bank a mandate for say, 3-7 year Treasuries, with a certain return objective.  If the goal was simply to diversify away from the US dollar and maintain a largely passive stance, the BOJ could have accomplished this on its own.  

Minutes from the recent Reserve Bank of Australia will be released and at the end of the week Governor Stevens will speak.  The statement after the meeting suggested to some participants that the monetary easing cycle is complete.  We are less sanguine and see still scope for another rate cut, though we acknowledge that it may not be delivered next month.  That said, the CPI figures (due early on Oct 23 in Sydney) will likely shape expectations.  

Although the partial closure of the federal government in the US is disrupting the collection and reporting of economic data, the Fed's reports and private sector data that does not rely on government data for inputs, will continue to be released.  This includes the Fed's Beige Book in preparation for the FOMC meeting this month.  Although initially after the Sept FOMC meeting, some pundits quickly pushed their taping view into Oct, this seems highly unlikely now.  

Separately the Empire State manufacturing survey and the Philadelphia Fed survey will be reported Tuesday and Thursday respectively, and offer the first "official" insight into the economy's performance here in October.   The risk is that the closure of the government is having a greater impact on the real economy than the performance of the stock market may be suggesting.