Five Points for Hump Day

We see five developments that investors note:

1. Disappointing US employment data removed a potential obstacle to the foreign exchange adjustment to the newly appreciated recognition that Fed tapering is increasingly unlikely this year. As we noted previously, the private sector and Fed data released during the government shutdown pointed to some slowing of the US economy. Job growth itself was slowing down, illustrated by the 3-month average lower than the 6-month average, which itself was lower than the 12-month. Surely, we should expect distortions in the October times series, which may also distort some November data. Overall, the US economy appears to be expanding at an uninspiring pace around 2%.

For several months, the view of Fed tapering was anchored in the minds of many to September. Now that it has lost its moorings,expectations appear more fluid. Although a majority, lie ourselves, according to surveys, now expect tapering to begin in March, the risk is that disappointing data, distorted or otherwise, will prompt some to push the tapering further out in time. In the current environment, the shifting tapering expectations has been the key change and primary driver, we suggest.

The benchmark 10-year yield has already retraced nearly a third of its increase from around 1.60% to 3.00%. It appears that the lion's share of the adjustment may be behind us. Based on the current information set and anticipation, it is difficult to see US 10-year yields much below 2.40%.

2. The ECB is expected to provide details of the general framework of the Asset Quality Review (AQR) it intends to conduct as the first part of doing its due diligence before taking over supervisory responsibilities. The purpose is to have a better understanding of the banks' assets portfolios, as there is a considerable amount of variance among the national authorities. This will be followed by a full review of the bank's overall balance sheets (and one would hope some consideration to off-balance sheet exposures). And finally, new stress tests conducted in conjunction with the European Banking Authority.

Reports yesterday suggested that the ECB will likely accelerate the implementation of EU rules that were expected to gradually tighten through 2019. The reports suggest the ECB will request banks hold capital equivalent of 7% of risk-weighted assets. The largest banks may be required to hold an additional 1% buffer. Based on current definitions and classifications, these rules would not be particularly onerous. If the thresholds are modest, it seems that the greater effort will be on definitions of assets (tax deferred credits?) and classifications (should restructured and rolled-over corporate loans be carried as full value?)

3. A Financial Times article yesterday made for interesting water-cooler conversation, but upon closer examination, it will be seen to be more noise the signal. In the Bundesbank's monthly report, the rise in apartment prices was recognized. The central bank's assessment was that apartment prices in the largest cities could be as much as 20% over-valued. In what appears to be pure conjecture from the reporters, they opined that "The warning will feed into German concern that the European Central Bank’s monetary policy is far too loose for the country."

Yet the there is other mention of the ECB in the article and much of the rest of the piece, quoting from the Bundesbank, shows what it is not very concerned. The BBK report did recognize the role played by low interest rates, but while the reporters seemed to think it was the low short-term interest rates set by the ECB, it is more likely the low long-term interest rates, which seems to be a function of low inflation, weak growth, a strong fiscal position and safe haven status. Indeed, the BBK goes on to suggest the bulk of the problem is supply not demand (which is implied by the interest rate focus). The BBK is clearly not as concerned as the FT reporters: It is “not very likely", the BBK notes, "that the price structure on real estate markets currently represents a serious macroeconomic risk. The observed price movements are an expression of delayed increases in supply.”

4. Australia's Q3 CPI was a little firmed than expected, rising 1.2% rather than 0.8%. However, the year-over-year rate slipped to 2.2% from 2.4%. The trimmed mean, an arguably robust way to think about core inflation, rose 0.7% on the quarter and is up 2.3% year-over-year, unchanged from the previous quarter. The Aussie was bid coming into the report and extended its gains. We do not see the inflation report standing in the way of another rate cut and see the strength of the Australian dollar as giving the RBA more incentive. That said, we recognize a rate cut is unlikely next month and we are now more inclined to see it early next year.

Of note, the Australian Treasury has indicated that it will recapitalize the RBA by injecting A$8.8 bln into its reserve fund. This will strengthen the RBA's balance sheet and brinks its primary capital buffer to 15% of its risk assets. It is currently just below 4%, according to reports. Last year, over the objections of the central bank the previous Treasurer insisted on taking a A$500 mln dividend from the RBA to help it achieve some fiscal goal, though few at the time, raised concerns about central bank independence. This was tantamount of about half of the RBA's earnings. The purpose of the reserve funds is to offer a buffer to absorb losses relative to the impact of the strength of the Australian dollar, which reduce the value of its foreign assets.

5. The prospects of low rates for longer has encouraged buying of risk assets and while some emerging markets (South Korea, Taiwan and India stand in terms of equity flows). Turkey and Hungary appear to have seen strong fixed income inflows. However, it is European equities which continue to shine. The Dow Jones Stoxx 600 has risen nine consecutive sessions through Tuesday. This is the longest streak in almost 3 1/2 years. Perhaps it was the Israeli central bank's decision to shift 0.5% of its reserves from US equity to German equity that captures the moment. Previously, 4.7% of Israel's reserves were invested in US shares and 0.24% in Germany (and 0.24% in France and 0.5% in the UK). Recall that back in February, the central bank approved plans to boost its equity holdings to 6% of reserves from 3%. At the end of September Israel's foreign currency reserves were just below $80 bln.