Sterling Steals Spotlight Ahead of FOMC

In a bit of a fluke in thin trading, sterling spiked below $1.6220 yesterday, but has rebounded smartly on the back of a strong employment report and is trading near four-day bests as the market awaits the FOMC decision.  

The jobs report was unambiguously strong.  The claimant count fell 36.7k, a little more than expected.  It follows a slightly revised 42.8k decline in Oct (from 41.7k).  Impressively, the ILO measure of unemployment fell to 7.4% from 7.6%, the lowest in four years.  The BOE has identified the 7% level as a threshold (not trigger) of a change in policy.  

To be sure, in addition to providing this economic pre-condition, BOE Governor Carney has intimated a time frame as well.  He does not envision of hike until closer to H2 2015.  

This kind of date-oriented forward guidance, which Carney had adopted at the Bank of Canada (though it has subsequently moved away from it), is the kind that Stanley Fischer, reportedly a candidate for the Fed's Vice Chairman seat to replace Yellen, has opposed, due, it appears, to questionable credibility.   This is precisely what the short-sterling futures strip shows.  The UK bank rate sits at 50 bp.  The implied yield on the Dec 14 contract is 73 bp and the March 15 contract implies 86 bp.  This is to say the market is pricing in the first rate hike well before Carney is suggesting. 

Separately, the MPC minutes do not appear to contain any surprises, though of note there seemed to be heightened concern about future appreciation of sterling.    The BOE's trade-weighted index rose a little more than 9% from the March lows to the high earlier this month.  

Earlier, Japan reported a JPY1.293 trillion trade deficit for November, following the slightly revised JPY1.093 trillion deficit in October.  Japan has been running a persistent trade deficit for nearly a year and a half.  Faced with a 18.2% year-over-year depreciation of its currency, many economists would have expected a stronger trade performance.  However, while we recognize a role for exchange rates, we generally think this is often exaggerated.  The more important key is the strength of demand, especially given the intricate international supply chains and the increase in trading parts and components (semi-finished goods).    

In addition, Japan's experience also is a reminder that the import side of the equation should also be considered.  Japan energy-related imports are significant and the yen's depreciation boosts these costs.  Japan's exports are up 18.4% year-over-year in November, while imports rose 21.1%.  Of note, exports to China were up 33.3% from a year ago (which had been depressed by China's apparent retaliation over the disputed islands that the Japanese government bought from a private family) and at JPY1.1426 trillion exceeded Japanese exports to the US (which were up 21.2% to JPY1.131 trillion).

The dollar has been confined to yesterday's range against the yen and continues to hold above the 20-day moving average, which is found just above JPY102.40.   Resistance ahead of the FOMC meeting is seen near JPY103.20. 

The business climate measure of the German IFO was spot on the consensus expectation of a small increase to 109.5 from 109.3 in November.  However, the euro hardly responded and remains confined to Monday's trading range (~$1.3727-$1.3799).  Investors have already taken on board the recent data pointing to an acceleration of activity. 

Similarly, the investors did not respond much to the RBA Governor Stevens testimony.  He largely reiterated his position.  The economy is likely to grow below trend in 2014.  While another interest rate cut is possible, he clearly prefers trying to talk the currency down, which seems to enjoy some success recently.  He also keeps the fx intervention card in play.  He does not rule out macro prudential policies to keep the housing market in check.  The Australian dollar has been confined to about a third of a cent range, well within yesterday's range. 

The main highlight (and arguably the last big event of the year) is conclusion of the FOMC meeting, which we suspect will be Bernanke's last as Chair.  Yellen is likely to be confirmed shortly.  It makes no sense to have two chairpersons.  A recent string of favorable data has many thinking the Fed can taper today.  Even one large fund manager put the odds at 60%.  We demur.  We have argued that such calls do not sufficiently appreciate the seriousness of the disinflation threat and more to come, as last Nov and Dec jumps in the core PCE deflator drop out of the year-over-year measurement.  In addition, we have argued that to maximize the effectiveness of forward guidance, which is expected to replace QE as the main conduit, it is important that the people who will enact it make the decision.  There are other reasons, as well, including the uncertain fiscal outlook with the debt ceiling issue coming back to the fore quickly and a preference to avoid year-end moves.

We do think the Fed can help guide the market toward expecting tapering in Q1 14.  We are inclined toward March, but can see a case for January, which we anticipate to be Yellen's first as chair.  Some observers continue to think that Yellen is some sort of super dove and a tapering move early in her tenure would help balance such perceptions. 

At the same time, because we, like others, can accept that tapering is not tightening,  we are not convinced that there will be a substantial and sustained reaction to the FOMC meeting.  That said, the dollar has generally weakened against the euro and sterling as the tapering story gained ground.  We note that the US-German 2-year interest rate differential which had fallen below 7 bp a week ago is near 12 bp now.  This may help the dollar bounce post-Fed.