Food for Thought in the Week Ahead

Developments in the week ahead will be understood within the context of last week's developments.  The most important of these are the strength of the US jobs report and cuts in growth and inflation forecasts by the European Central Bank and the Bundesbank.  

By two measures, the US employment report was among the strongest since the Great Financial Crisis.  First, the monthly increase in non-farm payrolls of 321k has only been surpassed three times since the fall of Lehman. Moreover, the job growth over the past two months was revised higher by 44k.    

The second impressive element of the report was the 0.4% increase in average hourly earnings. This matches the best since 2009.  While we prefer to allow more evidence to accumulate, some economists  see the earnings data as the first sign that the improvement in the labor market has begun pushing up wages. 

The key takeaway is that investors are more confident that the Federal Reserve will deliver its first rate hike next year.   This can be illustrated a number of ways.  Consider two.  The December 2015 Fed funds futures contract implies an effective rate of 63 bp at the end of next year. This represents a 20 bp increase from the start of the week.  The yield on the two-year Treasury note finished the week near 65 bp.  This is a new 3.5 year high.  

At the same time as investors appear to be getting more confident in the US economy, the ECB's staff and the Bundesbank cut growth and inflation forecasts.  The estimate for next year's growth in the euro area was slashed by a third to 1.1% from 1.6%.  The inflation projection was axed to 0.7% from 1.1%.   Draghi sees in the forecasts the urgent need to do more.  Those who oppose him see the forecasts as confirmation that the risks of deflation are being exaggerated.  While the situation is serious, it is not an emergency,  The policy prescription is for structural reforms to lift growth potential, not buying sovereign bonds that weaken the incentives for reforms.

For its part, the Bundesbank essentially halved next year's growth forecast to 1% from 1.9% it has projected in June.  It looks for a 1.1% increase in CPI near year rather than 1.5% it thought likely in June.  Just like ECB's more pessimistic forecast did not compel a policy response, so too it would be a mistake to expect a policy response from the BBK's new forecasts.  

Both parties in the grand coalition that govern Germany show no intention to deviate from the balanced budget objective next year. There is little chance that the government will add to the 0.1% increase in infrastructure spending is recently agreed to for the next three year.  This appears to be largely funded from the savings from debt servicing costs, ironically encouraged by speculation that the ECB will eventually buy sovereign bonds (again).  

II

There are five important events for global investors next week.  Two take place on Monday. The first is Japan's revision to its Q3 GDP estimate, which had the economy contracting an annualized rate of 1.6%.  This was one of the factors that ostensibly forced the BOJ to turn more aggressive the next time it met (October 31).  The revision is important because it will likely revise away much if not all of the contraction.  Prime Minister Abe could hardly hope for better news before the December 14 national elections.   This could see a bounce in the yen though the BOJ is still expanding its balance sheet by 1.4% (of GDP) a month.  

The second important event on Monday is the eurozone finance ministers meeting.  This, like revisions to Japanese GDP figures, is often not very important for investors.  It is important this time and likely negative for the euro.  The finance ministers are likely to insist that Greece's assistance program must be extended.  This is important because it undermines Prime Minister Samaras support.   

The European finance ministers have a vested interest in helping Samaras.  Such assistance is not unprecedented.  In fact, the latest willingness to give France a few months to identify and schedule  measures that will boost its growth potential (which is what is meant by structural reforms), may have something to do with not giving Le Pen more campaign fodder.  

Unless Samaras can cobble together a super-majority in parliament to pick a new president, new elections will be held in the spring.  Syriza, who has an anti-austerity measure, wants the EU, IMF, and ECB to take a haircut (as was previously imposed on the private sector).     This could very well renew the existential questions about EMU, and before National Front does it in France, or anti-EU parties do it in Italy, which we see an increased number of commentators discuss.

The third key event in the week ahead is the second Targeted Long Term Repo Operation conducted by the ECB.  Officials had initially hoped that this first two TLTROs would increase the ECB's balance sheet by 400 bln euros.  The first one saw disappointing participation with only about 82.8 bln euro taken down, for various reasons.  Everyone is looking for greater participation in the second offering.  Most estimates are between 125-180 bln euros.  

The weaker the participation, the more negative for the euro, and the more supportive for European bonds and stocks.  The logic here is a disappointing take down will increase the arguments of those who want the ECB to begin buying a wider range of assets, including sovereign bonds to ensure the balance sheet growth that is intended.   Draghi unambiguously ruled out buying gold, and when asked about buy foreign bonds, he said it was too much like intervention, which is a somewhat softer exclusion (since the ECB has intervened before and it is well within its legal authority).  

Fourth, China's reports several new pieces of data.  The likely takeaway will be that the domestic economy continues to slow (industrial production is expected eased to it slowest pace in 5.5 years) amid modest prices pressures (CPI unchanged at 1.6% and PPI deflation increasing to -2.4% from -2.2%).  In turn, this will boost expectations that the PBOC will ease policy further, with a cut in reserve requirements the most likely next step, before the end of the year.  

Since China surprised the investors on November 21 with a rate cut,  which we do not recognize the link that others have intimated between it and the BOJ's move on October 31 or the subsequent yen depreciation, Chinese stocks have been on fire.   The Shanghai Composite is up more than 20%. Volume has been heavy.  Account openings have reportedly surged.  It feels manic, which is a cautionary warning to value investors.  

Fifth, November retail sales are most important US economic report in the week ahead.  The headline measure may be constrained by the drop in gasoline prices, but the key component (used for GDP calculation purposes as autos, gasoline and building materials are picked up from other reports) is expected remain firm.  

The headline rate has been steady, averaging 0.3% a month over the past 6, 12 and 25 months. Over the past three months, however, it has slipped to 0.2%.  The Bloomberg consensus expects a 0.4% increase in November.   Over the past three months, the GDP components have risen by almost 0.35% a month.  In October, it rose 0.5%, and the consensus expects an increase of the same magnitude in November. 

III

Three major central banks meet in the week ahead:  New Zealand, Norway, and Switzerland. None is going change rates.  That said, if there is a surprise, Norway is the most likely candidate.  The mainland economy may not be sufficient robust to offset the weakening energy sector (though increased investment has already been signaled).  Some risk of easing has been priced into the OIS.  

The SNB meeting is a non-event, now that the gold referendum was soundly defeated.  The cap and LIBOR targets will remain the same.  The central bank's challenges may increase next year as the ECB eases monetary policy further under conditions of zero interest rates.  Thus far, if the SNB intervened to defend its cap, it was limited in terms of size and number of operations.  

The Reserve Bank of New Zealand has been engaged in a mini-tightening cycle.  It is likely to confirm market expectations that it is shifted to a more neutral stance.  Ironically, several countries that tightened monetary policy has had to reverse it, including the ECB, Riksbank, and the Reserve Bank of Australia.  

The market will look ahead to the following week's FOMC meeting.  With new forecasts and Yellen's press conference, given recent economic data, it is an opportune time to modify some of the forward guidance the Federal Reserve provided under somewhat different economic conditions.  In particular, the market appears to be pricing in the possibility that the statement significantly dilutes or eliminates entirely the "considerable period" description of when rates will rise. Anticipation of this may put a floor under near-term dollar pullbacks, allowing consolidation to be the worst case scenario for the greenback in the coming sessions.