Six Issues for the Last Week of 2014

We identify six key issues for investors in the holiday-shortened week ahead.   

1.  The recent string of US economic data showed not only an upward revision in Q3 GDP to 5%, but also strong consumption data, rising confidence and continued improvement in the labor market (weekly initial jobless claims). This has reinforced market expectations for the Fed's take-off next year.  Both the December 2015 Fed funds and Eurodollar futures contracts imply the highest rates in two months.   At the same time, it is important to recognize that after growing above trend in Q2 and Q3, the US economy should be expected to return to toward trend, even though holiday sales appear strong.    This anchor of the divergence theme remains solid.  

2.   The divergence theme is not just based on favorable developments in the US, but more accommodative polices in Europe and Japan.  Expectations that the ECB will expand the assets it is purchasing to include sovereign bonds are widespread, and have helped push many European bond yields to record lows (10-year benchmarks).  The money supply and lending report is arguably more important than the final manufacturing PMI (January 2, flash 50.6).  It is slowly improving, and this is important for the second phase of the TLTRO program which is linked to new non-mortgage lending.  

3.  Complimenting the unorthodox Bank of Japan monetary policy, the Abe cabinet approved a JPY3.5 trillion supplemental budget over the weekend.  It estimates this spending will boost GDP by 0.7 percentage points.  It has been under preparation for a couple of months, but follows on the heels of disappointing and unexpected declines in industrial production and retail sales.  Despite the BOJ expanding its balance sheet by 1.4% of GDP a month and the decline in the yen, inflation pressures continue to subside. The supplemental budget will be financed by tax revenue anticipated by the stronger growth and unspent funds.  About half of it will be used to public works.  Of the remaining half, a third will be used to revitalize regional economies and two-thirds on programs to help households (e.g. shopping vouchers and subsidized heating fuel for low income households)  and small businesses (low interest rate loans for businesses hurt by rising input costs, i.e., weak yen).  

4.  Greece's parliament will try for the third and last time to select a president on Monday.  Failure to do so would trigger elections for either late January or early February.  This seems the most likely scenario.  Prime Minister Samaras does not appear able to secure 180 votes for his candidate Dimas.  It seems it is more about Samaras than Dimas.  The latest polls show that the anti-austerity Syriza still enjoys a small lead in a national election. The situation is very fluid, and there is some speculation that the New Democracy could replace Samaras (one possibility is Dora Bakoyannis, whose father was a former ND Prime Minister that Samaras once helped topple), which might make an anti-Syriza coalition more likely.  The political situation is stalling the negotiations with the Troika, and this could have serious ramifications by the end of March.  A perfect political and economic storm is brewing.  

5.  Rosneft's estimated $7 bln payment was a major factor behind the Russian rouble's recent collapse.  The dollar reached almost RUB80 on December 16.  It finished last week near RUB53.50.  It was trading just below RUB50 at the end of November.  The government and central bank are marshaling its resource, including plans to draw down the roughly $170 bln in two sovereign wealth funds (which are often included in reserve figures).  It has doubled the amount for which deposits will be insured.  It may have to recapitalize part of its banking system.  The relatively mild capital controls could scale up if necessary.  There are reports of limited price controls, such as for vodka. The fear of a Russian default has subsided, but has not returned to status quo ante.  The 5-year credit-default swap spiked to 630 bp in mid-December and is now near 440 bp.  Since 2011 it has been capped below 300 bp.  Belarus was more fragile.   The president replaced the government over the weekend.  Capital controls have been instituted.  It has roughly $4 bln foreign debt due next year, which would absorb most of its reserves.  

6.  Three forces were behind the sharp drop in Chinese money market rates last week.  First, the IPOs were launched (two postponed until next year), and the demand was not as strong as had been anticipated, freeing up some funds.  Second, seasonal year-end demand also subsided.  Third, and most importantly, reports indicate that the PBOC will waive reserve requirements for some types of deposits.  This was seen as an easing measure, but one that may pushed into next year a formal cut in reserve requirements.   The PBOC's move also ended what appeared to have been the beginning of a correction among Chinese stocks.  The Shanghai Composite rallied 6.5% in its last two sessions; its best two day performance in five years.  The yuan itself has been trending lower against the US dollar.  It has weakened by more than 1.5% since the PBOC surprised the market with a rate cut on November 21.  However, it is also important to recognize the yuan is appreciating on a trade-weighted basis.