Dollar Eases as Key Events Still Awaited

The Reserve Bank of New Zealand and Sweden's Riksbank can still surprise investors, but it is the BOJ and FOMC meetings that are the talk of the markets.  

Surveys suggest that around 40% of investors expect the BOJ to expand its asset purchases program this week.  We are less convinced.  Moreover, many real money clients spoken think the BOJ sticks with its current target of increase base money by JPY80 trillion a year.   This raises the possibility that the surveys are not sufficiently up-to-date. 

There appears to be no pressure from the Abe government on the BOJ.  Finance Minister Aso and two government advisers have downplayed the need for more action now .  BOJ officials we have spoken with of course did not reveal what the central bank will do, but they pushed back against the arguments that emphasize the urgency of new action.

The BOJ wants to look past a rare but dramatic drop in oil prices, even though it formally target a narrow definition of core inflation (CPI excluding fresh food).  It also recognizes that inflation expectations are firm.  A BOJ survey of consumers found the perception that prices are rising around 5% year-over-year.  Businesses also expect greater price pressure next year.  There are reports suggesting Japanese households are showing a new preference for fixed rate mortgages.  

BOJ officials recognized that GDP may have contracted in the July-September quarter.  However, this also did not seem to instill a sense that a monetary policy response was required.  The problem is that potential growth is so low that the normal variance could see an occasional drop into negative territory without signaling economic deterioration.   Boosting trend growth is not a function of monetary policy, but underlies Abenomics 2.0. 

No one expected the Federal Reserve to change policy tomorrow.  Those who expect a move this year after focused on the mid-December meeting.   The overall assessment of the US economy is unlikely to have changed significantly.  It will be interesting to see how it characterizes the labor market after two soft nonfarm payroll reports.  However, other readings on the labor market do not confirm the deterioration.  Specifically, the ADP estimate showed no marked slowdown in employment and the weekly initial jobless claims (four-week average) is at new cyclical lows. 

Although many observers claim to be tired to a Fed move hanging over the markets, they will have to be patient for a bit longer.  The Fed's communication has shifted expectations from date-dependent to data-dependent.  To rule out a December hike, which some observers anticipate, would see to undo some of that necessary work. 

In addition, the Fed's leadership has continued to suggest that provided there are no new negative surprises, and the economy evolves as officials expect, it still anticipates a hike before the end of the year.  As there are two meetings left including this week's meeting, it puts the onus on the December meeting.

There are three things we have encouraged investors to focus on when trying to assess the risks of a December move.  First, listen to the Fed's leadership--Yellen, Fischer, and Dudley.  Dudley's warning in August that a rate hike was less compelling was a good tell of the September disappointment.  Second, watch the data on the US labor market.     Like in Japan, the continued improvement in the labor market offsets much of the disappointment elsewhere.  Third, watch the global markets.  Global stock markets need not rise, but ideally the current relative calm persists. 

Given that the September FOMC cited market-based measures of inflation expectations as a factor in their decision not hike rates, one might be tempted to focus on the break-evens.  The 10-year break-even (difference between the yield of a conventional 10-year bond and an inflation-linked bond) has firmed slightly since the end of September, but it struggles to sustain a move above 150 bp. 

However, we suspect the Fed had decided not to hike in September and then found the reasons.  As we noted, within a few days of the FOMC September decision, the San Francisco Fed released a paper that found that the break-evens were among the worst forecasts of future inflation.  It will be interest to see how the FOMC statement addresses inflation expectations.  The survey based measures remain fairly stable.  

The US dollar advanced sharply in the second half of last week following the dovish Draghi and easing by the PBOC.  It consolidated those gains yesterday and today in Asia.  A BOJ that does not increase its QQE could see a knee-jerk gain in the yen.  The JPY120.35-40 area offers initial support.  A break of JPY120 would be disappointing.  The euro has posted some upticks after dipping below $1.10, which did not spur new selling.  Euro gains could extend toward $1.1100-$1.1125 before frustrating the bears.  

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