Focus Shifts Away from the US

(Updates will be less regular during my business trip to Asia)

From the Federal Reserve's reluctance to raise interest rates in September, through the soft employment and retail sales report, and two Fed Governors arguing against a rate hike this year, the pendulum of expectations as swung hard.   The implied yield of the Fed funds futures does not rise above 37.5 bp, ostensibly the middle of the target range following a rate hike until July 2016.  Barring a contraction in the US economy or deflation in core measures of inflation, it is difficult to envision shift out in expectations.

The US economic calendar in the week ahead features the latest readings on the housing market. News from this sector is unlikely to shift expectations.  The dollar's recovery last week began with new that weekly jobless claims matched the cyclical low while the smoothed four-week moving average fell to new post-crisis lows.   Confirmation may be sought this week that it was no statistical fluke.  While US growth in Q3 may be soft (~1.0%-1.2%), the trend in weekly jobless claims is not consistent with a contracting economy.  

A Financial Times survey found none of the nearly 2/3  economists it polled that anticipate a Fed hike this year expect it to be delivered this month.  The focus is on the mid-December meeting.  The next nonfarm payroll report in early November is the next key piece of news for such expectations.  This means the focus will shift to Europe and Japan.

With the euro's upside momentum stalling in front of  $1.15 last week, we suspect it will be difficult to rebuild it ahead of the ECB's meeting this week.  At its September meeting, the ECB staff reduced growth and inflation forecasts.  This is how a shift in policy begins.  First, the economy does not perform as expected.  Next, a consensus has to be formed that a policy response is in order.  Then an agreement on that policy response is necessary.  

This week's meeting is still too early in the process to expect an agreement.  However, some progress toward building that consensus is likely, and that is what investors will be keenly monitoring.  There are three broad ways that the asset purchase program can be tweaked.  

1.  An extension to the current program, which has a soft deadline of September 2016 can be announced.   This seems to be among the favorite scenarios among investors.   Some talk about a six-month extension.

2.  The amount of asset being bought can be increased.  There is a certain logic to this.  If the amount is increased, then there may not be a need to extend the duration of the buying.  Increasing the duration of the program represents a longer commitment but not necessarily a more effective operation.

3.  The composition of what is being purchased can be altered.  The asset-backed purchases have not been particularly successful.  A more aggressive program could include bank bonds or corporate bonds.  

The ECB could also cut the negative deposit rate from its current minus 20 bp.  Given that the current rules prohibit buying government bonds with a lower yield than the deposit rate, this would also increase the assets available to it.   A more negative deposit rate may also have a greater immediate impact the euro, whose appreciation on a trade-weighted basis does the central bank's efforts to resist lowflation/deflation no favors.  It could also be a compromise between those who want to do more and those who are skeptical of the merits of QE in the first place.  

Attention will also shift toward the end of the month BOJ meeting.  Many economists expect that the Japanese economy contracted for the second consecutive quarter in the July-September period.  The BOJ's officially preferred inflation measure (consumer prices excluding fresh good) has slipped back into deflation territory.   

A year ago, without warning, the Bank of Japan raised its monetary base target to JPY80 trillion from JPY60 trillion on a 5-4 vote.  The market was shocked and is understandably afraid of getting bit by the same dog twice.  

Still, the BOJ seems reluctant to add to its already very aggressive and open-ended program.  Governor Kuroda continues to appear to look past the preferred inflation gauge, and toward a measure of consumer inflation that excludes both food and energy.  By this measure, Japanese inflation is above 1%.  This would imply no great urgency to deploy more monetary measures.  The government seems to recognize this, and there have been no reports (we have seen) that Prime Minister Abe or Finance Minister Aso are objecting or pressuring the BOJ for more action.  

There are other countries that could ease policy before the Fed finds the opportunity to hike rates.  The easing of consumer price pressures in China could spur the PBOC into easing monetary policy in the coming weeks.   Real interest rates are high, and there is plenty of room to cut the reserve requirements, which were a type of macro-prudential policy aimed at neutralizing the previous hot money inflows.    A rate cut by the Reserve Bank of Australia came back into play following last week's news that one of the country's largest banks raised the rate of variable rate mortgages.   The bank cited tightening of financial conditions.  The RBA could act to offset this.   Norway's central bank has already warned investors to expect another rate cut, without precommitting to it.

This is to say that the divergence meme is alive and well, and the focus is not so much on when the Fed will raise rates.  Lift-off is most unlikely to take place before the mid-December meeting.  However, the other side of divergence is what other countries are doing.  Those same forces that are giving the Fed pause may spur others to ease policy further.   Economic data and events will be seen through this prism.   

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