Eight Things on My Mind at the Start of the New Week

1. Nous Sommes Paris:  The attack in Paris is tragic and reprehensible.   Our thoughts and prayers are with the victims and the people in France.   There are several political and economic consequences, aside from the tighter security and elevated alertness.  The attack overshadowed other issues at the G20 meeting. On one hand facing terror, investors often reduce risk.  At the same time, officials often provide reassurances that they have the will and means to address any liquidity needs.  

The attack on France may have serious repercussions on the immigration/refugee debate that has already unleashed centrifugal forces pulling Europe apart as much if not more than the creditor/debtor dispute that focused on Greece earlier this year.  In terms of more parochial political issues, it may serve as an opportunity for a political reset for French President Hollande, whose support has been undermined by the poor economic performance.  In Germany, Merkel has taken a bold and controversial stance, and her critics are likely to use the Paris attack to press their case.

2.  SDR:  After the markets had closed for the week, IMF's Lagarde announced that the staff has concluded that China meets the requirements to join the Special Drawing Right.  Not only do they judge the yuan to be "freely usable", but also that China has "addressed all remaining operational issues identified in an initial staff analysis submitted to the Executive Board in July."  In recent days, some observers feared that nine consecutive higher dollar-yuan fixes and some re-widening of the spread between the onshore and offshore yuan (CNY and CNH) would jeopardize China's ascension. US and European officials have indicated that provided that China meets the IMF criteria, which the staff says it does, they will not block it.  

Assuming that this is the case, there are two immediate issues.  First, currencies in the SDR are assigned a weight.  What will be the yuan's weight?  Many observers who have addressed this issue anticipate that the yuan's initial weight is something more than the yen's 9.4% share and around sterling's 11.3% weight.  The risk seems to be on the downside. The weighting is determined the size of a country's exports and the use as a reserve asset.  The first consideration would appear to give China a high share given that it is the world's largest exporter. However, an important caveat is that Hong Kong, a part of China it refers to as a Special Administrative Region, takes in around 15% of China's exports, which are not really exports under the traditional definition.  As a reserve asset, China's share is well below even the Canadian and Australian dollars, let alone the yen and sterling.   The IMF estimates that it is around 1%.

The second issue involves the reaction by investors and reserve managers.  Recall new SDR basket will not be launched until September 2016.   The yen's inclusion in the SDR has not made the Japanese currency a major reserve currency or an important international currency.  Foreign investors tend to hold a low share of Japanese equities, and their Japanese government bond holdings are well below benchmark indices.  Inclusion in the SDR is not the necessary and sufficient condition to attract asset and reserve managers. The continued opening up of China's financial markets and greater transparency are the keys.    We argue that the real value of joining the SDR lies in the acknowledgment that China is one of the great financial powers.

3.  Fed and US Data:   The data in the week ahead is unlikely to shake investors' confidence that the Fed will raise interest rates next month.  The Reuters survey found that following the jobs data 15 of 17 primary dealers (~88%) expect a December lift-off.  A Wall Street Journal poll found 92% of business and academic economists expect a hike then as well.  Many Fed officials that have spoken, including the leadership, have noted the resilience of the US economy.  Moreover, due to recent inventory and trade figures, Q3 GDP is likely to be revised up, while the Atlanta Fed GDPNow is tracking 2.3% growth in Q4. The Federal Reserve will recognize that as a little above trend growth, which means it is consistent with further absorption of labor market slack.  

Minutes from last month's FOMC meeting will be released in the middle of the week. While offering some insight into the Fed's thinking about the downgrade of the global risks and the departure from the data dependence to specifically refer to "the next meeting", it is unlikely to alter opinions about the timing of lift-off.  

4.  ECB and EU:  Both monetary and fiscal policy issues will be on the agenda in the week ahead. The EU anticipates finalizing its assessment on draft budgets of its members for the new year.   Investors may concentrate on three countries:  France, Italy, and Spain, who appear to be seeking some degree of forbearance.    The EU reviewing draft budgets is a new post-crisis development, and represents some whittling of sovereignty, especially for EMU members, who can ostensibly be sanctioned.

The record of last month's ECB meeting will be published midweek.  Draghi sent dovish signals that raised confidence that the ECB would adjust its asset purchase program in some way (size, duration, instruments) and would also consider cutting the already negative deposit rate.   Previously Draghi had indicated that at minus 20 bp monetary policy had been exhausted.  However, other countries, such as Switzerland, Denmark, and Sweden have demonstrated that how ever far policy rates can be pushed below zero minus 20 bp is not the limit.

In recent days, Draghi has elaborated on his argument.  He anticipates that the new staff forecasts will project that reaching the ECB's inflation goal will take longer.  A possible uptick in the final October CPI to 0.1% from zero will not change the debate one iota. Draghi expressed disappointment that the previous signs of a sustained recovery in the core rate of inflation appears to be fizzling.  Some ECB officials have pushed back, and the record may offer insight into the relative strength of these objections.  The record will also be read with an eye toward assessing how the asset purchase program will be adjusted.

Cutting the deposit rate further would also potentially expand the universe of assets the ECB can buy. It is currently limited to buying instruments with yields above minus 20 bp.  This presently excludes two-four year German paper for example.  Buying municipal and regional bonds, which has been floated, would also increase the universe of German assets that can be bought.  Germany has the most developed sub-sovereign bond market.  We do not expect to see much discussion of this in the ECB's record.

Lastly, here may have been some discussion of the Emergency Lending Assistance program.  The Greek experience raised various questions about its operation.  Currently the ECB grants (2/3 majority required) the authority to the national central bank, who bears all the risk.  Given the ECB's function, it is not exactly clear what it means that the national central bank is responsible.   There are several ways that the Eurosystem is ultimately responsible.  There may be discussions of changes in the operation of ELA, and the direction is to formally make it more European and less national.

5.  Japan:  The first estimate of Q3 GDP will be released first thing Monday in Tokyo.  It will likely show a small contraction, which will probably be less than half of the Q2 contraction of 1.2%.   Business investment, public investment, and net exports are the suspected drags, while private consumption likely gained traction.  Pay no mind to those claims that Japan has fallen into a recession.   Remember recession has no fixed definition, though plenty of rules of thumb.  There is no reason to believe that Japan's business cycle has turned.  When trend growth is 0.5% or less as the BOJ suggests, the normal variance of GDP could push it into contraction territory without signaling anything very meaningful.  Importantly, Japanese officials, including BOJ's Kuroda are not going to respond as if it were a recession.  

6.  UK:  Following the guidance of the BOE's leadership, the market accepts that a UK rate hike is unlikely to be delivered in the next few months; that it will lag further behind the Federal Reserve than previously understood.  Data in the week ahead will give investors little reason to question this view.  Consumer inflation is expected to remain at -0.1% year-over-year, but the risk is on the downside.  However, looking at base effects, this looks to be the bottom for now and possibly for the cycle.   Retail sales are likely to be soft on a month-over-month basis as the rugby championship goose to sales unwinds.  As an alternative to the dollar, and as the long leg of crosses, sterling has much to recommend itself.  

7.   Canada:  Oil, interest rate differentials, and the general appetite for risk are the drivers of the Canadian dollar.  The three forces are moving against it.  The CPI and retail sales reports that will be released in the days ahead of unlikely to do it any favors.  Headline inflation is expected to be little changed while the core rate is anticipated to be steady at 2.1%.   The decline in oil prices is deflationary, but the Canadian dollar's deprecation is inflationary.  The more pressing problem for Canada is growth.  Retail sales will likely drag down by the decline in gasoline.  Excluding autos and gasoline, Canadian retail sales are expected to have risen by 0.4%.  We suspect the risk is on the downside.  

8:  Politics on the Iberian Peninsula:  Portugal finds itself at a precarious juncture.  The minority center-right government collapsed when a center-left coalition blocked its program.  However, rather than allowing the center-left coalition to form a government, there is pressure to allow the minority center-right government to serve as caretaker until elections can be called, which constitutionally would not be for several months.  Meanwhile, over the objections of the center-left, the government has gone ahead with the privatization of an airlines.  Before the weekend, DBRS affirmed Portugal's investment grade status, with a stable outlook.  This averts a crisis.  DBRS is the only ECB-recognized rating agency that gives the country such a rating.  For the others, Portugal is not investment grade.  If Portugal were to lose it, it could limit the use of the government bonds for collateral at the ECB, and prevent the purchases of those Portugal's bonds under QE.  The economy stagnated in Q3, and the EU is requiring more austerity measures.  

There are two main forces that are elevating the political risk in Spain.  First, Catalonia is pushing hard for independence, and this is a serious confrontation with Madrid.  The federal government and the judiciary are pushing back.  Ironically, the secessionists may impact the second source of political risk which is next month's national elections.  Although over past 18 months or so Spain has emerged with one of the more robust economies the-the euro area, Prime Minister Rajoy has received very little credit.  Scandals and frustration with the PP have seen the rise of a centrist alternative, which is running ahead in the polls.  The once vibrant Podemos is now polling around 10%.  While Syriza may not have helped, reports suggest internal strife within the party was its downfall. 

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