New Month, Same Drivers

On the very first trading day of the year, the Nikkei, DAX, and S&P 500 gapped lower, setting the tone to a particularly challenging month for investors.  The last week and a half has been better, and this will likely carry over into the start of the new month.  Before January could slip into the history books, the Bank of Japan sprung a last-minute surprise by adopting a tiered system that includes a minus 10 bp charge to new excess reserves.

BOJ Kuroda was understood to have told a Davos audience a week earlier that the central bank was not considering negative interest rates.  Speculators in the futures market went into the two-day BOJ meeting with its largest net long yen position in four years and the biggest gross long yen position since 2008.

A few hours before the BOJ's announcement, the government reported a poor set of economic data that raised the prospect that the Japanese economy may have contracted in Q4.  It contracted in Q2 and, what was initially reported as a further decline in growth in Q3, was subsequently revised away.  From the ECB's meeting in early December through January 20, the yen appreciated 7% on a trade-weighted index.  It had already pulled back 2%  before the BOJ's move and surrendered another 2% in response.

The BOJ's actions, which opens a new dimension to its monetary policy, as well as Draghi's intimation that new measures are necessary for the ECB to meet its mandate,  are an effective antidote to claims among some that central banks had reached the end of the road.  If we had a nickel for every time such claims have been made over the past five years; we might be able to fund our own QE.   Monetary policy remains central to the investment climate.  This is not an anomaly.  Going back to the late-1970s, this has been more often the case than not.

Among the major central banks, the Bank of England and the Reserve Bank of Australia meet. Neither central bank is expected to change policy.  At the most, McCafferty, the sole BOE member that has been advocating an immediate hike for several months, might rejoin the fold, but it signifies nothing.

Sterling's 3.4% loss in January, the worst performing major currency after the New Zealand dollar (-5%), was driven by three factors.  Disappointing economic data, recognition that it will take the BOE much longer to hike interest rates, and fears over Brexit.  Slightly better than expected Q4 GDP, leaving H2 growth at the same pace as H1, failed to arrest the slide.  Growth in Q4 was on a narrow base, and the PMIs, which will be reported ahead of the BOE meeting, are expected to continue to drift lower.  

At least partly influenced by Japan's adoption of negative rates, the December 2016 short-sterling futures contract staged its biggest rally since September to reach new contract highs. The implied yield of 58 bp is consistent with no rate hike this year.  It is one basis point more than the March contract implies.  Without anticipating a rate cut, it is difficult to see much more of a decline in the implied yield for the end of the year.  

Under the new communication regime, the BOE's quarterly inflation report will be released at the conclusion of the MPC meeting as well.  The 7.3% decline of sterling's TWI's from mid-November through January 19 was likely welcomed given the large merchandise trade deficit and low inflation. 

The base effect signals the year-over-year increase warns that when January UK CPI is released, it will likely have increased, but officials and investors will look through it.  Wage growth is slowing and the new decline in the price of Brent (though it has recouped nearly 70% of decline seen to start the year), warns of a forward guidance that confirms what the market has already discounted.  The BOE is in no hurry to follow the Federal Reserve in hiking rates.  

The RBA makes its decision on Tuesday.  Governor Stevens will likely recognize the downside risks on inflation and the recent turbulence in the global markets.  He is unlikely to be comfortable with the  4.6% appreciation of the Australian dollar on a TWI over the past couple of weeks.   Stevens will point to the scope to cut rates.  

However, it requires the prospect of a stronger currency, lower inflation and weaker growth in some combination for the RBA to deliver.    The quarterly monetary policy statement will be released at the end of the week, but the details typically flesh out the Governor's post-meeting press conference.  

Market expectations for Fed policy this year has also swung hard.  Judging by the Fed funds futures strip, not only are the Fed's four rate hikes, deemed appropriate by the median dot-plot from the middle of December, doubted by the market, but investors are not fully discounting a single hike.  The December Fed funds futures contract closed January with an implied yield of 55 bp.  It is consistent with about a third of a chance that the Fed does not even hike rates once.  

It is difficult to envision pendulum of expectation swinging much harder against the Fed.   The US January employment report on February 5 is important.  Given the recent averages, it is unreasonable to expect that job growth exceeded December's 292k.  The consensus is around 190k though we suspect the risk is on the downside.   Provided the surprise is not significant, attention can focus on the details.  There is a chance the unemployment rate cut tick down to 4.9%, a new cyclical low.  

Hourly earnings is also important.  The problem here is the base effect.  Last January hourly earnings rose 0.6%, and this will drop out of the year-over-year reading. Hourly earnings rose 1.8%  in 2014 and 2.5% in 2015.   In January, hourly earnings likely by 0.3%, which is a little above the 12- and 24-month average, but the year-over-year rate will fall back to 2.2%.

The employment data may also help quiet those who think the US is in a recession.  A well-known hedge fund managers have been critical of the Fed's hike, and at least, one has forecast QE4. A recent Bloomberg article discussed the wagers or insurance being purchased on the US having negative rates by the end of next year.   

Simply stated, a recession in the US requires a rise in unemployment.  It has been falling.  It requires a decline in payrolls.  Both the establishment and household surveys shows expansion.   It is true that the goods sector is doing poorer.  We share three observations.  

First, part of this is impact from the dramatic drop in oil prices.  This adversely impacts investment, orders, shipments, and output.  It does appear that employment in the states where energy production is important has seen a larger downdraft the output itself.  

Second, we need to be careful what is being measured.   There is a volume and value component. A decline in prices can have dramatic impact on value measure that overshadow the volume. Moreover, partly due technological progress, capital equipment, like other goods prices appear to be falling in real terms.  

Third, the worst for the manufacturing sector may be passed.  Markit's final January PMI reading for manufacturing is expected to confirm the improvement to 52.7 from 51.2 in December.  The ISM for manufacturing is also expected to improve from the lowly 48.2 reading in December.  The gap that we noted between the manufacturing and service ISM readings has begun narrowing in recent months and is expected to have done so again in January.  Lastly, even though US vehicle sales are slowing from the record pace last year, a small sequential increase from the 17.22 mln pace seen in November, is still robust and will support output.   

The process of selecting the next US President enters a new phase.  Individual states will hold contests.  The first is February 1 in Iowa.  The results of the Iowa caucus tends to be immaterial in the selection of the Republican nominee.  Moreover, the candidate that wins in Iowa tends to lose in the next contest (New Hampshire on February 9).   Iowa does a better job of picking the Democrat nominee.  The major blemish on its track recent track record is when a favorite son, a local or neighbor politician was in the contest as was Gephardt (Congressman from a bordering state) in 1988 and Harkin (Senator from the Iowa).  

PredictIt, a event-market site favors a Trump and Clinton victory in Iowa.  The confidence of a Trump winning is greater than the confidence in Clinton winning, and in recent days, reports suggest momentum is moving in Sanders' favor.   PredictIt shows Trump is the favorite in New Hampshire.  Sanders, who comes from neighboring Vermont, is expected to beat Clinton handily.  

Investors continue to be sensitive to movement of oil prices.  We can understand that reports of discussions for a 5% cut in output can excite the market.  However, we are struck by the resilience of prices even after the reports played down the chances of a Russian-Saudi deal.    Given geopolitical considerations, Saudi Arabia will be understandably reluctant to cede market share to Iran, which would seem to be the case if the Saudis agree to cut output in the coming months.  

Russia may grow increasingly confident that the sanctions imposed by Europe and the US over Ukraine will begin winding down around midyear.   The narrowness of the spread between the US WTI and European Brent, US oil exports will likely have a very slow take-up.  

It almost seems as if the Chinese yuan has been re-pegged to the dollar.  Consider that the dollar has been trading within the range set on January 8 (CNY6.5668-CNY6.5962) ever since.  And that even overstates the range.  In the last two weeks, it has been confined to a CNY6.5738 (seen before the weekend) and CNY6.5840.  

China has been pumping large sums of liquidity into the banking system, ostensibly ahead of the extended New Year's celebration.  Some suspect some more permanent action is being taken as well, but we are not sure the advantages of making it covert.   The Shanghai Composite stabilized in the second half of last week, but its durability is an open question.  We suspect officials want to get into the holiday period, which may help serve as a circuit breaker of sorts.   

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