October Monthly

Trade,  central bank policy, and Brexit dominated the investment climate in September. The US-Chinese trade conflict stopped escalating.  Although face-to-face talks are planned in October and the list of exemptions from the punitive tariffs has increased (US soy and pork, for example, are now exempt as are 10 components of Apple’s Mac Book Pro from China), the tensions remain high.  The conflict is more than about more than trade.  It is also about market access, unfair subsidies, and intellectual property rights. 

The October 1 increase in US tariffs has been delayed until October 15.  Another round is to be initiated on December 15.  A key metric of the success of the negotiations will be whether these dates can be extended, if not suspended.  More broadly, a limited US-Japanese deal was struck, and work is said to continue toward a more comprehensive deal.  Japan essentially granted the US similar terms as what was struck at the Trans-Pacific Partnership after the US withdrew. In exchange, the US dropped tariffs on some consumer products and machine tools.  Perhaps the agreement on digital trade is an element that can be a model for future trade agreements The US and India are moving to a short-term agreement.  There is risk that US attention turns to Europe with WTO-approval for retaliatory measures to compensate for improper subsidies to Airbus.  A decision on US auto tariffs is required by the middle of November.  There is some risk that the short-run limited agreements violate WTO principles and may be challenged. 

The Federal Reserve and the ECB eased policy in September as had been widely expected.  The Fed retains the “midcourse correction” framing of its challenge, while the ECB’s measures are trying to arrest a slowdown as it appears the German engine continues to sputter.  It seems that the economy contracted for the second consecutive quarter.  Fiscal support appears to be too little and too late.  On the other hand, the stronger housing activity the US has reported and consumption are what would be expected if a decline in interest rates were to support the economy. 

The strain at the very short-end of the curve means that these operational issues will remain important ahead of the FOMC meeting at the end of the month.  We expect that to help investors keep separate the plumbing issues from the conduct of monetary policy proper by announcing its policy on meeting the apparent reserve needs of the banking system at the end of October.   That, coupled with the better data, an acceleration in inflation, and a strong dollar can buy the Fed time.  We expect another 25 bp cut at the December 11 FOMC meeting. 

The UK departure from the EU has been a torturous process.  The EU Summit in the middle of October is event ahead of the month-end deadline.  If no agreement has been struck by then, Parliament has instructed the Prime Minister to request a three-month delay.  We expect that the UK will continue to be part of the EU come November 1 and anticipate elections before the end of the year. 

  

Dollar:  One of the reasons why the dollar performed better in September was that there was a marked adjustment in expectations of the trajectory of Fed policy.  The implied yield of the January 2020 fed funds futures rose about five basis points despite the Fed’s 25 bp cut and a plurality of Fed officials thinking that one more cut this year will likely be appropriate.  Market expectations have converged our understanding of the reference to midcourse correction.  Greenspan’s use in the 1990s, as Powell briefly referred to in his press conference, signaled three rate cuts.  We are still concerned about the dollar’s longer-term cyclical advance for reasons we have previously discussed.  However, developments in Europe, Japan, and China do not exactly boost the attractiveness of the alternatives. 

Euro:  Europe is in poor shape.  Imagine that Germany appears to have contracted in Q3, the second consecutive quarter despite its entire yield curve being below zero.  While fiscal policy seems to be the obvious lever to boost aggregate demand, the Stability and Growth Pact set limits.  That said, the new European Commission appears somewhat more sympathetic than the predecessor.  A weaker euro works in the same direction, which is one of the things that distinguish this big dollar rally from the Reagan-Volcker and Clinton-Rubin rallies.  The euro’s weakness is not problematic for Europe now.   A new ECB President and a new European Commission have their work cut out.  Trade tensions with the US will likely intensify in Q4. 

(previous in parenthesis, end of July indicative levels)

Spot: $1.0900  ($1.0982)      Median Bloomberg Forecast $1.0965 ($1.1037)     

One-month forward $1.0935 ($1.1010)      One-month implied vol  5.8% (5.8%)    

Yen: The yen was the weakest of the major currencies against the dollar in September, falling about 1.3%.  The decline in global yields would have been expected to favor the yen.  The equity markets were firmer, and that is typically associated with a weaker yen, even though the Topix return of more than 7% was easily the best performer in the G20.  The economy appears to have lost some momentum as Q3 wound down and ahead of the controversial sales tax increase at the start of October (from 8% to 10%).  Although the economic justification and fiscal need are not so clear, especially given the debt servicing costs, it appears to have taken on a political life of its own.  The BOJ meets at the end of the month.  Should the economy show adverse effects from the sales tax, we suspect the central bank will cut its deposit rate.

Spot: JPY108.10  (JPY106.28)      Median Bloomberg Forecast JPY107.00 (JPY105.96)    

One-month forward  JPY107.80 (JPY106.05)   One-month implied vol 6.6%  (8.1%) 

Sterling: The UK Prime Minister Johnson insists that the UK is leaving the EU on October 31, no matter what.  The issue is with or without an agreement.  Before it was illegally suspended (ruled by the UK Supreme Court), Parliament passed a motion instructing the Prime Minister to request a three-month delay in the exit if no deal had been found.  The Prime Minister has indicated he will not follow Parliament’s advice, setting the stage for a constitutional struggle.  PredictIt.Org indicates a swing in sentiment.  At the end of August, an October 31 departure was seen a little more likely than not (58%-42%).  It swung hard against in September and finished the month with a nearly a delay being the 4-to-1 favorite.  An extension would not so much lift the uncertainty that is weighing on the economy but would replace one uncertainty for another. After a delay is granted, elections and no party will likely get a majority.  Sterling appreciated for the first three weeks of August and peaked near $1.2580 before reversing lower.  It managed to hold on to about a 1.5% gain to lead the major currencies. 

Spot: $1.2290  ($1.2156)   Median Bloomberg Forecast $1.2300 ($1.2192)          

One-month forward $1.2305 ($1.2172)    One-month implied vol 11.1%  (11.0%)   

Canadian Dollar:   The Bank of Canada remains neutral in the face of US rate cuts and the Canadian dollar has remained softer than expected in this context.  The Canadian dollar drew little comfort from the greater risk appetites reflected in rising equity prices (S&P 500) in 

September.  National elections will be held on October 21.  The polls have tightened in recent weeks, but Prime Minister Trudeau holds a modest lead.  A robust labor market and low-interest rates are underpinning the Canadian economy.  When adjusted for the 1.8%-2.1% headline and core CPI, real interest rates are below zero in Canada.  The market has pushed out rate cut expectations from Q4 19 and into Q1 20. 

Spot:  CAD 1.3245 (CAD1.3311)     Median Bloomberg Forecast CAD1.3225 (CAD1.3283)

One-month forward CAD1.3240 (CAD1.3305)    One-month implied vol  5.4% (5.6%) 

Australian Dollar:  The October 1 rate cut, the third since April, coupled with the tax cuts, and currency depreciation provide the needed stimulus for the Australian economy.  The Australian dollar has fallen in eight of the last ten weeks and depreciated by about 3.65% against the US dollar in Q3.  This overstates the stimulative effect as the Australian dollar fared better on a trade-weighted basis.  It was mostly steady against the Chinese yuan and euro, about 3% stronger than the New Zealand dollar in Q3.   The The Australian dollar gained about 0.5% against the dollar in September. 

Spot: $0.6750 ($0.6845)      Median Bloomberg Forecast $0.6770 ($0.6750)     

One-month forward $0.6760 ($0.6740)     One-month implied vol 7.2% (7.8%)   

Mexican Peso:   With the beginning of an easing cycle in Mexico, the US dollar appears to have entered a new and higher range against the peso.  The MXN19.40 area was the upper-end of range earlier this year, and now that appears to be the lower end of the new range.  It is not clear, yet the upper end, but the dollar briefly traded above MXN20.20 in late August.  The peso will likely be sensitive to data that fans expectations for further rate cuts, especially.  At the same time, its function as a proxy for emerging market currencies broadly, the peso is also vulnerable to global growth concerns and risk appetites.

Spot: MXN19.7330 (MXN20.06)   Median Bloomberg Forecast MXN19.74 (MXN 19.99)      

One-month forward  MXN19.8660 (MXN20.17)     One-month implied vol 9.4% (11.4%)

Chinese Yuan:  The yuan gained about 0.5% in September but ended the month under pressure.  Although trade negotiations between China and the US will resume, the next set of tariff increases have already been postponed once and are now scheduled for October 15.  News that the US is contemplated curbs portfolio flows to China and is conceived as separate from trade highlights hurdles to a meaningful deal.  China’s purchases of US soy and pork are necessary and not so much a sign of goodwill any more than the US exemptions on ten of fifteen Apple requests were kindness to Beijing.  The risks seem asymmetrically biased toward a weaker yuan in the month ahead. 

Spot: CNY7.1483 (CNY7.1560)       Median Bloomberg Forecast CNY7.17 (CNY7.1375)       

One-month forward CNY7.1235 (CNY7.1470)    One-month implied vol 5.3% (6.4%)

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