China’s Plan That Could Change The World

FX: China’s Upcoming 383 Plan Could Change The World

Between the sharp rise in U.S. payrolls and the European Central Bank’s 25bp rate cut, it has been an extremely active week in the foreign exchange market. Investors have a lot to digest because the outlook for many currency pairs have changed as a result of this past week’s developments. There are no major U.S. economic reports on the calendar next week but a number of policymakers are scheduled to speak including Fed Chairman Ben Bernanke. Based on Friday’s comments from Fed Presidents Williams and Lockhart, the recent string of positive economic surprises have made policymakers more optimistic and willing to consider advancing their plans for tapering. While we don’t expect much clarity in the coming week, the dollar could extend its gains especially if U.S. Treasury yields continue to rise. Ten-year bond yields jumped approximately 15bp Friday, explaining the breakout move in USD/JPY. For the U.S., the most important event next week will be Janet Yellen’s confirmation hearing on November 15th. If it hits any snags, we could see a sell-off in the dollar.

However considering that no surprises are expected out of the U.S. in the coming week, the world’s focus will be on China because the ruling party is expected to unveil a comprehensive economic and political reform plan that could mean dramatic changes for China and the world. Over the past three decades, China has become a major player in the global economy and their pace of growth impacts many countries around the world. The decisions that led to China’s golden age were announced by Deng Xiaoping at the 3rd Plenum of the 11th central committee in 1978. The Chinese government holds plenary sessions every year but meetings with the central committees, which involves the China’s top 370 party members only happens every five years and the meetings that follow a major leadership change are even rarer. The first plenum usually introduces the new leadership, the second one the personnel and the third, the policies. The last time a third plenum of the central committees took place in 1993 after Jiang Zemin succeeded Deng and before then in 1978. That was the year the country’s “Reform and Opening” policy was announced, a program that completely transformed the nation, boosting annual incomes from $200 a head to $6000 Friday. Jiang Zemin introduced China’s “Socialist Market Economy” in 1993 but the results of his policies are debatable. China’s current party chief Xi Jinping has promised game changing reforms at the coming meeting and everyone is holding their breath to see if China will dazzle the world.

There are many areas in China that are in desperate need of reforms – state enterprises, land ownership and of course pollution. We already know what some of these reforms could look like because the Development Research Center of the State Council released an ambitious plan to create a “vibrant, innovative and inclusive economy protected by the rule of law” that focuses on the market, government and corporations last month. Dubbed the 383 Plan, it includes three areas of reform, eight sectors to reform and three major reform breakthroughs. A lot of these are social changes including a social security system, environmental protections, new land ownership and transfer rights, trade liberalization, policies to encourage innovation, plan to reduce corruption and government interference on the economy. The details are expected on November 12th but as we have seen with Deng Xiapoing, it could take years to implement his policies properly. Nonetheless if China achieves their goals, it could dramatically alter the livelihood of 1.4 billion people and shakeup the world.

The Third Plenum is not expected to have an immediate impact on currencies, although given the amount of buzz around this meeting and the promises that have been made, there’s always the risk of the announcements falling short of expectations. Economists will also worry if China will be able to achieve these goals without slowing growth dramatically because social reforms always cost money. This poses a greater downside than upside risk for high beta currencies but China needs these reforms and while there could be short-term pain, it should have long term gains for more than a billion people and the global economy.

Dollar Could Head Higher On Position Adjustments

Investors bought dollars aggressively on the back of the payrolls report and we think the greenback could head even higher. Considering that the most optimistic forecast from economists Friday was for 175k jobs, investors were clearly not positioned for such a strong report. According to the latest CFTC IMM report for the week of November 5th, investors cut their long EUR/USD positions by 50% but even with this reduction, speculators still hold more than 33k long EUR/USD contracts. With consistently positive U.S. data surprises coming at a time when the ECB just reduced interest rates and indicative their readiness to ease again if needed, we expect to see a further unwinding of long EUR/USD positions. At minimum we expect the currency pair to drop to the 200-day SMA at 1.3215 and if the move becomes extended down to 1.30. If the currency pair rebounds, 1.3450 should continue to cap gains in the EUR/USD. As for USD/JPY the pair has already broken through 99 and will likely test 100 in the near term especially if U.S. yields continue to rise.

Recent U.S. economic reports show that the government shutdown in the month of October had very little impact on the economy. Despite the uncertainty surrounding the fiscal crisis in Washington, U.S. companies added 204k workers last month, sending the dollar sharply higher. This was the second largest month of job growth since February and all of those gains were in the private sector with the government shutdown costing the U.S. economy only 8k public sector jobs. For the skeptics who doubted the Federal Reserve’s willingness to ease before March, Friday’s report extends a string of positive economic surprises that could give policymakers the confidence to reduce stimulus in the next one to three months. There were areas of weakness in the report but they should be temporary. The unemployment rate rose from 7.2% to 7.3% in the month of October while the participation rate dropped to a 3 decade low of 62.8% from 63.2%. The increase in both numbers are related to the loss of federal jobs and are therefore temporary. There was significant increase in temporary layoffs last month and without this impact, the unemployment rate would be much lower. In fact, if the government shutdown did not happen, the unemployment rate could be at 7.0% and with the anticipated snapback in government jobs in November, labor market conditions are strong enough for December tapering to be a serious option for the Fed.

EUR: Still Looking For A Move Below 1.33

While the euro traded lower against the U.S. dollar Friday, the sell-off is surprisingly mild considering the strength of U.S. payrolls, the rise in Treasury yields, weakness in euro-zone data and S&P’s decision to lower France’s sovereign debt rating one notch from AA+ to AA. Given this week’s developments, the EUR/USD should be trading much lower but the currency pair has found support from the hope that recent rate cut by the ECB will help spur a stronger recovery in the region next year. As the ECB’s goal is to shorten the period of inflation and promote stronger growth, these investors should eventually be proven right but in the near term, with U.S. yields shooting higher and the gap between ECB and U.S. monetary policy widening, we are still looking for the EUR/USD to drop below 1.33. Trade activity in Germany improved in the month of September but the upside surprise was offset by the sharp decline in French industrial production, validating S&P’s downgrade. The rating agency expressed concerns about the government’s current policy course and its ability to boost growth. They felt that “high unemployment is weakening support for further significant fiscal and structural policy measures.” A downgrade for France is bad news for the region but the announcement had very little immediate impact on the currency as investors looked to the ECB rate cut for support. Instead, EUR/USD only collapsed after the strong U.S. jobs report. Meanwhile in other rating news, towards the end of the U.S. trading session Moody’s upgraded its outlook on Portugal from negative to stable but that had no impact on the currency. Looking ahead, the most important event risk for the euro next week should be the region’s third quarter GDP report.

GBP: Rally Halted by Larger Trade Deficit

After four days of consistent gains, weaker trade numbers halted the rally in sterling. Due to a rising currency, exports declined 0.7% decline in the month of September while imports rose 0.2%. This caused the country’s goods trade deficit to widen from GBP 9.56 billion to GBP 9.92 billion. The sharp sell-off in EUR/GBP in particular drove the U.K.’s deficit with the European Union to its highest largest level ever and while sterling gave up its gains in October, it is now stronger than where it was in September. Trade activity weakened significantly in the third quarter and will most likely remain weak in Q4 unless sterling reverses its rise. The deterioration in trade will contribute negatively to GDP. The European Commission believes that Britain’s current account deficit, which includes trade in both goods and services will hit 4.4% of GDP next year, the highest of any major industrial country. Without an improvement in trade activity, U.K. policymakers will most likely err on the side of caution with regards to monetary policy. Looking ahead, we expect the pound to be one of the most active currencies next week. The Bank of England will be releasing its Quarterly Inflation Report and updates to their growth and inflation forecasts can have a significant impact on the currency. In addition to this closely watched report, inflation, employment and retail sales figures are also scheduled for release. Any one of these reports could trigger a big move in sterling and the fact that they will be released successively means that it will be a busy and active week in the currency.

JPY: All Eyes On Next Week’s Q3 GDP Report

All of the Japanese Yen crosses traded higher Friday thanks to the 1% rise in USD/JPY and the gains in U.S. equities. While the Nikkei dropped to a one-month low overnight, Japanese stocks should recover when they reopen for trading on Sunday and investors in Asia have the opportunity to digest the strong nonfarm payrolls report. We expect further gains in the Yen crosses as USD/JPY makes its way to 100. Next week will be a busy one in Japan and we may actually see Japanese fundamentals affect how the Yen trades. Third quarter GDP numbers are scheduled for release. Despite all the signs of a steady recovery in Japan, economists are looking for growth to slow from 0.9% to 0.4% in the third quarter as exports weakened. According to the retail sales report however, consumer spending has been healthy, which suggests that GDP growth could surprise to the upside, providing additional support to Japanese stocks and in turn USD/JPY. Even if growth weakens, a snapback is expected in the last quarter of 2013 and first quarter of 2014 as consumers rush to spend before the consumption tax is increased. Aside from GDP, the country’s trade balance, consumer confidence and the Eco Watchers survey are also scheduled for release next week. Japanese investors continue to buy foreign bonds and we suspect demand will only increase with the recent rise in U.S. yields.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.