FX Drivers For The Week Ahead

At the risk of oversimplifying, there seems to be a single overriding driver of the global capital markets in the coming days. It is how investors see the implications of last week's dismal jobs data.

In particular, many observers are suggesting that it raises doubts over the Fed's willingness to continue to pull back from its asset purchases, as generally outlined alongside last month's tapering decision. Some observers have linked it to arguments that the economy has become dependent on QE and at the first sign of withdrawal there is a loss of activity.

The immediate response was to send US Treasuries broadly higher and the dollar lower, against nearly all the major and many emerging markets currencies. The main exception was the Canadian dollar, which was weighed down by its own poor data and the beginning of speculation that the Bank of Canada may cut interest rates.

The weakest monthly jobs report in a couple years spurred speculation that the Federal Reserve may postpone the next tapering move. It was expected to be announced at the month-end FOMC meeting, and would have brought the Fed's asset purchases down to $65 bln a month, which, incidentally, is lower than the BOJ's own QE program. For some others, who had begun playing with scenarios about the possibility of an upside surprise for the US economy this year and the risk of an earlier Fed rate hike, the jobs data was also a blow.

We expect the Fed to go ahead with its slowing of QE purchases. Fed officials have argued that there has been a cumulative improvement in the labor market. A month's disappointment will not change that understanding, though a second dismal report may be harder to shake off. Moreover, one does not have to venture much beyond the weather which is seen as a mitigating factor.

That said, the market's apparent lack of conviction may be an important signal in its own right. Specifically, as we have argued, the Fed's recent decisions, and especially the forward guidance, was issued by, for the lack of a better option, a lame duck Federal Reserve chairman. Moreover, as Obama's nominations of two new Fed governors (and renomination of Powell, currently a governor), including a new vice-chairman to replace Yellen before the weekend, underscores, the seven-person Board of Governors is also changing. The fact that some say the Federal Reserve that provided the forward guidance is not the same Federal Reserve that is to implement it so simply cannot be as credible, is not right since in actuallity, it's the same personnel doing both. Still, 'there's many a slip twixt the cup and the lip', the English proverb teaches, so investors beware.

Nevertheless, the jobs data and this uncertainty means that the market will pay extra close attention to the Fed officials that speak and the data that's announced in the week ahead. Half of the twelve regional Fed presidents will speak during the week, as will Bernanke. The Fed will also release the Beige Book, ostensibly used for the next FOMC meeting. The same considerations that have prompted many economists to revise upward their forecasts for Q4 GDP (due the day after the next FOMC meeting), may see a relatively upbeat report.

Separately, the US real sector data, like retail sales, industrial production and housing starts, risks being on the soft side. These reports, like the jobs data, suggest that even if Q4 GDP is in the 2.50%-2.75%, the quarter ended with poor momentum (and this was before the polar vortex).

We already know that auto sales were poor and weakness in brick-and-mortar sales may be partly blunted by growing internet commerce. It is notable that household consumption is steady and this is with limited new credit card usage. The employment data and weather suggest some weakness in industrial production, though this may be mitigated by greater utility output. The outsized 22.7% jump in November housing starts and the weather factor highlight the downside risk to the December report.

If the real sector bias is on the downside, the bias on the price metric, import prices, producer prices and consumer prices is on the upside. This may in part be due to higher energy prices. However, given that the Fed chose to taper despite the lack of evidence that its preferred measure of inflation, the core PCE deflator was moving back toward the 2% target, means that barring new weakness, inflation measures are not very helpful in determining the near-term course of Fed policy.

While we expect a mostly US-centric week, there are a few economic reports from other countries to note. In light of recent Canadian developments, the central bank's senior loan officer survey, to be released Monday, may be important in assessing financial conditions. On balance, we think the recent sell-off has been too much too fast and anticipate some consolidative, short-term gains in the Canadian dollar, perhaps fueled by a bout of short-covering or exporter purchases.

Australia's December employment report will be released early Thursday in Sydney. The Bloomberg consensus calls for a 10k increase after the 21k rise in November. We suspect the risk is on the downside, a combination of firmer currency (back-to-back weekly gains and now more than 2% above the multi-year lows) and say a net loss of jobs, might be enough to revive speculation of an RBA rate cut.

A current account deficit for November, on a seasonally adjusted basis, would Japan's third in a row. The depreciation of the yen may boost exports, but it is also boosting the cost of imports, especially energy. What is driving the yen, however, is not its external position, but the US-Japan 10-year interest rate spread and Japanese equities. The yield differential narrowed sharply after the jobs data to 215 bp, its lowest level in a month and below its 20-day average for the first time in more than two months.

We note that the tight link between dollar-yen and the Nikkei has lessened. The 90-day correlation between the percent change of the two is a little over 0.42. The 60-day correlation is near 0.37 and the 30-day correlation is 0.35. This can also be seen simply in correlation on the level of dollar-yen and the level of the Nikkei. The 60-day correlation is 0.94, while over the past 30-days the correlation has fallen to a still lofty 0.75.

With the ECB and BOE meetings last week not adding much to the current information set or expectations, this week's data is unlikely to be very inspirational. The euro area is expected to report a solid increase in industrial output in November. The euro zone appears to have grown around 0.2%-0.3% in Q4 (not due until mid-February). It will also release its final estimate on the harmonized CPI measure.

The UK reports December inflation readings and retail sales. Bolstered by energy, the headline CPI may rise by 0.5% on the month, but due to the base effect, it may still leave the year-over-year figure at 2.1%. However, even if this measure does not increase in December, it may do so this month as last January the CPI fell 0.5%. The Bloomberg consensus has UK retail sales rising 0.3% on both the headline and ex-auto measures.

Finally, a brief word about two Latam emerging markets. Brazil's central bank is expected to continue to tighten monetary policy. Previously, many observers expected a 25 bp rate hike, but over the past week or so, the pendulum of market sentiment appears to have swung to another 50 bp move. The Selic rate currently is set at 10.0%. A local press report over the weekend suggested the government also expects a 50 bp move.

The Chilean central bank is expected to keep rates steady at the upcoming meeting, at 4.50%. Last week the government reported that December consumer prices jumped to 3% from 2.4% and the monthly headline and core rates were also firmer than expected. This seems to preclude a rate cut that some had begun talking about. The US dollar was trading at two year highs against the peso before the employment report and then proceeded to reverse course. A break now of CLP529 could see another 1% pullback, or a bit more, in the dollar.