1. Temporal Inconsistencies at the Fed: The Fed's decision to delay the beginning of the normalization of monetary policy undermines confidence in when lift-off will actually take place. It is clear that many, like ourselves, who thought September was a likely opportunity, have now pushed lift-off to December, largely skipping the October meeting due to its proximity and the absence of a scheduled press conference. In recent months, the FOMC has recognized that market-based measures of inflation expectations were soft but that survey-based measures were stable. Last week the FOMC singled out the softer break-evens as part of the justification to wait before hiking.
Similarly, the Fed seemed to give more weight to international variables that seem warranted. That China's economy is slowing is hardly news. Few, if any, believed that it was growing as fast as it claimed. When the Fed met last week, the S&P 500 had retraced more than 60% of the decline ostensibly inspired by the turmoil in China. The MSCI Emerging Markets Equity Index was nearly 10% off the lows it had seen on August 24.
That said, the shift in the reaction function is not unprecedented. We recall that many had expected the Fed to announce tapering of QE3 in September 2013. Instead, perhaps spooked by the earlier taper tantrum, the Fed waited until December. Some, who see the Fed waiting until next year, see year-end market conditions deterring it, but this does not seem like a significant obstacle.
2. Divergence Meme Alive and Well: The dollar bull narrative we have sketched out was never predicated on the precise timing of the beginning of the normalization process of Fed funds. It was based on the divergence of the trajectory of monetary policies. Since the end of QE3, the divergence has been driven by other central banks. This may continue to be the case a bit longer, so it appears.
The appreciation of the euro on a trade-weighted basis and the drop in oil prices has seen senior ECB officials emphasize the flexibility of its asset purchases program. This week the ECB offers its fifth tranche of TLTRO funds. The cumulative total of the first four tranches was a little more than 384 bln euros. Another 50-70 euros are expected be drawn this time. Japan may report this week that its core measure of inflation (excludes fresh food) fell back into negative territory in August for the first time since April 2013. This will likely boost speculation that the BOJ will have to expand its already aggressive unorthodox monetary policy. There is a good chance that Norway's central bank cuts its deposit rate by 25 bp to 0.75, though the Bloomberg consensus favors a stand pat stance.
A number of other countries, including Sweden, Switzerland, Canada, Australia, and New Zealand can still ease monetary policy. With high real rates and 18% reserve requirements, there is still scope for China to ease monetary policy. Several emerging market central banks meet in the week ahead (Columbia, Mexico, Hungary, Turkey, Nigeria, South Africa, Philippines, Taiwan, and Israel). Israel is the most likely candidate to cut rates. A 10 bp rate cut would bring the base rate to zero.
The divergence driven by non-US central banks is the first phase that we envision. The second phase will be when the Fed begins to raise rates while most other central banks are easing. We have wrongly anticipated the start of the second phase but we still think that it is coming.
3. Next year's US presidential race may be about to get interesting: Until know attention to the US presidential election has been dominated by the large number of Republican candidates, and especially the non-politician politician Trump. Over the past week, it appears Trump may have peaked. On the Democratic side, though Senator Sanders has challenged Clinton, few think he is truly electable on a national level. Clinton also has a stronger organization and greater financial resources. However, over the summer Clinton's support has begun weakening, especially in the swing states that are thought to determine the election outcome.
It is increasingly looking as like Vice President Biden is going to enter the race. If so, an announcement would likely come over the next month. October 13 is the first debate among Democrat candidates. Although Biden could afford to skip it, as his name recognition is high, and his office puts him in the news often, it may help raise funds. There are only four debates before the Iowa caucus on February 1. Around the middle of November, there are a number of deadlines to get placed on various state ballots. In some states it is not simply a matter of filling out a form, some require a signature petition. The planning and organization to do this takes at least a few weeks. There is some thought that the Vice President would want to make the announcement before Clinton's testimony about Benghazi on October 22 to avoid the appearance of political opportunism.
4. Moody's downgraded France to Aa2: It changed the outlook to stable from negative, completing the cycle. It cited the weak growth and institutional and political challenges. Moody's also recognized that France's debt is unlikely to be reduced over the remainder of the decade.
The downgrade is unlikely to impact French yields. It matches the ratings of the other two main agencies. It is still seen as well within investment grade status. Over the past three months, the French premium over Germany for 10-year bonds has narrowed 4 bp to 37 bp, while the 2-Year differential is steady at 4 bp.
The significance of the downgrade is its reminder that France continues to lag behind Germany. This gap makes the other EMU challenges more difficult.
Europe was previously seen as resting on two pillars, Germany and France. Sometimes it was expressed as the German hand in the French glove. Other times the imagery of a plane with two co-pilots. To be sure, it was not that France and Germany were in agreement, rather, that a compromise struck between them was a close approximation of a broader compromise of interests, especially between the creditors and debtors. Few observers seem to appreciate that the failure of France to turn the economic corner has serious political consequences for EMU.
The Socialist government has adopted the UMP (now Republican) program of tax cuts, reductions in social charges (~50 bln euros over three years), cut spending and adopt reforms aimed at making it easier to hire and fire employees. Among its successes, France's Finance Minister Sapin cites the cut in spending from 56.4% of GDP in 2014 to 55.1% next year. Nevertheless, the budget deficit that is projected to be 3.8% of GDP this year is not projected to fall to the 3% Stability and Growth Pact mandate until 2017.
5. S&P raised Portugal's rating one notch to BB+, matching the rating of the other two main agencies. The economic recovery and budget consolidation was cited by S&P in explaining its decision. Portugal's rating remains below investment grade, which it lost in 2012. S&P's stable outlook means it is unlikely to regain that coveted spot anytime soon.
Still, Prime Minister Coelho's attempt to run for re-election (October 4) will be support by S&P's decision. Most of the recent polls show a dead heat, though one poll before the weekend showed Coelho's ruling coalition ahead. Portugal has not experienced the social unrest seen in several other crisis-stricken countries, including Greece, Spain, Italy and France. The government expects Portugal to grow around 1.6% this year, with a budget deficit of 2.7%.
6. Greek elections on September 20: The latest poll, conducted by Kapa Research for the To Vim newspaper puts Syriza ahead 31.2 to 28.3 over the New Democracy. There was a 2.8 percentage point margin of error, putting the contest still at a statistical dead heat.
A coalition government is still the most likely outcome. Tsipras claims not to be inclined to form a government with the New Democracy, but there may be little choice if he wants to be part of the government. Golden Dawn is in third place, and his government's coalition partner on the nationalist right may not secure parliamentary representations.
From a global investment perspective, it may not matter the precise configuration of the government provided that it embraces the recently struck agreement with the official creditors. This seems to be the most likely scenario, fully recognizing, though, that there will be disputes over implementation along the way. Greece's 10-Year bond yield has fallen 109 bp over the past month, and Greek stocks have rallied nearly 10% (24% since the low reached on August 24). Barring an electoral shock, these rallies could continue.
7. China's Caixin manufacturing PMI: After declining in July and August, it is expected to tick up slightly in September. It will still be below the 50 boom/bust level. However, pessimism toward the Chinese economy may be extreme, and some stability, especially from non-government data sources, could be psychologically important. Chinese officials have taken direct and indirect measures to support the economy and some stabilization of the economy should not be surprising.
Just like China shuts down manufacturing output around Beijing or Shanghai for high profile international events, President Xi's trip to the Washington may generate a financial equivalent. Losses below 3000 in the Shanghai Composite, for example, could steal the headlines from a visit between leaders of the two largest economies. The currency has also steadied in terms of level and volatility.
A little more than a month after the initial move, it is still not clear the extent to which China is truly allowing market forces to drive the currency. However, it is clear that Chinese officials do not embrace market forces as a force of nature like so many Westerners. Rather China tries to shape market forces through regulatory/liberalization efforts, such as presently trying to encourage capital inflows.
8. The Bank of England's Financial Policy Committee: The meeting is unlikely to impact sterling or the UK debt market. However, unlike the Federal Reserve which seems distraught over the turbulence in China, the Bank of England seems less perturbed. This contrast does not mean the Bank of England is more likely to hike interest rates before the Federal Reserve. This is not to imply that the BOE is waiting on the Fed to act first, to test the waters, so to speak. It is that they are responding to essentially the same macroeconomic considerations, like low inflation and weak global demand.
On one hand, the UK appears to be experiencing greater wage pressure than is evident in the US. On the other hand, the UK economy is also more sensitive to an increase in interest rates than the US. The highly development mortgage market in the US means that most homeowners have locked in low interest rates, which are not sensitive to a rise in interest rates. Homeowners in the UK typically have variable rate mortgages that respond quickly to increases in the base rate.
9. The Dollar: From an economic rather than an investment point of view, the Fed's real broad trade-weighted index is the most important measure of the dollar. In August, it made a new cyclical high of 97.30. It finished last year near 90.55. It is up almost 21% from the July 2011 record lows. If this dollar rally matches the magnitude of the Clinton dollar rally (34%), the real broad trade-weighted index will rise toward 107. If the Obama dollar rally, driven by an extended divergence of monetary policy, is the average of the Reagan and Clinton dollar rallies (the other two dollar rallies since the end of Bretton Woods), the real broad trade-weighted index will rise toward 115.5.
The dollar does not appear to be making much headway this month. In fact, September could be only the third month this year (so far) that the real broad trade-index has not risen. Thus far this month, the dollar has fallen in nominal terms against its major trading partners save the Canadian dollar, against which it has risen about 0.6%. Through September 18, the yen has risen 1.0% against the dollar, the euro is up 0.8%, the Mexican peso is up 0.6%, and the Chinese yuan is up about 0.25%.