The Week Ahead: Post Taper Tantrum II

The prospects that the Federal Reserve would begin slowing its purchases sparked a market meltdown in 2013. The "taper tantrum", as it was dubbed, destabilized the capital markets. Now it is as if the markets have had a second tantrum, but this time US Treasuries rallied.

Falling market-based measures of inflation expectations, concerns about world growth prospects, and a strong dollar environment have seen the pendulum of market sentiment swing in favor of the persistence of disinflationary forces. That is why this week's September CPI report is important. While the weakness in energy prices will restrain the headline, the core rate is likely to remain firm, just below 2%. Higher housing costs and rents are behind the stickiness of the core.

There has been a longstanding narrative of an inflationary risk posed by the expansion of the Federal Reserve's monetary support. This was understood to mean something much more undesirable than a rise in the equity market. Many investors also feared that when the Fed would stop buying long-term assets, yields would rise.

Now the narrative is the rekindling of disinflationary forces if the Fed stops providing ongoing monetary support in the face of global headwinds that undermine growth. The market had already begun correcting its excesses before the weekend, and the CPI report can spur further correction. Still, with many investors stunned by the recent price action, and with the Federal Reserve meeting not until the end of the month, many may be reluctant to commit.

At the same time, developments in the eurozone underscore the negative outlook, and why more currency adjustment, on a medium-term basis, is still the most likely scenario. The week begins off with the launch of the ECB's covered bond buying program. The week finishes (October 26) with the publication of the results of the Asset Quality Review and stress tests. In between, the key flash PMI will be released; the first for Q4 and the composite is expected to have fallen for the third consecutive month.

The ECB and member national central banks will buy secured bank debt (covered bonds) starting Monday. Even at this late date, neither the quantity nor the frequency of the purchases has been announced. In anticipation, these instruments fared well in the recent market meltdown. An exception is made for Greece and Cyprus, where the ratings for the covered bonds are each country's own rating which is below the ECB minimum acceptance level.

That said, only the highest rates of these will be bought, and the issuers will update the ECB on a monthly basis on quality changes. Moreover, there is a greater haircut applied to such instruments (discount). In any event, beginning the covered bond buying program before the results of the asset quality review and stress tests are published seems to be putting the cart before the horse.

Next Sunday, October 26, midday in Frankfurt, the ECB will publish on its website the results of its assessment of 130 banks. This is the Asset Quality Review. and this is important because it is the precondition of the ECB taking over supervision responsibility of those banks. Separately, the European Banking Authority will issue the results of the EU-wide stress tests. Each will assess banks' capital needs. Banks deemed insufficiently capitalized will have two weeks to submit plans to the ECB outlining how the shortfall will be met.

Japan’s government will likely downgrade its economic assessment at the start of the week. The retail sales tax increase is having a larger and longer lasting impact that officials had expected, but the BOJ and the MOF still seem determined to go ahead with next year’s planned hike as well (Abe to decide by the end of this year). There is much political inertia too. It would require legislative action to postpone the tax increase.

Japan also reports September trade figures. Historically (past 30 years), September always shows improvement over August. The consensus looks for a JPY773 bln deficit after August’s shortfall of almost JPY950 bln. After falling in August, both imports and exports are expected to have increased.

The anticipated 6.5% increase in exports would be the strongest showing since February. If low oil prices are sustained, it could improve Japan’s external accounts on the margin, but could make it more difficult to achieve the BOJ’s 2% CPI target (includes energy but excludes the sales tax increase and fresh food).

Prime Minister Abe enjoys a clear parliamentary majority, but the Democratic Party continues to nip at his heels. The opposition DPJ have called for the resignation of the Justice Minister for distributing paper fans to her voters. More unsettling is the reported likely resignation of the Minister of Economy, Trade and Industry (METI), Obuchi. Obuchi was much touted as someone with a bright political future, leading perhaps to the Prime Minister's office itself, like her father. Her departure would be a setback for Abe, who appears to be struggling to regain momentum.

The UK offers its own highlights. It will be the first of the major countries to report Q3 GDP figures. A 0.7% quarter-over-quarter expansion is expected. While slowing from the 0.9% pace in Q2, it is still at the strong end of this cyclical expansion. Minutes from the MPC meeting will be released on Wednesday. The market expects that the two dissents remained in favor of higher rates (Weale and McCafferty). Despite that, the risk is that the minutes are dovish as the MPC sees the same thing the investors have by pushing out expectations for the first hike.

Canada's central bank meets in the middle of the week. It is most unlikely that it will change rates. However, its statement, and the monetary policy review that follows it is likely to be less dovish than the previous statement, within the neutral range. Core inflation is holding above 2.0% (from 1.2% at the end of last year), and the weakness of the exchange rate may help offset some of the global headwinds.

In the face of disinflationary worries that dominated last week's dramatic price action, the BoC may revise up its core inflation projections for this year. In July, the Monetary Policy Review forecast 2.2% core CPI this year and 2.4% next year. Canada is widely seen to be in between the US and UK on one hand, moving toward a rate hike, and the ECB and BOJ that remain deeply committed to easing monetary policy. Canada stands apart from Australia and New Zealand, who are expected to report declines in their Q3 inflation reports.

Norway's central bank meets on Thursday. No policy change is expected. Underlying inflation is stable around 2.3%. The krone suffered during the powerful euro short squeeze and thin liquidity, but is poised to recover. The euro can ease back below its long-term (100 and 200-day) averages in the NOK8.26-NOK8.27 area.

China is to give the latest reads on the real sector, including Q3 GDP in the coming days. Quarterly growth averaged 1.75% in the first half. Q3 growth is estimated 1.8%. Year-over-year growth is likely slow to 7.2% from 7.5% in Q2, which would be the slowest since Q1 09. The other high-frequency data will not alter the overall sense that the China's growth is gradually slowing.

In its recent report, the US Treasury recognized the recent recovery of the yuan. It has recouped a little more than 60% of what it lost earlier this year. The dollar has been broadly sideways in the CNY6.1200-CNY6.1550 range. The lower end of the range may be frayed, but we expect it to generally hold.

At a high level, this coming week’s data and events should reaffirm the underlying divergence between the US and UK on one hand, and Japan and the euro area on the other. The US economy continues to gradually move toward the Federal Reserve’s mandates. In some respects, the recent, nearly 10% pullback in the S&P 500, and the sell-off of risk assets in general, is (ironically) consistent with the Fed’s mandate of ensuring financial stability. Barring a marked deceleration of the economy, a rate hike around the middle of next year—8-9 months from now—should still be seen as the most likely scenario.