Is Seven Your Lucky Number?

The week ahead is among the most important of the year.  Rarely is there this type of confluence of events in a short time that will have far-reaching implications for investors known ahead of time as well as discussed so extensively.  One implications of this is the market discount of expectations.

The potential for sharp price gyrations and the dictates of money management should not draw attention away from from the big picture and the durable trends.  In this context, there are two important considerations long-term investors ought to keep in mind.

First, the divergence in the trajectories of economic policy has not peaked, or even come close to a peak.  When we agree this is the main car owner in the foreign exchange market, then assume further dollar appreciation on the trend basis.  There has been a dramatic re-build of long dollar positions since mid-October.  The late momentum traders are vulnerable at that time ahead.  It may occur after this week's events, or it might be after the FOMC meeting later within December.  Such a shakeout may supply long-term investors with a new opportunity to placement with the underlying trend.

Second, while all Fed tightenings do not lead to a dollar rally, the Reagan dollar rally and the Clinton dollar rally (the previous two significant dollar rallies since the end of Bretton Woods) were preceded by Fed rate hikes.  Recall Volcker's hikes prior to the 1980 election assisted set the stage for that dollar rally that ultimately lift the greenback more than 50% on a real trade-weighted basis before coordinated G7 intervention reversed it.

The Given raised rates in 94′.  This, combined with a new Treasury Assistant that promised not to make use of the dollar as a trade tool, spurred the five-year Clinton dollar rally.  It too ultimately ended with the help of coordinated intervention within October 2000.

Here is a thumbnail sketch of next week's seven key events:

1.  China's November May readings:   Expectations little altered.  The manufacturing economy likely slowed while the service field continues to expand.  The economic climate is transitioning away from production so the traditional go-to metrics, like railroad car loadings, electrical usage, and bank loans, were selected by Premier Li at an earlier stage of development.  Marketplace impact is likely to be minimal.  The actual China stock and relationship markets are trading on another dynamic than the macroeconomic condition.  The actual equity market posted an impressive loss before the weekend, but the global knock-on effect seemed minimum and the US S&P 500 eked out a small gain.  Frequently negative economic surprises through China weigh on item producers including the Australian buck.

2.  IMF's SDR decision:   It seems like the forgone conclusion now that the IMF will include the yuan in the next configuration of the SDR, which will be implemented in September 2016.  Assuming this is a reasonable assume, the real question is about the weighting from the yuan.  This is very much unknown partly because, as the IMF is the very first to admit, it is not a mechanical choice.  There is a large judgment component.  The literature suggests the IMF's own approach continues to be evolving toward more weight upon capital markets than the market for goods (exports).  In addition, the other currencies in the SDR are substantially more accessible and used than the yuan. 

If just relying on China's exports, the IMF staff suggested in the summer, the weighting of 14-16%. Many observers seemed to have taken this illustration from context, and this became the tough consensus of what will be announced.  We are less sanguine.  From China's point of view, the key now is getting into, not the weight.  That is high is scope for give up with those who think that yuan isn’t seasoned sufficiently, and much more work has to be done to increase the part of markets in setting key elements of the price of profit China. In addition, there is discomfort with the light capital regulates that China has imposed to deter capital outflows.

We expect the marketplace impact to be minimal.  We don’t expect central banks to instantly begin buying yuan.  Macroeconomic considerations nevertheless favor some depreciation within the yuan, though the large trade surplus and the shift away from manufacturing argue against a significant depreciation.  The gap between the onshore (CNY) and just offshore (CNH) yuan widened in recent times.  The IMF had indicated over the summer that this was not desired.  The gap has approached amounts at which officials appeared to consider indirect action.  The may also be arbitrage opportunities for large Chinese banking institutions.

3.  Reserve Bank of Australia policy decision:    The chances of an interest rate cut this week are very small, but the risk that the Two.0% cash rate is the bottom of the interest rate cycle has increased following the unexpectedly large falling Q3 capital expenditures.  The 9.2% decrease was three-times larger than the Bloomberg general opinion forecast, and it is more than twice the drop seen in Q2 (-4.4%).  It had been the fourth consecutive quarterly decline during which time capex has fallen through more than a fifth.  The changeover in China is helping to make a transition in Australia.

The combination of low interest rates and a depreciating forex (-15.6% over the past 12 months) is assisting the transition.  Barring an unexpected cut, which would likely send the currency back towards $0.7000, Governor Stevens' statement will likely form the market's reaction.  Before the capex data, he was obvious that the RBA was on maintain into Q1 16.  We think the RBA likely tell investors that there’s scope to cut rates again if needed.   The market may see this an increasing the likelihood of a rate within Q1 16.

4.  Bank of Canada policy decision:  The risk of a Bank of Canada price cut is also low, but the two rate cuts earlier this year may need to have a follow up within Q1 next year.  Recall that based on the monthly GDP figures, the Canadian economy contracted from last November through May.  The 0.4% expansion within June was the quickest speed that was achieved, and since after that growth has been decelerating (0.3% in July and 0.1% within August. The economy expects to have stagnated in September, which will be reported on Dec 4, two days after the Bank of Canada meeting.

The loss of economic momentum as the 1 / 4 proceeded may be more important than the Q3 figures reported at the same time (Bloomberg consensus forecast is 2.3% annualized).  Canada's jobs data before the weekend break are expected to be soft following an outsized rise in October (44k), however the fate of the Canadian buck is likely to be driven by the next three events. 

5.  ECB policy choice:   Even though there is great uncertainty about precisely what the ECB will do, anticipations for additional action seems almost universal.  There appear to be four moving parts:  the deposit rate, the pace of buys, the instruments that can be bought, and the duration of the program.  Each has been the subject of much discussion.  When there is a specific consensus, it seems that it’s for a six-month extension of the plan until March 2017.

On one hands, it may be the least significant motion because the current September 2016 termination was always soft.  However, it may be significant in that in confirms that the divergence of monetary coverage may persist, which in turn suggests the question of how much continues to be and can be discounted. 

There had been reports that the ECB was considering buying sub-sovereign ties and non-performing loans.  We are extremely skeptical of the latter and suspect that in these discussions, having chits one can sacrifice is helpful.  We doubt that sub-sovereign ties will be included.  Sufficient openness may be lacking.  However, enhancing the agencies whose debt can be purchased appears to be an ongoing process. 

The ECB recently raised the cap upon any one issue that can be bought.  While there is a limit on liquidity reasons, it shows that the ECB can revise its self-imposed rules.  For instance, there has been some suggestion in order to waive entirely the deposit rate as the floor with regard to yields that can be bought under the asset purchase program. 

The deposit rate currently sits at without 20 bp.  Previously Draghi had indicated that at this rate, monetary policy had been exhausted.  However, other countries showed that where ever the limit to unfavorable interest rates was, it was not Twenty bp.  More recently, Draghi (and others) have indicated that a lower deposit rate could still be helpful.  The actual OIS market appears to be pricing within a 5-7 bp cut in the deposit rate while studies suggest the market is divided in between 10 and 20 bp cut a slight majority in the lower end.  

There has been some dialogue that the ECB is considering applying a two-tiered system similar to the 1 used in Denmark.  At first we thought this would penalize the large banking institutions (especially from Germany and France), but it may be interpreted in such a way that it allows a somewhat less "penalty" to banks with large deposits.  This may assist minimize the disruptive effect in the money markets. 

Lastly, numerous expect the pace of purchases to be accelerated.  A common forecast is for an increase of Twenty bln euros a month to Eighty bln.  If this does materialize and starts in January, and also the program is extended by six months, this amounts to increasing the purchases to 1.Two trillion euros.  Under the existing program, the ECB would buy 60 bln euros for the first nine months of the coming year, or 540 bln euros.  This expectation has helped drive Eurozone yields lower in recent weeks.  It makes us more circumspect on the amount of bonds that can be freed up for purchases by a lower deposit rate. 

Even though the anticipation of action this week offers driven the euro lower, it may sell-off further on the news.  Very first, it is difficult to say with any confidence precisely what has already been reduced.  Second, despite the clear record of Draghi's tenure at the helm of the ECB, the market has repeatedly underestimated him.  He has repeatedly surprised on the dovish side. Note that Draghi speaks the next day at the NY Economic Club.   The third reason why profit-taking on short euro positions may be limited is because of the next key event.

6.  US work data:  This month's jobs report takes on extra special which means.  Barring a shockingly poor report, this report is the last hurdle to an FOMC decision later on December 16 to deliver the much-anticipated rate hike.  The most important thing to know about the employment report is that no one expects a repeat of the 271k increase in October nonfarm payrolls.  It was the best of the year. The every week jobless claims also point to some payback.  The consensus is for around 200k.  It would most likely 30k-50k for the pendulum of market emotion to swing very far, particularly if some of the internals, like average by the hour earnings, the unemployment, as well as under-employment (U-6) is constructive. 

Separately, we note that at the start of a new month, there’s a full slate of US financial reports, with the jobs report being the single most important one.  Also, we would draw your focus on US auto sales.  Even before the crisis, Americans rarely bought more than 18 mln vehicles (annualized pace) in a month.  Once they do occur, they look like one-month wonders.  Not only did Americans purchase 18.12 mln vehicles in September for the first time in a 10 years, but it looks to have repetitive the feat in Oct.    

The Fed's Beige Book that will be released two days before the jobs data is unlikely to have much market impact.  The market appears convinced that the US economy keeps growing around trend (seen ~2%) despite the fact that personal consumption in Oct soft (reported last week at 0.1% vs. consensus associated with 0.3%).  The Atlanta Fed cut its GDPNowcast to 1.8% from 2.3% in Q4 following the statement. 

There are no fewer than nine Federal Reserve officials that will speak for that week ahead. Yellen speaks several times, including at the Economic Club in Washington, and the Joint Economic Committee of Congress.  She is unlikely to break brand new ground.  Expect her in order to reiterate the progress that’s been made, and provide assurances that accommodation will be removed gradually. Fischer also speaks on Thursday at a conference on financial stability.  No doubt well-timed rate hikes are integral.  The regional presidents’ views are fairly well known at this point.  The only other Governor to speak is Brainard, and her views is going to be interesting given that she formerly was more comfortable with a later on lift-off.   

7.  OPEC meeting:   Barring a decision to cut output, we expect oil prices to continue to trend lower. The market continues to perceive a glut.  US rig count has fallen 18% because the summer, and 54% since the maximum in October 2014, but All of us output is still running regarding 145k barrels a day more than this did a year ago.

Many participants misunderstood the report that indicated that Saudi authorities were prepared to work with OPEC and non-OPEC producers to stabilize the market.  They thought this was a constructive development for prices.  The Saudis were softening their position.  Hardly.  Saudi Arabia was reiterating that there would be no unilateral cuts.  And since many OPEC as well as non-OPEC producers do not want or claim inability to cut production, the prospects for an agreement seem quite remote. 

There has been pressure on the Saudi riyal peg to the dollar.  We expect the speculators to be proven wrong.  The economic challenge has been greater than now, and also the peg remained.  It is an anchor associated with stability for Saudi Arabia and also the world.  Every so often someone gets a bee in their bonnet about testing the durability of one of the rare currency pegs to the dollar.   To their own detriment, such participants possess repeatedly underestimated the Saudi Arabia's will. 

The same may be accurate regarding the oil market.  It must be assumed that Saudi Arabia is actually pursuing a long-term strategy it realized would have near-term costs.  Have the costs been substantially a lot more than anticipated?  Is there a way to evaluate the strategy and assess the possibility of success? 

The answers, of course, are beyond the scope of this be aware, but the strategy is hardly a years old.  Saudi Arabia's exports to the US are at two-month highs.  Saudi Arabia recently increased its competition with Spain in Europe.  Competition within Asia remains fierce.  The declines in energy expense have been brutal and will effect in the medium term. 

Finally, we note if there is a change in the OPEC quota, rather than a cut, don't be surprised if there is an increase.  The increase may come as a surprise to many.  The market is vulnerable to headline danger. However, the issue may not be what it seems.  First, Indonesia, which had left OPEC rejoined.  It produces about 880k barrels a day.  This could prompt a 1 mln barrel increase in OPEC output, which essentially transfers from non-OPEC.  Through not impacting supply, theoretically it should not impact prices. 

The second issue is Iran's oil.  How will OPEC manage this?  If the overall quota is not adjusted, that will mean that other members' output would need to be cut to make room for Iranian oil.  Even if the political climate was less antagonistic, it is difficult to examine this taking place. 

Seven Events Next Week that will Shape the Investment Weather conditions are republished with permission from Marc in order to Market