The Broader Message Conveyed by a Stronger U.S.

The combination of the unequivocally strong US jobs report and the contrasting unexpected decline the german language factory orders and industrial production reported last week sets the broad investment construction for the period ahead.

The pendulum of market expectations has thrown decidedly in favor of the long-awaited Fed hike next month.  A Reuters opinion poll found 15 of the 17 primary dealers expect the hike at the December FOMC conference, up from 12 after the September FOMC meeting.  The median probability assessed at 80%. The actual US-German two-year swap rate (interest rate differential) completed last week just shy of 118 bp, which is the largest All of us premium in more than 9 years.  The premium had been near 80 bp even as mid-October. 

Whereas the euro-dollar exchange price seems sensitive to the two-year differential, the actual dollar-yen rate appears more responsive to the ten-year differential. The US premium has risen from about 166 bp in mid-October to a little more than Two hundred bp at the end of last week.  It’s less than a quarter basis point from the year's high and also the largest premium since Sept 2014. 

The argument of the discounting of the divergence meme by no means sat well with us.  We understand interest rate differentials and slopes of yields curves as creating incentive structures for new investments and hedging decisions and not simply the stock of current investment.  Moreover, if our macroeconomic analysis is correct, that premium the US offers should increase over the next several groups. 

This is to say that there is an incentive for investors to be long dollars by an increasing amount.  The opposite is also true, that the price of being short the buck will also become more onerous.  It has direct implications for the currency mismatches that still seem to exist for emerging market sovereigns and corporates that borrowed dollars to lock in low interest. 

II

Market sentiment does not move in an even continuous function.  It techniques in lurches and is prone to exaggeration.  A year ago, China was "ten-feet tall."  It was thought to be on its way to surpassing the US (by some estimates of purchasing power parity); its demand was setting commodity prices and its output, driving world prices.  Now some wonder if it is more like the actual "gang that can't shoot straight," with what one wag called "ham-fisted" response to the dramatic sell-off of Chinese shares after a wonderful rally. Its economy is slowing, and this exposes the excess capacity that is one of the forces behind the deflation in producer prices for near the past four years. It was confidence which China can avoid the middle-income snare.

German Chancellor Merkel often receives praise for her political astuteness; her quiet, subdued, focused approach, with a rare combination of determination and flexibility, has allowed her to outmaneuver her buddies and adversaries on several occasions.  Her laurels were sang far and wide.  Then the refugee/immigration challenge surfaced.  Now the pundits contemplate a post-Merkel Germany and post-Merkel Europe. Another dramatic reversal of fortune in a short period of time.   

Here is another dramatic swing in sentiment:  The yield on the US 2-year note offers risen 40 bp in the low on October 14 towards the high before the weekend. The actual 95 bp that it touched is the highest in six years. This is important for the next group of issues that are going to confront investors now that it is widely accepted that the Fed will increase rates next month, barring, of course, a significant downside surprise. That’s over the pace and degree of the Fed's tightening period.  To be sure, many if not all the Fed officials would reason that far from tightening, the Given is moving from a super-accommodative financial policy to a very, very easy monetary stance.  

If investors possess spent time parsing the Fed's meaning of "considerable period," "patience,” as well as "data-dependent," then they will now turn their attention to the meaning of "gradual" as with the pace of normalization of monetary policy.  The Fed's dot plot suggests four hikes annually through 2018.  This is a rate backpack essentially every other meeting.  This really is more gradual that Greenspan'utes 25 bp at every meeting. 

The market is almost there with regard to next year.  The Reuters survey found that the consensus among primary dealers anticipate that Fed funds will be at One.125% at the end of 2016. This is down Twenty five bp from the mid-September survey.  It is as if the Fed's failure to raise rates simply drops from the forecast rather than composed for later.  Assuming that the Fed lifts off in Dec, this implies 100% confidence of three rates hikes next year also it evenly divided on the prospects for the fourth hike.  

Unlike past cycles, the Fed's stability sheet can be part of making monetary policy less accommodative.  There are reportedly about $220 bln of US Treasuries the Fed owns that will older next year, for example.  Fed officials have indicated desire to stop re-investing proceeds after the normalization process has begun.  The Fed may not permit the full $220 bln (~5% of the Fed's balance sheet) to roll-off, but in it’s understanding, the easing associated with QE lies more in the keeping than the buying.  Any substantial reduction of the Fed's balance sheet is part of the gradual normalization process. 

III

The record rise in All of us consumer credit ($28.9 bln) in Sept reported just before the weekend break was likely lost on many investors, after a hectic week and cathartic jobs information.  The bulk continues to be accounted for through non-revolving credit (auto and student loans), with only $6.7 bln accounted for by revolving credit (credit cards).  Nevertheless, consumer credit is running almost $500 mln a week more than last year's pace ($2 bln a month), and credit card is trending higher. 

Credit in addition wage income stemming from the two mln net new work created in the first ten several weeks of 2015 has helped fuel consumption that has been fairly stable about a 3% annual pace.  The October retail sales report is the most important US economic report (due Friday) this week.  The actual headline will be constrained by the drop in gasoline prices and the fact that the new cyclical high in auto sales sequentially was small.  Overall, retail sales capture about 40% of personal consumption in the US.  However, with regard to GDP purposes, items like fuel, autos, and building materials pick up in other time-series.  A core measure that limits them has been weak during the last couple of months and declined by 0.05% in September.  Look for a snap back toward its long-term average (~0.25%).

The University of Michigan'utes consumer confidence report frequently gets passing interest through market participants.  However, this week's report will deserve somewhat greater attention.  Here is why: last month's statement showed the long-term (5-10 years) rising cost of living expectations, which in the past Fed officials have cited, fell to its lowest level since 2002 (2.5%).  Among the most powerful arguments against the Fed from tightening up is that price pressures remain modest and below focus on.  Separately, we note that the actual 10-year break-even has risen 12 british petroleum since the Fed's late-October meeting and 2 bp since the mid-September meeting. 

The UK's data, especially the latest blood pressure measurements on the labor market as well as wages, may help investors regain their balance after discombobulation by the dovish BOE.  Recall that the August statement showed a new cyclical low in the actual ILO measure of UK unemployment to 5.4%.  However, the claimant depend rose in both August and September and expects to possess risen against in October (~1.4k). 

Barring a major surprise, the focus is going to be on the earnings, which such as ILO unemployment, reports with an additional month lag.  Here the divergence is taking place between general earnings and those excluding bonus deals.  The former may quicken and the latter slow.  Although in the last three months the average pace has been the same 2.8%, the headline has risen for two sequential months and expects to have risen in September, whilst excluding bonuses; average every week earnings fell in July and expect to have slowed additional in September.

As we have noted, there seems to be a divergence between Eurozone economic data and the urgency which Draghi expresses to review the ECB'utes course with an eye in order to providing even more monetary support.  The Eurozone reports Q3 GDP at the end of the week.  Growth expects to possess maintained the 0.4% pace posted in Q2.   With small variance, this has been the pace of growth since the center of 2014.  It is more than two times the pace of the three-year quarterly typical. Moreover, if one uses similar definitions of core rising cost of living, it is roughly the same in EMU, UK, Japan, and the All of us. 

Swedish and Norwegian CPI reports can influence anticipations of the trajectory of their particular monetary policies.  Sweden's economic climate is doing ok.  Last week, the actual October manufacturing PMI reported at 53.5%, a little much softer than expected, while the non-manufacturing PMI rose to 57.Five, the highest since May.  Additionally, it reported September industrial result rose 2.0% on the 30 days (consensus was for a 0.5% decline) after a 1.7% increase in August.

Its challenge may not be rising cost of living but official perceptions associated with inflation.  September headline stood at 0.1% year-over-year.  It expects to be steady in October.  However, an under-appreciated source of downward pressure is coming from the sharp drop in interest rates.  The central bank's underlying measure of rising cost of living that uses fixed interest mortgage rates was at 1.0% in September and it expects to have checked up to 1.1% in October.  It is low, but how a worry is it really?

Norway's challenge is growth, and there is no threat of deflation.  The manufacturing May has been below 50 because May, and manufacturing output has fallen 3.5% in the first three months of this year. Headline inflation has averaged Two.1% year-over-year here in 2015, and this was the pace in September.  It is thought to have quickened to 2.3% in October. 

Norway's underlying rate, that excludes energy and taxes, has been accelerating.  It stood at 3.1% in September and may have maintained this pace in October.  It averaged 2.4% in 2014 and 2.6% within the first nine months of this year.  A firm report could dampen ideas that Norges Financial institution could cut rates from its next meeting, which is not until the middle of Dec.  However, the prospects associated with further ECB easing and data over the next month may be more important. 

In detailing its decision to leave rates on hold, the Reserve Bank of Australia specifically cited the improvement in the work market as a consideration.  Australia's October labor report is out toward the end of the week ahead.  September jobs report had been poor.  It lost a net 5.1k jobs and nearly 14k full-time positions.  The October statement expects to be better.  The actual Bloomberg consensus is for a 15k general increase in jobs.  There is no breakdown of full/part-time jobs.  The three-month average is actually 17k. The three-month average of full-time work is 3.4k.

IV

When the Given did not raise rates within September, it appeared to location emphasis on the unsettling developments in China.  By several measures, the impulse from China does not appear as alarming.  The yuan has strengthened against the dollar since late August despite the warnings from a Nobel prize-winning economist which China had taken "only" one chew at the cherry.  The dollar destabilized by a little more than 2% against the yuan, even though it has trended higher against the majority of currencies during this period. 

The Shanghai Composite offers rallied by more than a quarter since the scary late-August lows.   It completed last week with two consecutive closes above 3500, a vital chart point from past due August.  On its way to the next major objective (4000), there may be a few resistance in the 3740-3800 area.  Officials signaled a collective sigh of relief by indicating that preliminary public offerings will resume before the end of the year. 

One supply of anxiety has been the capital outflows from China.  While we recognize that there have been outflows, we have argued that much of the talk in the market seems exaggerated because it has not taken into account three things:  valuation swings, liberalization that allows corporates to hold on to foreign currency earnings, and possibly the seeding of other government arms, such as China'utes Development Bank. 

Some of the capital outflows from China went back home to Hong Kong.  These flows helped push the Hong Kong dollar to the upper end of its band.  In October, the HKMA intervened by buying $11 bln, the most for any month in six years.   A rate hike the following month by the Fed will require the actual HKMA to follow suit.  The HKMA may find that its work is cut out for it. 

China reported its October reserve and trade figures over the weekend.  Reserves rose by $11.Four bln, the first increase since 04.  Of what are to be its major exposures, the euro fell by 1.5% and the yen dropped by 0.6%.  Sterling rose through almost 2%, and both the Canadian and Australian dollars flower by about 1.8%.  Yields rose over this period.  Given the euro's decline and the rise in yields, we suspect that, if anything, valuation likely considered on China's reserve numbers. 

The October trade surplus of $61.64 bln is a new record.  The large surplus is one of the reasons why some economists do not think a sizable depreciation of the yuan is warranted, though the diverging trajectories of monetary policy suggests scope for some modest yuan devaluation, if market forces received sway.   

Ironically, the widening excess is happening at the same time as exports and imports are falling.  Exports fell Six.9% year-over-year in October, more than two times the pace that the consensus anticipated, and is the fourth consecutive decline.  Imports fell 18.8% compared with the consensus forecast of a 16% decrease.  This follows the Twenty.4% decline in September.  It is the 12th consecutive decline. 

The sharp drop in commodity prices is giving China a positive relation to trade shock, which is the reflection image of the negative relation to trade shock that is striking commodity producers.  On top of that, China's domestic economy and slowed down, and officials are trying to transition the economy.  Many creating countries are facing a double blow–the Federal Reserve is likely to increase rates and China's transfer appetite has faded. 

China reviews more data in days ahead.  The inflation reviews will garner much attention.  Another tick down is expected.  The rising specter of disinflation is likely to prompt the PBOC to cut rates and/reserve requirements if not later this year then early next.

Investors need to bear in mind the transition China is undertaking toward consumption as well as services when they review the brand new data, including retail product sales, industrial output, and expense.  One can get a sense that the transition is working if list sales remain firm and industrial output and investment slows (on a trend basis).  The transition also means that the Li Keqiang index, which enjoys widespread use by investors (train cargo volume, electricity result, and loans disbursed like a better measure of China's growth) may be less revealing of computer previously may have been.

Data to be Recognized thru Divergence Lens is republished along with permission from Marc to Market