FX Themes and Drivers
News of greater political uncertainty in Italy and poor European data is spurring risk-off moves, with the dollar and yen firmer, emerging market currencies mostly softer, global equity markets lower and core bonds a bit firmer.
Following much weaker than expected German industrial production figures last week has been followed in kind by disappointing French and Italian output figures today. Italy reported a 1.1% decline. The consensus was for a 0.2% decline and the Sept series was revised lower. French output fell 0.7%. The consensus was for a 0.3% increase. Yet it is really the Italian political scene that is the key driver today with the benchmark 10-year yield up more than 30 bp, dragging up peripheral yields generally. Italian shares have been particularly hard hit and a couple of banks were limit down and stopped trading.
This week is the last before the holiday mood sets in. We identify ten considerations that will drive the capital markets.
1. Italian Politics: Monti has done a good job keeping Italy out of the cross hairs of Mr Market. The gig is up. Berlusconi's PDL party withdrew support at the end of last week. The situation is quite unsettled, but a few things are clear. Berlusoni is going to run for premier again, seeking a fourth term in office. Once the 2013 budget and financial stability act are passed, parliament will be dissolved and an election date provided. The most likely scenario, if we can say such a thing in such fluid circumstances, is for parliament to be dissolved January 7 with elections in late-Feb or early-March. Investors fear rearguard action that will dismantle the reforms of Monti's unelected technocrat government.
2. Fiscal Cliff: It now seems that going over the cliff creates a situation more in line with what the Democrats want than Republicans. Opinion polls suggest the Republicans will be blamed more than Democrats. The progress that is being reported in the media seems to be a function of a defection of a relatively small number of Republicans. Investors seem to be largely looking past this on ideas if the cliff is gone over, it might not be for long, as middle-class tax cuts (and some other measures) for example, are restored. In any event, drag on growth from fiscal policy is expected, but not what it is implied by going over the cliff. And the US is still expected to be among the fastest growing high income countries.
3. FOMC One of the supports for the US economy is coming from monetary policy. At the last FOMC meeting of the year, officials face two decisions. One is urgent and the other can be decided in the coming months. The urgent issue is with Operation Twist coming to an end, what the Fed will do. Most investors, like us, expect it to roll some of those Treasury purchases into QE3+ (this formulation recognizes the open-ended nature of QE3 compared with its two predecessors). It has been selling short-term coupons for longer-term Treasuries at a pace of $45 bln a month. The current QE3+ program is buying $40 bln a month of MBS. To roll the full Treasury purchases under Operation Twist would more than double the size QE. We suspect that is more than FOMC leadership is prepared to do and see a half measure, $20 bln-$20 bln and clear indication that it is prepared to do more as needed.
The other decision involves how the Fed guides market expectations. Among its tool, the Fed presently gives a calendar time frame to how low rates will remain extraordinarily low. A move toward macro-economic measures has been discussed and seems to enjoy majority support, with technical details being worked out. As Bernanke enters what we expect to be his last year as Chairman, we recognize he has guided the Fed in a more transparent and more accessible direction.
4. Greece’s Bond Buy-Back: The initial target of the bond buy back scheme was to retire 30 bln euros in debt for 10 bln euros of EFSF bills. Reports suggest that something a little shy of the target was achieved. Hedge funds reportedly kept some of the longer-term paper so they are still positioned for a further recovery in price. Domestic financial institutions understandably held back, perhaps hoping to minimize the impact of the second haircut of the year. However, the deadline will likely be extended and Greek banks will likely capitulate, seeing this as the only way to secure recapitalization funds.
5. Canada’s Decision on Foreign Investment: After the markets closed last week, the Canadian government approved China’s CNOOC $15.1 bln for Nexen and Malaysia’s Petronas $5.2 bln bid for Progress. It warned that it will only grant further state-owned investment (aimed at majority ownership) in the oil sands on an exceptionally basis, but still welcomed their minority interest. This is the most pro-investment outcome that could be expected and would be generally supportive of the Canadian capital markets and the Canadian dollar.
6. Chinese Economic Data: Evidence continues to accumulate that the world’s second largest economy has stopped slowing in Q4 for the first time since the end of 2010. Over the weekend, China reported industrial production rose 10.1% from a year ago, the fastest pace in 8 months. Retail sales picked to 14.9% year-over-year from 14.5% in October. Fixed investment was steady at a 20.7% year-over-year pace. Inflation ticked up to 2.0% in November from 1.7% in October, which was a 33-month low. Food accounts for about a third of the CPI basket and it is up 3% year-over-year, flattered by an 11.3% weather-induced rise in vegetable prices. The non-food components are up 1.6% year-over-year. The PBOC injections of liquidity in the coming sessions are likely linked to year-end considerations and not a policy signal.
China's November trade surplus was reported at $19.6 bln, well below the Oct surplus $32 bln and expectations for a $26.8 bln surplus. The surprise was on the export side, which rose 2.9% year-over-year. In Oct, exports were up 11.6% and were expected to be up 9%. Imports were flat, while the consensus looked for a 2% rise after 2.4% in Oct. China's iron ore imports were up 17% to near a 2-year high in November and this detail seem to aid the Australian dollar's resilient tone. Separately we note that Australia's domestic data, remains soft and a rate cut in Q1 13 still seems the most likely scenario.
7. Swiss National Bank Meeting: The SNB meets on December 13. Credit Suisse recent decision to in effect change a negative interest rate on high franc deposits spurred speculation that the SNB would do likewise and the Swiss franc did sell off against the euro. However, the franc’s losses were recouped as the focus turned to the ECB’s economic downgrade and greater opportunity for a rate cut. We see no reason for SNB action. Credit Suisse is not the first bank to do so. The SNB is not opposed to efforts that lead to reduced speculation in the franc, but there the current efforts are yielding some benefits and the cost (reserve accumulation) appears to have slowed.
8. European Summit: The heads of state meeting in the second half of the week culminates what will be seen as a successful year even if a trying one. Contrary to much speculation, the euro zone is still together and more. The summit will demonstrate that the project of greater European integration is still very much alive, at least in Brussels. The most important measures did not, arguably come from governments as much as the ECB and the controversial LTROs and OMT programs. A banking union agreement may be a step too much for this summit. It is not clear whether the situation is clear enough for the heads of state to grant final approval for the Greek tranche or conclude an agreement with Cyprus. Spain’s Rajoy is a flirt, showing now urgency to consummate the relationship and there is little than can be done, but carefully watch Italian political developments.
9. Juncker to Step Down: Eurogroup head Juncker has indicated he will step down at the end of the year. This has long been signaled and it appears officials are prepared to have an institutional solution. Germany had sought a permanent office, but appears to have backed. The creditor nations know they are outnumbered and can see how one-country one-vote does not protect their interest. While weighted voting at the ECB itself is controversial, there may be in its supervisory functions. At the same time France is anxious not to be at a disadvantage. It is possible that German and French finance ministers take turns as Eurogroup head. There is some indication that France’s Moscovici would take the first term, allowing Germany’s Schaeuble to focus on the election later in 2013.
10. Japanese Elections: Japan’s Tankan Survey (December 13) will be overshadowed by national election a few days later (December 16). Many observers have boiled down the issue to the size of the LDP’s victory. However, even if the LDP secures an outright majority, it may seek coalition partners to take a larger mandate to enact aggressive fiscal and monetary policies. The market has been anticipating Abe to once again be Prime Minister for several weeks. While the 10-30 year JGB spread has steepened, reflecting long-term concerns, indicative pricing in the CDS market, shows little anxiety. During this time the Japanese stock market has outperformed and the yen has weakened. The market is vulnerable to “buy the rumor, sell the fact” type of activity after the election.
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