The combination of the outright deflation in the eurozone and the seemingly immunity of the US economy to the poor global developments has encouraged investors to extend the dollar's gains. The euro has been pushed below $1.18. Sterling neared $1.50. And the dollar, which was at three week lows against the yen on Tuesday, near JPY118, is knocking on JPY120 again. Meanwhile, yesterday’s recovery in the US equity market has helped lift global markets today. The MSCI Asia Pacific Index rose 1.2%, with only the Chinese markets not following suit. In Europe, the Dow Jones Stoxx 600 is up nearly as much. US shares are trading broadly higher, pointing to around 0.4% opening gains in the S&P 500. Benchmark bond yields are slightly higher, though Greek and Portuguese bonds yields have slipped lower. Oil prices are steady.
The dollar bullish divergence theme was underscored by the -0.2% preliminary eurozone CPI reported yesterday and the stepper than expected 2.4% drop in German factory orders reported today. The consensus had expected a 0.8% decline after the 2.5% rise in October (revised to 2.9% today). At the same time, the US ADP data pointed to another good monthly national report due tomorrow. The smaller than expected US November trade deficit also showed little sign that the dollar's strength is biting.
For their part, the FOMC minutes confirmed our interpretation of the policy signals from the Fed's leadership. If the labor market continues to heal, as most signs suggests, which includes some preliminary upward pressure on labor costs and wages, then the Federal Reserve is likely to raise rates in the middle of the year, even if there is little if any progress on inflation from here. Recall that the 2004 tightening cycle began with the core PCE deflator (which was not a target then) was near current levels.
At the same time, the market takes for granted that the ECB will announce a wider asset purchase plan. It is now debating the "modalities". We have argued that the divergence with the euro area had been a key hurdle to such a program, but now that the German economy has lost its momentum, and is also on the verge of outright deflation, the opposition to a larger asset purchase program has softened.
That said, we expect a modest program of 500-600 bln euros, and for the national central banks to bear the risk buy keeping the purchased bonds on their balance sheets, unlike the SMP bond buying program under Trichet. We suspect that the national central banks will not buy instruments with negative yields. This will force the core countries to buy longer maturities than the periphery, which also has implications for the relative risks and yield curves.
In the US experience, the dollar would often sell-off and Treasuries would rally on anticipation of QE, and then reverse when the announcement was made. This could play out in Europe too.
Turning to Australia, the much better than expected building approvals report helped the Australian dollar resistant the US dollar's strength today, but it does not change the trend. Building approvals in November jumped 7.5% compared with a consensus forecast of a 3% decline. It follows on the heels of better trade figures earlier in the week. The Aussie recovered nearly a cent off yesterday's low below $0.8035 but ran out of steam again as the 20-day average was approached near $0.8140.
The politics that investors seem most interested in is the Greek election on January 25, three days after the ECB meeting. However, there is another election that is receiving practically no attention, but could be very revealing. The prefecture of Saga in Japan holds an election Sunday that could give insight into how much Prime Minister Abe is going to be able to enact his reforms. We have argued that the main hurdle to real structural reforms is the LDP itself. It is a coalition, like most major parties. There are forces of order and forces of reform within the LDP. Abe himself has a foot in both camps. His appointments and policies reflect this.
The election in Saga pits an agent of reform, Hiwatashi, the ex-major of Takeo (a city in Saga) against Yamaguchi, an ex-bureaucrat. These are the two main candidates. Hiwatashi is supported by the LDP in Tokyo (Abe). However, some parts of the LDP are supporting Yamaguchi. This seems especially true of the Japan Agricultural Cooperatives (JA). Hiwatashi enjoys a small lead according to the polls, though Yamaguchi appears to have narrowed the gap. There appears to be greater misgivings of Abenomics in Japan than the super-majority that the LDP-led coalition secured again would suggest. If Yamaguchi draws the protest vote and wins, it could stymie Abe's third arrow, and invigorate the resistance to significant concessions in the Trans-Pacific Partnership trade talks. That said, the election in just one confrontation between the agents of change and the agents of order in a larger struggle over Abenomics and the soul, if not the future of Japan. It may not the decisive battle, but it offers insight into the early days the Abenomics 2.0.
