The investment climate has become more treacherous. Weak wage growth and disinflationary headwinds are making market participants question likelihood of a Fed rate hike around mid-year.
The Swiss National Bank's jettisoning its prior strategy has thrown many investors off balance and less secure of their footholds. OPEC's unwillingness to make room for a continued increase in US oil output has unleashed both powerful positive and negative forces.
The world's second largest economy, which has contributed mightily to global growth, is slowing. The Bank of Japan is engaged in an unprecedented monetary experiment; expanding its balance sheet by 1.4% (of GDP) a month. At the same time that European political uncertainty has grown, the ECB is on the verge of accelerating the increase in its balance sheet. The IMF will update its World Economic Outlook. In October it forecast the global economy to grow 3.8% this year. It is expected to shave its forecasts as did the World Bank recently.
Here is a thumbnail sketch of our top ten things to watch this week:
1. ECB Meeting: There are widespread expectations for the ECB to announce a broader asset purchase plan this week. The complexity of such a program leaves plenty of moving parts that can be fought and compromised over. Reports already suggest the direction of the compromise that will win a majority support, though once again probably over the objections of German representatives.
In exchange for limiting the risk to the ECB itself, there may be an agreement for a more aggressive program. While the ambiguity of an open-ended program may be strategically superior, national central banks are unlikely to be given carte blanche either. There is also an issue of the quality of asset that can be bought. The easiest decision would be to declare any asset good acceptable for repo operations is good enough to buy. Another challenge is the significance of initial conditions. Roughly a quarter of the eurozone sovereign debt have negative yields. Given market positioning we caution of the risk of disappointment or buy the rumor, sell the fact type of activity.
2. Greece: The national election is a week away. Syriza's small lead has been maintained. Flight from Greek banks has accelerated, and at least two banks have request emergency funds from the central bank, which needs the approval of the ECB to grant. At the same time, Greek banks are reportedly buying the T-bills that foreign investors are reluctant to roll-over. Many foreign banks also may be less willing to do repos with Greek banks. Although we do not expect Greece to leave the monetary union, we recognize that a period of political uncertainty likely lies ahead. Italy's presidential selection begins at the end of the month and promises its own drama.
3. Switzerland: The SNB's decision to abandon the franc's cap was momentous. Apparently even the Swiss government learned of it in the eleventh hour. It is ironic that since the crisis, many observers have expressed concern that the independence of central banks was being encroached, and here when a central bank exercises precisely that independence it annoys the very same critics. Moreover, unlike the devaluations that were denied until the very last minute, or the BOE abandoning the ERM peg but only after losing billions of sterling, or the US unilaterally breaking the dollar-gold link, here the Swiss franc appreciated. This is not a beggar-thy-neighbor policy. The SNB's decision was unanimous. The Danish peg came under attack following the SNB's action. We suspect Denmark's first line of defense will be a return to negative interest rates.
The SNB apparently judged that the cap-strategy, which replaced its strategy to buying foreign bonds had out-lived it usefulness. Abandoning it now would arguably be less costly than defending if, as it seems likely the euro will continue to decline and the dollar will continue to appreciate. It seems to be hoping that the more negative interest rates will help minimize the upside pressure. The Swiss 10-year government bond now sports an unprecedented negative yield. It is not only a hit for Swiss exporters, but also for the value of Swiss owned foreign assets, both publicly owned, such as reserves, and privately own. Switzerland's net international surplus investment position just narrowed significantly.
4. Japan: The Bank of Japan meets. It will likely reduce its growth and inflation forecasts. Yet cutting the inflation forecast will fuel expectations for even more monetary efforts unless there is a clear signal from BOJ Governor Kuroda. This need not be the abandoning of the 2% target, but modifying it in light of the drop in energy prices. Separately, note that the opposition DPJ held its leadership election. Although the party is trying to rebuild, its new leader Okada is not seen as offering a fresh alternative, but rather a continuation of the status quo. The ruling LDP is a large coalition, and the rifts between its factions are more important in shaping policy than the competition between parties.
5. UK: In the run-up to the May elections, the labor market continues to improve. The UK is expected to report that its unemployment rate fell below 6% for the first time since before the crisis. Moreover, average earnings should continue to recover. The fall in inflation may be doing households more good than employers for boosting real incomes. Still, the high frequency data is noisy, and some pullback in retail sales in December is expected. The BOE minutes will be released. Despite the fact that the MPC needed to write a letter explaining to the Chancellor why it undershot on inflation, McCafferty and Weale likely maintained their dissent in favor of immediate rater hike.
6. Canada: Canada was not particularly exposed the to derivatives that imploded in 2008-2009. However, we under-estimated how much it was levered to high oil prices. While the Bank of Canada is not going to cut rates at this week's meeting, it will shift to a more dovish shade of neutrality. It will likely cut its growth and inflation estimates. A weaker Canadian dollar is part of the adjustment process. The December CPI report will be released before the weekend. The headline rate will fall sharply, but the core rate could tick up, which may see the Canadian dollar find some support, albeit temporarily.
7. China: The monthly data series including retail sales, industrial production, and investment figures are set be reported. China will also report Q4 GDP figures. It will be difficult to see in the data the gradual slowing of the Chinese economy. However, the actions by the government and PBOC to provide extra stimulus, though in targeted rather than a generalized way, confirms a slowdown is taking place. The preliminary HSBC manufacturing PMI is expected to show the second consecutive reading below the 50 boom/bust level. The weakness in China's demand for industrial commodities has weighed on sentiment. That said, the downside pressure on copper and oil prices eased at the end of last week. Separately, Premier Li will speak before the World Economic Forum in Davos (that just became considerably more expensive to attend).
8. Oil: Even as US oil and gas rigs fall, output continues to rise. According to Baker Hughes, the number of mainland rigs in the US was reduced by 72 to 1676. This is the third largest weekly decline since 2000. The number of rigs operating is 101 lower than a year ago. The number of oil rigs fell by 55 to 1366. The number of oil rigs peaked in October 2014 at 1609. Over the past four weeks, 170 rigs have been decommissioned. This represents a marked acceleration from the previous four weeks when 38 rigs were shut down. Even as the rig count falls, the EIA expects US oil production to rise this year to an average of 9.3 mln barrels a day, up from about 9.0 mln last year. This includes a forecast for a 3% decline in output during the May through September period. Meanwhile, capital expenditure budgets are being slashed, especially by the exploration and production groups. A credit squeeze also continues to unfold. Before the weekend, S&P cut the rating of eight small E&P companies and put another nine on negative watch.
9. Emerging Market Central Banks: Brazil is tightening both fiscal and monetary policy. The new finance team is consolidating fiscal policy. The central bank is expected to hike rates by as much as 50 bp, which would lift the Selic rate to 12.25%. On the other hand, falling inflation and political pressure point to a rate cut by Turkey's central bank. Nigeria's central bank is expected to hold rates steady after hiking them at late last year.
10. US: Economic data in the week ahead is largely limited to housing starts/permits and existing home sales. President Obama delivers his sixth State of the Union address. Most of the initiatives will be leaked before the speech itself and will require Congressional support, which will be hard to come by given the Republican majority in both houses. The Federal Reserve meeting is still a week away (January 28), but expectations for a mid-year lift-off have been weakened. The implied yield of the December 2015 Fed funds futures contract fell 10 bp last week to 41.5 bp. The implied yield of the December 2015 Eurodollar futures contract fell 11 bp to 69 bp. Both yields are the lowest since the mid-October flash crash.
We suspect that the pendulum of market expectations has swung nearly as far as it will. The University of Michigan survey showed long-term (5-10 years) inflation expectations remained unchanged at 2.8%, despite the fall in 1-year expectation to 2.4% (from 2.8%). We expect the Fed’s leadership will continue to argue in favor of looking past the decline in energy prices, which on balance will still be a net positive for US growth. There is a compelling reason for the FOMC to emphasize core inflation over headline inflation. For at least the past 50 years, headline inflation has converged with core inflation—not the other way around.
