The ingredients are in place for continued dollar strength. The US data has come in stronger than expected, the Fed has become less dovish, and the outlook for the rest of the world has worsened. Recently, St. Louis Fed President James Bullard noted that the US is doing better than the rest of the world and the dollar is strong as a result. That is our bullish dollar call in a nutshell, and also explains why US rates should remain higher than the rest of the world.
The US political outlook remains cloudy and fluid. It is impossible to say with any certainty where the impeachment process will end up. The base case that has developed is that the House will impeach by a simple majority, but the Senate will not vote to convict by a two-thirds majority. Yes, some legislation will likely be derailed, like the USMCA. For now, we think markets can live with this outcome.
Investors cannot look at past impeachments as guidance for how financial markets might react, as that sample size is one. Furthermore, the alleged crimes are very different. Obviously, the big question on everyone's mind right now is whether the current political uncertainty will impact the US economy. We don't think so. Our biggest worry remains the trade war but other than that, the US economy is pretty much on auto-pilot. This uncertainty shouldn’t prevent consumers from consuming and that's what is driving the economic strength right now.
As expected, the Fed cut rates in September by 25 basis points (bp) to a range of 1.75-2.00 percent. The Federal Open Market Committee (FOMC) was split on the need for more easing and so overall, we’d characterize this as less dovish than expected. Some were looking for a 50 bp cut or for signs of further cuts but we got neither. The Fed was generally upbeat on the economic outlook but noted some downside risks. Fed Chair Jerome Powell pledged to act as needed and stressed that if the economy weakens, more extensive rate cuts may be needed. However, we believe he downplayed the need for further easing.
Due to a perfect storm of unrelated events, the US repo market basically seized up in September. Powell downplayed the recent funding pressures as a technical problem. He sees no impact on the real economy and felt that the stresses took most by the surprise, even the market experts. Powell acknowledged that the Fed will have to revisit the notion of increasing the size of its balance sheet. He did take pains to stress that it would be “organic” and technical with no policy implications. As such, markets shouldn’t expect another round of quantitative easing.
Chicago Fed National Activity Index (CFNAI) came in better than expected at 0.10 for August. Even though July was revised down to -0.41, the three-month moving average (CFNAI-MA3) still fell to -0.06 from -0.14 in July, the lowest since January. Note that a value of zero shows an economy growing at trend. Positive values represent above trend growth, while negative values represent below trend growth. CFNAI-MA3 is moving further away from the recession threshold of -0.70 and so market expectations for the Fed need to be adjusted significantly.
Yet WIRP suggests 62 percent odds of a cut October 30, while the CME model suggests 64 percent. We believe both are way too high in light of less dovish than expected signals recently from Fed officials. Unless there is a sharper drop-off in the US growth outlook, we do not think the Fed is in any hurry to cut again.
The European Central Bank (ECB) delivered a little bit of everything at its September meeting. When all is said and done, however, the moves were timid and somewhat less than the sum of its parts. The deposit rate was cut 10 bp to -0.5 percent but tiering was introduced to mitigate the impact of negative rates. Monthly asset purchases resumed at a pace of €20 billion per month and will continue “as long as necessary.” Lastly, the ECB loosened the terms of the latest targeted longer-term refinancing operations (TLTRO) by lowering rates and offering longer tenors.
Despite the mild nature of these measures, ECB President Mario Draghi reportedly faced pushback from core Europe. Central bankers from France, Germany, and the Netherlands all opposed the resumption of quantitative easing (QE), and were joined by Austria and Estonia. This suggests that Draghi’s successor Christine Lagarde will face strong opposition to any future easing.
Yet more easing will undoubtedly be needed. Germany appears to have slipped into recession, as weakness in the manufacturing sector has spread to other sectors. Its composite purchasing managers index (PMI) fell below 50 to 49.1 in September for the first time in this economic cycle, while manufacturing fell to a cycle low 41.4.
Eurozone political risk is likely to rise in Q4. Italy is widely expected to engage in its annual back-and-forth with the EU over its annual budget. While the situation could end up better due to the ejection of former Deputy Prime Minister Matteo Salvini’s League from the ruling coalition, the sailing will be anything but smooth as its coalition partner, the Five Star Movement, and the Democratic Party are simply in a marriage of convenience. Elsewhere, Spain is headed for the polls once again on November 10 after the major parties were unable to form a working government.
UK Supreme Court ruled that Prime Minister Boris Johnson’s suspension of Parliament was unlawful. The court added that Parliament has a right to a voice in the Brexit debate and should meet as soon as possible. This is good news at the margin for British democracy, but does this really get us any closer to a Brexit resolution? After a recent burst of optimism, Irish Foreign Minister Simon Coveney gave markets a dose of reality and warned that a deal is “not close.”
The odds of a no-deal Brexit have likely fallen. However, the outlook remains muddy and there are rising odds that we get another delay beyond the current October 31 deadline. Some have urged Prime Minister Johnson to resign but he has so far refused to do so. Fresh elections appear more and more likely this fall. Opposition Leader of the Labour Party Jeremy Corbyn said he wants elections, but only after the threat of a no-deal Brexit is off the table.
The Bank of England (BOE) is clearly on hold until the Brexit outlook becomes clearer. World interest rate probabilities (WIRP) suggest 13 percent odds of a cut November 7, rising to 20 percent December 19 and 35 percent January 30. July data had come in mostly firmer than expected, but August has so far been disappointing. Yet the BOE has stuck with its belief that absent a hard Brexit, the likely direction for the policy rate is higher.
Bank of Japan (BOJ) kept rates steady in September, as expected. There were two dissents, with one in favor of lower rates and one in favor of changing forward guidance that currently sees current policy through at least spring 2020. The consumption tax hike goes into effect October 1. As such, the BOJ will likely wait to gauge the potential impact on the economy before moving again. WIRP suggests 54 percent odds of a cut October 31 and 83 percent December 19.
Press reports suggest that a US-Japan trade deal is stalling out. Talks ended this month and negotiations are reportedly at an impasse over the US threat to slap tariffs on Japanese autos. Japan is asking for a sunset clause that ends any deal if the US imposes such tariffs. The two countries had been working toward signing a limited trade deal, but more work is needed.
Japan has also been impacted by US-China trade tensions. However, it is also experiencing a homegrown crisis with its intensifying spat with Korea over the issue of colonial-era reparations. Both countries have put some trade restrictions into place on sensitive and strategically important material inputs.
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