It seems like I’ve been here before. I’ve previously written about the correlation between stocks and currencies. Basically, if stocks are going down you want to buy JPY or CAD and sell CAD, AUD or NZD, in that order.
What about bonds? What if bond prices are rallying in response to falling stocks? This is going to be a bit more difficult, because while many of the major global bond markets are indeed closely correlated, some aren’t, such as the disastrous ones (Italy) or the ones where their government is stuck on zero (Japan, Switzerland). Furthermore, currencies (or, more accurately, currency pairs) aren’t closely correlated at all with the movement of bond yields; they’re correlated with the movement of bond spreads, that is, the difference between two bond yields. If though the major bond markets are highly correlated (which they are), then the correlated moves of these markets are not likely to have as big an impact on currencies as the change in risk sentiment overall, as reflected in stock market behavior.
In any event, it’s clear that the currency markets just aren’t where the drama is nowadays. As you can see, the vol of EM FX options was much higher a few months ago but has been coming down, while G7 vol has barely budged recently. In contrast, the VIX index has exploded.
Meanwhile, the global tightening continues. The Bank of Canada was the latest central bank to raise rates this week, and it also hinted at a more aggressive pace of tightening to come. Comments from this week’s Fed speakers, such as Cleveland President Mester and the new Gov. Clarida, show continued optimism on the US economy that make me think it will take more than a correction in stock prices to dissuade them from the tightening path that they’re on.
In fact, despite the rise in rates, widening of bond spreads and fall in stock markets, overall financial conditions in the US are still looser than they were when the Fed hiked previously in this cycle. It would take far more than this to deter them, in my view.
The same may not be said for the EU, however. The manufacturing purchasing managers’ indices (PMIs) show growth accelerating in the US, but continuing to slow in Europe. ECB President Draghi acknowledged the recent weak data, but drew no conclusions. Presumably he’s waiting until the next meeting in December, when the new forecasts will be available, before pronouncing any views on the outlook.
The week to come: UK Budget, PCE deflators, Bank of Japan, Bank of England, NFP
Aside from the internal affairs of the markets, there will be enough external affairs to keep people busy as well.
The week starts with the UK FY2019 budget. Chancellor Hammond is basically a fiscal hawk who would like to meet the Government’s target of eliminating the deficit by the mid-2020s. However, with only a narrow majority in Parliament and the deficit narrowing anyway, it would be difficult for them to pass any major tax increases or spending cuts (never mind that PM May promised to “end austerity”). Moreover, it would be silly to make any major changes just a few months before the uncertain end of the Brexit process. Against that background, a neutral budget is likely. Any additional spending is likely to depend on the outcome of the Brexit negotiations – a “soft” Brexit would probably allow more spending on popular programs, while a “hard” Brexit is going to require substantial government resources to deal with the fallout. GBP neutral
On Monday we also get the US personal consumption expenditure (PCE) deflators as part of the personal income & spending data. These are expected to show headline PCE inflation falling back to 2.0% yoy, while the core PCE deflator – the Fed’s preferred inflation gauge – is expected to stay at that rate. Since that’s the Fed’s inflation target, it still means there’s no obvious reason for the Committee to change its expected rate path. USD-positive.
The Bank of Japan meets Wednesday in Tokyo. The BoJ-watching community has become like the famous dog Hachiko, much beloved in Japan, who showed up every day to meet his master’s train even though his master had died a long time before. I doubt if we’re going to get what we’re waiting for this time, either. The semiannual Financial System Report released in the past week contained no major changes, which gives us no reason to expect any big moves at the BoJ meeting, either. The Financial System Report did take a more negative view of the impact of low interest rates on financial institutions’ profitability and the financial strength of regional institutions. We might therefore get some language to that effect from the BoJ. But no hint of an exit or change in guidance is likely. JPY-neutral
As you can see from the graph, market estimates of the BoJ’s likely rate path haven’t changed much recently.
The Bank of England meeting as always is likely to be a more interesting event. Here again, there’s no hope of any change in rates – having hiked in August, they wouldn’t dream of hiking again just a few months before the denouement of the Brexit ordeal, especially since inflation is moving in their direction anyway. In that case, it will be the tone of the statement and Gov. Carney’s comments afterwards that impact the market – much like the old song, I would expect them to repeat their usual comments about limited and gradual hikes over the forecast horizon and for the meeting to have slight if any impact on the pound. GBP-neutral.
Finally, it’s nonfarm payrolls week. After September’s lower-than-average figure, October is expected to rebound somewhat to 190k. That compares with 203k for the six-month moving average. But that moving average, like the graph below, is based on the revised NFP data. If we just look at the initial figure, the recent 6-month moving average is 182k. So in effect the market is looking for a figure more or less in line with the recent trend, as seems reasonable. The unemployment rate is expected to stay at the extremely low level of 3.7%.
Average hourly earnings are expected to be up a modest 0.2% mom, but given that they fell in October 2017, this would bring the year-on-year rate to 3.1%, the first time it’s traded with a 3-handle since the Global Financial Crisis. That’s likely to be more important for the markets than another run-of-the-mill NFP number, in my view. With inflation running at their target, jobs continuing to grow and earnings accelerating, it looks to me like the data only confirms expectations of further Fed tightening. The number should be positive for the dollar.
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