One Question Dominates: Correction or Reversal?

October 11, 2015

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There is a sense that the markets are at crossroads. Many suspect there has been a trend change. The reason for many to buy the dollar was the Fed was going to raise interest rates. Lift-off may not be simply postponed until December, as was the decision to begin tapering, but a growing number of participants do not see it until March.

Meanwhile, the OPEC and some non-OPEC countries will meet just as the US Department of Energy warns that US oil output is likely to trend lower through the middle of next year. This sent oil prices back above $50 for the first time in two and a half months. Since late-August the CRB Index is up 10%.

Some argue the emerging markets have discounted too much bad information. With the ECB and BOJ still engaged in unorthodox easing of monetary policy, and likely to do more rather than less, China is gradually easing and providing more fiscal support, the global economy remains awash with liquidity. Over the past three years, the MSCI World Index (DM) is up almost 28% while the MSCI Emerging market equity index is down nearly 14%. However, since September 29, this has changed. Emerging market equities are up 12.5% while the World Index is up 8.5%.

The euro bottomed in March near $1.0450. It spiked to almost $1.1715 on August 24 and has been carving out a new range. The $1.1100 area looks to be the bottom of the range. It is the top side that is being fished for presently. As it is, three-month implied volatility has fallen seven-month lows (9.4%). There is scope for additional declines in the implied volatility, but such a decline often precedes strong moves.

The same broad narrative applies to the yen as well. The dollar recorded its highs against the yen four months ago near JPY125.40. On the August 24 it crashed to around JPY116.20 and has been in a new range since between JPY118.60 and JPY121.60. The implied volatility (three-month) fell below 9.2% before the weekend, the lowest level in two months. This is also reflected in the narrowness of the Bollinger Bands (analysis here). While we suspect the coil may continue in the near-term, it is setting the stage for a potentially powerful move.

II

Nevertheless, our analysis leads us to conclude that this is a market correction not a reversal of the underlying trends. How investors should respond is a question of timeframes and risk appetites, which cannot be deduced from first principles.

While central banks quantitative easing may have contributed to the low interest rates, the low inflation and subdued real growth offers a more robust explanation. It also can explain why the QE route was chosen in the context of not only the zero-bound (which the ECB, SNB, and Denmark and Sweden's central banks demonstrate, there is no such a bound in the first place) but also given the lack of much appetite for sustained and substantial fiscal stimulus.

The main conditions in the high income economies that are producing the weak growth are poor productivity gains and slow workforce expansion. There is nothing to suggest that these conditions have changed in the past few months. In the US, for example, the labor participation rate is sitting in its trough six years into recovery/expansion and with unemployment at 5.1% (the unemployment rate for college graduates is half of that). Productivity gains are dismal. The 0.7% rise over the past year is a third of the long-term average.

The Federal Reserve accepts that US potential growth has slowed. This can be seen in the Fed's observation that the US economy had been growing above trend. This is what it means when NY Fed President said before the weekend that nonfarm payroll growth of 120k-150k is likely sufficient to continue to push the unemployment rate down.

The Fed's staff estimate suggests trend growth in the US is about 1.75% through the end of the decade. It means that those warning that the US economy has not achieved that famed "escape velocity" are using a metric that may no longer apply. The strong growth was, in part, made possible by baby boom generation. Population growth has slowed, and in an increasing number of high and medium income countries, falling,

Dudley also acknowledged that an inventory overhang will weigh on growth here in the second half of the year. That instructs us to watch final demand (GDP-inventories) and consumption. Consumption is around two-third of the economy, and provided consumption remains robust, we should not rule out a December hike.

Auto sales in September were a robust 18 mln unit annual pace, something not seen for a decade. Watch the measure of retail sales, due at midweek that excludes gasoline, auto, and building materials that feed into GDP calculations. The Bloomberg consensus calls for a 0.3% increase. Such an increase would mean that this core measure of retail sales in Q3 was either the best or second-best quarter since Q1 12.

US inflation gauges should not offer much fresh news. It is widely appreciated that there price pressures of modest at best. Core CPI is expected to remain unchanged at 1.8% year-over-year. The weakening of the US industrial sector has been seen the entire year, and it appears to have continued into September. Industrial output is expected to have fallen 0.3% for the second month in a row. It would have fallen in seven of the first nine months this year.

Manufacturing is holding up only slightly better. A 0.2% decline in September would also be the second consecutive drop. It would have fallen in six of first nine months. This reflects the painful adjustment in the energy sector and weaker foreign demand. Weaker foreign demand has two components, and it is difficult to separate the two: exchange rates and weak growth abroad.

The Fed's Beige Book will be released, and at least six Fed officials are scheduled to speak in the week ahead. However, outside of some headline risk, the impact is likely to be minor. The anecdotal color on the economy may be interesting, but is unlikely to change the overall perception of the state of the economy. The October meeting is not seen to be live, despite official claims. The signal from the Fed's leadership is clear: Provided there are no new unpleasant surprises, a rate hike before the end of the year is still appropriate.

As Q3 earnings season moves into high gear, several large banks, and tech companies report. First Data is reportedly preparing for what appears to be the biggest IPO of the year. Dell is offering to acquire EMC in a transaction that is worth more than $50 bln. The first Democratic Party debate may garner attention as Clinton's support continues to ebb and speculation is rising that Vice President Biden is getting close to announcing his bid. Clinton's balked at the Trans-Pacific Partnership pact, and this too

III

The ECB has trumpeted its easing bias. It could expand, extend or alter the composition of its asset purchases. It seems the process to build a consensus has just begun. The staff's cut in the inflation and growth outlooks is a necessary but insufficient step.

It is easy to claim that the eurozone has not achieved escape velocity, but that assessment may also reflect more wishful thinking than reality. Consider that for the past four quarters growth in the euro area has risen by an average of 0.4%. In 2005, ostensibly near the pre-crisis peak, quarterly growth averaged 0.47%. Expectations are that Q3 growth was also around 0.4%.

Data in the week ahead will likely reinforce two related themes. The first is that even if euro zone growth in Q3 was in line with recent quarters, economic momentum might be fading. This week, investors will likely learn that the decline August's industrial output offset the 0.6% rise in July. It will likely be confirmed that after being banished in March, deflation returned in September.

The second European theme is the sharper slowdown that appears to be hitting Germany. Recent data has been uniformly disappointing. This includes the PMIs, retail sales, industrial orders and output. The 5.2% fall in August exports was the largest single-month decline since the heart of the 2009 crisis. This coupled with the DAX's loss over the past month likely undermine the ZEW measure of investor sentiment that will be reported Tuesday.

A Bloomberg poll found two-third of the respondents expect the ECB to extend its asset purchase plan before the end of the year. This would be a compromise formation even if it does not secure unanimous support. Buying more assets would have a greater impact than extending the end of the program.

The US QE3 and the BOJ's current QQE were open-ended. The assets would be bought until officials judge otherwise. There were monthly and/annual targets, but no pre-set termination point. The ECB has yet to make that transition from date/size dependency to data-driven. Indeed, investors might not respond very much to the ECB's formal announcement as many investors had long assumed this was going to be the case. No central bank that has bitten the QE fruit has been content with its first bite. It next meets October 22.

The Bank of England has signaled that it too may soon have to consider hiking rates, but it appears to be in no hurry. The data will be interpreted through this lens. The implied yield of the June 2016 short-sterling futures contract fell from 1.13 bp in late June to 66 bp, a contract low, on October 2. It has since drifted up to 73-75 bp.

A poor CPI figure (the consensus expected no change on the month and leaving the year-over-year rate at zero, but the risk is on the downside) would weigh on sterling for the same reason that the dollar has come under pressure. The timing of the first rate hike is tricky. The same considerations that may delay a Fed hike into next year are also pushing out expectations for the timing of the BOE's first move

Perhaps the most important UK news will come Thursday with the jobs report. Average weekly earnings are reported with an extra month lag so that the August period will be covered. Earnings growth reported on a three-month year-over-year basis is expected to have ticked up to 3.1% from 2.9%. Recall that in June 2014, average earnings had fallen by 0.2%. The pace of increase, with a tight labor market, by various measures, is the one key argument for the hawks, but whether McCafferty can get others to join his lone dissent (twice now) is a different story.

There are two other inflation reports. The first is from Sweden. The consensus call for a 0.3% rise in September's CPI would be sufficient to lift the year-over-year rate back to zero after spending the preceding three months in deflation territory. The central bank meets later this month (October 28), and it may stay the present course which includes a -35 bp deposit rate. However, the central bank may lean against the 4.5% appreciation of the krone on a trade-weighted basis over the past two months.

The second is China. Consumer price increases are expected to have risen by 1.8% in September after a 2.0% pace in August. That was the fastest since August 2014. Most of the consumer inflation is to be found in food prices. Real interest rates are high in China. That means that its traditional monetary tools are still available (interest rates and reserve requirements). Producer prices remain in deeply negative territory. They have been below zero since early 2012.

China's trade balance will also attract attention. Exports have fallen every month thus far this year but two. The February gain was skewed by the Lunar New Year and the 2.8% rise in June seems like a statistical fluke. The three-month average has been negative since May. The consensus forecasts a 6.0% decline after a 5.5% fall in August. Imports are expected to have fallen by nearly 16% (-13.8% in August). Be careful to separate price from volumes.

IV

On balance, the data and events in the week ahead are unlikely to change the underlying dynamics very much. The Fed is off the table until at least December. The ECB and BOJ expand their asset purchase programs, but there are limited chances in the near-term. The ECB meets first, but official comments are clear that it is still assessing the situation. The BOJ meets at the end of the month, and although there is some expectation for a more aggressive stance, and the economic may seem to warrant it, BOJ Kuroda seems in no hurry.

The corrective forces have scope from macroeconomic considerations to technical analysis. The dollar has held to the lion's share of the gains scored since the middle of last year. The 38.2% retracement for the euro is found a little above $1.18. The same retracement of the greenback's gains against the yen is near JPY116.50. Sterling, aided by thoughts that a BOE rate hike is not long after the Fed's, has retraced 50% of its losses at $1.5880.

The US dollar has barely retraced 38.2% of its leg up from May against the Canadian dollar, which is near CAD1.2870. The 50% retracement is just below CAD1.2690. Similarly, the Australian dollar has only approached the 38.2% retracement of its decline since May. It is at $0.7380.