Raining on the Parade

The US dollar is consolidating yesterday’s gains against most of the majors, with two notable exceptions.  Perceptions of heightened prospects for Fed tapering has pushed up US Treasury yields and lifted the dollar to its highest level against the yen since July,  just shy of JPY101.  

Ironically, the low yielding yen’s weakness has been largely matched by the decline in the Antipodean currencies,   The Australian dollar was sent to 2-month lows in response to a disappointing flash HSBC manufacturing PMI for China and a speech by RBA Governor Stevens raising the concern about the Australian dollar’s value a notch by openly discussing the costs/benefits of direct intervention.
It was not just that the HSBC flash PMI headline slipped to 50.4 from 50.9, reversing the gains over the past two months, but the forward looking details were poor.  Export orders fell to 3-month lows, while overall orders fell to 49.3 from 51.3.
The euro initially extended yesterday’s losses, but found a bid near $1.3400, which corresponds to a 61.8% retracement of the rally since the ECB’s rate cut.  Resistance now is seen in North America around $1.3440 and $1.3470.  Yesterday’s losses, with the euro having initially trade above Tuesday’s highs finished well below Tuesday lows, reflecting a deterioration of the technical tone.  The fundamental tone has been undermined by the flash PMI readings.  The EMU flash composite PMI slipped to 51.5 from 51.9, the second consecutive decline. This is a function of the unexpected weakness of the French readings and warns of some risk that the second largest economy in the euro area may be contracting here in Q4.
The German readings were strong, with the manufacturing PMI at 2.5 year highs of 52.5, while the service reading rose to 54.5 from 52.3.  The weakness from earlier in the year has faded and the German economy appears to be accelerating into the end of the year. France is clearly lagging.    French manufacturing contracted to 47.8 from 49.4 and the services fell to 48.8 from 50.2.  Weakness in orders, exports and jobs make for a dim outlook.
While we continue to believe that the (growing) divergence between France and Germany is a critical fundamental fissure within the euro area, we recognize that the level of anxiety in the markets is low.  The spread between German and French bonds has actually narrowed slightly today and France’s Novy has been nominated to be the chair of the ECB’s new bank supervisory board.
Earlier in the week, we suggested the foreign exchange market was looking for inspiration.  It appears to have gotten it.  However, we are skeptical of the merits of that inspiration.  First, was yesterday’s Bloomberg report out of Frankfurt that unnamed sources suggested that the ECB was considering cutting the deposit rate to -0.1%.   This does not seem to be consistent with other signals coming from the  ECB officials, especially in downplaying the real deflation threat.  Weidmann just yesterday cautioned against signaling further monetary ease.    Despite the reporters being in Frankfurt, it is unreasonable to suspect the unnamed sources were German.  However, there are others that may have wanted to counter Weidmann or talk down the euro.
The ECB has not exhausted other measures before turning to an unprecedented and risky course as a negative deposit rate.  Already some banks have complained that the low rates are squeezing their margins just as regulators are requiring more capital. It seems incongruent to minimize the risk of deflation and suggest a high risk policy response.  Since more officials aligned with the former, logic suggests it is the signal and the latter is noise.
The other source of inspiration yesterday was the FOMC minutes,  The market seemed to take to heart the notion that the Fed is still prepared to taper at one of the next few meetings.  This is not news.   The minutes did not break new ground.  Bernanke has said the same thing earlier this week.    Surveys had shown the consensus for tapering to be announced in March.
In addition, the minutes also confirmed what the market already suspected about the reliance on forward guidance instead of asset purchases.  The Fed want to anchor expectations that tapering is not tightening.  And the tapering is likely to be accompanied by stronger forward guidance.  It seemed much of the discussion was about how to drive home this message.  There were many idea, all of which the market has discussed, like lowering the threshold for unemployment, introducing an inflation threshold, and cutting interest on excess reserves (IOER).  None of these measures were widely supported.
A cut in the IOER, currently 25 bp, grabbed attention yesterday, perhaps, in part because of the report about negative deposit rates in EMU.  However, the benefits were seen as small and in the past Yellen argued that such a move could be disruptive for the financial markets.  Still, there may be a small benefit through the signaling channel.  A cut in IOER at the same time as tapering might help drive home the message that interest rates will remain low, even though a lower IOER does not really tie the Fed’s hands.
The minutes obscure who are voters on the FOMC and who are not.  The structure of the Fed is a strong Board of Governors and a less role for the regional presidents.  Methodologically, we continue to find merit in focusing on the Fed’s central committee, if you will, or the Troika of Bernanke, Yellen and Dudley.  This is, we think, where the real signal emanates.
We continue to expect Yellen ‘s nomination to be confirmed next month or early Jan and the she, not Bernanke chairs the January meeting.  We do recognize a risk that she tapers at her first meeting, which would send a powerful signal, but if the fiscal negotiations are not resolved, it could be problematic.    On balance, then the March meeting, what we expect to be Yellen’s second as chair,  is a more likely scenario. 

This piece is cross-posted from Marc to Market with permission.