The highly anticipated US employment data for the month of October released last Friday has sufficiently jolted market participants, busting the greenback from its shackles and elevating it against the majors. The greatest number of jobs added since December of last year, average earnings reaching new cyclical highs on a year-over-year basis, and the U6 Unemployment rate dropping below 10% for the first time since May of 2008, all reinforce the divergence meme investors had been beginning to question. While US domestic data has contributed to the resurgence of monetary policy divergence narrative, it is not the sole perpetrator for the greenback’s strength in a currency landscape that is exhibiting heightened volatility. Downgraded inflation and GDP forecasts for 2016 from the Bank of England has trimmed the value of the pound as expectations of a rate hike in 2016 are shaken; dovish commentary from European Central Bank chief Mario Draghi has lifted the prospects of more accommodative monetary policy from the central bank, with the next meeting on December 3rd looming like an ominous black cloud and pressuring the euro lower. Therefore, even though market participants are coming around to the fact that a December rate hike from the Fed is the most likely scenario, the shifting tectonic plates of monetary policy overseas are also contributing to the investment climate conducive to be long the big dollar.
While the pendulum has indeed swung back in favour of the monetary policy chasm between the US and the rest of the developed world widening at a quicker pace, we would caution the speed at which markets are currently expecting this to take place. Even though we have been in the camp that suggested a December rate hike was the most likely outcome since the Chinese equity meltdown shook markets earlier in the year, lift-off for the Federal Reserve and the speed of monetary policy divergence are two different beasts. Assuming a rate hike from the Fed does materialize in December, market participants will quickly resort to deciphering how the Fed defines a gradual normalization of monetary policy, and how that takes shape. Like the dot plots from the Fed that have constantly undershot inflation expectations, the estimation of interest rate levels is likely too ambitious, and policy normalization will probably follow a more gradual course than many on the FOMC currently anticipate. In addition, the Fed also has a robust balance sheet which it can utilize to drive monetary policy outside of the benchmark rate, and simply deciding to stop, or slow, the reinvestment from the proceeds of maturing securities could be used to influence policy while keeping interest rates low.
Outside of the domestic landscape in the United States, the heightened probability of further monetary policy accommodation from the ECB has gripped market participants and led to some blood-letting for the euro. While the risk of action from the central bank in December is indeed high, it appears a consensus among the governors has yet to have been forged, and it looks as if Draghi’s urgency for further action is at odds with the incoming data. German factory orders and industrial production was disappointing last week, but core inflation is holding up relatively well around the 1.0% mark, and the flash GDP reading for the third quarter released at the end of this week is expected to come in at a pace of 0.4%, matching that which was registered in Q2. With Draghi speaking throughout the week and the flash GDP numbers on the economic docket, we would caution upside risk for the euro is lurking, with the common-currency susceptible to short-covering rallies should Draghi’s tone change or GDP surprise to the upside.
A lively week of Chinese data kicked off over the weekend with the trade surplus in China reaching a record high at $61.6bln. Not particularly encouraging were that both exports and imports fell faster than expected, though the slide in imports slowed from the 20.4% decline experienced in September to post only an 18.8% drop in October. The decline in imports as a factor of the positive terms of trade shock resulting from lower commodity prices is likely not a worrisome development for the Chinese government, yet slipping international demand resulting in exports falling by over twice the expected pace will raise eyebrows. If the inflation data released later tonight continue to suggest disinflationary factors are taking hold throughout the Chinese economy, a sharper than expected decline in CPI will give the government further ammo to ease either rates or reserve requirements before the year is up.
So while the divergence meme has indeed resurfaced on the heels of the better than expected NFP report from Friday, investors will be wise to heed caution to the multiple forces that will dictate the speed of that divergence.
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