Greenback Marks Time Ahead of FOMC

Overview: The S&P 500's largest advance in three weeks helped extend the recovery in Asia and European equities.  All the equity markets in Asia rallied, led by the Nikkei's 1.8% gain, except for China, were modest losses were recorded.  The MSCI Asia Pacific Index has gained in six of the past seven sessions.  In Europe, the Dow Jones Stoxx 600 is reaching its best level in nearly a month with a 0.6% gain in late morning turnover.  It is the seventh gain in the past nine sessions.  Benchmark 10-year bond yields are mostly one or two basis points higher, though Italian bonds are underperforming.  The dollar itself is narrowly mixed against the major currencies ahead of the results of the FOMC meeting.  The Swedish krona is the strongest of the majors (~0.4%), boosted by comments from the central bank governor indicating that a rate hike could be delivered as early as next month, though many see February as a more likely time frame. Among emerging markets, the volatile Turkish lira and South African rand are nursing 0.6%-0.8% declines, while the most active EM currencies, the Chinese yuan and Mexican peso are fractionally lower (-0.15%).  

Asia Pacific

The central bank of New Zealand kept the cash rate unchanged at 1.75% as universally expected.  RBNZ Governor Orr reiterated that while the next move in interest rates could be in either direction, he did not anticipate a change next year.  The New Zealand dollar's upside momentum that carried it above $0.6800 yesterday stalled near a retracement objective of this year's decline.  An NZD1.0 bln option struck there expires today.  It is over-extended and trading above its upper Bollinger Band that is set two standard deviations above the 20-day moving average (~$0.6765)  A break of the $0.6750 would be an early indication the high may be in place.  

China reported strong October trade figures. Exports rose 15.6% while imports surged 21.4% from year-ago levels. This compares with median forecasts in the Bloomberg survey of 11.7% and 14.5% respectively. This resulted in a trade surplus of $31.3 bln after $34.0 bln in September.  It appears that China and its customers are front-loading orders to beat the tariffs and this is also ahead of the increase in the tariff on $200 bln of goods from 10% to 25% on January 1.  Also, the US has threatened to put a levy on the remaining roughly $250 bln of Chinese goods that have yet to be hit by the Trump tariffs. China's exports to the US rose 13.2%, representing small pullback from the record set in September,  while imports from the US fell for the second month. China claims a bilateral surplus of $31.8, down from the record $34.1 bln in September, though how it calculates trade with Hong Kong may understate it. Many economists are forecasts a sharp fall in Chinese exports next year. 

Japan reported horrific core machinery orders. The 18.3% plunge on the month, twice the decline expected, was a record. From a year ago, the core machinery orders are off 7%.  There are some mitigating factors, like the typhoon and earthquake, but it could be an early warning of the end of a capital investment cycle in railroads and semiconductor fabrication in China. Separately, Japan reported that September's current account surplus was in line with expectations and the trade balance swung back into surplus from the deficit in August. The dollar traded on both sides of Tuesday's range yesterday and closed just above the high. The outside up day has not seen follow-through buying as the greenback holds a little below yesterday's high near JPY113.80, but the intraday technicals suggest the session high may not be in place yet. There are options for about $520 mln struck between JPY113.75 and JPY114.00 that expire today and a $1.1 bln option at JPY113.60 expires tomorrow.  

Europe

The Bundesbank has warned that the German economy may have stagnated in Q3 and today's September trade figures are consistent with that assessment. Exports were expected to have risen after the 0.1% decline in August. Instead, the decline was revised to a gain and exports fell 0.8% in September, the largest decline in February. In the first nine months of the year, German exports have fallen in six months.  Imports have fallen in four of the nine months with a 0.4% decline in September. The trade surplus edged to 18.4 bln euros in September from 17.1 bln in August. The trade surplus has averaged 19.4 bln euro this year compared with 20.7 bln euro average last year.    

The French trade deficit narrowed a bit, but the details were soft. Exports fell 1.8%. It was the second consecutive monthly decline. Imports were off 1.6%. Spain's industrial output fell 0.7% in September, a bit more than expected and offsets the 0.6% gain in August. The September manufacturing PMI fell to 51.4 from 53.0 in August but rebounded in October. Separately, Spain raised 4 bln euro in debt sales of various maturities that were oversubscribed with better bid-cover ratios. The French bond auction was also well received. 

Another UK cabinet meeting is looking likely to finalize an agreement with the EC. Speculation that a deal could be close is helping support sterling, even though the Irish border issue has not been resolved.  May seems to hope to deliver her critics a fait accompli.  It is either what she is able to negotiate or no deal. Sterling is consolidating yesterday's gains and is in roughly a 25 tick range on either side of $1.3125.  A break of the $1.3040 area is needed to suggest a high is in place. The euro is treading water in tight ranges. There is a 556 mln euro option at $1.1417 that will be cut today but look at the chunky options that expire tomorrow. There are 6.2 bln euros in options between $1.1375 and $1.1425 that are on the bubble and another 7.7 bln euros between $1.1500 and $1.1541 that also expire.     

North America

The Federal Reserve meets today for last time without a press conference. There is a scheduled press conference after the December meeting and next year there will be a press conference after every meeting like the ECB and BOJ practice. This is no doubt that the Federal Reserve will stand pat today. Given the economic backdrop and the comments by several Fed officials, a hike in December is largely a foregone conclusion, and the Fed should not be expected to dissuade the market in any way. 

There seems to be some confusion. Both the CME and Bloomberg models suggest that roughly an 80% chance of a hike in December is discounted. Why? The equity market has bounced back smartly from the October meltdown, Could it be that some think that the President Trump's criticism, shared by many others, that the Fed is being too aggressive will have the desired effect? 

Most likely there is another explanation that allows us to square the circle. First, recall that the Fed funds futures contracts are settled on the average effective Fed funds rate for a given month. Second, appreciate that for some technical reasons, the effective Fed funds rate was creeping to the top of the band. In order to alleviate the pressure, the Fed lowered the rate of interest it pays on the reserves from the top of the fed funds target range to five basis points inside it. The interest the Fed pays on reserves is theoretically and operationally a significant cap. However, the effective fed funds rate is at that cap and some similar but different money market benchmarks, including SOFR (secured overnight financing rate) which is the official alternative to LIBOR. 

The CME and Bloomberg models appear to be not taking into account the risk that when the Fed hikes in December, it does raise the interest rate paid on reserves by the same amount. It could put a little bit more of a spread (five basis points?) between the interest on reserves and the upper end of the target range. In concrete terms, here is what it means. The average effective fed funds rate is 2.20%. If the Fed hikes the target range by 25 bp next month to 2.25%-2.50% but lifts the interest on reserves by only 20 bp, the new effective rate would likely be 2.40%. The January 2019 Fed funds futures contract implies a yield of 2.41%. A rate hike in December is fully discounted.  Q.E.D.

The S&P 500 gapped above the 200-day moving average yesterday and closed on its highs.  It is trading nearly 0.5% lower. The gap is found roughly between 2756.8 and 2774.1. How it performs around the gap will be technically important.   

Canada reports October housing starts and September new house prices. Canada's housing market is closely watched by investors, but it probably will not have much impact on the Canadian dollar.  The Canadian dollar had a broad range yesterday, but the close was little changed as range trading continues. Yesterday's US dollar range of approximately CAD1.3050 and CAD1.3170 will likely continue to confine prices.

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