Strategic Currency Briefing

Outlook:

We get the National Association of Home Builders housing market index for Nov, likely a rise. We also get the PPI, probably -0.1% in the headline and +0.1% ex-food and ener-gy. This seems good but inflation near zero is not, as we have seen, “good.” We also get ICSC retail store sales, Redbook chain store sales, and at the end of the day, the Treasury International Capital (TICS) report.

Everywhere we look, we see inflation emerging as the key focus of central banks. In Japan, postponing the sales tax increase serves the purpose of letting Abenomics stimulus do its work—and the goal of Abenomics is to raise activity specifically in order to raise inflation. The fiscal prudence of the sales tax hike was not actually part of Abenomics but rather a separate initiative to pull Japan out of its ratings funk. It was doomed to have a deadening effect and when energy prices started falling, became a poison pill to the recovery plan. The Nikkei rally following the announcement was, therefore, logical and war-ranted. The problem is that Japan has other problems, including demographic and cultural problems, that contribute to the slump and can’t be modified overnight, or even in a decade.

In Europe, yesterday Draghi started his remarks by naming inflation. "We need to remain alert to possi-ble downside risks to our outlook for inflation, in particular against the background of a weakening growth momentum and continued subdued monetary and credit dynamics. We therefore need to closely monitor and continuously assess the appropriateness of our monetary policy stance. If necessary to fur-ther address risks of too prolonged a period of low inflation, the Governing Council is unanimous in its commitment to using additional unconventional instruments within its mandate."

According to Market News, “Draghi said the Bank's current package of measures, including record-low interest rates, asset purchase programmes and liquidity operations would support the overall transmis-sion of monetary policy and support credit creation and new lending in the single currency area. Collec-tively, he said, the measures will have a ‘sizeable’ impact on the ECB's balance sheet that are expected to return it to the ‘dimension’ last seen in early 2012.”

In the US ,we get PPI today, the Fed minutes tomorrow and CPI on Thursday. The WSJ opines that both measures will be up 0.1% in the core but down 0.1% in the headline number—far, far away from the Fed’s 2%. The WSJ survey indicates we won’t hit the Fed target until 2016. The Fed doesn’t much care about newspaper surveys but has its own measure saying much the same thing. Last week Boston Fed Pres Rosengren said the Fed should wait until stronger evidence price pressure emerges. Also, Philly Fed Pres Plosser noted the Fed should focus on expectations and sit out temporary effects like the strong dollar.

We see inflation expectations in the bond market, notably last week when retail sales failed to goose yields higher. The yield is capped at 2.40%--what do we have to see to get the 10-year yield over 2.5% (let alone 3.5%)? Market News notes the University of Michigan survey of inflation expectations showed a decline, with the 5-10 year forecast down to 2.6% for the first time since 2009.

The Market News fixed income analyst notes that the bong gang is holding its breath for tomor-row’s minutes of the Oct 29 policy meeting—to hear what the members think about inflation. It’s more than a preoccupation—it’s an obsession. One analyst said "The Fed stands increasingly alone in its willingness to look past the mounting signs of disinflation." Remember that the UK was complacent for a while, too, and then freaked out when inflation crashed farther than anyone had imagined.

But there is a ray of light. Yesterday the San Francisco Fed released a study saying "projections that ac-count for the different policy tools used by the Federal Reserve suggest that inflation will remain low in the near future. Moreover, the relative odds of low inflation outweigh those of high inflation, which is the opposite of historical projections. An important factor continuing to hold down inflation is the per-sistent effects of the financial crisis."

Well, that’s a poke in the nose. Who would have blamed something that happened 6 years ago for infla-tion expectations today? The study says “the risk of high inflation collapsed in 2008 and has remained well below normal since. Importantly, according to the model, there is little evidence that monetary policy constitutes a major source of inflation risk."

If we are reading this right, the San Francisco Fed study indicates the Fed can raise rates without also raising inflation expectations. This should be significantly dollar-favorable. We just need to get past the latest buy-on-dips/sell on rallies mentality in the euro. In other words, we have been looking for a cata-lyst to get beyond the positioning that has (perversely) favored the euro of late. Maybe the Fed minutes are it. We wouldn’t count on it, but coming at the same time as a sell-the-rally moment could do the trick. Stay alert.