The Week Ahead
- New FOMC voters to set the tone
- US labor data in focus
- Should the UK stage a competitive devaluation of sterling?
- Has the European sovereign debt crisis stabilised?
- No change expected from the RBNZ
New FOMC voters to set the tone
The FOMC will hold its first meeting of 2013 and the Committee will see a shift in the composition of its voting members. St Louis Fed President James Bullard, Chicago Fed President Charles Evans, Kansas City Fed President Esther George, and Boston Fed President Rosenberg will rotate in as voters as Atlanta's Lockhart, Cleveland's Pianalto, Richmond's Lacker, and San Francisco's Williams rotate out. We will learn where the new voters stand with regards to the Fed's policy decision as the statement will detail the voting positions of each member.
Last year's lone dissenter, Lacker, is no longer a voter and there is a chance of George or Bullard (both hawkish) as possible dissenters. Evans and Rosengren are both very dovish and Evans will be one to watch as his past policy suggestions have been implemented. Evans was supportive of open-ended easing as well as the numerical thresholds which were ultimately adopted by the Fed. The January statement which will detail votes and may tweak communication towards an end of QE, will set the tone for this year. For now, we expect the Fed to stay the course as labor market activity has shown no notable improvement. The unemployment rate in November was revised higher to 7.8% from 7.7% and December saw no change at 7.8% unemployment.
As we noted in our Q1 outlook, we expect that George will dissent as she has voiced her opposition to QE3. Bullard's stance is more questionable. While he maintains a more hawkish view, he is likely to vote with the consensus early on as the pace of progress on the Fed's employment mandate has been rather disappointing. Bullard is likely to be in favor of reducing or halting purchases earlier than his colleagues, however this is more likely to be seen in the minutes rather than the statement.
The USD is likely to respond to the tone of the statement. Indications that the recovery is weaker than initially thought would underscore the possibility of prolonged easing (and therefore a weaker USD), while a more optimistic view may suggest an earlier end to asset purchases which could be viewed as a positive for the buck. Based on recent data, our outlook is for the Fed to maintain its dovish bias.
US labor data in focus
Economic data out of the US next week will include key employment releases. The January Bureau of Labor Statistics (BLS) employment report is due Friday morning and will likely to show steady job growth of around 155k which is in line with the average over the past couple years (the monthly headline NFP average of 2011-2012 is 153k). Thursday's weekly initial claims have fallen to multi-year lows, but this may be partly due to January adjustment issues and the January ADP report may moderate from last month's 215K reading.
Markets will remain focused on US employment data and its impact on Fed policy which make next week's labor reports key drivers of market activity. Reports earlier in the week (ADP, ISM employment components, jobless claims) will give clues about Friday's BLS report. However, non-farm payrolls are susceptible to surprises as we have often seen. The reaction in the currency markets are likely to see the USD gain on positive surprises as positive labor data reduces expectations of prolonged Fed accommodation, while disappointing jobs data is likely to have the opposite effect on the greenback.
Should the UK stage a competitive devaluation of sterling?
The economic news out of the UK last week was nothing short of dire. The economy contracted at a 0.3% quarterly pace in Q4 and 2012 growth on the whole was flat. The boost to the economy in the third quarter from the Olympics and Paralympics now seems like a distant memory, in fact the Office for National statistics said that the boost to growth in Q3 from Olympic ticket sales was 0.2%, however this led to a decline of a similar amount in Q4. Added to that borrowing is moving up again and the UK may overshoot its GBP 121 billion borrowing target by GBP10 billion if we continue to borrow at this rate.
So how does the government get the economy moving again? The first way to answer this is to define the problem areas of the UK economy. The chief reason for the decline in the economy was production, which contracted 1.8% over the last three months of the year and contributed to the whole of the 0.3% decline in GDP in Q4. The service sector registered flat growth and construction rose 0.3%. Production was weighed down by a sharp decline in mining and quarrying, which fell by 10.2% in Q4. This industry alone contributed to a 0.2% fall in GDP. Production is the weakest link for the UK economy, the ONS reported that this sector has declined in each quarter of 2011 and 2012, and is now 5.1% lower than in Q4 2010. Manufacturing, the largest sector in the productive industries, accounts for 10.5% of GDP, has also seen a fall of 2.4% over the last two years. Thus, for the UK to stage a meaningful economic rebound we either need to see a pickup in mining and manufacturing or a significant increase in other sectors of the economy like services, which have been managing to stay in expansion territory in recent years, but are hardly registering stellar growth.
While it is hard for the government to boost the mining sector due to the costs of production and risks involved, the manufacturing sector is easier to help. A weak pound could boost our manufacturing exports and give it the much-needed boost it requires. Some may argue that the 25% decline in GBPUSD in 2008-09 had no economic impact, however, the economic cycle has changed and a weak pound could start to reap benefits. Firstly, the stabilisation in the sovereign debt crisis could help boost exports to our largest trading partner. Germany is already powering ahead and this week we found out how strong our trade links are with the largest economy in the currency bloc. If sovereign concerns can remain on the sidelines and growth continues to recover this could be a major source of demand for UK-made goods and services in the future. Likewise, China and the US are also showing signs of a strong recovery in 2013.
While the UK's manufacturing sector has been woefully neglected in many years, our service sector has flourished. Service sector exports could be one of the main routes to economic recovery and a weak pound would help boost the UK's competitiveness in this important area.
In the current environment of "currency wars" it has never been more important to have a weak currency. Central banks around the world seem to be orchestrating competitive devaluations including Japan and Switzerland. Both countries argue it is necessary to protect their economies, surely the UK could argue likewise? The minutes of the last Bank of England policy meeting, released last week, mentioned the pound and said it could be too strong to help the re-balancing of the economy. However, trying to influence the pound would be a diplomatic nightmare for the BOE as Governor Mervyn King has referenced. He said in a speech last week that it is hard to be optimistic about the "tensions" resulting from currency wars. Thus, using the pound as a policy tool to combat the UK's weak growth would be littered with concerns.
Luckily for the BOE, the domestic economy is weighing on the pound and doing some of the "devaluation" for it. The pound nose-dived last week and dropped more than 1% on a broad-based basis. The GDP data also caused GBPUSD to breach 1.58 support, however, it managed to recover later on Friday. There are two factors that could cause a further decline in GBP in the coming days and weeks: 1, weak economic prospects and the threat of a rating downgrade and 2, stabilisation in the currency bloc reducing the need for GBP to act as a safe haven. In the medium-term we believe that GBPUSD could fall back to the 1.5360 lows from June 2012, we may also see 0.9000 in EURGBP if sovereign concerns remain stable. In the shorter term, next week's manufacturing PMI data for January will be a good litmus test to see if 1, growth remained weak at the start of the year and 2, if the snow had a meaningful economic impact. Expect more volatility in the pound.
Figure 2: GBPUSD daily chart
Has the European sovereign debt crisis stabilised?
This is turning into one of the biggest themes of the year - the Eurozone recovery play. Not only has Spain managed to sell long term debt in recent days, but investors don't seem to be put off by its huge debt schedule, it still has to issue EUR 148.5bn of debt this year, with EUR36bn scheduled for March and April. Its 2-year bond yield remains close to its lowest level in a year and 10-year bond yields are now well out of the danger 7% zone. There are even signs that Europe's banking system is recovering after the ECB announced last week that 278 banks are paying back LTRO loans to the tune of EUR 137 billion. This was much larger than expected, and suggests that banks can 1, meet their financing needs in the capital markets and 2, don't feel the need to horde cash as aggressively and believe the sovereign crisis has stabilised. Of course not the entire banking sector is on the road to recovery, and most of the 278 banks were large ones that were better equipped to deal with the crisis in the first place. This week the IMF will make a visit to Spain to complete its second report on Spain's banking sector reform; the report should be released on Friday 1st Feb. This report will be important as it will include some of Spain's most troubled small domestic banks that are still on ECB-liquidity life support. If these banks are not on the road to reform and recovery then Spain's sovereign problems could re-surface once more. Thus, although Madrid can sell debt today, the history of the sovereign debt crisis tells us that situations are fluid and can change very rapidly.
But while the worst of the financial side of the crisis might be behind us, the market is focused on the economic side. For the sovereign debt crisis to be truly solved we need to see growth come back into the currency bloc. The PMI surveys for January released last week, showed that growth in the manufacturing and services sector had picked up at the start of 2013, albeit from a very low base. Germany is powering ahead and its service sector PMI rose to the highest level since mid-2011. However, things are not so good in Spain where its unemployment rate rose to a fresh record in Q4 2012 to more than 26%. Unemployment is a lagging indicator, so if growth in Spain does start to recover we could see the unemployment rate drop later this year.
The biggest surprise was France. Its PMI surveys tanked to 2009 levels in January. France is beginning to resemble a peripheral economy more and more. It has a huge debt burden, confidence is low and the government has not implemented many pro-growth policies since it took over power in 2012. French bond yields have been moving higher in line with Germany; however, in future France is at risk of becoming the currency bloc's weakest link. If growth continues to falter then we could see ratings cuts and the bond vigilantes start to take notice.
The euro shrugged off the bad news from Paris and closed the European session above 1.3450 on Friday, which is a very bullish development for this pair. It is being led higher by a combination of strong risk sentiment and also the de-facto tightening of the ECB's balance sheet through the repayment of LTRO loans. Thus, if we continue to see a stabilisation in the debt crisis then the euro may climb even higher in the medium-term. This decisive break above 1.34 (the top of the recent range) opens the way for a move to 1.3495 - the 200-week moving average and red line on the chart below - and then 1.3700.
Figure 3: EURUSD weekly chart
No change expected from the RBNZ
The Reserve Bank of New Zealand (RBNZ) will announce policy on Wednesday and we expect no change in the level of interest rates (currently 2.50%). The Bank is likely to maintain its neutral stance and may present a more positive outlook of the external environment as Euro zone risks appear to have been reduced and Chinese data continues to paint an upbeat picture. This is likely to be balanced with softer domestic data such as slowing GDP growth and inflation readings since the last meeting. 3Q GDP slowed to 2.0% y/y from 2.5% previously and consumer prices unexpectedly fell -0.2% q/q in 4Q with a yearly rate of 0.9%.
Also of note, the NZD remains elevated and this may be a concern highlighted by the RBNZ. The Bank noted at its December meeting that, "the high New Zealand dollar continues to be a significant headwind, restricting export earnings and encouraging demand for imports". Recent trade balance figures underscore the bank's worries as the country's trade deficit widened to -700m from the prior -666m as imports rose to the highest levels since 2008. NZD/USD was trading around 0.8250 in early December when the RBNZ last met and it is even higher now, currently around 0.8350.
Technically, NZD/USD remains in a long term bullish trend channel which dates back to May of last year. The pair sees channel support converge with the 100-day simple moving average (SMA) which is currently around 0.8250 and the kiwi also faces a long term double top around 0.8470. The pair was rejected from the 0.8470 area in February 2012 and again in December. A break above this horizontal resistance area is likely to see gains extend while a break below the 100-day SMA may see a decline towards the 200-day SMA around the 0.8100 figure.