Last week was a busy week.
- The Fed met to set policy. As expected they maintained rates, announced an October start date for balance sheet normalization and reaffirmed a December rate hike and 3 rate hikes for 2018.
- The USD rallied briefly. All things being equal, the hawkish tone of the Fed is likely to support the USD, however, the EUR will depend on what the ECB says and does when it meets Oct 26.
- Bond yields rose as the Fed’s message was slightly more hawkish than expected. The pace of normalization will be glacial but will still be equivalent to some 20-25 bps widening per year at the long end.
- Germany held its general election with a widely expected result of a CDU/CSU victory and a fourth term for Merkel. The AfD won representation in the Bundestag for the first time in a rise of the Far Right. The SPD were the losers and announced that they would not ally with the CDU/CSU, leaving Merkel to seek an alliance with the FDP and the Greens.
- While a Merkel victory was expected the loss of votes and the slump of the SPD means Merkel will have a more complicated coalition building process in the coming months. This could impact sentiment and the EUR.
- The Big Six (Ryan, McConnell, Mnuchin, Cohn, Senate Finance Committee Chair and House Ways and Means Chain) are expected to release a draft tax overhaul midweek this week as a precursor to a tax deal which would cut corporate taxes to 20% and top rate of income tax to 35%, among other things. It will be the first concrete sign of the vaunted Trump tax reform with which investors were enamoured when Trump came to power.
- This week, the Brent forward curve pivoted into sustained backwardation. While the first two nearby contracts had been in backwardation since August, the curve out to Dec-19 made such a move on Wednesday, September 20
- It is early days for an oil recovery but sustained backwardation indicates a tighter physical market in both crude, distillate and gasoline. Backwardation is supportive of the flat price.
The case for Europe:
The European economy is growing, supported by household consumption and an upturn in investment. The banking system has been recapitalized and is functioning again and loan growth and interest margins have bottomed. Although Brexit and and Italian elections lie on the horizon the political sentiment in Europe has calmed down. The German election while a small setback for Merkel and her ruling coalition is likely to return a stable government. European companies are very global and we see opportunities of an indirect emerging markets and China play as well as a trade and manufacturing rebound play. We see momentum building in the current economic upturn which could last longer. We see the ECB as remaining dovish, recent comments notwithstanding. The tapering of QE is likely driven by technical constraints of the ECB’s capital key and not a pivot to tightening let alone neutral policy. We think Brexit and a more insular US will encourage greater unity in Europe which is positive for funding costs and liquidity. The risks to the scenario are policy mistakes by the ECB such as tightening too quickly, overly hawkish Brexit negotiations, the possibility of a messy Italian election leading to fears of another EU member seceding and finally too strong a currency.
Central Bankers speaking everywhere.
This week, we have 2 ECB officials and 3 Fed governors speaking on Monday, 2 more from the Fed on Tuesday, 2 more on Wednesday and the Kuroda on Thursday. The message from the ECB will be closely followed since they are next up on the calendar now that the Fed and BoJ have got their meetings out of the way.