Highlights

• Will Black Friday save Q4?
• Can EURUSD stay above 1.30?
• A new, more dovish BoJ may on the horizon
• The RBA’s minutes were dovish, but do they suggest a December rate cut?

With a reported 150 million Americans shopping on Black Friday retailers will hope they can turn around their fortunes this holiday season. At the time of writing the extent of sales was not known, but retailers will be hoping for a bounce in sales after a 0.3% decline in October, reversing an increase in sales growth in Q3.

While TV reports show people camping overnight and heading to the shops on Thanksgiving evening on the hunt for a bargain, the main risk to retail sales this holiday season is the fiscal cliff. With the US out for the latter part of last week negotiations on Capitol Hill to avoid the cliff edge were on hold. They are expected to continue this week as members of Congress get back to work. With a little over a month to go, the markets are looking for a neat resolution to this crisis, which would help the S&P 500 to convincingly stay above 1,400.

Recently we have seen signs that the Republicans in the House are willing to compromise to reach a deal. As long as both sides look like they are inching towards a deal then confidence should remain high. If there are signs that the US may go over the cliff edge then the holiday shopping season could be cut short as consumers temper their spending until they are certain of potential tax increases and public spending cuts for 2013. If the Democrats get their way and we see some limited tax increases and the continuation of some spending programmes, this could be the optimal outcome for the financial markets as it may cause the least disruption to growth. Thus, at this stage of the negotiations it does not appear that an age of austerity is waiting for America in the near-term, which is good news for the S&P 500 and also for the dollar in the medium-term.

While the US was enjoying the festivities last week the greenback was sold sharply. The dollar index fell more than 1% as the US gave up ground verses the euro, the yen and the Aussie. There was no single fundamental driver for the dollar weakness and better tone to risk. Next week we see some meaty data releases from the US including durable goods for October and house price data. Durable goods are expected to decline 1%, after strong gains in September. There is a risk that the decline will be more severe as businesses hold off investing until there is an outcome to the fiscal negotiations. To balance any weak durable goods sales we could see another month of positive house price growth. If the S&P/ Case Shiller prices do increase in September it would be the eighth consecutive month of house price growth in the US. This may boost expectations for a deeper recovery in 2013, and we could see stocks and other risky assets start to price in a recovery in this important sector of the US economy.

If fiscal negotiations continue to make progress and house prices are positive then we may see the SPX 500 drift higher next week. There may also be some buying pressure as the US indices were closed all day Thursday and half day on Friday, thus US indices may play catch-up during the early part of next week.

The weekly close below the 200-day sma on Friday 16th November looks like a false break. In the S&P 500 the major levels to watch are 1,385 – the 200-day sma – on the downside. 1,420 – the 50-day sma - is near-term resistance. Above here opens the way to a re-test of 2012 highs at 1,475.

The big news in the FX market last week was the ease with which EURUSD broke above a number of key resistance levels to close the European session within touching distance of 1.30 – the highest level for a month.

The question for investors to ask now is whether or not this level in EURUSD is justified and can sustained? To answer this we need to look at relative monetary policy at the ECB and the Fed, the political backdrop in the currency bloc and the macroeconomic data.

Looking at the political backdrop first, Greece is likely to receive its next tranche of bailout funds on Monday 26th November. This removes a cause of near-term anxiety for traders as it means that Greece is not going to default any time soon and can easily meet its next major EU 5 billion bond redemption payment due in mid-December. The EU budget negotiation may be pushed out to January 2013, but this is second tier data for the financial markets and as such the lack of a resolution did not have much impact on euro-based assets at the end of last week.

Spain comes to the fore this weekend with elections in Catalonia on Sunday 25th November. The Premier Arthur Mas called this snap election when the central government in Madrid refused to re-negotiate the process of internal transfers. Catalonia, one of the richest regions in Spain, ends up paying more to Madrid than it gets back in benefits. This has led to an increase in secessionist rhetoric from Mas who is calling the election a referendum on independence. However, the independence parties are lagging in the polls with only two days to go, and they are unlikely to steal victory at this late stage. The Spanish people are expected to vote to keep the status quo. While this election by itself does not make Spain any more or less solvent, it removes a complication for the country as it continues to evade requesting financial aid. As we have said in previous research notes, we don’t expect Madrid to request aid this year as its bond yields have continued to fall (the 10-year yield fell 30 basis points last week) and it has easily sold debt at all maturities in recent auctions. Thus, the political back-drop, at least in the near-term, is showing signs of stabilisation into year-end, which could help the euro to rally in the medium-term.

What about interest rate differentials, a key driver of FX markets? The rate spread between Germany (as a benchmark for the EU) and the US has traded sideways and not kept pace with the spike higher in EURUSD, as you can see in the chart below. However, the Fed has sounded more dovish than the ECB of late. While the ECB remains ready to buy Spanish debt if it needs to, it is not expanding its monetary base and will sterilise all purchases made by its OMT programme. In contrast, Fed Governor Bernanke said in a speech last week that the Fed would be willing to extend monetary support if the economy starts to flag. In the next few weeks the focus will be on how the Fed will deal with the end of Operation Twist, which expires at the end of this year. The Fed may decide to increase QE3 to the tune of $85bn of long-term asset purchases to ensure there is no tightening effect from the end of Operation twist. Thus, at this juncture the Fed’s policy stance appears more accommodative than the ECB. This could be positive for EURUSD in two ways. Firstly, the rate differential may start to move in the Eurozone’s favour, which is euro positive. Secondly, the Fed’s commitment to QE3 helps to depress volatility, which is good for risky assets like the euro and can cause selling pressure on safe havens like the dollar.

The last thing to consider is the macro backdrop. Recently we have seen a chasm develop between the sentiment data and the real economic data. The PMI data in Europe remains very weak, but the GDP data was not as bad as the surveys suggest. There were some good signs from Germany. Strong exports in Q3, they expanded by 1.4% on the quarter more than the 1% expected, helped to support Q3 GDP. Also, the IFO index, Germany’s most important business sentiment survey, beat expectations this month. Stronger confidence levels were reported for exports demand from China, which is good news for an export-based economy like Germany’s.

Overall, the break above 1.2805 – the 200-day sma – keeps us constructive on the outlook for EURUSD in the medium-term. We think that a break above 1.30 could be on the cards, but we would expect the 1.3175 level – the high from September – to be a major stumbling bloc. The risk to this view is a flare up in sovereign concerns and a spike in Spanish bond yields. However, in the absence of a major risk-off event the stabilisation in the political backdrop combined with a dovish Fed could help EURUSD to drift higher in the coming weeks.

At its latest meeting the BoJ’s board unanimously voted to leave policy unchanged, which included keeping interest rates on hold and not increasing the size of its asset purchase program (APP) or credit loan facility. The move was widely expected by the market as the bank has previously eased policy twice at its preceding three meetings, which included a 21 trillion expansion of its APP. This doesn’t mean the BoJ has stopped easing, however. In fact, the expected power handover in Japan in mid-December has created the possibility of a new era of extremely aggressive easing from the BoJ.

If the LDP comes to power, which it is expected to do, it is likely to put pressure on the BoJ to ramp up easing. The head of the opposition party has launched an attack on the BoJ and, indirectly, Governor Shirakawa, stating monetarily policy loosening needs to go into overdrive, even going as far as saying the bank should pursue negative interest rates and start to underwrite government debt. The latter would bring the BoJ’s independence to question, but LDP Chief Abe doesn’t seem to have a problem with re-writing the Bank of Japan act.

At the very least it seems likely the LDP would attempt to install a new, more dovish BoJ Governor when Mr. Shirakawa’s term ends on April 8, 2013. Whilst the government doesn’t have a direct say over who sits on the bank’s board, parliament does need to sign-off on new appointments. Hence, they would be able to reject those they see as not dovish enough.

The consequences for monetary policy could be severe, as the appointment of a more dovish BoJ governor would mean the doves would hold a majority on the BoJ’s board. Thus, it is likely the BoJ would open the flood gates to more easing.

Nonetheless, whatever the outcome from December’s election, we expect to see more easing from the BoJ. Even the current board has made it clear they intend to continue loosening policy in order to boost inflation.

The implications for the yen can already be seen in price action, with USDJPY rocketing around 300 pips higher since the announcement that Parliament was to be dissolved last night. The pair broke through a massive resistance level around 82.00, before running out of steam around 82.80. Given the possibility of more easing, and the shear aggressiveness of current easing, further JPY weakness may be on the horizon, at least until the election on December 16.

The release of this month’s RBA meeting minutes created a bit of a commotion, with the bank sounding more dovish than when it decided not to cut the official cash rate at the meeting earlier this month. In particular, the market focused on one line from the minutes which hinted at the possibility of more easing down the track. A significant portion of the market agrees that the RBA will need to loosen policy at some stage, but they disagree over the timing.

The minutes from the RBA’s last meeting didn’t overly tip the scales in one way or the other, despite the aforementioned line from the bank. The bank remains very downcast about the prospects for European growth, but is somewhat upbeat on China and fairly neutral on the US. The RBA added it would be a positive for the US if politicians prevent the world’s biggest economy from plunging off its fiscal cliff.

Domestically, members acknowledged that inflation during Q3 was higher than expected, but added they recognise part of this was due to the carbon tax. The RBA noted the labour market had gently softened in the months leading up to its last rate decision. This month the unemployment rate decreased from 5.5% to 5.4%, underpinned by a 10.7K increase in employment and a drop in the participation rate from 65.2% to 65.1%. Overall, the report was fairly neutral, with the drop in the unemployment rate counteracted by the fall in the participation rate, which suggests people are leaving the labour force as well as finding jobs.

Other domestic indicators have been fairly mixed, leading us to the conclusion that domestic data hasn’t deteriorated enough for the RBA to justify a rate cut. However, there has been a deterioration in sentiment in Europe, albeit not massively. A key factor for the RBA may be this week’s capital expenditure survey, which should provide the bank with a better idea of how non-mining sectors of the economy are performing. If the survey reflects a turn in sentiment in these sectors, then the RBA may choose to ease policy to offset this. Overall, it is going to be another close call come December.

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