02/11/2024 Market Analysis

Week Ahead: Make America Great Again

Markets are highly reactive, shifting focus rapidly from trends like the carry-trade unwind to U.S. election impacts. Beijing’s recent steps to support its property and stock markets, along with efforts to stabilize local government debt, have now been overshadowed by the approaching U.S. election, which is expected to drive substantial market shifts.

Earlier, expectations that Donald Trump would push for a weaker dollar to reduce trade deficits and support reshoring production influenced dollar trends. However, as the race tightens, a potential Trump victory now implies higher debt and interest rates, likely strengthening the dollar. Tariffs on imports, while primarily affecting domestic buyers, also reduce demand for exporters. Trump’s plan focuses on reshoring rather than near-shoring, impacting countries like Japan and Europe.

Trump’s trade stance echoes Reagan’s 1980 proposal for a North American trade zone, later realized and revised with stricter domestic content rules. Trump’s criticism of automakers producing in Mexico for U.S. markets signals potential tariff policies, though these may be campaign rhetoric rather than concrete policy.

Kamala Harris, the Democratic candidate, is unlikely to cut the deficit significantly, and analysts, including investors Larry Fink and Paul Tudor Jones, expect inflation and Treasury supply to rise regardless of the election outcome.

The Fed will likely cut its target rate by 0.25% shortly after the election, reacting to lagging inflation data despite solid economic growth. Although inflation has significantly declined, Fed rates have barely adjusted, indicating an increasingly restrictive policy stance.

Meanwhile, China’s stimulus targets property and stock markets and aims to boost consumption, which remains around 53% of GDP. Criticisms of China’s export dependency overlook that it exports a smaller GDP percentage than several high-income countries, with nearly a third of exports from foreign-invested firms. Despite comparisons with Japan’s rise, China’s impact on global markets is unique due to its size and political structure.

Low inflation across several G10 countries supports an extended easing cycle. The ECB and Bank of England are expected to continue rate cuts, with the Bank of Canada and New Zealand also easing aggressively. However, recent hikes in U.S. yields influence global rates, pushing up European yields and potentially shifting policy responses.

This blend of U.S. election uncertainties, Fed rate trajectories, and China’s market interventions continues to shape the global financial landscape.

United States of America

Dollar Strength from Rising U.S. Rates

October saw the dollar strengthen as U.S. interest rates rose, continuing a climb that began in late September. Initially, this increase was driven by traders closing positions after the Federal Reserve’s 0.5% rate cut, but rates got another lift from a stronger-than-expected September jobs report. As October went on, the narrative shifted—now driven by the anticipation of a rising supply of U.S. Treasuries due to larger deficits, which many expect will boost inflation.

Fed’s Path to Rate Cuts

Despite the increase in rates, the U.S. economy is still performing as the Fed anticipated, making a rate cut on November 7 highly probable. There’s also an 80% likelihood of an additional 0.25% cut in December, according to derivatives markets, although there is some debate. On November 13, October CPI data will be released, likely showing slight year-over-year increases in headline and core rates, but the Fed will have another CPI report to review before its December meeting.

Election’s Influence on Market Sentiment

The U.S. election remains a significant, unpredictable factor impacting global markets. Polls, betting markets, and top investment managers suggest that a Trump win, while less surprising than in 2016, could stir volatility, especially with talk of tariffs, which some see as bargaining tools rather than firm policies. A Harris win would likely calm markets and potentially fuel a more optimistic risk environment.

Key Points:

• Dollar gains came from rising U.S. interest rates and anticipation of a larger Treasury supply.
• Fed rate cuts are anticipated in November, with a high chance of another in December.
• The election outcome is pivotal, with Trump seen as a potentially disruptive force, while Harris may support a more stable market atmosphere.

Australia & New Zealand

Australian Dollar’s Recent Fluctuations

The Australian dollar gained 5.7% across August and September but reversed sharply in October, falling 4.8%. This drop reflects both the broader strength of the U.S. dollar—driven by rising U.S. interest rates—and a cooling reaction to China’s initial economic support measures. While the Reserve Bank of Australia (RBA) convinced markets it would hold off on rate cuts this year, weaker Q3 inflation (2.9% compared to 3.8% in Q2) has boosted expectations for a rate cut in Q1 2025. The RBA’s upcoming November 5 meeting is expected to keep its neutral stance unchanged.

New Zealand Dollar Weakness and Central Bank Actions

The New Zealand dollar dropped 5.8% recently as the Reserve Bank of New Zealand (RBNZ) enacted a substantial 50-basis-point rate cut. Market sentiment is leaning towards another sizable RBNZ cut before year-end, adding to the currency’s challenges.

Technical Outlook for the Australian Dollar

The Australian dollar’s pullback has been more extensive than expected, with the potential to decline further toward the $0.6470–$0.6500 range in November. A movement above the $0.6625–$0.6650 level would improve the technical perspective, suggesting possible recovery.

Key Points:

• The Australian dollar’s retreat follows strong gains in August and September.
• RBA is expected to hold its stance in November, but Q1 2025 may see a rate cut.
• Further rate cuts from RBNZ may pressure the New Zealand dollar.
• Australian dollar may drop to $0.6470–$0.6500, with recovery possible above $0.6625–$0.6650.

Canada

Canadian Dollar’s October Decline

The Canadian dollar fell by nearly 3% in October, pressured by a combination of aggressive rate cuts from the Bank of Canada and a widening yield gap with U.S. interest rates. The Bank of Canada has been among the most proactive central banks, lowering its target rate by 75 basis points in Q3 and another half-point in October. While core inflation remains flat, the drop in headline inflation to 1.6% (down from 2.0%) has become a priority for policymakers, even as job growth surged with 112,000 full-time positions added in September.

Expectations for Future Rate Cuts

With another employment and CPI report due before the Bank of Canada’s next meeting on December 11, the market currently prices a slightly better than 50% chance of another half-point rate cut. The central bank’s strategy has been to front-load cuts, and the swaps market anticipates another 90 basis points of cuts through the first half of 2025.

Yield Spread and U.S. Dollar Strength

The yield spread between U.S. and Canadian two-year bonds has expanded to over 110 basis points, its widest since 1997, reflecting Canada’s more substantial rate cuts relative to the U.S. This widening differential is supporting the U.S. dollar, with the potential to break past its August high near CAD1.3945, a level not seen above CAD1.40 since the pandemic-driven market volatility in early 2020.

Political Tensions and Economic Implications

Political pressures are mounting on the Liberal minority government, heightening the risk of a crisis that could topple the administration. Even if the government remains intact, waning support for Trudeau’s Liberals could strengthen the Bloc Quebecois, potentially renewing discussions around Quebec’s independence. Canada’s next national election must occur by October 2025.

Key Points:

• Canadian dollar’s decline was driven by the Bank of Canada’s aggressive rate cuts and U.S. rate advantage.
• Bank of Canada may cut rates again in December, with further cuts expected in H1 2025.
• U.S. dollar is poised to test its August high against the Canadian dollar.
• Political instability and growing separatist sentiment could impact Canada’s economic outlook.

China

Yuan Follows Dollar’s Movements

The yuan has closely followed the dollar’s trajectory. During Q3, when the dollar weakened, the onshore yuan appreciated by 3.5%. However, as markets began to reconsider the Federal Reserve’s policy outlook, the dollar bounced back in October, bringing the yuan down with it.

Anticipated Stimulus from Beijing

Despite recent measures, many analysts believe China’s efforts to support the economy have not been strong enough, expecting further actions from Beijing in the weeks ahead. Possible steps include additional rate cuts and lower reserve requirements by year-end. Following the upcoming National People’s Congress session—which ends soon after the U.S. election—China could potentially introduce a substantial domestic demand package, possibly totalling CNY3 trillion (~$420 billion).

Weakening Correlation with Yen, Stronger Link to Dollar Index

Specific factors in both Japan and China have weakened the previously strong correlation between the yen and the yuan. The correlation between their movements dropped from over 0.80 in Q2 to below 0.30 by October’s end. Meanwhile, the yuan’s movements have increasingly aligned with the Dollar Index, with the 30-day rolling correlation climbing from about 0.50 in late September to nearly 0.70 at the end of October.

Technical Outlook for the Dollar-Yuan Pair

After reaching a low of around CNY7.00 in late September, the dollar has settled into a range between CNY7.10 and CNY7.13 over recent weeks. While there is a chance for further upward movement, it’s likely nearing a limit, with the potential to test the CNY7.15–CNY7.18 range.

Key Points:

• Yuan’s fluctuations closely mirror dollar movements, particularly as the Federal Reserve’s policy trajectory shifts.
• Beijing may announce further stimulus measures, including rate cuts, to bolster economic demand.
• Yuan shows a stronger correlation with the Dollar Index and reduced alignment with the yen.
• Dollar-yuan pair is stabilizing, with limited potential for further dollar gains near CNY7.15–CNY7.18.

Europe

Euro Declines for the First Time in Four Months

In October, the euro experienced its first decline in four months, primarily influenced by rising U.S. interest rates and speculation about potential rate cuts from the European Central Bank (ECB). The market had considered the possibility of a half-point cut, but this speculation waned following stronger-than-expected Q3 GDP data, which showed Germany’s economy expanding and avoiding consecutive contractions. Additionally, the October CPI figures also came in slightly higher than anticipated.

Impact of U.S. Tariff Threats

Although the U.S. and the eurozone do not share a free-trade agreement, the looming threat of broad tariffs under a potential Trump administration poses a significant risk to the eurozone economy. As the euro continues to track the U.S.-German two-year interest rate differential, this differential reached a low just before the euro itself did in late September, hovering around 135 basis points. This relationship has instilled confidence that the $1.12 area could represent a near-term peak for the euro.

Interest Rate Differential Trends

The premium between U.S. and German rates subsequently widened, surpassing 200 basis points to reach yearly highs observed in April. However, this premium has pulled back to approximately 185 basis points. Given the stretched momentum indicators, there are indications that a bottom for the euro may be forming.

Peripheral Premium Insights

In the context of a rising European interest rate environment, the premium of peripheral eurozone countries over Germany has narrowed in October, including the premium for France. This shift occurs despite two major rating agencies placing France on negative credit watch, following S&P’s recent downgrade of France’s rating to AA-, the first cut since 2013. Moody’s and Fitch may follow suit with a similar negative outlook.

Key Points:

• The euro fell in October due to rising U.S. rates and speculations about ECB rate cuts.
• Strong economic indicators from Germany helped temper expectations of aggressive ECB rate cuts.
• U.S. tariff threats could significantly disrupt the eurozone economy despite the absence of a free-trade agreement.
• The U.S.-German interest rate differential indicates potential stabilization for the euro around the $1.12 mark.
• Peripheral eurozone premiums narrowed, signalling shifts in market sentiment despite negative credit outlooks for France.

Japan

Significant Decline in the Yen

In October, the yen experienced one of its largest monthly declines in years, falling approximately 5.5% to levels not seen since late July. This depreciation was largely influenced by rising U.S. yields and the uncertainty following Japan’s election results, where the ruling coalition of the Liberal Democratic Party (LDP) and the Komeito Party lost their majority.

Political Landscape and Fiscal Measures

The most plausible outcome in Japan appears to be a minority government led by the LDP, which would depend on the support of independents and other parties on a case-by-case basis. Alternatively, there is a possibility that the Democratic Party for the People could join the coalition. Regardless of the configuration, a substantial fiscal package is anticipated, aimed at providing household subsidies. The 2023 supplemental budget was set at JPY 13 trillion (approximately $86 billion), and expectations suggest that this year’s package will be even larger.

Monetary Policy Outlook

The Bank of Japan (BOJ) is not yet done with its monetary policy normalization. Governor Ueda has made it clear that if the economy continues to develop as expected, further rate increases are likely. The BOJ projects growth to accelerate to 1.1% next year, up from 0.6% for the current fiscal year. Additionally, core inflation is forecasted to dip below 2% in the next fiscal year, a scenario that is closely tied to the BOJ’s policy decisions.

Limited Response from Officials

Despite the yen’s significant depreciation in October and the accompanying volatility, there has been little visible concern from Japanese officials. Verbal warnings regarding the yen’s decline have been minimal and mostly indirect, suggesting a degree of tolerance for current market conditions.

Key Points:

• The yen fell 5.5% in October, marking its largest decline in years due to rising U.S. yields and political uncertainty in Japan.
• The likely formation of a minority LDP-led government could lead to a significant fiscal stimulus package, surpassing last year’s JPY 13 trillion.
• The Bank of Japan is poised to continue normalizing monetary policy, with potential rate hikes if economic conditions align with forecasts.
• Projected growth for Japan is expected to rise to 1.1% next fiscal year, while core inflation may dip below 2%.
• Japanese officials have shown limited concern regarding the yen’s depreciation, indicating a possible tolerance for volatility in the currency market.

United Kingdom

Sterling’s Significant Decline

In October, sterling experienced a notable drop of 3.55%, marking its largest monthly loss since September 2023. After reaching a two-and-a-half-year high near $1.3435 in late September, the currency fell through the $1.29 mark by the end of October, following the budget announcement.

Technical Outlook for Sterling

Momentum indicators for sterling are currently stretched, suggesting potential for further decline toward the $1.28 level. However, a movement above the $1.3100 threshold could improve the technical outlook for the currency, signalling a potential reversal in the trend.

Market Expectations Ahead of BOE Meeting

The Bank of England (BOE) is scheduled to meet on November 7, with the market pricing in approximately an 80% chance of a second quarter-point rate cut, following the first cut implemented in August. Conversely, the likelihood of a December cut has diminished significantly, dropping from around 60% to less than 15% after the recent budget announcement.

Impact of Upcoming Economic Data

Despite the BOE’s upcoming decisions, there are key economic indicators on the horizon, particularly the employment report set for November 12 and the October Consumer Price Index (CPI) due on November 14. Market participants and the BOE itself are expected to be particularly attentive to these figures, which could influence future monetary policy.

Budget Implications for the UK Economy

Labour’s first budget is projected to increase UK taxes to a record 38.3% of GDP by 2027-2028, according to the Office for Budget Responsibility. Although the tax and borrowing measures are primarily aimed at investment, day-to-day public spending is expected to rise by only 1.5%, a figure lower than the Conservative Party’s proposed 1% increase. Market reactions to the budget have been negative, reflected in the sharp rise in the 10-year Gilt yield.

Market Reaction to Gilt Yields

Before the budget announcement, the 10-year Gilt yield had fallen to approximately 4.20%. However, within 48 hours post-announcement, the yield surged above 4.50% and closed October near 4.45%, levels not seen since November 2023.

Key Points:

• Sterling dropped 3.55% in October, the largest monthly loss since September 2023, falling from $1.3435 to below $1.29.
• Momentum indicators suggest the potential for a further decline toward $1.28, with a resistance level at $1.3100.
• The Bank of England’s upcoming meeting on November 7 is expected to deliver a second quarter-point cut, while the chance of a December cut has dropped to below 15%.
• Key economic data releases, including the employment report and October CPI, will be critical for future monetary policy considerations.
• Labour’s budget plans forecast record tax levels, with mixed reactions from the market leading to a significant increase in Gilt yields following the announcement.