Two main issues dominated the week, the Yellen speech in front of the senate and the BoE inflation report.
Ms. Yellen’s tone was strongly dovish and we understand why. The US economy is not ready for a December tapering. Inflation is declining from 2% in July to 1.2% now and the participation rate is at the lowest point from the decades. This makes puzzling using the unemployment threshold for monetary policy. US 10Y is basically unchanged, with the level at 2.70 from a peak of 2.74%. We are keen on betting on March tapering and we see the 10Y at 2.6% by the end of next week.
However, the employment data will be the key. Last data points to a reversal of the downtrend in the US labor market and GDP growth surprises on the upside (2.8 versus 2.0%). The difference is only due to an increase in inventories, which can be a good thing if consumption is expected to rise or a bad one if it results from lower sales. Best to keep an eye on the data for next week.
UK releases surprising data showing a strong contraction in the inflation level (Y-o-Y), 2.2% vs 2.5%, and retail sales down. Unemployment gives a positive surprise (7.6% vs exp. 7.7%). Most important, BoE raised significantly its expectation of hitting the threshold of 7% unemployment quicker. As a result, the GBP/USD spiked to 1.6118. However, UK gilt 10Y is little changed at 2.70% and the market was not hit significantly by this assumption.
Why is that? The market has already priced in a quicker hitting of the threshold and the rates were already high. However, there are some concerns about the UK recovery and some believe that it may require some adjustment before the economy reaches the escape velocity. Moreover, UK rates are still moving really close to the US ones and thus it is unlikely to see a spike up. We are keen on a dovish surprise in the UK. We would receive 2y1y or 2y2y.
Another interesting issue is the situation in the EM space. The usual trio Indian rupee, Turkish Lira and Indonesia rupiah, the three countries with current account deficit and significant dependence on foreign capital inflow, has resumed the recent decline although Ms. Yellen dismisses early tapering. We believe that this is given by the uncertainty in the US monetary policy. Indeed, we strongly believe that even if tapering will be definitively postponed to March 2014 these currencies would never rally as they did this spring.
Indeed, the summer sell-off was too dramatic and too fresh in investors mind. Moreover, these countries have not implemented the required structural reforms. In addition, the recent Indonesia rate hike had little effect. Now the level is not attractive anymore but if they should rally, I would short these currencies for what has been said above.