There are four large macro forces shaping the investment and business climate here at the start of the last quarter of the year. First, the US economic outperformance has been stark. This has helped underpin US rates and bolsters the dollar. The divergence is likely to narrow in coming months as US growth slows rather than stronger growth prospects in other high-income countries.

Second, Beijing has taken numerous measures, which although stopping well shy of the fiscal bazooka (like in 2008) many critics advocate, the cumulative effect boosts the chances that the 5% growth objective is achieved. 

Third, OPEC+, and especially Saudi Arabia, are committed to keeping world oil supplies tight. This has driven the price of oil above $90 a barrel. In the first instance, it will elevate headline measures of inflation and measures of nominal retail sales. However, for most countries, it will act as a headwind for growth. In last month's forecast update, the OECD noted that Europe is more vulnerable than the US from surging oil prices, as it lifted its US growth forecast (to 2.2% this year and 1.3% next from 1.6% and 1.0%, respectively), while reducing its forecast for the eurozone to 0.6% and 1.1% (from 0.9% and 1.5%, respectively). 

Fourth, the post-Covid monetary tightening cycle is ending, though there may still be scope for some G10 countries to raise rates in Q4 23 or even Q1 24. Still, investors typically respond to what is perceived to the last hike differently than the first move in the cycle. Speculation is shifting toward the timing of the first cut. Several emerging market countries, especially in South America, have already begun an easing cycle, as has Poland. Over the past 30 years, the Federal Reserve, for example, delivered the first rate cut, on average, of about 10.5 months after the last hike. The range has been five to 18 months. Currently, the derivatives market is anticipating something around the average. That dovetails with around when the market expected the European Central Bank to cut rates, which is in early Q3 24.

Japan is an outlier. It is the only country that still has a negative policy rate (-0.10%). Also, the Bank of Japan’s balance sheet continues to expand, while other major central banks are allowing the previously bought assets to roll-off the balance sheets. The upper-band of the 10-year bond yield has been doubled twice over the past year to 1.00%. It finished Q3 at it high a little above 0.75%. Bank of Japan Governor Ueda seemed to have suggested rates could be hiked late this year, but then appeared to soften the rhetoric after the recent policy meeting. Some observers think that Yield Curve Control will be abandoned before the central bank exits from the negative policy rate. Still, the swaps market seems to be pricing in a small rate hike at the end of Q1 24. 

Politics is never far from the surface, though perhaps the widespread practice of import-substitution industrial policies make the invisible hand more visible. The polls warn that the Labour government could be replaced by a center-right government in New Zealand. Switzerland holds the first part of its federal elections in October and the second part in December.

Poland's national election may have the most far-reaching implications. The Law and Justice Party is seeking a mandate for its third consecutive government. When Russia first invaded Ukraine, Poland absorbed nearly seven million Ukrainian refugees. An estimated 1.5 mln remain in Poland, but the focus has shifted to keeping Ukrainian grain out and this has strained the bilateral relationship. Moreover, some link the upcoming election in late October to Warsaw's stance toward Ukraine. The government said last month that it would not send new weapons to Ukraine. This is somewhat bombastic, as Poland's contribution was rarely about its weapons transfers and more about it being a conduit for other countries to get their weapons into Ukraine. Warsaw indicated this would continue.

Still, between the dispute over Ukrainian agriculture goods (Poland is not the only EU country to maintain a ban) and the push back in the US among (some) Republicans against the administration's proposal, from Moscow's (and maybe Beijing's) perspective, the coalition may fray. At the same time, overcoming an earlier reluctance, the US will send long-range army tactical missile systems. They will expand Kyiv's firing zone. The takeaway is that the war is likely to persist and could broaden in the period ahead. By early next year, Ukrainian pilots would have completed their training for the F-16 fighter jets the NATO members, including the US, are providing. 

The UK will likely hold a general election late next year, but there are two byelections in October that portend insight into the mood of voters. One is for a district that the Tories held, but previously by a Johnson Tory, not from the Sunak-wing. The question is whether the Tories, who are trailing well behind Labour in the national polls, are still fighting. More important for Labour's fortunes may be a byelection in Scotland. The election is for seat a lawmaker whose constituency recalled him for violating Covid lockdown rules. To solidify its rejuvenation, Labour needs to rebuild its Scottish presence.

Germany's Bavaria holds its election, and the CSU has a firm grip, and it will most likely return with its junior partner, the Free-Voters of Bavaria, a local center-right party. The center-left national government is unpopular and in the previous Bavarian election, the SPD drew less than 10% of the vote, coming in fifth place. It may slip further, while the right AfD could see its fortunes increase (10.2% in 2018).

Perhaps the most notable developments suggestive of the important changes coming to the global capital markets was JP Morgan's announcement that as of next June, it will include India in its emerging market bond index. It is among the benchmarks asset managers use. Other benchmark providers are likely to follow suit, even if with a lag. JP Morgan's announcement will build liquidity and could improve access, making it more tempting and attractive for others. At first, Indian bonds will have a maximum of 10% weighting in the index, and some asset managers will begin accumulating a position before next June. JP Morgan's decision is seen boosting capital inflows by $25-$40 bln. One of the implications is that as India is incorporated into the global capital markets, the liquidity in the assets and currency improves.

India occupies a unique space on the geopolitical chessboard. As in the non-aligned movement during the first cold war, India is seeking its own course. It is a member of the Quad, the security-sharing effort (with the US, Japan, and Australia), and it has agreed to give US navy access to port of call and repair privileges. At the same time, it is a big buyer of Russian oil and gas (and appears to have recycled it back to Europe) and buys munitions from Russia. Initially after the sanctions on Russia, Moscow accepted rupees but the limits of what it could do with India's currency given the capital controls made it refuse. Recent reports were of an agreement to pay in UAE dirham, which is pegged to the dollar. Reports suggest India may be developing a financial instrument that could appeal to Russian investors. India and China not only have a disputed border, but the sheer scale and proximity, coupled with ambition, makes them “natural” rivals. According to some accounts, Russia and China are blocking India's (and Brazil's) bid to join the UN Security Council.

India holds national elections early next year. The ban on the export of most types of rice appears to be inspired by politics more than economics. Reports indicate there are more than sufficient rice stocks, but the restrictions ensure lower domestic prices. India accounted for about 40% of world's traded rice and as a result of its actions, the price of rice, the staple of around half the world's population, has surged to 15-year highs. India is also caught up in a dispute with Canada, which claims to have credible evidence that Indian security killed a Sikh leader (and Canadian citizen) in British Columbia a few months ago. New Delhi has stopped granting visas to Canadians and have requested that Ottawa reduce its diplomatic presence in India. 

The Bannockburn World Currency Index (BWCI), a GDP-weighted basket of the currencies of the largest dozen economies (EMU is counted as a single economy) has anticipated the greater role for India. Using World Bank GDP figures, the Indian rupee's weighting rose to 4.3% (from 3.8%) to move ahead of the UK into fifth place (behind the US, China, EMU, and Japan). Making some conservative assumptions, India's economy could surpass Germany's in a couple of years. 

BWCI fell for the second consecutive month, bringing to almost the multiyear low set last November. The weakness of the index reflects the fact that component currencies fell against the dollar in September. Sterling and the Japanese yen were the weakest components of the basket, losing about 3.8% and 2.6%, respectively. The euro followed closely, falling by about 2.5%. 

Among the emerging market members, the Indian rupee was the strongest, with a 0.3%. The Chinese yuan was close second. Despite the numerous formal and informal efforts by Chinese officials, the yuan fell by about 0.55%. The Mexican peso and South Korean won were the weakest among the emerging market members of the index, falling by 2.1% and 2.0%, respectively.

Even though the BWCI has approached last year's lows, most of the components have not.  The Australian dollar and Indian rupee have come the closest.  And sterling (3.9% weighting), the Canadian dollar (2.7%), the Brazilian real (2.4%) and the Mexican peso (1.8%) have risen against the US dollar this year.  Combined, they account for almost 11% of the BWCI.  The Russian ruble has a small weighting (2.8%), but it is off nearly 24% this year and the yen, with a 5.3% weight in the index, is off more than 12% year to date.  The drag on the index of the two are almost the same.  Still, BWCI may be near an important low if our assessment of the gathering headwinds on the US is fair. 
 
U.S. Dollar: Through its updated Summary of Economic Projections the Federal Reserve offered a full-throated endorsement of a soft-landing for the US economy. Surely, the US economy has proven more resilient than Fed and market economists expected, helped by a significantly higher federal deficit and a robust labor market and an increase in real wages. However, significant headwinds are accumulating, and this warns of the risk of a dramatic slowdown in Q4.

The weak link remains the financial sector. Deposits are still leaving banks and credit conditions are tightening. The Fed's balance sheet unwind continues (average $117 bln over the past six months since the March bank stress flare up), which is extinguishing reserves. Bank share prices are falling and are near three-month lows. The UAW strike may continue to broaden. Initially, a shutdown could last a couple of weeks and some reports from Washington see the October 13 payday for US troops. In addition to the disruption for the millions of households that depend on federal government services, and the important work done by regulators, the economic data due out that is supposed to inform the Fed's decisions will be interrupted in a partial shutdown. The rule of thumb estimate is that a government shutdown costs about 0.2 percentage points of GDP a week and most of it is recouped when the government re-opens.

Moody's, the last of the three main rating agencies that still grants the US AAA status, notes that a government closure would be negative credit implications. In addition, student loan servicing will resume for the first time in three years, and this is seen squeezing consumption, which already looks set to slow. Tightness in the labor market is easing. Higher oil and gasoline prices are also a headwind for consumers, even if the US is a net exporter of energy and businesses have long-term contracts. The Fed funds futures strip implies three rate cuts next year, while the FOMC's median forecast envisions two. The market has all but given up ideas of a November hike (less than a 20% chance). The Dollar Index rallied for eleven consecutive weeks into the end of Q3. This is the longest advance since 2014, driven chiefly by the stark divergence. We look for the divergence to moderate due to the slowing of the US economy rather than better economic news from Europe and Japan and expect this to cap the greenback after an incredible two-and-a-half month run.

Euro: The euro's decline since the mid-July peak near $1.1275 extended to within a few hundredths of a cent of the year's low set in January near $1.0485. While this partly reflects the broad strength of the US dollar, the news stream from Europe is poor. The economy remains weak, near stagnant, and there is no stimulus to be found. The swaps market sees the September rate hike as the last in the cycle and has the first cut fully discounted in Q3 24. Although the central bank meets on October 26, the focus will shift to fiscal policy in the coming weeks as the 2024 budgets need to be submitted to the EU. The Stability and Growth Pact fiscal targets were suspended during Covid and extended since Russia's invasion of Ukraine. They are intended to be restored in 2024, though given the near recessionary conditions in many members, some flexibility may be shown.

Last year's natural gas shock has given way to an oil shock this year, compounded by the euro's weakness. At last month's meeting, the ECB shaved this year's growth projection to 0.7% from 0.9% and next year to 1.0% from 1.5%. It tweaked its inflation forecast to 5.6% this year and 3.2% next from 5.4% and 3.0%, respectively. The euro has fallen for 11 consecutive weeks through the end of September. It is the longest decline since 1996. It is extremely oversold, and the catalyst for a recovery may not be good news from the eurozone but negative news from the US. That said, the next important chart area is near $1.04. A correction could carry the single currency back toward $1.0660-$1.0700 without necessarily improving the outlook. For that the euro may need to resurface above $1.0770-$1.0800.

As of September 29, indicative closing prices, previous in parentheses: 
Spot: $1.0575 ($1.0780) Median Bloomberg One-month forecast: $1.0650 ($1.0840) One-month forward: $1.0585 ($1.0800)   One-month implied vol: 6.8% (6.8%)  
 
Japanese Yen:  The market has been on "intervention watch" since early September when the dollar surpassed JPY146, where officials had intervened last year. The rhetoric and word cues deployed that have signaled intervention in the past. However, what contributed to the success last October's intervention (and the failure in September) was in timing the operations to pick a top in US Treasury yields. However, with the increase in supply, the resilience of the US economy, and higher oil prices, the US 10-year yield rose more than 45 bp last month to the highest level in 16 years. The implication is that when there is a reasonable chance that US yields have peaked, the risk of intervention increases. Given the market positioning, intervention could knock the dollar down by around five years.

Although the Bank of Japan meets at the end of October, the focus in the month ahead will shift to fiscal policy. The government is drafting a supplemental budget, which could be JPY15-20 trillion (~$100-$135 bln). In addition to extending subsidies for energy, the government is talking about tax cuts to encourage wage increases and investment in strategic areas, like semiconductors. Even though a cabinet reshuffle in September failed to lift popular approval for government, Prime Minister Kishida is believed to be considering a dissolution of the Diet to hold elections either late this year or early next year, the tax cut proposal may be a central plank in a gambit to shore up support. Contrary to conventional wisdom, despite rising domestic market rates, Japanese investors stepped up their buying of foreign bonds in the eight weeks since the bond adjustment at the end of July. They purchased about JPY5 trillion of foreign bonds compared with JPY700 bln in the previous eight weeks. Japanese investors have bought a modest amount of foreign stocks over the period JPY440 bln. Foreign investors have dumped Japanese bonds and stocks (~JPY8.7 trillion) in the same period.

Spot: JPY149.35 (JPY146.20) Median Bloomberg One-month forecast: JPY146.85 (JPY144.10) One-month forward: JPY148.55 (JPY144.50) One-month implied vol: 8.7% (9.0%) 

 
British Pound: Sterling was the weakest of the G10 currencies, losing almost 3.7% against the US dollar in September (~six cents) before stabilizing at the end of the month. That is the largest decline since the sterling crisis last September and August that saw the pound fall to record low near $1.0350. The softer than expected August CPI (September 20) and the Bank of England's decision to stand pat at the MPC meeting the following day, did sterling no favor. Though by that time, sterling was already fraying support around $1.2400, and by the end of September, it was trading at six-month lows near $1.2100. Initially, risk on the downside risk extends toward $1.20, though the $1.2075 area corresponds to a technical retracement target. Beyond that, the next target may be closer to $1.1750. On the upside, sterling needs to resurface above $1.2350-$1.2400 to lift the technical tone. The BOE cut its forecast for Q3 growth to 0.1% from 0.4% it projected in August. Also, the central bank announced that over the next 12 months starting in October, it will reduce its balance sheet from GBP100 bln to GBP658 bln. In the previous 12 months, it reduced its holdings by GBP80 bln. The central bank meets next on November 2. The swaps market has slightly less than a 50% chance of a hike discounted and around a 70% chance of a hike before the end of the year, making the employment and inflation reports on October 18-19 especially important

Spot: $1.2200 ($1.2850) Median Bloomberg One-month forecast: $1.2305 ($1.2620) One-month forward:  $1.2205 ($1.2590) One-month implied vol: 7.6% (7.6%) 
 
Canadian Dollar: The US dollar extended its rally against the Canadian dollar that began in mid-July into September, reaching almost CAD1.3700. While the broader dollar gains continued against the euro, yen, sterling, and the Chinese yuan, its gains against the Canadian dollar were halved (~CAD1.3380). The 0.2% contraction in Q2 overstated the weakness of the Canadian economy and a stronger performance appears to be unfolding in Q3. This, coupled with disappointing CPI, have spurred a shift in market expectations toward a Bank of Canada rate hike in Q4. However, a disappointing July GDP report (flat) helped lift the greenback to CAD1.3565 at the end of September saw the market reduce the chances of a hike in Q4. The market may have to re-test the CAD1.3600-50 area. In the swaps market, the implied odds of a hike at the October 25 meeting doubled in September to around 45% but fell back to about 30% in response to the July GDP report.  The market priced in an almost 80% chance of a quarter-point boost in Q4 but pulled back to around 60% at the end of the month. It was about a 20% chance at the start of September. Ahead of this month's central bank meeting, StatsCan will report September CPI figures on October 17, and the market will be particularly sensitive to the underlying core rates, which rose more than expected in August. 

Spot: CAD1.3575 (CAD 1.3590) Median Bloomberg One-month forecast: CAD1.3 515 (CAD1.3510) One-month forward: CAD1.3580 (CAD1.3570) One-month implied vol: 5.8% (5.5%) 

Australian Dollar: The Australian dollar fell to a marginal new low for the year in September. The low slightly above $0.6330. The next target is the $0.6270-$0.6300 area. The futures market sees practically no chance of a hike by the Reserve Bank of Australia at the October 3 meeting. The market is not convinced the RBA is done, though, and is discounted about a 50% change of a hike in Q4, and around an 80% probability of a hike in Q1 24. The US pays about 110 bp more that Australia to borrow for two years and this is historically a large premium. When the Australian dollar was trading near $0.6900 in mid-July, the Australia's 10-year yield as nearly 30 bp above the US Treasury yield. It finished September at a 20 bp discount. The still uninspiring performance of the Chinese economy, and weakness in many industrial metals and wheat prices may also have weighed on sentiment. Speculators in the IMM futures have amassed a record large, short Australian dollar position. A close above $0.6500, which the Aussie has not done since August 10, would suggest a bottom of some importance was likely recorded.

Spot: $0.6435 ($0.6455) Median Bloomberg One-month forecast: $0.6490 ($0.6495) One-month forward $0.6445 ($0.6465)    One-month implied vol 9.8% (10.2%) 

Mexican Peso:  The peso was unable to fully recover from the sell-off that followed the official decision in late August to wind down the currency hedging facility. The market’s reaction seemed outsized compared with immediate volume it entails (~$7.5 bln) and may have been related to market positioning. Speculators in the IMM futures appear to have reduced their net long peso position for the third consecutive month in September, off by nearly a third over the run. The dollar briefly traded below MXN17.00 before the late September FOMC meeting. But the higher-for-longer message and risk-off mood helped lift greenback to four-month highs a little below MXN17.82. It approached the 200-day moving average, which it has not traded above in a year (~MXN17.85). While the price action needs to be respected, the forces that have underpinned the peso still are intact. The carry trade rate differential) remains attractive. Here, we note that Chile and Brazil have delivered two cuts in their new easing cycle and more rate reductions are expected in Q4. As recently, as June, Chile and Mexico overnight rates were at 11.25%. Now, Chile's overnight rate is at 9.50% and Mexico's remains at 11.25%. The market has pushed its rate cut expectations for Banxico well into next year. Meanwhile, the strong worker remittances more than covers Mexico's trade imbalance, while the near-shoring and friend-shoring memes, underscored by the USMCA agreement, draw foreign direct investment.

Spot: MXN17.42 (MXN17.09) Median Bloomberg One-Month forecast MXN17.39 (MXN17.1750) One-month forward MXN17.52 (MXN17.18) One-month implied vol 12.2% (11.4%)
 
Chinese Yuan: Chinese officials seemed to get more serious about supporting the economy in recent weeks. While stopping short of large-scale fiscal steps, the numerous measures, and the exercise of soft power to encourage desired behavior seems to have begun yielding constructive results. Similarly, officials have managed to limit the yuan's descent to a little more than 0.5% in September, less than most other currencies. A squeeze in liquidity in the offshore market was arranged and reserve requirements for currency deposits were adjusted. Orders to buy more than $25 mln came under closer official scrutiny. Banks were discouraged from selling the yuan in proprietary trading. The central bank's daily fix has consistently in favor of the yuan. At the same time, interest rates and bank reserves were cut, extending the policy divergence with the US. Judging from some portfolio flow reports, it does not appear that foreign investors have been persuaded to return to Chinese stocks or bonds. There is scope for additional adjustment of China's monetary policy before the end of the year, even if not in October. The Golden Week holidays will shut mainland markets the first week in October. Barring a new setback, the groundwork for a Biden-Xi meeting in November at the APEC gathering appears to be falling into place.

Spot: CNY7.2980 (CNY7.2665) Median Bloomberg One-month forecast CNY7.2800 (CNY7.2225) One-month forward CNY7.1960 (CNY7.2075) One-month implied vol 5.2% (6.4%) 

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