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October Opportunities - A Tricky Month or One Full of Potential?

Posted on: 04 October 2018 , by: Pepperstone Support , category: Market Review

October Opportunities by Chris Weston and Darren Sinden

October can be a tricky month for the global markets and it's one that has often been associated with sharp corrections or outright crashes, as demonstrated in 1929, 1987, 1997, 2002 and 2007. 

There is an ongoing debate among market participants about exactly where we are at in the current economic cycle and equity bull market. This month, there are no obvious signals that a significant correction is nearing but we should remember that black swans tend to come out of nowhere. However, we can say with certainty that the economic calendar is bursting with key data releases and opportunities for traders, with more than 50 high impact data points due for release this month

Currency Recap

The cries of policy normalisation from a number of major central banks have been the overriding theme in September with an evolving narrative from key ECB and Fed officials driving FX moves.

In the case of the ECB, talk from Mario Draghi of a potential ‘vigorous’ pick-up in underlying inflation has confirmed that the ECB is starting a more radical communication to the market, using forward guidance as a tool to smooth its transition away from quantitative easing (QE) and towards interest rate hikes, likely in late 2019.

European interest rate markets have responded, pricing in a higher degree of policy tightening in the period between 2019 to 2020. However, we can see that increasing interest rate hike expectations are not exclusive to Europe, and this is also the case in Australia, Canada, Norway and the UK. It is also worth noting that Turkey increased its one-week repo rate by 625bps, with rate hikes also in the US, Ukraine, Czech Republic, Russia and Indonesia.

Despite concerns around US-China trade tensions, developed market economies are seemingly in good health, and traders are sensing more ‘normal’ monetary policy in the years ahead. This can be seen, as a case-in-point, with the Federal Reserve changing its long-held view at the 26th of September FOMC meeting that its monetary policy setting was no longer ‘accommodative’, and with another rate hike likely in December, it’s clear the Fed is getting closer to a more neutral policy rate.

The USD was a pillar of strength in August, closing up 0.6% and gaining for a fifth consecutive month. However, flows in G10 FX markets were far more mixed in September. Scandinavian currencies were the star performers, with the SEK and NOK gaining 3.0% and 2.8% respectively, also assisted by Brent crude pushing above $80 (the highest level since November 2011). The JPY was the weakest link with USDJPY gaining 2.4% on the month and pushing into ¥113.71 – a new year-to-date high (scope for 115 weekly). AUDUSD has found good interest from clients, with the pair working nicely within a bearish channel, and we can draw a simple regression and see price respecting a two standard deviation move from the line of best fit, which currently sits at $0.7163. There seems to be a ceiling on EURUSD at $1.1800 and, until EURUSD breaks here on a closing basis, it’s hard to be overly bullish this pair. Traders have been happy to play a 1.18 to 1.15 range.

GBPUSD has also been well traded, despite ever-changing rhetoric around the Brexit negotiations, where reactions and news headlines have made trading the GBP on any time frame over four-hours almost impossible. Still, having been as low as $1.2662 in mid-August, we can see GBPUSD above 1.30, and this is a must-watch pair through October and November.

Key Economic Events

The Reserve Bank of Australia Interest Rate Decision - 2nd of October 04:30 AM GMT (07:30 AM Server Time GMT+3)

Australian interest rates have remained static at +1.50% for more than two years and in fact, the last adjustment the RBA made was to cut rates by 25bps back in August 2016.  Australian money markets continue to imply that domestic interest rates will rise within the next 12 months, and that they’ll be above 2.0% in the next 3 years. However, the central bank remains on the defensive. It's highly unlikely that the RBA will take any action at this meeting, but it may shed light on changing interest rates drivers and the timescales that this could happen over.   

Changes in the Australian yield curve: Note the differentials in the curve today (cyan line) compared to September 2017 (yellow line).

Changes in the Australian yield curve

What we expect 

No change in Australian interest rates and therefore no obvious reason for the AUD to break out of its long-term downtrend versus the US dollar. Price action in late September saw the Aussie test back to that line, which can be traced back to 26/01/18, yet it remained unbroken. Support at 71.44 and the recent low of 70.805 are potential downside levels to watch in AUDUSD as a result.

 

Nonfarm Payrolls - 5th of October 12:30 PM GMT (15:30 PM Server Time GMT +3)

US Nonfarm PayrollsUS Unemployment Rate
Forecast 188k: Previous 201kForecast 3.8% : Previous 3.90%

Job creation in the US rebounded in August with an impressive 201k, a figure that was approximately +10k above consensus forecasts. Wage growth also picked up, with average hourly earnings growing by +2.9%, on an annualised basis.

The lack of wage growth during the US recovery has puzzled economists and traders, not least because unemployment keeps falling and job vacancies keep rising. It seems to me that two factors are at play: 

  1. Globalisation, meaning a sizeable foreign labour force can be accessed through offshoring. This overseas labour pool has encouraged the growth of the gig economy and flexible working in the USA, which in many cases may mean zero-hours contracts that erode workers wage bargaining power.
  2. US corporates have become increasingly adept at retaining a larger share of their profits for themselves and their shareholders, rather than their staff. The chart below illustrates this point nicely.  

Employee pay as a share of national income

Source: US BLS, Reason.com

US Job vacancies vs US disposable personal income

One potential benefit of Donald Trump's tax cuts and his stance on trade is that jobs may be repatriated as offshoring becomes less attractive. Though, as we noted in last month's piece, there are clear skills gaps in the US labour force that need to be bridged, if this is to be a workable solution longer term. On the other hand, if we look at the chart below, we can infer that those US workers that are in a job, are benefiting from the increasingly tight US labour market. 

Forecast for the September NFP numbers are in the region of +185k, however, our final chart shows us the payroll numbers tend to deviate sharply from both the consensus and the prior months reading. 

NFP deviation from forecast and prior readings

What we expect:

The Fed has all but confirmed a further rate rise by the end of 2018 and to that end, the US market must get used to the idea of tighter monetary conditions. That’s not necessarily good news for US equities that have benefitted from a decade of low rates and easy money and raises the possibility that a strong job creation number, whilst good for the economy, will not be viewed as positive for stock prices. The US30 index is the most sensitive barometer to these changes. The index is up by more than 6% YTD and therefore has plenty of scope for a retracement on a decent NFP number.     

 

China Q3 GDP - 19th Of October 02:00 AM GMT (05:00 AM Server Time GMT +3)

China’s GDP is one of the most hotly debated economic data points. The debate centres around whether the data accurately reflects the real situation within the Chinese economy. That question arises because so much of the Chinese economy remains in state hands and many businesses whether state or privately owned, continue to receive state subsidies. Economists argue that under these conditions the Chinese authorities can effectively ‘paint the tape' or create the GDP numbers that they wish to see. Despite this controversy, the data still retains sentimental importance to traders and the markets alike. China has been the engine of global growth over the last two decades, and the sheer scale of its population and economy make it a barometer, not only for the fortunes of the APAC region but for the global economy as a whole. 

China GDP growth rate vs China GDP annual growth rate

China's economy has been slowing over the past five years, and the annual rates of growth above +7% that were seen in 2013 are now a distant memory; that said on the quarterly basis, growth improved in Q2 when compared to Q1 (+1.80% vs +1.40% respectively). 

When we plot the annualised rate of GDP growth against the quarterly measure (as we have done above) the suggestion is that the Chinese economy is accelerating once more. However, I think we have to be pragmatic and not just rely on backwards looking and lagging indicators. Instead, we should look at what leading indicators for the Chinese economy can tell us. PMI or Purchasing Managers Index data is the obvious choice, but once again we have to wrestle with discrepancies between the state’s own data and data gathered by the private sector. The image below clearly shows what we are talking about. 

China's growth gauge diverge

Source: The Financial Times

The private sector Caixin survey data diverged sharply from the official PMI data across both services and manufacturing during August. As such, we may not be any wiser as to the real state of play in China, even after the Q3 GDP data is released.

What we expect:

Forecasts are for growth of +6.6% on an annualised basis or +1.5% QoQ, both of which are below their respective prior prints. Markets can probably live with numbers in that ballpark but a significant deviation in either direction would raise eyebrows. Chinese equities have had a tough year but have recently started to rally. The HK 50 index acts as a proxy for mainland equities and is therefore likely to react the GDP numbers. But rather than trying to preempt that reaction, I think it might be prudent to wait for a trend to develop post the numbers and join accordingly as there too many variables and unknowns at play to take a directional approach to the announcement.

Political Opportunities

Politics is by far the biggest driver of volatility for any currency, as the outcome of a political event will often cause changes in fiscal policy, and alter consumer and business behaviour. This, in turn, could require tweaks to monetary policy to offset any change in financial conditions. As we have seen over the years, traders often fail to adequately price risk, becoming emotional and often irrational and the discipline needed to stick to the trading plan goes out of the window. We can make an argument this is precisely what we are seeing unfolding now in the Brexit negotiations.

So, October sees the Brexit negotiations really heat up. Not that things weren’t already getting spicy, where the recent Salzburg Summit not only showed a lack of progress to find common ground on key debates such as the Northern Irish border, but openly showed disagreement and division. The market will want to see Theresa May hand over a workable proposal to the European Union (EU) at the 18 October EU Summit, or we can expect sterling volatility to ramp up as the market increases its probability of a ‘no deal’ Brexit. It seems unlikely common ground will be found at this stage, although expectations for an agreement at this summit are already quite low.

It seems logical that GBPUSD will be one of the more heavily traded currency pairs through mid-October, as will EURGBP and GBPJPY. However, where the GBP goes is really anyone’s guess, because on any time frame higher than that of a four-hour chart and we are merely just a slave to news headlines, which makes trading incredibly tricky. So, as we approach what could arguably be a far more volatile period my view is to keep position sizing low, as there will likely be increased leverage in the market and of course to keep an eye on news sources (Twitter is best here), although price, as always, is still the best guide.

The US midterm elections on the 6th of November could become a volatility event, with the balance of probabilities stacked on a split Congress. This dynamic would act as a sizeable headwind for the USD, although the timeline for traders to reduce USD long positions are not yet known.

What we expect

My view is to watch USDJPY around this event, although USDCNH will also be an influential cross. Increased concern that, as a result of a Democrat-controlled House it will become harder to pass future legislation, with the US debt ceiling debate coming back into focus, and traders will reduce USD exposures and gravitate to the safety of the JPY. The logic here is that traders will pair back expectations of deep rooted fiscal reform should we get a Democrat-controlled House. While the debt ceiling could become a concern for markets in early 2019, which will naturally benefit the JPY. 

At the time of writing, USDJPY is unphased by the midterms and the pair is in a strong uptrend. However, a move back through ¥113.17 (the 19 July high) would suggest turning more bearish on this pair and signal that the world is now acting on the midterm elections.

 

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