Global De-Sync Continues

The divergence between U.S. and European data continues.

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The ZEW survey of German investor sentiment hit a major snag in October, sinking into negative territory for the first time in almost two years. Investor confidence has clearly been undermined by weak economic performance in the euro area. The results of the ECB’s bank stress tests, which will be released at the end of the month, could potentially remove one headwind that has been holding back risk-taking in the euro area. But it is unclear whether that will be enough to put a floor under sentiment.

Meanwhile, in the U.S., economic performance is stable. The NFIB survey showed that small business sentiment is holding up. The “good time to expand” index has hit a post-2007 high, although the employment-related components were slightly weaker. All told, there are few signs that problems outside of the U.S. are inhibiting economic growth domestically.

Our view is that global growth dynamics will support the dollar bulls. Sentiment is clearly stretched, but the de-synchronization of growth between the U.S. and elsewhere appears primed to last for at least a few more months. The latter should keep a solid floor under the dollar for now.

FOMC: Dots At A Turning Point?

The surge in the dollar has made clear that the U.S. economy will not be spared the deflationary pressures emanating from outside the country. The Minutes from the September FOMC meeting revealed that policymakers recognize the threat to growth, and the risk that additional dollar appreciation could drive inflation even further below the 2% target.

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The Minutes calmed fears that the FOMC might have a high pain threshold in terms of deviating from the current projected path for rate hikes beginning in 2015. Policymakers are clearly incorporating the dollar’s move and softening in global demand into their deliberations, and they may opt to maintain the “considerable time” language in the October statement.

The Minutes also highlighted that the FOMC places great importance on long-term inflation expectations, which were described as “stable” at the time. Since then, however, the 5-year CPI swap rate, five years forward, has dropped sharply and is close to levels observed around the time of QE2, operation twist and QE3. Policymakers are surely concerned. Some of the decline in inflation expectations reflects dollar strength and weaker commodity prices, but it could also reflect a loss of confidence in the Fed to deliver on its 2% inflation target in the long run.

The decline in long-term inflation expectations is alarming, although it would probably require one or two disappointing payroll reports for the FOMC to lower its projection for the policy rate (i.e. the median “dots”). Meanwhile, the 10-year Treasury yield has returned to the middle of its downward-sloping trend channel, after having tested the upper end of the range. The 2-year yield has fallen to the bottom of its upward-sloping channel. A breakout to the downside would require some combination of continued weak global economic data and softness in upcoming U.S. payroll reports.