Highlights

  • The looming sequester: what is it?

  • Sequester: not catastrophic, but could spook investors

  • Sequestration, jobs and the Fed

  • What to watch out for: Europe and the UK

  • Abe to announce BOJ nominee next week

The looming sequester: what is it?

Next week, Congress faces the deadline of March 1 before automatic cuts trigger resulting in a reduction of $85B in spending this fiscal year and $109B in each of the next 9 years. Including the assumed debt service savings, the “sequester” – the term used for the automatic cuts – totals $1.2 trillion over the next decade. The cuts apply to discretionary spending and are divided between defense and non-defense. Cuts would be seen across the board in areas such as education and job training, scientific research, infrastructure, public safety and law enforcement, housing and social services to name a few.

The sequester was a result of failed negotiations in 2011 and was created as an incentive for Congress to act to reduce the budget deficit. Clearly, there has been limited progress in Washington and the initial deadline of January 2 was pushed to next week. We think that the likelihood of a deal being reached in the coming days is slim as the two parties are far apart and therefore we believe that it is more likely that sequestration is triggered or the deadline is pushed out yet again. The full impact will not be felt immediately as the $85B in cuts will be spread out through the end of the fiscal year on September 30. However, as economic conditions deteriorate it will place more pressure and urgency on lawmakers to reach a deal.

Sequester: not catastrophic, but could spook investors

Analysing the market impact of the sequester you need to take into account a few things: firstly, a deal might be done at the last moment, secondly, even if the sequester goes ahead this Friday, the public sector spending cuts could be scaled back in the next few weeks and we wouldn’t rule out another deal in the future if Washington can agree a path for spending cuts going forward. At this stage the outcome of the sequester and the political impact still remains very uncertain.

Usually uncertainty is bad news for markets; however, over the last two years the US has lurched from one fiscal crisis to another, the most recent at the start of this year. Thus the markets are getting used to political deadlock these days, and the impact of the outcome of the sequester may not cause as much volatility as the debt ceiling debacle back in August 2011 when the US lost its top credit rating and the S&P 500 dropped 20% in the weeks that followed. Added to this, the sequester issue could end up looking like small change if another debt ceiling debate later this year causes the US credit rating to fall further.

Here are two scenarios that could occur post the sequestration:

1, The sequester goes into full force on March 1st:

The markets take an immediate lurch lower on the back of the news as they digest the impact of cuts to the defence budget and non-discretionary public spending and public sector job cuts. The sequester is expected to shave at least 0.5% off 2013 GDP and cause 700,000 job cuts, which could cause some trepidation on the part of investors, especially as US stock markets are at stretched levels already. However, we expect dips to be fairly shallow. In the S&P 500 1,475 then 1,450 are good short-term support levels, the 50- and 100- day moving averages respectively. Interestingly, the sequester could actually be good news for stocks in the medium-term as it may keep pressure on the unemployment rate, which may cause the Fed to keep interest rates lower for longer and also think twice before ending its QE programme any time soon. Added to that, QE is most effective during periods of financial market stress, so the sequester could actually boost the impact of QE for the Fed.

Stock markets around the globe wobbled last week after the Fed minutes seemed to suggest that Committee members were debating the effectiveness and costs of open-ended asset purchases. The markets sensitive to uncertainty about the future of Fed policy, thus if the sequester keeps monetary conditions exceptionally loose for the medium-term this may be good news for investors as stocks tend to rally when central banks keep policy accommodative.

Regarding the dollar, we could see an initial spike higher as the dollar attracts safe haven flows; however, the prospect of indefinite QE continuing could keep dollar gains capped in the medium-term, which may thwart USDJPY on its march to 95.00 and then 100.00.

2, The sequester is avoided at the last moment:

This situation is more difficult to predict as avoiding the sequester could mean that politicians kick the can down the road and set another date a few months out to either reach a deal or implement emergency cuts. If this happens there could be an immediate relief rally in stock markets in the days after the news, however the rally could be tortuous and hard going as investors keep at the back of their mind the new deadline for these cuts. This could cause markets to fail to make new highs, and keep investors cautious. We still think the Fed will stick to its QE path, as the threat to the labour market would remain.

Overall, although the sequester is likely to have an impact on global markets, we think its impact will be felt mostly in US stock markets, the dollar and the Treasury market. Whatever happens this week we think that fiscal policy is set to get tighter in the US in the coming months, which supports the Fed sticking to its QE programme for the foreseeable future as the unemployment rate is pressured by public sector job losses. This is likely to limit dollar gains in the medium-term and could keep Treasury yields capped. This could have a big impact on the future trajectory of USDJPY.

Chart 1: USDJPY

USDJPY

Sequestration, jobs and the Fed

As President Obama stated this week, “these cuts are not smart. They are not fair. They will hurt our economy. They will add hundreds of thousands of Americans to the unemployment rolls. This is not an abstraction – people will lose their jobs. The unemployment rate might tick up again”. Some estimates suggest a loss of about 700,000 jobs by the end of next year and reduction in growth of 0.6% this year. A decline in government spending would weigh on economic growth as we have already seen as the -0.1% drop in 4Q GDP coincided with the largest drop in defense spending in 40 years. It is of note however that the contractionary reading was the first estimate of 4Q GDP and next week will see a revised estimate which we think may tick higher as the December trade deficit narrowed by much more than expected.

The loss of jobs is significant as it would be a headwind to the Federal Reserve Bank, whose mandate is to achieve maximum employment. The Fed has engaged in unconventional monetary stimulus with asset purchases in efforts to bring down high levels of unemployment while maintaining price stability. Members of the Fed expressed concern over fiscal policy as the minutes of the latest FOMC meeting indicated that “near-term uncertainties remained, including the prospect of automatic budget cuts. Participants generally agreed that fiscal negotiations could develop in a way that would result in significantly greater drag on economic growth than in their baseline outlook.”

Adverse economic conditions resulting from sequestration could potentially force the Fed to remain accommodative for longer as the Bank struggles to achieve its dual mandate. This means that QE3 may be needed for more than initially anticipated and that recent talks of tapering the amount of monthly purchases may be premature. This would weigh on the USD as more asset purchases tends to weaken the greenback.

Chart 2: Dollar Index

Dollar Index

What to watch out for: Europe and the UK

The results of the Italian elections will be eagerly anticipated by the markets when they come out some time on Monday. The results are highly uncertain due to the blackout on pre-election polling, and could have large implications for the euro and peripheral bond markets if there is no clear winner, or if the Italian people vote for anti-austerity candidates. Read our fundamental update for more on this. Also on the political front the pro-austerity candidate is expected to win the second round of voting in the Cypriot election this weekend. This could make it more likely that the German court will vote to release funds for a bailout for Cyprus; the vote is scheduled for next month.

The key economic data highlights this week include the February inflation estimate along with January unemployment data. These reports will be pivotal as we lead up to next week’s ECB meeting. The market expects the unemployment rate to rise to 11.8% after falling back to 11.7% in December. The latest European Commission economic forecasts, released on Friday, made for grim reading. Unemployment is expected to rise this year for France, Italy and Spain among other members, while the Eurozone is expected to endure another year of negative growth. Thus, this week’s data could reinforce the need for ECB policy action, and speculation could grow that a rate cut from the ECB could be on the cards in the coming months.

The combined political and economic risks this week are euro negative in our view. Thus, we could see further declines towards 1.30 in the near term.

In the UK the second reading of GDP will be the major economic release, however the market does not expect any change from the -0.3% initial estimate. This may highlight the economic woes of the UK, which could continue to weigh on sterling. The pound fell sharply last week on the back of an increased number of MPC members voting for more QE at the February meeting. This caused a sharp decline in GBP, and GBPUSD fell below 1.52 at one stage on Wednesday. This Tuesday MPC members Bean and Tucker (who did not vote for more QE) will join David Miles (who did vote for more QE) when they all testify to the Treasury Committee. Bean and Tucker are worth watching to see if they could be persuaded to vote for more QE. If it looks like their arms could be twisted then expect another lurch lower in GBP.

Abe to announce BOJ nominee next week

Japanese Prime Minister Shinzo Abe is expected to announce his nomination for the next Bank of Japan (BOJ) Governor when he returns from his meeting with President Obama in the US. Current Governor Shirakawa will be stepping down on March 19 along with 2 of his deputies leaving openings for Abe to nominate members that he believe will act sufficiently to combat deflation. Before making his announcement, Abe will consult with opposition parties as his LDP party does not have the majority needed in the upper house of parliament which approves BOJ nominees.

Frontrunners for the position are Haruhiko Kuroda, the current president of the Asian Development bank, Toshiro Muto, a former BOJ deputy governor and Kazumasa Iwata, also a former BOJ deputy governor. All three potential candidates are dovish and likely to pursue continued easing to achieve the Bank’s 2% inflation target, however Iwata would be the most dovish while Muto is seen as the least dovish of the group.

We expect continued weakness in the JPY over the long term as policymakers act to fight deflation and attempt to restore economic growth. Markets are likely to see an initial reaction to the announcement based on the perceived dovishness of the candidate – however the April BOJ policy meeting will be the true indication of the stance of the new governor. In the week ahead, the JPY may gain if Muto is nominated, a nomination of Iwata would likely see further JPY weakness, and a Kuroda nomination may also see JPY trade softer as he has indicated the potential need for more asset purchases this year.

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