The Central Bank of Russia is expected to continue the series of the key rate cut. There is a 100 percent possibility for the CBR to continue cutting its key interest rate, noted Nordea Bank in a research report. Inflation in the country is at the lowest levels since the post-Soviet period. Furthermore, the inflation expectations are trending lower.

In the meantime, the Russian economic growth figures are not positively surpassing expectations at present. Growth in retail sales continues to be negative, while capital construction fell 5.4 percent in the first quarter of 2017. Also, investment activity growth continues to be symbolic. Thus, certain stimulus is required and it can be achieved through easing of the monetary policy.

Firms in Russia do not mention the interest rates as the top thing as the hindrance for business development. Meanwhile, money market rates have already begun pricing in a rate cut.

There are some factors that might prevent the Russian central bank from aggressive rate cuts. There is uncertainty regarding the OPEC/OPEC+ agreement for the second half of this year. If the agreement is not prolonged, oil prices might decline and inflation might accelerate in tandem resulting in depreciation of the RUB. Meanwhile, high consumption growth can also pose as a threat to the inflation. Additional aggressive rate cuts would stand out against the central bank’s cautious rhetoric and earlier take steps, stated Nordea Bank.

Geopolitical tension intensified between the United States and Russia as the United States attacked the Assad regime by launching 59 tomahawk cruise missiles targeting airports in response to an alleged chemical weapon attack by the Assad regime. This week, the Assad regime reportedly used chemical weapons that claimed the life of 80 people including women and children in the rebel-held town of Khan Sheikhoun in Idlib province. Speaking at the Mar-a-Lago resort in Palm Beach Florida, President Trump confirmed the ordering of the missile launches. He said, “I ordered a targeted military strike on the airfield in Syria from where the chemical attack was launched…..It is in the vital national security interest of the US to prevent and deter the spread or use of deadly chemical weapons.” US missile attack reportedly destroyed 14 Syrian jets and destroyed much of the air facility in the area. Pro-government journalists in Syria have warned that actions like these will only boost the morale of the terrorists.

This action taken by the Trump administration puts it in direct conflict with Russia, who gave a different narrative of the situation. According to Russia, the Syrian government attacked a rebel-held arms depot in the area, which contained the chemical weapon; Sarin nerve agent.
The US Secretary of State warned against reading too much into the attack as according to him, the stance of the current administration is Syria remains unchanged and he insisted that the missile attacks only show that the President is willing to take decisive actions when called for.
While most of the US lawmakers lauded the President’s action, some still remain skeptical and feel that it is plausible that the Russian narrative could be true. Prominent senators like Rand Paul, Ted Lieu condemned the President’s action as he did not seek congressional approval before the attack. Senator Thomas Massie said that it was not in the interest of the Assad regime to use chemical weapons and believes that the Russian narration might be true.

Russia had already warned the United States on military actions against Assad regime saying that it will have negative consequences. Next few weeks would see a flurry of activities on this front and the attack has triggered a lot of uncertainties.

The CBR meets to set interest rates today. Our team in Moscow look for a ‘dovish hold’ today as do a majority of participants, although there are a few analysts looking for a 25bp or even a 50bp cut. The arguments for a cut are that CPI is falling slightly quicker than expectations and the CBR has started to sound a little more dovish. This year we do see 150bp of rate cuts, taking the policy rate to 8.50%, but see the 50bp per quarter cuts starting in 2Q. Given recent strong flows into EM debt product, we doubt a surprise cut would impact the RUB too severely and 10 year OFZs might have a chance to break under 8%. Equally an on hold outcome is unlikely to alter market expectations much. Expect RUB to stay relatively supported, especially with large tax deadlines due early next week. We tend to favour a USD/RUB move to 56.50/57.00 short term.

The Political establishment in Washington went into a frenzy last year after then-candidate Donald Trump said that he wants to restore relations with the Russians. Every time, Mr. Trump refused to criticize either Russia or Russian President Vladimir Putin, the established anti-Russia establishment in Capitol Hill went after him and that includes several media outlets like CNN, which colluded with the Clinton campaign during the election and more. The skepticism with Russia runs so deep in Capitol Hill and within the establishment that President Trump is considered by many as a Russian spy and they are still looking to prove connections between Trump and Putin.

A recent incident in Capitol Hill proves how deep the hatred runs. Senator John McCain of the Republican Party presented a proposal that envisions bringing Montenegro, a small Balkan country within the umbrella of North Atlantic Treaty Organization and that proposal was rejected by another Republican senator Rand Paul, who did not want to make additional military commitments when the US debt is already at $20 trillion. Russia allegedly took part in a failed coup during last year’s Montenegro election. Mr. Rand Paul’s refusal triggered a furor in Senator McCain, a well-known Russia hawk, who accused Mr. Paul of working with or for the Russian President Vladimir Putin.

Russia-US-Montenegro are part of global geopolitics and there is also nothing wrong being a Russia-hawk but when one accuses a colleague of working for Russia, then probably it’s not just hawkish; it’s a phobia, Russia-phobia.

The real question is, can President Trump overcome these phobics and reconcile with Russia?


Ruble strength, fiscal rule and CBR

The gov’t/CBR comments that RUB strength is a temporarily fuelled RUB correction. We do see RUB weaker going forward, but generally in a modest/orderly way. There were several officials’ comments about RUB and CBR policy on Friday, which clearly explain some RUB correction. Specifically, CBR deputy Ksenia Yudayeva commented to Bloomberg with the following points:

 · The RUB is not significantly overvalued, its deviations from fair-value estimates are “within the limits of the norms”, and the hot money inflows are not the only factor driving RUB stronger, so the CBR doesn’t see any threat for financial stability from this and, so, there is no need to react.

  • · Not only the level, but excessive RUB volatility adversely affects competitiveness, which requires removing the dependence from oil in the FX rate, which will likely be achieved through inflation targeting and the MinFin FX buying under the “budget rule”.
  • · The focus stays on CPI/anchoring inflation expectations at the 4% target, which may require higher rates for longer, so the current 4%+ real rate may persist.
  • · MinFin FX buying and the disinflationary impact from the transitory factors of RUB and good harvest leave risks to reaching the 4% target, so the CBR remains concerned that the disinflation trend may slow soon.
  • · The lower and shorter recession in 2015-16 than was initially expected justifies the CBR’s cautious stance.

After these, MinEco Maxim Oreshkin also commented saying that the recent RUB strength looks temporary, seasonal and not related to fundamentals, so the RUB may see some moderate weakening followed by a stabilisation. All in all, the CBR comments look like a rather hawkish message also making clear that the CBR doesn’t see any need to react from their side to RUB strength. At this point, the probability of rate cuts in Mar-17 is clearly below 50%, but we think it may still change if CPI slows down as in previous weeks, and the RUB stays resiliently strong. As for the RUB outlook, we do share the view that the recent strength looked excessive, so it would be natural to see some retracement back to 59-60/USD levels all else being equal.

Monthly Global EM Outlook, Trump Policies and Inflation

From the current starting point, the near-term inflation outlook is generally unthreatening in most markets that have a large weight in the international benchmark indices for EM local currency debt.

Inflation has risen in some EM countries during the past half year in response to currency depreciation and increases in global oil prices; but the CPI impact of exchange rate weakness has in most cases diminished and the oil price effect is probably about to peak. Beyond the group of EM countries that now have large weights in the EM debt indices, it is notable that core inflation is on the rise in China.

 The current level of core inflation (2.2% year-on-year) is not seriously disconcerting but if it continues to creep upwards then it will eventually become a constraint on China’s monetary policy. This represents a risk for the entire EM/commodities complex, but it is more likely to be a risk for the second half of 2017 than a focal point in the next few months. More imminently, the main risk of abrupt policy rate increases in the EM universe comes from the US in the form of the possibility of a surprisingly large batch of Fed rate hikes during the remainder of the year and/or a border adjustment tax. Either of these shocks could force a swathe of EM central banks to choose between raising their policy rates substantially or having to live with undesirably steep currency depreciation.

Given the current predominantly unthreatening EM inflation trends and residual labor market capacity slack in many countries, a large share of the EM central banks – especially in Asia – look set to be able to leave their own policy interest rates unchanged if the Fed keeps raising rates at a gentle pace and if the US border adjustment tax fades away.

An important source of inflation volatility in the EM world in recent years has EM currency depreciation (in nominal trade-weighted terms) that has led to increases in prices not only for imports, but also for those domestically produced goods that compete against foreignproduced items either in the domestic market or the export market. However, this problem dissipated in most of the EM world during the course of 2016, and only a few of the large EM countries – Mexico and Turkey to be precise – are seeing this problem unfold right now

Two other large EM countries – Brazil and Russia – are in the opposite camp. Inflation has fallen sharply in both countries in the past year. This reflects in part a swing from large-scale currency depreciation in late 2015 and early 2016 to equally forceful currency appreciation during the past 12 months. Deep recession, widening output gaps, and cautious monetary policy in both countries have also helped contain inflation. The view of our Brazil-based economists is that recent currency appreciation will continue to help drive down the country’s inflation in the present year whereas the main drivers of last year’s fall in inflation were a large decline in the pace of adjustment in government controlled prices (in part reflecting currency dynamics and a big change in global oil price inflation), the depth of the recession and, related to this, weakened wage pressure in the labor market.

To be sure, the behavior of EM currencies, inflation and policy rates would be highly likely to become much messier if the Fed were to accelerate the pace of its rate hikes substantially beyond what is currently priced into the US rates curve, perhaps in response to stronger wage data or aggressive future plans for unfunded US tax cuts. There is also, in our view, a very real risk to EM investors associated with the plan of Republican members of US Congress for border adjustment taxation (BAT), or from the possible imposition by the US of other types of import taxation. As we have argued multiple times on these pages, the BAT and import tariffs are likely to be highly dollarsupportive. If Trump’s decides to support either, and if he secures congressional approval, dollar-based holders of EM local-currency-denominated assets are likely to take a hit.

It might seem inviting to think that the BAT would help curb inflation in the EM world, because it would be likely to drive down the dollar price that EM-based importers pay for goods from the US (as US exporters would be entitled to a new subsidy) while also driving down the dollar price that EM-based exporters would obtain from sales to the US (because their sales would be subject to taxation at the US border). But the inflation “benefit” would be eroded by EM currency depreciation against the dollar. EM currency depreciation would most likely be sufficient to drive the local-currency prices for EM countries’ exports and imports (in trade with the US) almost all the way back to their pre-BAT levels.


 US Financial and Monetary Conditions, Yellen, Inflation & Oil, China and RMB

US financial and monetary conditions continue to improve as market indicated real yields remain muted while stocks and other real assets break into higher valuation territory. The S&P 500 has exceeded the 20trn market capitalisation mark on the day when all four major US equity indices reached new historic highs. The advance seems broad-based with cyclicals like financials taking the lead. The stock market trades reflation and, with US markets leading, markets seem to be taking the view that global reflation is centered in the US.

Against this background the Fed’s Yellen will appear before the Senate Banking Committee at 3pm (Ldn) today and the House Financial Services Committee tomorrow. A prepared testimony will be the same both days and will probably be released when the Senate hearing starts but sometimes gets released earlier by the committee. Here Yellen will have to present the Fed’s view which at times has differed from her more dovish attitude. Hence, it is not surprising to see markets walking into these risk events with a relaxed attitude, seeing the Fed hiking only cautiously and not as aggressively as signaled by the median Fed dots. Should Yellen divert from the moderate projection of the interest rate path as currently priced into the market, the USD may rally. This risk is asymmetrically priced leaving us comfortable with our USD long positioning against low yielding currencies EUR and JPY.

Animal spirits are now often mentioned in press reports. The last time the US was experiencing animal spirits goes back to the 90s when James Rubin ran the US Treasury. Then it was the high tech boom driving many asset classes. The stock market started to correlate with retail sales as wealth effects kicked in. We have not yet seen this effect in the US, but with the continued asset rally the likelihood of animal spirits taking over is not insignificant. Last year, it was the shaky international background pushing the USD sharply lower as the Fed eased the markets’ rate expectations via dovish talk. Today even the global environment looks better with EMU economic and political divergence providing the exception.

Inflation and oil. This morning saw China’s PPI growth beating market estimates by a wide margin with rising commodity prices and a strong January base effect providing the main catalysts. US bond yields coming down faster than the Japanese yields may dampen USDJPY, but it does not generally weaken the USD. As long as the reason for lower oil prices is due to higher US oil output the decline of oil may even work in favour of the USD in the long term. Yesterday the US (EIA) reported its oil output increasing by 80k. Oil rigs are on a fast rise as shale companies experience better funding conditions and the ability to sell oil at higher prices.

RMB in focus. According to the WSJ, President Trump’s administration may be considering alternative strategies with regard to currency issues with China. “Under the plan, the commerce secretary would designate the practice of currency manipulation as an unfair subsidy when employed by any country, instead of singling out China, said people briefed on or involved in formulating the policy.” There are two issues coming into our minds. First, the administration hoping China may push USDCNY lower via using its reserves or tightening its own monetary conditions. This strategy comes at relative costs to China and is beneficial for the US. Should this scenario work out then China may switch some of it FX reserves into JPY or EUR even if this comes with potential future FX reserves valuation losses. Secondly, China may turn into an infrastructure investor into the US. Japan seems to already be leaning in this direction. It would help the US in creating jobs while giving China a good investment return for its foreign-held assets. In this scenario the US yield curve would stay steep and the USD strong.

US Bond Yields and USDJPY, US Risk Premium, BoJ Meeting Notes, BoC and EURUSD

US bond yields and USDJPY have scaled back to levels drawing a technical dividing line between a bull and a bear market interpretation. US political volatility seems on the rise in the aftermath of the recent imposition of immigration controls, possibly giving markets the impression that the rules could change quickly for anyone dealing with the US. Our global risk demand index (GRDI*)has scaled back from levels above 2 which is generally associated with markets runninghigh levels of complacency. GRDI was at 1.07 at market close yesterday. Precious metals have turned higher with Silver building a key reversal formation. Today Trump is expected to announce the new Supreme Courtnomination.

Certainly, the risk premium to hold USD denominated assets has increased as US politics have become more difficult to predict. However, we regard the glass still as half full and differentiate USDJPY driven in the near term by risk sentiment, while in the long term higher US capital demand should drive rate and yield differentials in favour of the USD. US December consumer expenditure rose by the highest rate in three months suggesting that the US economy has entered 2017 with strong momentum. The Fed statement tomorrow may reflect recent data strength. Seeing US nominal GDP expanding at a faster pace compared to the rise of US rates seen over the past year plus accelerating credit creation by US commercial banks suggests that US monetary conditions have eased. The Fed may like to reduce accommodation from here which should put the current USD downward correction to rest.

Today’s outcome from the BOJ meeting underlined their firm commitment to managing the yield curve (policy rate at – 0.10%, 10yr JGB yield target at 0%, 80tln annual bond buying). The statement underlining downside risk to inflation indicates that there is little risk of seeing the BoJ moving away from keeping 10-year JGB yield near zero. Interesting are comments from PM Abe’s economic adviser Kozo Yamamoto calling the 5-8% VAT increase of 2014 a mistake, suggesting Japan may operate a new round of fiscal stimulus to ensure the country overcomes inflation. The text book would suggest fiscal expansion supporting the currency, but this interpretation requires the central bank to turn less accommodative in response to the fiscal stimulus. However, Yamamoto has clarified that Japan can only then engage in a fiscal stimulus under conditions of debt sustainability suggesting funding costs staying south of nominal GDP expansion. When the three pillar ‘Abenomics’ kicked in in 2013 with Japan engaging in monetary easing, fiscal stimulus and structural reform, the JPY sold off hard. The JPY is driven by real yield differentials. Japan staying accommodative via its monetary policy and easing fiscally may (via rising inflation expectations) push Japan’s real yield level lower which, in turn, should support Japan’s equity market and weaken the JPY. Note, Japan inflation expectations (10y breakeven) are on the rise again and are thus ignoring recent risk volatility.

BOC’s Poloz will speak today and we think he will present a dovish message in line with yesterday’s comments from the Deputy Governor Sylvain Leduc highlighting the level of household indebtedness and elevated housing prices unlikely to withstand a persistent spike in unemployment. The fact that indebtedness is rising for the most indebted households is ‘really worrisome’ according to the BoC. The employment data for Canada are going to be important to watch for the CAD. The CAD should come under selling pressure today and this selling pressure has the potential to add momentum should oil prices extend recent selling pressure. Oil has broken lower on reports suggesting US rigs reaching their highest level since November 2015.

We remain EUR bearish with potential selling pressures coming from two sides. First, the new US administration focusing its new trade policy on areas running pronounced surpluses against the US may drag EMU into the trade debate. EMU’s crisis response was to consolidate fiscally and to seek higher employment via increasing net trade, allowing the EMU to convert its 2008 current account deficit into a 3% surplus. Secondly, EUR hedging costs have declined as shown in the chart below, which in light of current inner-EMU spread widening could lead to EUR selling. As JPY hedging costs have remained high EURJPY could turn as a catalyst for EUR weakness.


South Africa news flow and changes to the CPI Index

First, the National Treasury will today at noon London time publish National Government budget data for December. We expect that the budget recorded a seasonal surplus in the month, of ZAR20bn. If this proves correct, then the annualized consolidated budget deficit would widen to an estimated 3.8% of GDP from 3.5% recorded in November, according to our estimates.

Second, the Reserve Bank will tomorrow at 6:00am London time publish monetary aggregate data for December. Domestic private sector credit growth likely stayed low, near a nominal 5% yoy, according to our estimates.

Third, the South African Revenue Service will tomorrow at noon London time publish external merchandise trade data for December. We expect that the trade account recorded a seasonal surplus in the month, of ZAR10bn. If this proves correct, then the annualized trade surplus would improve to an estimated 0.5% of GDP from 0.4% recorded in November, according to our estimates.

Fourth, the National Automobile Association (NAAMSA) of South Africa will on Wednesday (1 February) publish new vehicle unit sales data for January. In December 2015, sales (non-seasonally adjusted) were down 10% mom and down 15% yoy. For calendar 2016, unit sales were 11% lower than in 2015.

Fifth, the Bureau for Economic Research (BER) will on Wednesday at 9:00am London time publish its PMI for January. The index remained below 50 for five consecutive months to December 2016.

Sixth, Statistics South Africa will on Thursday (2 February) at 11:00am London time publish electricity production data for the month of December. In November production volumes (in seasonally adjusted terms) were down 0.4% mom, following growth of 1.5% in October. The sector looks likely to have been a positive contributor to GDP growth in the 4Q 2016, according to our estimates. On Friday (27 January) Statistics South Africa published new weights for the consumer price index. We think that there may be some good news for inflation in 2017 given the changes.

First, the ‘Food & NAB’ category increased to 17.24% from 15.41%. If we are correct in our expectation of a decline in domestic agricultural prices this year, then the deflation impact on headline CPI inflation could be more pronounced. Second, the ‘Transport’ category declined to 14.28% from 16.43%. Similarly, if our expectation of a weaker ZAR and higher oil prices proves correct, then the inflation impact on headline CPI could be less severe.

Russia Rate Meeting, Sanctions and FX Interventions

The main event this week is the central bank’s (CBR) rate-setting meeting on Friday (3 February). We expect the CBR to leave the policy rate unchanged, at 10.00%. This is in line with the Bloomberg consensus forecast. Although the majority of respondents to the Bloomberg survey expect the policy rate to remain unchanged, some expect a 25-50bps cut. It is worth highlighting that the CBR is no longer committed to keeping the policy rate unchanged (in contrast to its message in September 2016) and the government has recently decided not to spend extra oil and gas revenues. We see a number of other arguments in favor of a policy rate cut, but none of these is strong enough for the CBR to act at this week’s meeting, in our view. In particular, we would like to highlight the favorable inflation data in January and weak consumer demand indicators in December. We strongly believe that the decision of the Finance Ministry to introduce regular FX purchases is neutral for the prospects of policy easing. We believe this will be explicitly highlighted in the CBR’s post-meeting statement this week. Although the CBR will not hold a press conference or release a monetary policy report (with updated forecasts and assumptions – pretty important in light of rising oil prices) this week, we expect some comments from the CBR officials as 3 February is also the day when the Finance Ministry will reveal its daily FX purchase volumes, according to the intervention mechanism. We expect the CBR to cut the policy rate at its next meeting on 24 March. On Thursday (2 February), Rosstat will reveal the preliminary estimate of real GDP growth in 2016. We estimate real GDP was down 0.4% in 2016 (after a drop of 3.7% in 2015). A Bloomberg consensus forecast for this variable was not available at the time of writing. On Saturday (28 January), Russia’s President Putin had a phone call with US President Trump. It was the first official call among the two leaders. According to a press release by the Kremlin, the two leaders discussed the crisis in Ukraine and the situation in the Middle East, their countries’ cooperation in fight against global terrorism, Iran’s nuclear program and other international issues. The Kremlin concluded that the call was “positive and productive”. On Friday (27 January), the rally in the Russian local markets was driven by comments from US Presidential Adviser Kellyanne Conway, who noted that rolling back of US sanctions against Russia may be discussed between Putin and Trump on Saturday. Although Kremlin’s press release did not refer to this issue, it does not mean that the issue was not discussed. In our view, the current backdrop may be challenging for those investors who are short Russian assets due to a potential positive headline risk as was the case on Friday

Russian USDRUB Intervention Mechanism, FX Purchases explained by CS

? In our view, it makes sense to resume regular FX purchases due to (1) the strengthening of the rouble in REER terms, (2) the decision of the government to save windfall oil and gas revenues, and (3) higher oil prices.

? We expect the mechanism of regular FX purchases in 2017 to replicate the fiscal rule (which will be approved by parliament in 2018), with the parameters of the FX purchase mechanism being reset on a monthly basis.

 ? The CBR is likely to be in charge of regular FX purchases in 2017, while the Finance Ministry is likely to take over in 2018-2019, if the Brent oil price stays above $50/bbl.

 The rouble’s response to the announcement of the details of FX purchases will depend on the amount of daily FX purchases. In our view, a daily volume of $50mn (as was noted by unnamed government officials on Bloomberg today) would not have a major negative implication for the rouble in 1Q due to the expected favorable balance of payments dynamics during that period.

? In the longer run, during the course of this year, we expect the rouble to converge towards our annual average forecast of 62.5 against the dollar.

? We also expect the intervention mechanism to reduce the rouble’s volatility, which would make it even more attractive as a carry trade, in our view.

 ? The decision on interventions will be either neutral or marginally more favorable for the monetary policy, in our view. We are not changing our expectation for a policy rate cut by the CBR at the second meeting of 2017, on 24 March.

Russian USDRUN Intervention Mechanism, FX Purchases explained by CS

? In our view, it makes sense to resume regular FX purchases due to (1) the strengthening of the rouble in REER terms, (2) the decision of the government to save windfall oil and gas revenues, and (3) higher oil prices.

? We expect the mechanism of regular FX purchases in 2017 to replicate the fiscal rule (which will be approved by parliament in 2018), with the parameters of the FX purchase mechanism being reset on a monthly basis.

 ? The CBR is likely to be in charge of regular FX purchases in 2017, while the Finance Ministry is likely to take over in 2018-2019, if the Brent oil price stays above $50/bbl.

 The rouble’s response to the announcement of the details of FX purchases will depend on the amount of daily FX purchases. In our view, a daily volume of $50mn (as was noted by unnamed government officials on Bloomberg today) would not have a major negative implication for the rouble in 1Q due to the expected favorable balance of payments dynamics during that period.

? In the longer run, during the course of this year, we expect the rouble to converge towards our annual average forecast of 62.5 against the dollar.

? We also expect the intervention mechanism to reduce the rouble’s volatility, which would make it even more attractive as a carry trade, in our view.

 ? The decision on interventions will be either neutral or marginally more favorable for the monetary policy, in our view. We are not changing our expectation for a policy rate cut by the CBR at the second meeting of 2017, on 24 March.

Russian Oil Revenues, Budget Outlook and USDRUB levels

Inflation in the week to 16 January slowed to 0.1% wow, from 0.3% wow in the first nine days of January. On our estimates, headline inflation was 5.3% yoy as of 16 January, down from 5.4% yoy in the previous week. We expect headline inflation to drop to 5.1%-5.2% yoy in January. In its meeting last Monday (16 January), the government decided not to spend windfall oil and gas revenues. According to Finance Minister Siluanov (who revealed this news yesterday), the government made a decision to save extra oil and gas revenues from higher oil prices, instead of spending it. According to the government estimates, the government will receive additional RUB 1tn (1.1% of GDP) with the average Urals oil price at $50/bbl, or RUB 1.4tn (1.6% of GDP) with the average Urals oil price at $55/bbl. (In the federal budget law, the government assumes average Urals oil price at $40/bbl in 2017- 2019.)

The decision to save windfall oil and gas prices is favorable for the prospects of the policy rate cut by the central bank (CBR) and for sovereign credit (as Russia would not use its declining fiscal reserves for financing the deficit). Although the government is unlikely to reduce net OFZ issuance in the local market (according to the law the government will increase net issuance to 1.2% of GDP in 2017 from 0.5% of GDP in 2016), the CBR’s more accommodative policy will support demand for OFZ from local investors. In our view, the decision should be taken positively by fixed income investors. Another near-term implication of this news is that the market should price in a policy rate cut as early as in the next rate-setting meeting (on 3 February).

We are not saying that the CBR will cut the policy rate at that meeting but the likelihood of such an outcome has increased to around 25%, in our view. We are still expecting the first policy rate cut in the second meeting of 2017 (on 24 March). The CBR may consider regular FX purchases for the replenishment of Russia’s FX reserves, if the scenario with higher oil prices materializes. Such FX policy will be coordinated with the Finance Ministry, in the absence of a fiscal rule. Although this news (revealed yesterday) is in line with our expectations, it does not provide us with any new information about the conditions under which the CBR will resume regular FX purchases. However, we reiterate our view on that issue.

We expect the CBR to resume FX interventions (to buy FX) in 1Q 2017, as it did in 2015, when the rouble strengthened beyond 50 against the dollar. Our view is based on the idea that, in real effective exchange rate terms, the rouble is trading as strong as in 2015. In 2015, the CBR held volume-based intervention in the amount of $200mn a day (for more than two months) and purchased roughly $10bn in the local FX market. In our view, both, the CBR and the government are quite sensitive to potential further strengthening of the rouble (especially in real effective exchange rate terms). In our view, the CBR will be reluctant to allow the rouble to strengthen beyond 57-58 against the dollar.

Russia Outlook and Central Bank

The main event this week is the central bank’s rate-setting meeting on Friday (16 December). We expect the central bank (CBR) to leave the policy rate unchanged, in line with the CBR’s previous commitment to refrain from policy easing until 1Q-2Q 2017. In our view, the meeting will be crucial in terms of the signal it might provide for the prospects of policy easing in 2017, in the aftermath of the OPEC’s 30 November agreement to cut oil output. Furthermore, the outlook on oil prices will shape the CBR’s forecast revisions that are due to be published the same day in the Quarterly Monetary Policy Report. We believe the CBR will be more optimistic on the pace of recovery in economic activity, as well as more comfortable on the attainability of its 4% inflation target in 2017. We think the CBR will also make a hint this Friday with regards to a possible policy rate cut in the first meeting of 2017 (3 February).

Also this week, the focus will be on the following economic data releases:

 ? Tomorrow, Rosstat will publish the second estimate of 3Q real GDP data and its supply-side breakdown. According to the preliminary estimate, the pace of contraction in real GDP fell to 0.4% yoy in 3Q from 0.6% yoy in 2Q. We expect Rosstat to confirm the preliminary estimate.

? At some point this week, the Finance Ministry will publish the federal budget execution data for November. On a 12-month rolling basis, we expect the federal budget deficit to widen in November from 3.6% of GDP in October.

? On Thursday (15 December), Rosstat will publish the November industrial output data. We expect industrial production to have picked up in seasonally adjusted terms in November, in line with the strong manufacturing PMI data since July 2016.

Rosneft Sale, Oil Price and Ruble

The government managed to sell its 19.5% stake in oil company Rosneft for EUR10.5bn ($11.3bn). The stake was sold to the consortium of Glencore Plc and Qatar Investment. Both will have 50% share in the stake. In a meeting with Rosneft’s CEO, President Putin urged Rosneft to develop a joint plan with the central bank (CBR) and the government for a smooth conversion of FDI inflows into rouble. We are not aware of the details of this scheme, but given the context of Putin’s comments the implications of this deal on the market should be neutral for the rouble. Having said that, we think this deal should be positive for the sentiment in the local market, as the market did not expect foreign investors to be involved in this privatization. Following this news (late in the evening local time), the rouble strengthened by almost 1.0% against the dollar. Inflation expectations improved only marginally in November. According to the central bank survey, year-ahead inflation expectations (based on normal and uniform distribution) fell to 5.6% and 5.5% in November, from 5.8% and 5.7%, respectively, in October. According to the CBR’s statement, inflation expectations remain elevated relative to the CBR’s 4% inflation target. In the CBR’s view, elevated inflation expectations justify a relatively tight monetary policy stance. Inflation in the week to 5 December was 0.1% wow, on par with the previous week. On our estimates, headline inflation was down to 5.7% yoy as of 5 December. We expect headline inflation to reach 5.6% yoy by the end of this year, which is consistent with the CBR’s forecast. According to Finance Minister Siluanov, the government may spend the windfall oil revenues in 2017. In our view, this is a very likely scenario if the average Urals oil price stabilizes above $40/bbl in 2017 (the base assumption for the federal budget law in 2017- 2019). The increase in spending will be supported by the proximity of presidential elections in early 2018 and an almost two-year-long recession. The news is negative for the prospects of a decline in nominal interest rates, in our view.

Emerging Markets, MXN, RBI Suprise, Drop in Chinese Reserves

EM currencies could continue to stabilise over the next week ahead of the FOMC meeting, and MXN could bea beneficiary. The latest round of oil block auctions went well, with 80% of deepwater blocks successfully auctioned. USD/MXN could head down to 20. RBI’s surprise hold decision, looking beyond the transitory impact from the currency replacement scheme, shows that INR macro stability remains the focus in India. EUR/PLN is near multi-year highs and we believe PLN is cheap. Our economists expect some dovish commentary from the NBP today, which could provide a better entry point for long PLN. While valuations have played a big rolein the reported drop in China’s FX reserves, capital outflows are continuing and we expect to see more CNY weakness. The USD could stabilise in the near term ahead of next week’s FOMC decision. Long USD positions have been popular and as we approach yearend investors could be more inclined to reduce risk and lock in gains. While a rate hike from the FOMC is fully priced in. In such an environment, EM will likely do well.

Several EM currencies look cheap, including TRY and MXN. However, as we highlighted yesterday, we are not looking to participate in any TRY rebound. MXN, meanwhile, could have a short-term bounce. MXN outperformed yesterday, and we believe in the current environment of a USD moderation, this could continue. Adding further support to MXN are the latest round of oil auctions, which were quite strong, with an 80% success rate in the first set of deep water auctions. This is not to say we are sanguine about the risks that a protectionist US stance poses for MXN, and the potential for spillover to Mexico’s own domestic monetary political picture. The oil auction, while successful, is unlikely to change these risks – it simply removes a potential risk for the currency, rather than adding a strength. However, given valuation, the potential for a USD pause, and the strength of yesterday’s oil auctions, we do believe that the currency could keep stability, and even strengthen a bit more into year end.20 will be a key level for the currency, as it hasn’t traded below here since the elections. For now, we prefer to position in 2s/10s TIIE steepeners in Mexico.

The RBI surprised markets today by keeping rates on hold, against consensus expectations for a 25bp cut, as the committee awaits more clarity on the impact from the government’s currency replacement on growth and inflation. With base effects falling out of inflation starting in December and going into the expected Fed hike in December, the RBI observed caution in maintaining the real rate at 1.25% given its projected inflation rate of 5% by March 2017. 10y IGBs have sold off by ~16-18bps following the policy announcement. With future easing expectations getting priced out and system liquidity also expected to neutralize over the coming weeks we would expect a further correction in bonds. However, the RBI credibly keeping to its real rate framework and maintaining adequate buffer in preparation for the steepening global yield curves implies that macrostability remains a priority over growth. If the growth impact from currency replacement are indeed transient,as our economists expect, we believe a recovery in growth and equity markets would be supportive of the INR.

The slightly larger than expected drop in China’s FX reserves was the biggest monthly decline since Jan 2016, but will to a large extent reflect changes in exchange rate and bond valuations, since the USD rose by about 3.5% versus the majors and US bond yields rose notably. Nonetheless, China continues to experience capital outflows and some FX intervention has occurred, as noted by SAFE. The authorities responded to outflows by imposing new restrictions at the end of November, but we expect continued medium-term depreciation in the CNY. China’s November trade data will be released on December 8,and our economists are more or less in line with consensus with their expectations of – 4.7% and -2.0% export growth, respectively. Trade data from Asia for November has so far been upbeat, with both South Korea and Taiwan posting better than expected export numbers. While positive, we believe that the expected medium term slowdown in China combined with uncertainty over the future of global trade ,as well as domestic constraints on growth, will lead to currency weakness for both KRW and TWD over the medium term.


Russia Outlook – Update

CPI inflation surprised the market to the downside in November. According to Rosstat, CPI inflation fell to 5.8% yoy in November from 6.1% yoy in October. The outcome was in line with our expectation but marginally lower than the Bloomberg consensus forecast (5.9% yoy). Food price inflation was 5.2% yoy in November, down from 5.7% yoy in October. Durable goods inflation slowed to 6.7% yoy from 7.0% yoy in October, while services price inflation fell to 5.3% yoy from 5.4% yoy in October.

Official core inflation (net of fruit and vegetables, but including most other food items) dropped to 6.2% yoy from 6.4% yoy. Our definition of core inflation (net of all food and energy products) also dropped, to 4.9% yoy from 5.3% yoy in October. The runrate of core inflation (on our definition) was 4.3% in November, down from 4.7% in October and the lowest in almost three years. We project headline inflation to drop to 5.6% yoy in December.

Russian Central Bank keeps interest rate unchanged, likely to slash rates early next year
Russian central bank kept its key interest rate on hold at the monetary policy meeting held Friday, but said it might cut rates in the first or second quarter of next year.

Russia’s central bank decided to hold its key interest rate unchanged at 10.00 percent, the bank said in a statement on its website on Friday.

“The Bank of Russia will assess inflation risks and compliance of economic performance and inflation with the baseline scenario when it makes its key rate decision in the upcoming months,” Reuters reported, citing the statement of the Bank of Russia.

With moderately tight monetary policy, the bank forecasts that annual growth in consumer prices will be less than 4.5 percent in October 2017, dropping to its target of 4 percent by the end of that year.

But the bank warned there was still a risk that its target might not be met because of domestic inflation expectations, a possible weakening in household saving, and higher real wages not supported by any rise in labour productivity, Reuters reported.

Meanwhile, the next rate setting meeting will be accompanied by a news conference with Elvira Nabiullina, the central bank governor, and is scheduled for Dec 16.


Cross Currency Basis Swap Levels in Developed and Emerging Markets


Selected Developed Markets

• Negative basis circumstances remain in place versus USD for most key developed market currencies.

• The most extreme versions are in JPY, CHF and DKK followed by EUR. SEK basis circumstances are less extreme and close to zero for long tenors.

• CAD pushes into positive territory for longer tenors, while AUD is the outlier with positive basis circumstances right along the curve.

• Large negative basis currencies can be played by overlaying issuance in USD or bond holdings in the FX in question (with CCS), while for AUD, long CAD and long SEK the opposite holds.

Selected Emerging Markets

• Negative basis circumstances remain thematic in Emerging markets space, with the most extreme version of this to be found on the front end of the CZK curve.

• The back end of the RUB curve has seen basis widening too (deeper negative), while long end MXN has seen some tightening (lower negative).

• TRY basis circumstances remain wide and negative. And negative basis circumstances obtain for the likes of PLN, HUF and KRW too. The outlier remains ZAR, which continues to show positive basis circumstances.

• Negative basis circumstances imply a premium being attached to USD, and so makes local currency issuance swapped into USD through CCS relatively expensive (to varying degrees).


Russia Sovereign Credit


Russian sovereign credit lagged the rally in oil prices. Russian sovereign credit spreads have “underperformed” the rally in oil prices since late September. In stark contrast to US energy corporates and a few other EM oil credits, Russia’s sovereign credit was almost unchanged since late September (Figure 1). To illustrate how oil prices had little impact on Russia credit we note that on our calculations, the 60-day rolling correlation between Russian Eurobonds spreads and oil prices rose to -20% currently from around – 50% in mid-September.

We suspect that local selling of sovereign bonds was one of the reasons behind recent underperformance. Our understanding is that the recent purchase of state-owned energy company Bashneft by state-own energy company Rosneft could have led to a temporary spike in demand for dollars by local investors. As a result, it could have been that some local investors were looking to sell their Eurobonds holdings. The sharp decline in the rouble’s xccy basis (to -180bp currently at the 5y point from -140bp in endSeptember) could also signal that demand for US dollars funding could have increased recently. Renewed concerns about tighter sanctions from the EU were also probably another reason behind the negative sentiment to this asset class.

There are still near-term headwinds, but a catch-up with oil prices is likely. First, the tension with the West around Syria is likely to remain at least until the US elections (8 November). Specifically, the temporary ceasefire in Syria ended over the weekend and could bring more tension between Russia and the West. Second, we cannot rule out further technical weakness given Rosneft’s part in the purchase of Indian energy company Essar Oil which may also result some local selling pressures. However, based on its historical price action, we expect Russian credit to catch-up with oil prices over time.

On a relative basis, we think that Russian sovereigns start to look attractive against Qatar or Kazakhstan. The z-spread differential between Russia 26s and Qatar 26s rose by 20bp since mid-October to around 93bp currently. In addition, we suspect that Qatar could see some selling pressure as some holders potentially switch to the new issuance of Saudi Arabia (see more details on this issuance in the next page). Meanwhile, the zspread differential between Kazakhstan 25s and Russia 26s fell substantially to -38bp currently from close to flat at the time of Russia 26s issuance.



Central Bank of Russia This Week and the RUB


This week the main event is the central bank’s (CBR) rate-setting meeting on Friday (28 October). We do not expect the CBR to cut the policy rate this year, in line with the CBR’s previous statement, in which it ruled out further policy easing until 1Q-2Q 2017. Although the CBR has ruled out any policy action in 2016, it does not mean the meeting will not be watched closely by investors. In our view, in its statement, the CBR has to find the right balance between the impact of higher oil prices, recent recovery in consumer demand indicators (especially against weak supply-side data) and the recent fiscal policy discussions (that eventually may not be as favorable for the CBR’s 4% inflation target). We believe the CBR is going to play down the sustainability of the recent recovery in oil prices while focusing more on the latter two factors (real sector data and fiscal policy discussions) as a significant risk to its 4% inflation target in 2017. In our view, the impact of the actual inflation data on the CBR’s stance should be either neutral or negative, mainly because there was no favorable pass-through to inflation from the stronger rouble. Overall, we think that the CBR’s statement will be more hawkish than the previous one.


Ruble, Ruble Swap Curve and Bonds


RUB: back in the black. Trading activity slowed down yesterday, with the MICEX reporting only USD 2.6bn in USDRUB turnover. In the first half of the day, USDRUB traded in a range of 62.80-62.90, yet it touched 63.0 as the US opened. However, judging by the relatively low turnover, international profit taking had subsided yesterday. Meanwhile, general risk sentiment bounced, with the S&P500 index closing up 0.67% last night. Meanwhile, the EM FX space firmed 0.6-0.8%, with ZAR and MXN trading 1.8% and 1.4% up, respectively. On top of that, Brent bounced to USD 52/bbl (+0.9%) on the back of the API report that US crude oil inventories had declined (in contrast to expectations). In light of this, RUB gained 0.9% vs. USD and closed at 62.54. Chinese GDP increased 6.7% YoY in 3Q16, in line with expectations and within the government’s target range for this year of 6.5-7.0%. However, there has been little reaction from the Asian equity markets this morning so far. Today’s agenda includes the publication of the Fed’s Beige Book, which is expected to confirm steady economic activity and keep open the prospect of a December rate hike. There is also the final US Presidential TV debate, though the polls give Hillary Clinton a significant lead.

Money market: rates ease. Yesterday, the overnight FX swap closed down almost 2.0pp at 8.6%, while the weighted average rate declined 24bp to 9.75%. The liquidity situation is perhaps gradually improving on the back of inflows from the budget. Meanwhile, banks secured only RUB 94bn from the CBR in the overnight repo facility (-RUB 31bn vs. Monday). NDF rates closed nearly flat yesterday, as international profit-taking on the FX market slowed down. Hence, the 3M NDF is at 9.67%, while 9M is at 9.44%.

Local sovereign debt: no bounce so far. The market opened on a stronger footing, driven by some international bid. In particular, the belly was in demand and traded 5bp tighter by the middle of the day. We also noted that local accounts were on the bid side as well. However, with the openning of the US session, the offer strengthened. Subsequently, all the initial gains were pared and the curve ended the day nearly flat. Overall, the curve has moved up around 30bp in the belly and 35-40bp in the long end in October. We think that ongoing profit-taking from international accounts is tactical (and thus temporary). At current levels, we think that the belly, trading at 8.6-8.7%, is starting to look attractive to buy. On the other hand, technically international long positioning in OFZs had been building fast this year, so it would take more than just a few days to rebalance.