US Labor Market Report, Italian Referandum, ECB QE Exit Speculation

Ahead of the October US labour market report we find a short positioned bond market as the US 10y yield is around 5bp away from crossing the June high. The bond put option premium has risen to levels suggesting a short term asymmetric profile. A strong labour market report may not take bond yields and thus the USD much higher, while a weak report could lead to a pronounced setback. However, we think FX investors should differentiate between the trend and the correction. The USD is within a secular uptrend driven by relative return differentials which themselves find their foundation in a global output gap differential. Hence any USD setback should be regarded as welcome to add to USD longs. This applies especially for our main call suggesting a medium term USDJPY target of 130 or higher. Mondays 111.35 USDJPY low should now limit the downside.

After the strong ADP release on Wednesday , risks to the upside with non-farm payrolls today. US data continues to come in on the strong side with yesterday’s ISM hitting a 21-month high of 53.2from an improving orders outlook (53.0) and production (56.0) and strong October construction spending pushing up our Q4 GDP tracker to 1.6% after 1.5%. We would need a very large miss on today’s payrolls figure to lead markets to price out the December Fed hike or even much of the 39bps of hikes priced for 2017.

Our more constructive GBP outlook is paying early dividends as the UK government appears to takes a more realistic position in respect of maintaining access to the common market. Yesterday, Brexit Minister Davis suggested the UK would consider paying for EMU market access. Even if his comments were not a new line from the conservative party (May’s speech at the party conference said an end to contributions was not a red line), the FX markets were more optimistic after a similar line came from EU side. Dutch Finance Minister Dijsselbloem, who is also president of the Eurogroup, suggested that the EU could design a way for the UK to enter the internal market but it would not be as easy or cheap as it is now. GBP longs towards 1.30 offer a good opportunity to weather any short term USD setback.

Italian Referendum. As investors prepare for an interesting week ahead for Eurozone related events, we have put together a few of our thoughts on the potential outcomes.First, the Italian referendum is taking place on Sunday, where polls will close at 10pm GMT. Exit polls are expected and a partial count of the votes. We should have a reliable idea in the early hours of Monday morning (around 3am GMT). We think that FX markets are not too complacent about the referendum. Italy’s complicated politics mean a “No”vote (as expected) doesn’tnecessarily follow through to the 5-star movement coming into power or Italy getting closer to an EU referendum. We expect moderate EUR weakness on a “No”vote but don’t like trading EUR short at these levels.

A Reuters article published yesterday suggesting the ECB is preparing to exit is QE programme should be taken with a pinch of salt. Firstly, the ECB was likely discussing how they may communicate to markets when they plan to exit in order to keep volatility down, with no indication of timing. Secondly, the ECB discussing logistics may be part of a strategy to keep the hawks on the ECB happy, suggesting that QE purchases are not going to last “forever”. Some may also argue that the ECB has very little choice than keeping BTP volatility controlled. Italian banks holding 18 percent of their assets in BTPs are a convincing reason to keep the ECB involved in controlling inner EMU bond spreads. Next weeks’ ECB meeting is likely to be filled with many technical discussions and measures. In this piece we go through the likely EUR impact for each measure in isolation.