Three Market Hurdles This Week -- And What They Mean for the Fed

The markets face three important hurdles this week: many corporate earnings, initial report on Q317 US Real GDP, and an ECB announcement regarding the start of tapering its asset purchase program.  The stock market rally is likely to be sustained through these events, as corporate earnings so far have proved to be better than expected, Q317 GDP is likely to be above trend, and the ECB announcement arguably risks being benign.  The Treasury market should continue to face downward pressure from the first two events, but not necessarily from the third.

These events, as well as a favorable response by the stock market, may very well persuade the Fed to keep a December rate hike in play when the FOMC meets October 31-November 1 -- even as inflation remains low.  This realization could give pause to the stock market rally after the meeting.

Corporate Earnings
Many large corporations report this week, including McDonald's, GM, Ford, Microsoft and Google.  S&P 500 earnings appear to be up about 5% so far, above the 4.4% consensus estimate.  The above-consensus strength seen to date is consistent with the favorable macroeconomic background for corporate profits (see my blog of September 24).

Q317 Real GDP -- due Friday
Consensus expects 2.6% (q/q, saar) Real GDP Growth in Q317, close to the Atlanta Fed model's projection of 2.7% and above the NY Fed model's 1.5% projection.   Consensus and the Atlanta Fed are below the 3.1% Q217 pace but above the 2.3% H117 average and the 1.5% estimated longer-run trend.  The strength is especially noteworthy inasmuch as the hurricanes are estimated to have shaved up to 1.0% pt from Q317 Real GDP Growth.

The above-trend pace is likely to continue in Q417, boosted by post-hurricane rebuilding as well as favorable fundamentals.   The NY Fed model's early projection is 2.6%.  Much of the pickup in GDP Growth this year is attributable to strength in exports (reflecting better growth abroad), a rebound in oil production (thanks to higher oil prices), and a speedup in non-oil related business fixed investment (helped by a Trump-related boost in business sentiment?).  All three are likely to continue into Q417.  The next evidence on business fixed investment will be this week's report on September Durable Goods Orders.

ECB Announcement -- due Thursday
The ECB is expected to announce that it will start tapering but extend the time-frame of its asset purchases in January.   The markets are focused on the size of the reduction in monthly purchases and the length of time the program will be extended.  According to a Reuters survey, as reported by CNBC, consensus among economists is for a reduction in the monthly purchases to 40 Bn euros from the current 60 Bn pace.  The consensus is divided between expecting a 6-month or a 9-month extension.  A market neutral announcement would be a reduction to 20 Bn euros for 12 months, to 30 Bn for 9 months or to 40 Bn for 6 months, according to Citi economists.  My guess is that the risk is for a more market friendly announcement, since the ECB probably prefers not to boost the Euro further, inflation remains low, and time is on their side.

The Fed
A dovish ECB -- with positive implications for European economic growth -- would provide more reason for Fed officials to believe a rate hike is warranted.  Indeed, the US economy's strength is likely to continue to be evident in the following week, with the October Mfg ISM remaining strong and Payrolls rebounding sharply from the hurricanes. 

Fed officials continue to downplay current low inflation in the latest speeches:

Yellen: "the economy [is]now operating near maximum employment and inflation [is] expected to rise to the FOMC's 2 percent objective over the next couple of years."

Dudley:  "Slightly above-trend growth is gradually tightening the U.S. labor market, which should support a rise in wage growth over time.  When combined with a firmer import price trend—partly reflecting recent depreciation of the dollar—and the fading of effects from a number of temporary, idiosyncratic factors, I expect inflation will rise and stabilize around the FOMC’s 2 percent objective over the medium term."
  
And, they see the need to continue gradual tightening, particularly in light of easier financial market conditions:

Dudley: "even though inflation is currently somewhat below our longer-run objective, I judge that it is still appropriate to continue to remove monetary policy accommodation gradually.  This judgment is supported by the fact that financial conditions have eased, rather than tightened, even as the FOMC has raised its short-term interest rate target range by 75 basis points since last December." 

Note that Dudley's emphasis on the easing of financial market conditions suggests that a favorable stock market response to this coming week's events will reinforce a somewhat bearish decision at the following week's FOMC meeting.   While he views the easing of financial market conditions in the face of Fed tightening as a conundrum, the easier financial conditions can be explained by my "optimal control" approach to understanding market reactions to the Fed (see my blog of September 20).    This approach implies that financial market conditions will tighten when the Fed signals that economic growth is too strong -- which, so far, Fed officials have not.