Watching With Rigor

Though Draghi said data of late
May not have appeared all that great
We’re watching with rigor
Inflation that’s vigor-
Ously rising at a high rate

After a multi week decline, the dollar is showing further signs of stabilizing this morning. And that includes its response to yesterday’s surprising comments by ECB President Mario Draghi, who indicated that despite the ECB lowering its forecasts for growth this year and next, and that despite the fact that recent data has been falling short of expectations, he still described the underlying inflation impulse as “relatively vigorous” and reconfirmed that QE would be ending in December with rates rising next year. In fact, several of his top lieutenants, including Peter Praet and Ewald Nowotny, indicated that rates ought to rise even sooner than that. Draghi, however, has remained consistent in his views that gradual removal of the current policy accommodation is the best way forward. But as soon as the words “relatively vigorous” hit the tape, the euro jumped more than 0.5% and touched an intraday high of 1.1815, its richest point since June. The thing is, that since that time yesterday morning, it has been a one-way trip lower, with the euro ultimately rising only slightly yesterday and actually drifting lower this morning.

But away from the excitement there, the dollar has continued to consolidate Friday’s gains, and is actually edging higher on a broad basis. It should be no surprise that the pound remains beholden to the Brexit story, and in truth I am surprised it is not lower this morning after news that the Labour party would definitively not support a Brexit deal based on the current discussions. This means that PM May will need to convince everyone in her tenuous majority coalition to vote her way, assuming they actually get a deal agreed. And while one should never underestimate the ability of politicians to paint nothing as something, it does seem as though the UK is going to be leaving the EU with no exit deal in place. While the pound is only down 0.15% this morning, I continue to see a very real probability of a much sharper decline over the next few months as it becomes increasingly clear that no deal will appear.

There was one big winner overnight, though, the Korean won, which rallied 4.2% on two bits of news. Arguably the biggest positive was the word that the US and Korea had agreed a new trade deal, the first of the Trump era, which was widely hailed by both sides. But let us not forget the news that there would be a second round of talks between President Trump and Kim Jong-Un to further the denuclearization discussion. This news is also a significant positive for the won.

The trade situation remains fascinating in that while Mr Trump continues to lambaste the Chinese regarding trade, he is aggressively pursuing deals elsewhere. In fact, it seems that one of the reasons yesterday’s imposition of the newest round of tariffs on Chinese goods had so little market impact is that there is no indication that the president is seeking isolationism, but rather simply new terms of trade. For all the bluster that is included in the process, he does have a very real success to hang his hat on now that South Korea is on board. Signing a new NAFTA deal might just cause a re-evaluation of his tactics in a more positive light. We shall see. But in the end, the China situation does not appear any closer to resolution, and that will almost certainly outweigh all the other deals, especially if the final threatened round of $267 billion of goods sees tariffs. The punditry has come around to the view that this is all election posturing and that there will be active negotiations after the mid-term elections are concluded in November. Personally, I am not so sanguine about the process and see a real chance that the trade war situation will extend much longer.

If the tariffs remain in place for an extended period of time, look for inflation prints to start to pick up much faster and for the Fed to start to lean more hawkishly than they have been to date. The one thing that is clear about tariffs is that they are inflationary. With the FOMC starting their meeting this morning, all eyes will be on the statement tomorrow afternoon, and then, of course, all will be tuned in to Chairman Powell’s press conference. At this point, there seems to be a large market contingent (although not a majority) that is looking for a more dovish slant in the statement. Powell must be happy that the dollar has given back some of its recent gains, and will want to see that continue. But in the end, there is not yet any evidence that the Fed is going to slow down the tightening process. In fact, the recent rebound in oil prices will only serve to put further upward pressure on inflation, and most likely keep the doves cooped up.

With that in mind, the two data points to be released today are unlikely to have much market impact with Case-Shiller Home Prices (exp 6.2%) at 9:00am and Consumer Confidence (132.0) due at 10:00. So barring any new comments from other central bankers, I expect the dollar to remain range bound ahead of tomorrow’s FOMC action.

Good luck
Adf

 

Just How He Feels

On Wednesday the Chairman reveals
To all of us, just how he feels
If dovish expect
Bulls to genuflect
If hawkish, prepare for some squeals

This is an early note as I will be in transit during my normal time tomorrow.

On Friday, the dollar continued its early morning rebound and was generally firmer all day long. The worst performer was the British pound, which fell more than 1.0% after Friday’s note was sent. It seems that the Brexit story is seen as increasingly tendentious, and much of the optimism that we had seen develop during the past three weeks has dissipated. While the pound remains above its lowest levels from earlier in the month, it certainly appears that those levels, and lower ones, are within reach if there is not some new, positive news on the topic. This appears to be an enormous game of chicken, and at this point, it is not clear who is going to blink first. But every indication is that the pound’s value will remain closely tied to the perceptions of movement on a daily basis. Hedgers need to be vigilant in maintaining appropriate hedge levels as one cannot rule out a significant move in either direction depending on the next piece of news.

But away from the pound, the story was much more about lightening positions ahead of the weekend, and arguably ahead of this week’s FOMC meeting. The pattern from earlier in the week; a weaker dollar along with higher equity prices around the world and higher government bond yields, was reversed in a modest way. US equity markets closed slightly softer, the dollar, net, edged higher, and 10-year Treasury yields fell 2bps.

The big question remains was the dollar’s recent weakness simply a small correction that led to the other market moves, or are we at the beginning of a new, more significant trend of dollar weakness? And there is no easy answer to that one.

Looking ahead to this week shows the following data will be released:

Tuesday Case-Shiller House Prices 6.2%
  Consumer Confidence 312.2
Wednesday New Home Sales 630K
  FOMC Decision 2.25%
Thursday Initial Claims 208K
  Goods Trade Balance -$70.6B
  Q2 GDP 4.2%
Friday PCE 0.2% (2.3% Y/Y)
  Core PCE 0.1% (2.0% Y/Y)
  Personal Income 0.4%
  Personal Spending 0.3%
  Chicago PMI 62.5
  Michigan Sentiment 100.8

So clearly, the FOMC is the big issue. It is universally expected that they will raise the Fed funds rate by 25bps to 2.25%. The real question will be with the dot plot, and the analysis as to whether the sentiment in the room is getting even more hawkish, or if the CPI data from two weeks ago was enough to take some of the edge off their collective thinking, and perhaps even change the median expectations of the path of rate hikes. I can virtually guarantee you that if the dot plot shows a lower median, even if it is because of a change by just one FOMC member, equity markets will explode higher around the world, the dollar will fall and government bond yields will rise. However, my own view is that the data since we have last heard from any Fed speaker has not been nearly soft enough to consider changing one’s view. Instead, I expect a neutral to hawkish statement, and a little pressure on equities.

But the big picture narrative does seem to be starting to change, and so any dollar benefit is likely to be short lived. Be ready to hear a great deal more about the structural deficits and how that will force the dollar lower. One last thing, tariffs on $200 billion of Chinese imports go into effect on Monday, which will only serve to add upward pressure to inflation data, and ultimately keep the FOMC quite vigilant. I remain committed to the idea that the cyclical factors will regain their preeminence, but it just may take a few weeks or months for that to be apparent. In the meantime, look for the dollar to slowly slide lower.

Good luck
Adf

A Terrible Day

The UK’s Prime Minister May
Last night had a terrible day
Her plans for a deal
Were seen as unreal
As hawks in the EU held sway

But elsewhere the market’s embraced
The concept that fear was misplaced
Instead, stocks they’re buying
And so, fortifying
The idea, for risk, they have taste

Arguably, the key headline this morning was the extremely poor reception British PM May received from her 27 dinner companions at the EU dinner last night. She continues to proffer the so-called Chequers deal (named for the PM’s summer residence where the deal was agreed amongst Tory members several weeks ago), which essentially says the UK will toe the EU line when it comes to manufactured and agricultural goods, but wants a free hand in services and immigration. French President Macron was quick to dismiss the notion as he remains adamant that leaving the EU should be seen as a disaster, lest any other nations (Italy are you watching?) consider the idea. At any rate, while the pound had been rallying for the past week, reaching its highest level since early July, that all came a cropper last night. The growing hope that a Brexit deal would be found has been shattered, at least for now, and it should be no surprise that the pound has suffered for it. This morning, it is leading the way lower, having fallen 0.6% from yesterday’s closing levels.

However, while the dollar is modestly firmer this morning across the board, my strong dollar thesis is being severely tested of late. We have seen the dollar fall broadly all week despite the resumption of the march higher in US yields. Or is it because of that movement that the dollar is falling? Let’s consider the alternatives.

Several months ago I wrote about the conflicting cyclical and structural aspects of the market that were impacting the dollar’s value. The cyclical factors were US growth outpacing the rest of the world and the Fed tightening monetary policy faster than any other central bank. This combination led to higher US rates and a better investment environment in the US than elsewhere, and consequently, an increase in dollar buying for global investors to take advantage of the opportunities. Thus higher short-term interest rates led to a higher US dollar, along with a flatter yield curve.

On the other hand, the structural questions that hang over the US economy consist of the impact of late cycle fiscal stimulus in the form of both tax cuts and increased spending. The fact that this was occurring at the same time the Fed was reducing the size of its balance sheet meant that at some point, it seemed likely that increased Treasury supply would find decreased demand. The growing budget and current account deficits would in turn pressure the dollar lower while the excess Treasury supply would push long-term yields higher ending up with a weaker dollar and a steeper yield curve.

Starting in April, it became clear that the cyclical story was the primary market driver, with strong US growth pushing up short-term rates as well as US corporate earnings. Investors flocked to the US to take advantage with the dollar rallying sharply while US equity markets significantly outperformed their foreign counterparts. This was especially notable in the EMG space, where a decade of QE had forced funds to the highest yielding assets they could find, which happened to be those EMG markets. But now that there was an alternative, those funds were quick to return to the US, driving EMG equity markets lower and hammering those currencies as well. There was also a great deal of concern that if the divergence in markets continued, it could result in much more significant losses elsewhere that would eventually come back to haunt US markets.

But a funny thing happened last week, US CPI printed lower than expected. Now you might not think that a 0.1% miss on a number would be that important, but essentially what that signaled to markets was that the Fed would be more likely to ease back on the pace of tightening, thereby slowing the rise in the short-term interest rate structure. It also indicated that US growth may not be as robust as had been previously thought, and therefore, opportunities here, while still excellent, needed to be weighed against what was going on elsewhere in the world. At the same time, elsewhere in the world we have seen continued central bank rhetoric about removing policy accommodation, with ECB President Draghi’s press conference seen as mildly hawkish, while the BOJ seems to be in stealth taper mode. We have also seen the trade situation get pushed to the back of the collective market’s mind as the US imposed a lower tariff rate than expected on Chinese goods, and has not yet moved forward on any other tariffs.

But wait, there’s more!, after four months of selling off, EMG assets have suddenly started to look like they represent a ‘value’ play, with the first buyers tentatively dipping their toes back into those markets. And finally, remember that the speculative long dollar position has been building for months and reaching near record levels. Adding it all up leads to the following conclusion: there is room for the dollar to continue this decline in the medium term. Continued fund movement into EMG markets combined with the reduction of the long dollar positions will be more than sufficient to continue to drive the dollar lower.

That combination is what has taken place this week, and despite the break today, it seems quite viable that we will continue to see this pattern for a bit longer. In the end, I don’t think that the market will completely ignore the cyclical dollar prospects, but for now, the broad structural story is holding sway. Add to this the idea that market technicians are going to get excited about selling dollars because it has reached levels below the 50-day and 100-day moving averages, and thus is ‘breaking out lower’, and we could be in for a couple of months of dollar weakness. If this is true, while individual currencies could still underperform, like the pound if the Brexit situation collapses, it is entirely possible that Chairman Powell could find himself in the best position he could imagine, continuing to remove policy ease while the dollar falls, thus ameliorating the President’s concerns. But it’s not clear to me that is such a good thing overall. We shall see.

Good luck and good weekend
Adf

Money More Dear

Next week, though it’s certainly clear
The Fed will price money more dear
The dollar’s incurred
Some selling and spurred
More weakness than seen since last year

The dollar remains under pressure this morning with a number of stories having a separate, but a cumulative impact on the buck. For example, overnight we learned that New Zealand’s GDP grew 1.0% in Q2, higher than the expected 0.7% outcome, and sufficient to get investors and traders to consider that the RBNZ, which just last month promised to maintain record low interest rates until at least 2020, may wind up raising rates sooner than that. A surprise of this nature usually leads to currency strength and so it is this morning with NZD higher by 0.8%.

Or consider the UK, where Retail Sales data surprised one and all by rising 0.3% in August (3.3% Y/Y), a much better performance than expected. This was enough to overcome the ongoing Brexit malaise and drive the pound higher by 0.7% and back to its highest level in two months. In truth, this is somewhat surprising given the quite disappointing outcome from the EU meeting Wednesday night in Brussels. Rather than more positive remarks about the viability of a deal being completed, we heard more of the hard-core negativity from the French and Irish, basically saying if the UK doesn’t cave, then there will be no deal. This is certainly not a welcome outcome, especially since there are only 190 days until Brexit will occur, deal or no. Meanwhile, PM May continues to fight a rearguard action against the avid pro-Brexiters in her party in order to retain her position.

Logically, I look at the situation and believe there is no real chance of a satisfactory deal being agreed on time. Frankly, the Irish border issue is intractable in my view. But given that this is entirely about politics, and the Europeans and British are both famous for kicking the can down the road, I suspect that something along the lines of a pure fudge, with neither side agreeing anything, will be achieved in order to prevent a complete disaster. However, there is a very real probability that the UK will simply leave the EU with no deal of any sort, and if that is the case, the initial market reaction will be for a sharp sell-off in the pound.

Interestingly, despite the fact that the little Eurozone data released was on the soft side, the euro has managed to continue its recent rally and is higher by 0.4% as I type. This seems more of a piece with the general dollar weakness that we have witnessed the past two sessions than anything else.

Another potential conundrum is US interest rates, where 10-year Treasury yields jumped to 3.08% yesterday, their highest level since early May, and now gathering momentum for the breakout that many pundits have been expecting for a while. Remember, short Treasury futures are one of the largest positions in the market. This thought process has been led by two concurrent features; the Fed continues to raise short term rates while the Treasury, due to increased fiscal policy stimulus and a growing budget deficit, will be forced to increase the amount of debt issued. When this is wrapped up with the fact that the Fed is reducing the size of its balance sheet, thus removing the one true price-insensitive bid from the market, it seemed a recipe for much higher 10-year yields. The fact that we remain at 3.08% nine months into the year is quite surprising, at least to me. But it is entirely possible that we see a much more aggressive sell-off in Treasuries going forward, especially if the Fed tweaks their message next week to one that is more hawkish.

In this context, let me give a concrete example of just how important the central bank message really is. This morning, Norgesbank raised interest rates in Norway by 25bps, as was universally expected. This was the first time in 7 years they raised rates, and are doing so because the economy there is expanding rapidly while inflation moves closer to their target. But in their policy discussion, they reduced the forecast pace of future interest rate hikes, surprising everyone, and the result was a sharp decline in NOK. Versus the euro it fell more than 1%, which translated into a 0.7% decline vs. the dollar. The point is the market is highly focused on the policy statements as well as the actual moves.

This is equally true, if not more so, with regard to the Fed. Current expectations are that the Fed will raise rates 25bps next week and another 25bps in December. Where things get cloudier is what next year will look like, and how fast they will continue to tighten policy. It is for this reason that next week’s meeting is so widely anticipated, because the Fed will release its updated dot plot, the effective forecasts of each Fed member as to where Fed funds will be at various points in the future. If the dot plot implies higher rates than the last iteration in June, you can expect the dollar to benefit from the outcome. Any implication of a slower pace of rate hikes will certainly undermine the dollar.

In the end, the mixture of new information has been sufficient to push the dollar lower by 0.3% when looking at the broad dollar index. Interestingly, despite its recent weakness, it remains within the trading range that has defined its movement since it stopped appreciating in April. Frankly, I expect this range trading to continue unless the Fed significantly changes its tune.

This morning brings a bit more data with Initial Claims (exp 210K) and Philly Fed (17.0) due at 8:30 while Existing Home Sales (5.35M) are released at 10:00. Yesterday’s housing data was mixed with New Home Sales rising more than expected, but Building Permits plunging. And remember that both of those data points tend to have a great deal of volatility. With that in mind, looking at the longer term trend shows that while Housing Starts seem to be rebounding from a bad spot, the trend in Permits is clearly downward, which doesn’t speak well for the housing market in the medium term.

In the end, as I wrote yesterday, continued modest dollar weakness seems the most likely outcome for now, but I suspect that we are coming to the end of this soft patch, and that the dollar will find its legs soon. I remain confused as to why there is so much bullishness attached to the Eurozone economy given the data continues to underperform. And there is no indication that the ECB is going to suddenly turn truly hawkish. Current levels strike me as attractive for dollar buyers.

Good luck
Adf

 

Rate Hikes to Condone

Today’s UK data has shown
The pace of price rises has grown
Surprising most folks
And likely to coax
Mark Carney, rate hikes to condone

The British pound is outperforming today, currently up 0.35%, as the market responds to a higher than expected inflation reading released this morning. CPI printed at 2.7%, well above the 2.4% consensus view and perhaps signaling that UK inflation, after a summer reprieve, is set to return to its post-Brexit peak of 3.1%. This has traders increasing their estimates of rate activity by the BOE, starting to price in tighter policy despite the ongoing uncertainty created by Brexit. As such, it should not be too surprising that the pound is firmer.

But the pound is by no means alone in its performance characteristics this morning, with the dollar weaker against virtually all comers. In fact, only two of the G10 bloc has suffered today, CHF (-0.45%) and JPY (-0.1%), the two haven currencies. The implication is that risk-taking is back. Certainly equity markets have been holding up their end of that bargain, with US markets strong performance yesterday feeding into strength throughout most of APAC last night led by Shanghai’s 1.1% gains and the Nikkei’s 1.0% rally. European shares, however, have seen a less positive reaction, as they are up at the margin, but only a few basis points, with some markets, notably Italy, actually suffering. (Italy, however, is feeling the effects of the imminent budget deadline with no cogent plan in place and significant differences between the government’s election promises and the fiscal restraint imposed by the EU.) But the other haven asset of note, US Treasuries, has also sold off, with the 10-year yield now trading at 3.05%, its highest level since late May. All told, despite the ongoing trade tensions, it seems that market participants are increasingly comfortable adding to their risk profiles.

More proof of this concept comes from the huge leveraged debt financing completed yesterday by Blackstone Group, where they borrowed $13.5 billion to purchase 55% of a Thompson-Reuters data company called Refinitiv (who comes up with these names?) At any rate, despite ratings of B- by S&P and Caa2 by Moody’s, and a leverage ratio of between 7x and 8x of EBITDA, the deal was massively oversubscribed with yields printing at, for example, 8.25% for 8-year unsecured notes, down from an initial expectation of 9.00%. High leverage, covenant lite debt is all the rage again. What could possibly go wrong?

But I digress. Back in the currency world, the dollar’s weakness has manifested itself in the EMG bloc as well as G10. For example, despite a softer than expected inflation reading from South Africa, where the headline fell to 4.9% while core fell to 4.2%, the rand is firmer by 1.8% this morning. The story here is confusing as some pundits believe that the central bank may be forced to raise rates in order to help protect the rand, which despite today’s rally is still lower by 10% this year. We have seen this type of behavior from Russia, India and Indonesia, three nations where domestic concerns have been outweighed by their currency’s weakness. However, there is a large contingent that believe the SARB will stay on the sidelines as they seek to encourage growth ahead of the presidential elections scheduled for the middle of next year.

It is not just the rand, however, that is showing strength today, but a broad spectrum of EMG currencies. These include MXN (+0.35%), INR (+0.45%), TRY (+1.5%), RUB (+0.5%) and HUF (+0.25%); as wide a cross-section as we are likely to see. In other words, this has much more to do with broad trends than specific data or stories. And with that in mind, it is hard to fight the tape.

It has become increasingly clear that most markets have made peace with the idea that the trade situation is not going to improve in the short run. Next week the US will impose 10% tariffs on $200 billion of Chinese imports and the administration is already preparing its list for an additional $267 billion of goods to be taxed. No economist believes that this will enhance the pace of growth; rather the universal assumption is that global growth will slow amid this process. And yet investors and traders have simply decided to ignore this outcome, with a large contingent explicitly declaring that they believe these are simply negotiating tactics and that there will be no long-term impact. While I hope they are correct, I fear this is not the case, and that instead, we are going to see this process carry on for an extended period of time, driving up prices and inflation and forcing the Fed to tighten policy more than currently priced by markets. If I am correct, then the likelihood of a significant repricing of risk is quite large. But again, that is only if I am correct.

As to today’s session, we see our first real data of the week with Housing Starts (exp 1.23M) and Building Permits (1.31M) as well as the reading on the Current Account (-$103.5B). But with risk-on today’s theme, these data would have to be drastically weak, sub 1.0M, to have an impact. Instead, it appears that the dollar will remain under pressure today, and perhaps through the rest of the week into next as the market awaits the Fed rate hike next week, and more importantly the statement describing their future views. Until then, this seems to be the theme.

Good luck
Adf

 

Little Fear

Much to all Free Traders’ chagrin
More tariffs are set to begin
But markets appear
To have little fear
This madness will cause a tailspin

As NY walks in this morning, there has been very limited movement in the dollar overall. While yesterday saw a modicum of dollar weakness, at least against the G10 currencies, we remain range bound with no immediate prospects for a breakout. It does appear that US data is turning more mixed than clearly bullish, as evidenced by yesterday’s Empire Manufacturing Survey data, which printed at 19, still solid but down from last month’s reading of 25.6 as well as below expectations of 23.0. A quick look at the recent history of this indicator shows that it appears to be rolling over from its recent high levels, perhaps signaling that peak growth is behind us.

At this point, it is fair to question what is causing this change in tone. During the summer, US data was unambiguously strong, with most releases beating expectations, but lately that dynamic has changed. The most obvious catalyst is the ongoing trade situation, which if anything worsened yesterday when President Trump announced that the US would be imposing 10% tariffs on an additional $200 billion of Chinese imports. In addition, these are set to rise to 25% in January if there is no further progress in the trade negotiations. As well, Trump threatened to impose tariffs on an additional $267 billion of goods, meaning that everything imported from China would be impacted. As we have heard from several Fed speakers, this process has grown to be the largest source of uncertainty for the US economy, and by extension for financial markets.

Yet financial markets seem to be quite complacent with regard to the potential damage that the trade war can inflict on the economy and growth. As evidence I point to the modest declines in US equities yesterday, but more importantly, to the rally in Asian equities overnight. While it is fair to say that the impact of this tariff war will not be directly felt in earnings results for at least another quarter or two, it is still surprising that the market is not pricing the potential negative consequences more severely. This implies one of two things; either the market has already priced in this scenario and the risks are seen as minimal, or that the rise in passive investing, which has exploded to nearly 45% of equity market activity, has reduced the stock market’s historic role as a leading indicator of economic activity. If it is the former, my concern is that actual results will underperform current expectations and drive market declines later. However, I fear the latter situation is closer to the truth, which implies that one of the long-time functions of the equity market, anticipating and discounting future economic activity, is changing. The risk here is that policymakers will lose an important signal as to expectations, weakening their collective hands further. And let’s face it, they need all the help they can get!

Turning back to the dollar, not only has the G10 has been dull, but EMG currencies are generally benign as well. In fact, the only substantive movement has come from everybody’s favorite whipping boy, TRY. This morning it is back under pressure, down 1.3% and has now erased all the gains it made in the wake of last week’s surprising 625bp rate hike. But in truth, beyond that, I can’t find an important emerging market currency that has moved more than 20bps. There are two key central bank meetings this week, Brazil tomorrow and South Africa on Thursday. Right now, expectations are for both to stand pat, leaving interest rates in both nations at 6.50%. However, the whisper campaign is brewing that South Africa may raise rates, which has undoubtedly helped the rand over the past two weeks as it has rallied some 4.5% during that time. We will know more by Thursday.

This overall lack of activity implies that traders are waiting the next important catalyst for movement, which may well be next Wednesday’s FOMC meeting! That is a very long time in the market for treading water, however, given the US data the rest of this week is second tier, and the trade situation is widely understood at this time, it is a challenge to see what else will matter until we hear from the Fed. And remember, the market has already priced in a 100% probability that they will raise rates by 25bps, so this is really all about updated forecasts, the dot plot and the press conference. But until then, my sense is that we are in for a decided lack of movement in the FX world.

Good luck
Adf

 

Things Went Awry

A decade has passed since the day
That Lehman collapsed all the way
It sank several banks
And brought us Dodd-Frank
In effort to curb foul play

And during those ten years gone by
A number of things went awry
Some xenophobes won
And they’ve overrun
Attempts, good ideas, to apply

The upshot is markets worldwide
Have started to feel the downside
Of higher Fed rates
While there are debates
If euros or dollars will slide

Despite a number of ongoing stories that may ultimately impact markets, notably the US-China trade situation, Italian budget discussions and Brexit negotiations, movement overnight in the FX market has been benign. This morning, the broad dollar index is lower by about 0.25%, with most G10 currencies having strengthened by similar amounts, but the EMG bloc remains under pressure with TRY (-1.5%), INR (-0.75%), KRW (-0.5%) and ZAR (-0.5%) all leaning in the other direction. However, when stepping back to get perspective, the situation can fairly be summed up by saying EMG currencies have been weakening pretty consistently for the past six plus months, while the G10 has barely moved at all since the end of May when the dollar’s sharp rise came to a halt.

Given the relatively uninteresting state of markets this morning, and the fact that there is virtually no data of note until Wednesday this week, I thought I might take a short retrospective look at how things have changed since the financial crisis ten years ago.

Remarkably, last Friday was the tenth anniversary of Lehman Brothers bankruptcy filing. The ensuing ten years has brought about significant changes in the way markets behave, regulators oversee things and investors approach the process. Arguably, the bigger question is what will the next ten years look like. And while there is no way to be sure, there do seem to be several trends that have further to run.

The hardest thing to understand is how a debt fueled crisis resulted in policies designed to increase debt further. While during the immediacy of the extremely deep recession in 2009 there were few complaints about central bank policy trends, which were seen as emergency measures, the first eyebrows were raised when interest rates went negative in Sweden, and then followed throughout Europe and then finally in Japan. But even that would likely have been seen as generally reasonable if the interest rate cycle had been of a more normal duration. Instead, central bankers around the world collectively decided that expanding global money supply inexorably for ten years was the prudent thing to do. Consider that despite global growth chugging along at about 3.5%, global money supply has risen more than 100% since 2008, which means it has grown at nearly an 8% annual clip. As evidenced by the large gap between economic and monetary growth, it is clear that some great portion of that new money found a home outside the ‘real’ economy.

In fact, it is this situation that has defined market activity since 2008, while simultaneously confusing half the economic community. That money has found a home in global debt and equity markets, causing massive inflation there, while only trickling into the real economy and thus allowing measured price inflation, like CPI or PCE, to remain subdued. Most market analysts understood this concept within months of the process beginning, but mainstream economists and policymakers claimed to be puzzled by the lack of inflation, and so were willing to maintain ‘emergency’ policy for ten years, despite rebounding global growth. Now, clearly through this period there were areas in the world that had slowdowns (notably Europe in 2011 and China in 2015), but the idea that flooding the market with funds and then leaving them in place for nigh on ten years was economically prudent seems hard to swallow.

And of course, there were real consequences to these actions, not simply numeric arguments. Income and wealth inequality exploded, as those already rich were the main beneficiaries of the global stock and bond market rallies. At the same time, lower skilled labor found themselves under enormous pressure from a combination of technological improvements in production, reducing the demand for labor and globalization increasing the supply of labor. In hindsight, it should be no surprise at all that we have seen a significant increase in the number of nationalists being elected around the world, especially in the G10. After all, it is much easier to demonize foreign workers than industrial robots, especially since they don’t vote.

The thing is that while the Fed has, at least, made some strides to finally reduce the money supply, both raising rates and allowing their balance sheet to actually shrink, they remain the only central bank doing so. And even though the ECB is slowing its QE purchases, they are still adding funds, while both China and Japan continue to add money to the system indefinitely. Current forecasts show that global money supply will not start to shrink until the end of next year at the earliest based on current policy trajectories and expectations. However, that makes the heroic assumption that when money supply starts to shrink, financial markets will be unaffected. And that seems highly unlikely given how crucial those excess funds have been to financial market performance for the past decade.

Summing up, the Lehman bankruptcy triggered a global crisis that was built on excessive leverage, notably in the US housing market. The crisis response was to cut short-term interest rates dramatically while flooding the markets with cash in order to drive down long-term interest rates. The consequences of this policy, which was repeated around the world once the Fed led the way, was a massive rally in both equity and fixed income markets, and a modest rebound in economic growth. Financial engineering became the norm (issue cheap debt to repurchase shares and drive up EPS and stock prices while increasing balance sheet leverage), whereas R&D and Capex shrank in comparison. The dollar, meanwhile, initially rallied sharply as a safe haven, and despite periodic bouts of weakness, it has continued its long-term uptrend, thus pressuring export industries to move production offshore. And the result of all that economic and financial change has been the rise of nationalist political parties around the world as well as significant pressure on the global free trade movement amongst nations.

There is a great irony in the fact that for many years after the crisis, central bankers were terrified of global deflation, and sought aggressively to push inflation higher. Well, now they have done so in spades, and it will be quite interesting to see how they respond to this more traditional monetary phenomenon. As the Fed continues on its current policy path, we are seeing an increasing number of EMG central banks forced to raise rates as well, despite suspect economic growth, as inflation is breaking out all over the bloc. Friday saw Russia raise rates in a surprise, and all eyes are on Brazil and South Africa this week. My fear is that ten years of emergency monetary accommodation has left the world in a precarious position, one where the future will see even bigger problems than the crisis ten years ago. Ask yourself this, how will global markets respond to a debt “jubilee”, where debt is simply erased from the books and investors are left in the lurch? Don’t think it can’t happen.

And with that as a backdrop, let’s quickly look ahead to a very limited week of data as follows:

Today Empire Manufacturing 23.0
Tuesday TIC Flows $65.1B
Wednesday Housing Starts 1.23M
  Building Permits 1.31M
Thursday Initial Claims 210K
  Philly Fed 16.5
  Existing Home Sales 5.36M

With the FOMC meeting next week, all eyes are going to turn in that direction. While expectations are universal for a 25bp rate hike, the question is how hawkish or dovish will they sound. The interesting thing is that recent comments by Fed speakers have been far more focused on the potential of the ongoing trade issues to negatively impact the economy. (Secretly I believe that they are actually quite happy with this as if things turn south they will be able to blame someone else and the market will accept that explanation.) At any rate, the data of late has been mixed, with the wage data showing stronger than expected growth, while CPI was actually soft. Given the dearth of important data this week, I expect that the dollar will continue its recent wishy-washy performance, with some days of modest rallies and some days of modest declines, but no new trend evolving.

Good luck
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