From Brussels the market has learned
The talks about Brexit have turned
At Ireland’s border
May soon have both sides unconcerned
In what cannot be very shocking
To pounds, many traders are flocking
But elsewhere the buck
Has had all the luck
As stocks in the US keep rocking
This weekend’s press focused on the still glacial pace of Brexit negotiations and the increasing odds that no compromise would be reached regarding the Irish border before the key EU meeting at the end of next week. While PM May and the EU’s Michel Barnier are scheduled for lunch to discuss things today, hopes were not high that sufficient progress had been made to move the process on to the trade situation. The biggest problem had been the resolution of the Irish border that I discussed on Friday, but it seems that questions over the European Court of Justice’s role in legal questions for EU citizens in the UK had also resurfaced. With this as the backdrop, it was no surprise to have seen the pound cede some of Friday’s gains. In fact, at its nadir, the pound had given up about 0.75% of that move. But then, the following headline hit the tape: *BARNIER TOLD MEPS BREAKTHROUGH IS LIKELY TODAY: LAMBERTS.* Philippe Lamberts is a Belgian MEP and his comment was all the pound needed to regain all of its lost ground and then some, with it now sitting 0.4% higher than Friday’s close. While no details have been released, the fact that progress continues to be made is seen as a key support for Sterling. And today, support for currencies other than the dollar has been rare.
In fact, the dollar is having its best overall day in a while, having rallied against virtually every currency aside from the pound. It seems that investors continue to pour money into the US equity markets, as evidenced by their regular record setting performances, and, of course, in order for foreign investors to by US equities, they need first to convert their cash into dollars. While I remain uncomfortable that equity markets can maintain their momentum, clearly I remain in a minority.
But something else supporting the dollar this morning is Treasury yields, with the 10-year higher by ~4bps and the 2-year, which typically has much smaller movements, rising by 2.5bps. Concerns continue to grow in the market that the yield curve is getting set to invert soon, and as I’m sure you are all aware by now, an inverted yield curve has historically been a harbinger of a recession. The Fed continues to be puzzled by the flattening as their models consistently point to a strong correlation between short end rates and the long end. Thus as they push the front end higher, they expected to see the back move up alongside it. The thing is, as long as they and their central bank brethren continue to buy bonds, demand for safe fixed income assets will remain, and those yields are unlikely to rise very much. Which is, of course, the reason they are so concerned over the shrinking of their balance sheet. While the conundrum of rising front end rates and falling back end rates may be somewhat concerning, although arguably quite logical as I just highlighted, a situation where back end rates are rising more rapidly than the front will be of much greater concern. That means they are no longer in control, and based on the history of the past decade, that is what they fear most, lack of control.
How might that come about? Consider the reality of your personal inflation, as opposed to the measured sort on which they focus. There are many inflation indicators (e.g. NY Fed’s Underlying Inflation Gauge (UIG) that just printed at 2.96%, its highest level since 2006!) that are pointing to inflation being much higher than the Core PCE reading the Fed worships. And it is entirely possible that we are going to see real price pressures make a far more sudden appearance in the CPI or PCE readings than the Fed seems to currently anticipate. I assure you if PCE jumps to 1.9% in Q1 of next year, they will not be happy. Inflation is something that can only be addressed with a lag, and a surprisingly sharp rise would force a much more aggressive Fed policy response. For a group that has preached gradualism, having their hand forced will be very problematic for their policies and for the current benign attitude toward market risk. In other words, things will could get messy. And as I have consistently highlighted, messy markets tend to drive people into dollars.
As to this week, we have a combination of ongoing political stuff, with hopes high that a tax package will come closer to reality, as well as that the government won’t shut down on Friday. And this doesn’t even include the ongoing investigations and recent bombshells about potential election issues. We also have a decent amont of data, culminating on Friday with the monthly payroll report:
Today Factory Orders -0.4%
Durable Goods -1.0%
Tuesday Trade Balance -$47.4B
ISM Non-Manufacturing 59.0
Wednesday ADP Employment 190K
Nonfarm productivity 3.3%
Unit Labor Costs 0.2%
Thursday Initial Claims 240K
Consumer Credit $16.75B
Friday Nonfarm Payrolls 198K
Private payrolls 200K
Manufacturing Payrolls 17K
Unemployment Rate 4.1%
Avg Hourly Earnings 0.3%
Avg Weekly Hours 34.4
Michigan Sentiment 99.0
In addition, a number of central banks meet this week, including Australia and Canada, although neither is expected to change policy or even hint at it.
For the past week, the dollar has made no headway in either direction. Barring an extraordinary outcome from Congress, or some new significant political bombshell, I feel like the ongoing consolidation in the euro will continue. FX markets are not the primary focus of investors, except perhaps in the UK where the Brexit situation remains fluid. But otherwise, its bitcoin, equities and bonds, in that order!