Funding is Lacking

The government in the US
Has lately been under some stress
Considering backing
For funding is lacking
This could turn into quite a mess

While I don’t necessarily agree that it is a crucial issue for the FX market, the fact that there is a threat of another government shutdown in the US has certainly been the most discussed topic in the press this morning. But I question whether the trading community is in accord. Ostensibly, the dollar’s recent weakness can be partially attributed to the fact that there is a broad loss of confidence in the US due to the current administration’s combination of policies and internal discord, and so investors are seeking other homes for their funds. But that doesn’t make sense to me given that the US economy continues to lead the G10 in the economic cycle, has shown no sign of slowing down yet, and has had continued substantive gains in its equity markets. Those are hardly reasons to shun a market. Rather, I believe the dollar’s recent weakness is a product of the ongoing narrative that the recent uptick in growth elsewhere in the world is going to cause other G10 central banks to tighten policy more quickly than the Fed on a relative basis. Or perhaps more accurately, FX traders are betting that the Fed will tighten less than current market pricing anticipates while the ECB, BOJ and other G10 central banks will tighten more. That would certainly explain the dollar’s weakness, but I think it is a mistake. If anything, I believe that the exact opposite will be the outcome in 2018 and that the dollar will be higher when all is said and done. We shall see.

But weaker the dollar is this morning, albeit not dramatically so. In the G10, the yen has been the best performer, rising a further 0.3% as the discussion in Tokyo continues to be about the timing of any change in policy there. There seems to be a growing belief that Kuroda-san will begin hinting at the end of QE in next week’s meeting despite the fact that inflation in Japan remains at 0.9%, well below the target of 2.0%. This is especially troubling because services inflation is running at just 0.1% and wage pressures have not yet made themselves felt. So though oil prices are higher and goods prices are beginning to rise, based on current central bank groupthink, it is not yet time to get aggressive. In fact, we could be having virtually the identical discussion about the ECB here, where the market has become quite keen on the idea that the end of QE is nigh, or at the very least the announcement of that timing is at hand despite the fact that the inflation story in the Eurozone remains equally stagnant. My money is on both Kuroda and Draghi to remain dovish in their statements next week.

One interesting thing about the yen this morning is the fact that it is stronger despite the fact that the UST-JGB spread has expanded to its widest level since 2010, and is more than 250bps. This is due to the fact that the 10-year Treasury continues to climb in yield. Historically, a yield spread of this magnitude has been a signal for Japanese investors to switch into Treasuries from JGB’s and the dollar has been the beneficiary. But thus far, we have not seen that play out.

The one other newsworthy item from the G10 was the weaker than expected December Retail Sales print from the UK (exp -1.0%, actual -1.6%) which has weighed on the pound helping it to fall 0.2% despite broad-based USD weakness.

In the EMG space, alongside Japanese strength we have seen the rest of APAC outperforming the greenback today with much of the space up nearly 0.5%. It has become increasingly clear that investors are quite enamored of APAC again. This is evidenced by the equity market performance there (Nikkei, Hang Seng and Shanghai indices are all up more than 7% so far this year) and the ongoing search for yield which leads many to these countries where yields dwarf G10 yields. While this story is in full swing currently, I wonder how well things will hold up as US policy tightens further. If you recall, I highlighted the 10-year Treasury yield of 2.627% as a key technical point for traders. That was the highest yield we saw back in March during the reflation trade craze. Well, this morning, we are higher, breeching 2.63% and, in my view, set to head toward 3.00% in the near term. As the US Treasury market sells off and yields rise, look for many of the current assumptions underlying asset prices to be called into question. As to the rest of the EMG space, interestingly, despite strength in the euro, EEMEA is actually under pressure today. TRY is the worst performer, down 0.75%, on the back of discussions of Syrian attacks by Turkish forces and an increase in chaos in the region. Meanwhile ZAR is lower by 0.5% in what seems like some profit-taking after an extended run of strength. The CE4 are all slightly softer, although there don’t seem to be any significant news items there.

While yesterday’s housing data showed Starts falling in a surprise and Permits holding up, the only data point this morning is Michigan Sentiment (exp 97.0). We will hear from Atlanta’s Raphael Bostic shortly, although it would be shocking to hear anything new at this time. While the Fed doesn’t meet until the 31st, next week brings both the BOJ and ECB meetings, which will be watched closely for any hints of tighter policy. Essentially, the market is pricing in movement in that direction, but I don’t believe we will see it. As for today, if the 10-year yield continues to climb, and I believe it will, I think the dollar will find its footing. Look for a modest USD rebound into the weekend.

Good luck and good weekend