Like Stentor

Economists shouting like Stentor*
Have put inflation front and center
Investors are edgy
And seeking a hedge-y
For new trades they’re now scared to enter

*Stentor – A mythic Greek herald whose voice was “as powerful as fifty voices of other men” according to Homer

You cannot read an article or listen to a commentator these days without the conversation turning toward inflation. With this in mind, let me recap the recent trajectory of that conversation. We all know that central banks have been (overly?) terrified of deflation ever since the Japanese economy was afflicted with it in the wake of their market crash back in the late 1980’s. Policy errors by the BOJ helped insure that prices couldn’t rise because they supported so many zombie-like companies and never allowed the requisite bankruptcies and losses that would have allowed the markets to clear. And don’t get me wrong; deflation can be difficult for central banks to address, certainly compared to inflation. At any rate, with the financial crisis of 2008-9, central banks, led by Benny the Beard, were hyper focused on deflation again and did all they could to prevent it from occurring. Hence, the creation of QE and ZIRP and NIRP. Of course, the problem with those policies was they didn’t directly address inflation as we know it, basically CPI, but rather served to inflate asset prices dramatically. This is how we had come to see both stock and bond markets at their most overvalued levels in history. And despite the impact those policies had on markets, central banks have all been singing from the same hymnal and doing everything they can think of to raise inflation. We have heard it from Yellen, Draghi, Kuroda, Carney, Poloz and every other central banker on the planet. Taken together, the lack of measured price inflation (and especially wage inflation) and the ongoing desires of central bankers to see it come about have been the keys to keeping monetary policy ultra accommodative.

Which brings us to the past few weeks. A look at price data more recently shows that there are finally signs that inflation is seeping into the economy. Clearly, the Fed has already begun to tighten policy, as has the BOE and BOC. The market narrative continues to expect the ECB to move in that direction and even though the BOJ denies any possibility of change soon, the market narrative has them starting to remove accommodation as well in the near future. But the market had been sanguine over the pace of this change, pricing a far flatter trajectory of rate rises than even the central banks themselves have been highlighting. So with this as a backgound (the shortest 30-year history you will ever read), we get to the US employment report a week and a half ago, where the Average Hourly Earnings data surprised sharply to the upside and printed at 2.9%. Suddenly, investors and traders figured out that perhaps things on the inflation front were moving more rapidly than they had been led to believe, and that the central banks would need to become more aggressive to fight inflation. With global growth synchronized and moving up, all the pieces were suddenly in place to allow central banks to roll back their extraordinary policies, and to do so more quickly than previously expected. You all know what happened to asset markets since then, and now the question is whether or not this was just a hiccup and long-overdue modest correction, or the beginning of something new, namely an unwinding of risk.

There are myriad arguments on both sides with the bulls pointing to the still strong economic growth and earnings data while the bears highlight the change in monetary policy as being sufficient to overwhelm that data. We shall see. But there is no question that the next chapter to the story will be Wednesday’s CPI print here. While the Fed targets PCE, which will be released at the end of the month, CPI remains the market perception of what inflation is all about. And so virtually every market commentary article, and this is no exception, has been focused on how that number will impact market sentiment, and by extension markets. It is a very simple equation, with a strong print, above 0.3% (1.9% Y/Y) having immediate negative consequences for both equities and bonds, and a weak number allowing the ‘buy the dip’ crowd to get back to business. Tomorrow should be fun.

But in the meantime, today is still ahead of us, and so we must look at what has been ongoing in FX markets so far. Broadly, the dollar is weak, significantly so against some currencies, as it appears market participants are ramping up their bets that the rest of the world will tighten faster than the Fed. Of course, if this is the case, you would expect equity markets to fall as well, and lo and behold, that has been the overnight price action, with APAC markets lower, EMEA markets lower and US futures pointing in the same direction. The most noteworthy data overnight was from the UK, where core CPI surprised on the high side (see a pattern here?) at 2.7%. This has served to encourage the rate hike story in the UK, with May now seen as a virtual certainty, and helped underpin the pound, which has rallied 0.5%. But the dollar’s decline is not really data based, I would argue, rather it is a sentimental move. Take a look at the yen, which despite no data or comments whatsoever, has rallied more than 1.0% overnight. This is more in line with a derisking rather than a rate story. As to the rest of the G10, the movement has been somewhat less aggressive than that of the pound, with modest strength in the 0.2% area the norm.

In the emerging markets, while the dollar is generally softer, the movement has also not been that significant. There is, however, one surprising outcome and that is the South African rand. A vote was taken by the ruling ANC party to remove President Zuma, something that the market has been clearly very keen to see, and something they have priced in as can be seen from the rand’s now 17% rally since mid-November. And the rand is firmer today by another 0.25%. BUT, President Zuma ignored the vote and did not step down! In fact, from what I have read he appears to be digging in his heels even deeper. I am no expert on the politics of South Africa, but one thing is certain, and that is that if Zuma somehow manages to remain in office for much longer, the rand is going to start to give up some of these gains. Markets and investors have already priced in a President Ramaphosa and are quite bullish on the idea. If that fails to come about, watch out!

But those are the only interesting currency stories of the day. Today’s only data point is the NFIB Small Business Optimism Index, which was just released at a slightly better than expected 106.9. This is a historically high level, and one that has indicated peak optimism in the past. We also here from Cleveland Fed President Mester this morning, but unless she is suddenly dovish, which I sincerely doubt, it will be difficult for her to change many opinions I think. So today will be another one where we follow the equity markets as we await tomorrow’s CPI data. If equity markets resume last week’s decline, I expect that the dollar will find support and likely rebound a bit. However, if the bulls regain the upper hand, then the dollar should suffer as well.

Good luck
Adf

 

No Delay

There once was a banker named Jay
Who had a quite trying first day
A week has now passed
And he’s been steadfast
That rate hikes will see no delay

Investors, however, are sore
‘Cause most of the ten years before
Each time stocks would sink
The Fed Chair would blink
And open the taps even more

So what can we look for ahead?
Is this market bull really dead?
It’s still early days
But I think this phase
Has room to become more widespread

This morning’s market activity is far more subdued than what we saw last week, which is not that surprising. As I have written many times, periods of extreme volatility tend to be short-lived simply because traders don’t have the stamina to maintain the pace of activity. This is especially so these days since most traders have barely even seen this type of market movement and are uncertain how to respond. When all your trading models are predicated on markets rising forever, falling markets can be quite confusing.

Friday’s late day equity rally was quite interesting in both its timing and power. It appears that a research note from JPMorgan was released which essentially sounded the all-clear signal. The essence of the note was that they estimated the bulk of the risk-off selling had been completed, so no need to panic further. It is not often when somebody rings the proverbial bell and tells you the market has either topped or bottomed, but apparently, that is what we just saw. Personally, I remain skeptical that the volatility has ended and I make that case because a quick peek at the 10-year Treasury this morning, currently making new highs at 2.88%, highlights that the initial driver, rising yields in the US, are continuing on their merry way. Once again I will point out that we have had nine years of QE and extraordinary monetary policy and a nine-year equity and bond market rally (actually the bond market rally has been about thirty years). As monetary policy tightens, and there is no indication at this point that the Fed is changing their tune, those two rallies are certain to suffer. A one-week correction is not sufficient to offset a nine-year rally. I’m sorry, but there is more downside to come.

Turning our gaze to the FX market, the dollar is under very mild pressure this morning. While it is weaker against a majority of its major counterpart currencies, the magnitude of the decline is tiny, probably about 0.1% on average. In other words, I wouldn’t put much stock into stories describing the dollar’s decline as being significant. I find it interesting that the FX narrative revolves around tighter policy elsewhere in the world, hence the idea that the dollar has further to fall, but the equity narrative is that rising rates will have no impact on stock prices. This seems to be a conundrum given the historic relationship between interest rates and equity markets. In fact, the anomaly has been the fact that during a powerful equity market rally we saw declining yields, which is historically very rare. Normalization of monetary policy is very likely, in my view, to reinvigorate historical relationships. It is why I believe that Treasury yields will continue to rise; why I believe that the equity market will come under further pressure; and why I believe the dollar will find support. Until the Fed changes their current storyline of continuing to gradually raise rates and allow the balance sheet to shrink, we are going to be subject to ongoing downside activity and increased volatility. [A quick aside on this. The Fed is NOT selling any bonds in the market, although that has been widely reported. The change they have made has been that rather than take the proceeds of the bonds that are maturing in their portfolio and reinvesting them, thus buying more bonds; they are simply letting a portion of these maturities roll off without being replaced. These funds then disappear from the market in exactly the opposite manner as when the Fed ‘printed money’ from thin air and bought bonds. I assure you that if the Fed were actually selling bonds in the market, Treasury prices would already be much lower and so would stock prices!]

This week has a much more active data calendar but I think that all eyes will be on Wednesday’s CPI reading which, given the importance of the inflation debate, has the ability to be a market mover. Remember what happened with the AHE number two weeks ago. Here’s a listing of what is upcoming:

Today Monthly Budget Statement -$23.0B
Tuesday NFIB Small Biz Optimism 106.2
Wednesday CPI 0.3% (1.9% Y/Y)
  -ex food & energy 0.2% (1.7% Y/Y)
  Retail Sales 0.2%
  -ex Autos 0.4%
  Business Inventories 0.3%
Thursday Initial Claims 229K
  Empire Mfg 17.3
  Philly Fed 21.1
  PPI 0.4% (2.5% Y/Y)
  -ex food & energy 0.2% (2.1% Y/Y)
  IP 0.2%
  Capacity Utilization 78.0%
Friday Housing Starts 1.23M
  Building Permits 1.3M
  Michigan Sentiment 95.5

On the speaker front, only Cleveland’s Loretta Mester is on the schedule, and she is a known hawk, so unless she turns dovish, it is unlikely to have a major impact on markets.

For today, if the equity market picks up where Friday closed, and futures are pointing nicely higher right now, about 1%, then I expect the dollar will potentially edge a bit lower. However, if we experience the next wave of derisking, look for the dollar to find support.

Good luck
Adf

The Flames Have Been Fanned

Most people just don’t understand
The reasons the flames have been fanned
For markets to fall
While growth doesn’t stall
And so, now relief, they demand

However, the Fed’s displayed phlegm
Amid the increasing mayhem
The moves must be bigger
If they are to trigger
Some comments, the fall to condemn

As we have seen all week, the equity markets remain the dominant discussion topic and continue to be the market driver. Arguably, the proximate cause of yesterday’s sharp decline was the lackluster 30-year treasury auction, which helped to extend the recent narrative of higher US rates undermining equity valuations and cause a repricing of risk. But at this point, with stocks closing yesterday down 10% from their recent peak, we are beginning to see an increasing amount of downward momentum in the stock market. That means that we may not need much in the way of continued bad market news to see this process continue. And it is important to remember that economic news is not necessarily market news. The stock market can continue to decline and we can see a significant uptick in volatility across all markets, while the economy performs well. In fact, I would contend that is a reasonably high probability outcome.

Consider the fact that one of the key drivers of all asset prices since the financial crisis has been the extraordinary monetary policies implemented by the major central banks around the world. The $15 trillion of liquidity that they created to purchase assets never found its way into the price of goods or services because it was too busy flowing into the price of assets. The result was the greatest simultaneous bull market in stocks and bonds ever seen. But now, as the central banks embark on the process of removing all that liquidity, it should be no surprise that asset prices are falling. In fact, it would be shocking if they didn’t. So perhaps, maybe it wasn’t only yesterday’s Treasury auction that caused problems, but also the comments from the BOE. If you recall, Governor Carney hinted at further rate hikes and the removal of accommodation from markets due to improving growth prospects and increasing price pressures. While the pound was the immediate beneficiary yesterday, it has since given back much of those gains as the bigger picture of asset price retreats overwhelms everything else. Markets remain very interconnected but more importantly, virtually all asset prices have been the beneficiaries of monetary policy for the past nine years. As that policy changes, all assets are going to be negatively impacted. And the one thing that will get those policies to change is strong GDP growth! So for the time being, we are likely to see good economic news lead to declining stock and bond markets around the world.

One other thing to remember is that I assure you the central banks will be looking at percentage movements, so the fact that the Dow has fallen more than 1000 points in two of the past four sessions is far less impressive given the level of the Dow. 4% declines are not life threatening. One-day declines of 8% or 10% are going to be required to increase central bank angst.

But on to FX. Actually, the biggest mover overnight has been the Norwegian Krone, falling more than 1.25% after data releases showed inflation pressures remain subdued despite ongoing growth. The market saw this and discounted the idea that the Norges bank would be tightening their policy any time soon, hence the NOK’s decline. The next biggest loser in the G10 space has been the pound, which despite yesterday’s BOE comments, has responded to a series of poor data. IP fell a more than expected -1.3% and the Trade Deficit grew dramatically to £4.9B (exp £2.4B). This has removed all of yesterday’s gains and then some. In fact, from the peak, it is lower by 1.7%, although from the close just 0.7%. At the end of the day, it remains difficult for me to foresee how Brexit is going to be a near-term positive for the currency, and I continue to believe that the BOE remains far more quiescent than the market expects. This idea has been bolstered by reports that PM May is encouraging her Brexit negotiators to remain firm on British commitments to free trade without sacrificing sovereignty. I don’t know how well that will end.

Pivoting to the emerging markets, ZAR has once again benefitted from the stories that President Zuma is going to be resigning soon, having rallied a further 0.5% this morning. The rest of EEMEA, though, has been far less interesting, with de minimis changes similar to the euro’s virtually unchanged stance. Interestingly, despite the ongoing rout in Chinese equity prices, CNY has actually strengthened overnight, gaining 0.4% and unwinding some of yesterday’s losses. This could be funds coming home to cover equity losses, or potentially funds coming home ahead of the Chinese New Year. Keep in mind that markets there will be closed for most of the next two weeks. I continue to believe the CNY will fall throughout this year, but thus far, I am on the wrong side of that trade.

There is no US data today nor any scheduled Fed speakers. The one consistent thing we have heard from the Fed has been that the recent equity market movement has been “healthy” and the magnitude, given how far we’ve come, has been “small potatoes”. One thing Dudley did say was that if the market fell far enough, it would impact his personal view on the timing of policy changes, which means that the Fed put still exists. But I continue to believe it is still far out of the money. Equity futures are pointing slightly higher this morning, but I see no reason for the downward momentum there to wane. I like the dollar to continue to hold its own overall amid another down day in the stock market.

Good luck and good weekend
Adf

No Bed of Roses

For those in the stock market’s grip
A common plan was ‘buy the dip’
But for the past week
Which has been quite bleak
It’s lost some of its sponsorship

A sample of markets exposes
That China’s been no bed of roses
The yuan, late last night,
Caused many a fright
As that bubble now decomposes

The dollar is broadly stronger this morning as markets remains far more volatile than we had gotten used to over the past several years. Equity markets remain quite uncertain, as evidenced by yesterday’s 500 point range in the Dow. Consider this, the VIX index, which is a measure of S&P 500 volatility, had been trading around 10% prior to the recent activity. Meanwhile, a 2% daily move in the underlying market represents annualized volatility of ~32%. It should be no surprise that the short volatility trades are under pressure here, given what has actually occurred of late. If your position basis is 10%, then a 32% outcome is quite painful. Nowhere is that more evident than in China, where the Shanghai Composite has fallen more than 4% in the past week, and started to raise some red flags. Of direct interest to us is the Chinese yuan, which fell nearly 1.0% last night, its largest one-day loss since the PBOC devalued the currency in 2015. It seems that the combination of local stock market declines, weaker than expected trade data (Imports jumping 36.9% and the Trade Balance falling to a $20.3B surplus from $54.7B last month) and the approaching Chinese New Year (which has raised concerns over liquidity) has conspired to undermine some of the currencies recent gains. The cynic in me wonders whether the much reduced Trade Surplus is real or simply a more acceptable political outcome given the current angst between the US and China on the subject. But the market response to the data should be no surprise. Will the renminbi continue to fall? My view is that over time, that will be the case, but that is in the context of my view the dollar will continue to rally as the year progresses.

Elsewhere, however, the dollar’s rise overnight has, thus far, been far less robust, averaging something on the order of 0.3%. German trade data, which was essentially the only notable release, was right in line with expectations. As well, there have been no comments from ECB members, so the euro’s continuing slide is really a dollar rally. This is also in evidence vs. the yen, which has fallen despite the reduction in risk appetite that has become evident around the world. In other words, the dollar seems to be benefitting from other issues.

Arguably, the news about a budget agreement in the Senate is one of the key stories. If the House follows through, this will remove the prospect of a government shutdown as well as talk about the debt ceiling. When the headline hit yesterday afternoon, the euro fell almost 90 pips within minutes and has continued slowly lower since. But something else underpinning the dollar is likely US interest rates. Yesterday’s 10-year auction was lackluster and the yield has risen back to 2.84%, essentially its level Monday morning, before the real equity market fireworks went off. Nothing has changed my view that 10-year yields have further to climb, that inflation remains a growing problem and that the Fed is going to respond accordingly. It was heartening to hear yesterday’s Fed speakers Dudley and Kaplan both ignore the recent stock market gyrations with regard to their views on future rate hikes. It appears that the Fed’s reaction function toward equity market declines has been somewhat reduced, or in other words, the Fed put is much further out of the money than it has been in the past. What this means is that a further equity market corrections (which I believe is coming) will not be met with any change in rhetoric, let alone action, unless it becomes a real rout, something like a 25% or greater decline. And so, I continue to look for the dollar to benefit from this set of circumstances.

The last thing of note is the BOE, which has just released its statement, along with its updated growth and inflation forecasts. Ahead of the release, the pound was essentially unchanged on the day, but the remarkably hawkish sentiment put forth by the MPC inspired a nearly 1% gap higher with the pound touching 1.40 again. The essence of the statement was that growth was picking up in the UK, albeit at a somewhat slower level than the rest of the world. However, slack in the economy was shrinking and they explicitly said that rates would likely rise faster than had been expected in November when they last updated their forecast. Market expectations are growing for a 25bp rate hike at the May meeting, although I remain concerned that the ongoing Brexit story will prevent that action. However, for now, that is the scoop and the pound should benefit in the short term.

One other thing to take away from this is that a more aggressive BOE simply adds to the story of central banks taking away the proverbial punch bowl. The point is that asset valuations that have been so reliant on excess liquidity are going to find themselves with some ‘splaining to do when that liquidity dries up. In fact, this is the key reason I believe that recent equity market price action is just the beginning of the correction, and that dip buyers are going to need to be more discriminating in the near term.

As to the rest of the day, the only data here is Initial Claims (exp 232K) and we hear from two more Fed speakers, Philly’s Harker, and the uber-dove, Minneapolis’ Kashkari. There is also a 30-year Treasury auction, which if it disappoints is likely to add further downward pressure across the curve. In the end, I think the dollar will hold its own, and very likely edge higher from here.

Good luck
Adf

 

No Jury’s Adjourned

There once was a market condition
Where stock prices were on a mission
To rise ever higher
Like they were on fire
And bears were accused of sedition

Since Friday, however, we’ve learned
That thesis has been overturned
The question at hand
Will stocks now crash land?
Is one where no jury’s adjourned

I know this note is technically about FX markets, but sometimes other areas are the obvious drivers and so must be addressed. And clearly, all eyes remain on the equity markets right now, which means we can’t escape them when considering the dollar. With that as a prelude, yesterday saw another extremely volatile US equity session, with a substantially lower open and then a sharp rebound that resulted in stock prices here higher by more than 2% at the end of the day. As I had suggested yesterday, however, two of the short volatility contracts that had been among the most popular trading strategies for the past two years have now disintegrated after their values fell by more than 80%. Overnight, equity markets had a more mixed response, with not every market following the price action here. For instance, while Japanese stocks eked out a small gain, virtually every APAC market fell further led by China’s nearly 2% decline. Europe is faring a bit better, with most markets higher there, but the gains are modest, averaging around 0.5%, and hardly enough to offset recent declines. And as I type, US equity futures are pointing to another lower opening, something on the order of 1% right now. I highlight this because it is important to understand that markets have not yet found a new equilibrium. In fact, I would be surprised if we go back to that slow steady appreciation of prices any time soon. After all, if central bank behavior is changing, and clearly it is, then the rationale for constantly higher stock prices has likely ended as well. Rather, individual companies will need to demonstrate they are worth the investment, and I assure you, some won’t be able to do so.

So what does this have to do with FX? Well, it means that the FX markets are likely to be shaken out of their doldrums as well. At this point, it is quite clear that my view of dollar strength is in the tiny minority of global analysts. In fact, I read this morning that given the dollar’s early weakness this year, nearly two dozen of those analysts have raised their year-end target price for the euro, with the median expectation now 1.25, up from 1.22 just a month ago. I also know that long euro positions are near record levels on futures exchanges, which implies that the market is massively short dollars. Let me say that I feel much better about my dollar view when taking this new information into account. The combination of a higher volatility environment and an extreme short dollar position seems to me to be a perfect situation for the dollar to turn around and rally. One thing I have learned over the years is that the market is expert at finding the ‘pain trade’, which is defined as the one that will cause the most players the most losses. We saw that recently in the short volatility trade in stocks and I expect we will see it in the dollar as well. And to that end, the dollar, this morning, is higher vs. most of its counterparts.

In the G10, only the yen has outperformed the dollar overnight in what is clearly an ongoing risk-off sentiment. The worst performer in this space has been the pound, which has fallen back below 1.39 and is down nearly 3% in the past week. I have been particularly bearish on the pound relative to the Street and continue to be so. Its recent woes can be attributed to the weaker than expected Halifax Housing Price data (-0.6%, exp +0.2%) released this morning, as well as Monday’s much weaker than expected Services PMI data. But on top of the data has been the ongoing debacle of the Brexit process, where PM May continues to be unable to find a coherent voice with which to negotiate. I maintained early on, and continue to believe, that there will be no transitional deal, that the UK will simply exit the EU and its customs union next March, and that the idea that the BOE is going to raise rates ahead of this occurrence is daft. As it becomes clearer that there is no plan, the BOE will find itself completely unable to address what will almost certainly be rising inflation. The pound has further to fall.

As to the euro, the only notable data this morning was a widely expected decline in German IP in December, but given the volatility of that data, it doesn’t really take the shine off the economy there. The other German news of note was that Chancellor Merkel has reached a tentative deal with the center-left SPD to form a governing coalition, although that deal has yet to be approved by the SPD membership. I am confident it will be approved, but also expect that German leadership in the Eurozone is likely to be somewhat lacking going forward. I understand the hawks on the ECB have become more vocal, and that is certainly why the euro has performed well so far this year, but I continue to look for the Fed to be more aggressive than currently expected and the ECB to be less so, and the dollar to benefit accordingly. This morning’s 0.3% decline in the euro just means the euro has given back about 1.5% since its recent high at 1.2536. That is hardly enough to shake things up, and quite frankly, until we see the Fed actually acting in a more hawkish manner, the euro probably has a bit more upside. But come year-end, I remain confident in my view.

In the EMG bloc, the dollar’s performance has been more mixed. While EMEA currencies have all fallen vs. the dollar, following the euro lower, APAC saw a very different picture. In fact, the leader there has been CNY, which, after a 0.3% rise overnight, has appreciated 4% in the past month. In truth, this is an impressive performance, but one that I am not sure I can ascribe entirely to market forces. While it is possible that demand for renminbi is rising rapidly, it is also entirely possible that the central bank has pushed Chinese companies to repatriate funds in order to give the appearance of robust demand. As with all things China, it is always difficult to tell where the market impact is the driver as opposed to the government impact. But in fairness, most of the rest of APAC currencies also performed well overnight, with only INR falling after the RBI left rates on hold at 6.0%.

Turning to the day’s upcoming events, the only data point is Consumer Credit (exp $20.0B) and unlikely to move the needle. Of more importance is we have four Fed speakers; Kaplan, Dudley, Evans and Williams. Yesterday, Bullard maintained a dovish view by explaining that just because wages were rising, it didn’t mean inflation would follow. Of course, given that has been the entire Fed argument for the past four years, that seems a pretty ironic statement. But I guess when arguing your book, you make whatever case you can. If pushed, I would expect that the equity market has a far less rosy finish today than it did yesterday, and I expect that the dollar will cede some of its overnight gains. Treasury yields rebounded from Monday’s lows, and I expect that this will continue to be the underlying driver of everything for now.

Good luck
Adf

Has Goldilocks Died?

The question, Has Goldilocks died?
Has recently been asked worldwide
If this is the case
Prepare for the pace
Of selling to be amplified

OMG! Well, yesterday was certainly an interesting one in the markets. And to think, all that digital ink was spilled over Friday’s much smaller decline! Here’s the deal folks, markets can fall, and they can fall a long way without any obvious catalyst.

Remember Goldilocks and her economy? You know, strong global growth without inflation would allow central banks to continue to leave rates at rock bottom levels thus fostering further economic growth, spectacular earnings and a never-ending bull market in both stocks and bonds. Yeah, well not so much after all. She was always most likely to be slain by inflation and once again I will point to Friday’s AHE number as the sign that markets are getting a bit more nervous over future inflation readings. But when markets get going like this, they decouple from the underlying story and become the story themselves. That is classic market behavior and I see no reason for it to change now.

Funnily enough, I do think this time is different, just not different in a good way. This is because over the past three to five years, there has been a significant increase in the number of algorithmic strategies and the amount invested in them. As well, the idea that the retail investor was actively trading implied volatility movement is another true difference from previous bouts of market disruption. And the upshot is that all of those, and other, systematic strategies that have been instrumental in leading the great bull market higher are very likely to be what leads the market lower now that it has turned when it turns. The hallmarks of this type of behavior were seen just after 3:00pm yesterday, when the decline accelerated sharply and the Dow fell an additional 2.1% in just minutes before rebounding slightly into the close. That was very clearly machine algorithms being triggered by some signal like a moving average or a relative strength indicator or something else, and responding exactly as programmed. The thing is, this type of market behavior can be self-reinforcing, and so several more days of sell-offs is quite realistic. Being different in this case is a distinct negative. The magnitude of the ramifications of those strategies being unwound is hard to determine, although the direction is easy.

A moment about the volatility trading I mentioned above. Let me explain that trading volatility is extremely difficult. I spent some fifteen years trading and running options businesses and I know from whence I speak. In order to be effective, one needs to be deeply involved in the underlying market, which for me was mostly FX but also commodities and government bonds, as well as in the day-to-day activity in the options market. Understanding how the second derivatives impacted positions and profitability was critical to any level of success. The point is, the popular strategy of buying the XIV or SXVY (short volatility ETN’s) and leaving them in your account was never going to be a long run success. It appears that both of those ETN’s may actually disappear today, which means that despite closing at 99.00 yesterday, the XIV could actually be delisted today as its value approaches 0.00! I have not read the prospectus so am not certain that will be the case, but if you were counting on gains in that security as part of your portfolio, things just got a lot worse.

Back to the market. So we know that stocks fell sharply, and in what cannot be a great surprise, Treasury prices rallied alongside the dollar. That whole risk-off, flight to safety concept remains a fundamental part of the market, and as risk was being jettisoned yesterday, the true safe havens were highly sought after. So, 10-year Treasuries saw prices rise 1-½ points and the yield fall 15bps. The dollar rallied vs. most of its counterparts with only the yen, also a traditional haven currency, rallying further. On the flip side, aside from equity market declines, we saw commodity prices fall sharply too. And I would be remiss if I did not mention that Bitcoin, the erstwhile digital gold, fell sharply as well, on the order of 15%. Meanwhile, gold, as a traditional haven, rallied slightly, about 0.5%, showing that when it comes to a store of value, the barbarous relic has it all over the digital variety.

In this market environment, there is no room for a story about a particular currency or country. We continue in the midst of a significant readjustment and quite frankly, I believe there are only two things that can change this. The first is if we get central bank reaction such that the market believes that QE is not going to end. If, for example, the Fed halted its balance sheet roll-off, or Jens Weidmann started talking about the benefits of further QE, the decline would stop in its tracks. But I think we are a long way from that happening. The other thing is time. Essentially, sharp movements in the market tend to peter out not so much because anything has changed, but because time has passed and positions have finally been adjusted. That however, portends further pain for risk asset holders to come.

One last thing on bonds. It is somewhat ironic that Treasury prices rallied so far given that much of the blame for the equity market’s undoing can be laid at the feet of the fact that Treasury prices were falling so rapidly. Of course, the decline was based on changes in inflation expectations, while the rally was pure risk-off behavior. The thing is, if equity prices continue to fall, I expect that Treasuries will continue to rally. But when we finally settle down, inflation continues to be on an upward trajectory and Treasury prices are very likely to give back all these gains and then some.

Looking at today’s activity, we do get the Trade Balance (exp -$52.0B) and we hear from St Louis Fed President, and uber-dove, James Bullard just before 9:00. However, if Bullard is dovish, that is not news. On the other hand, if KC President Esther George is dovish when she speaks Thursday evening, the market would immediately take notice. Certainly equity markets are going to open lower again this morning. My guess is they maintain those losses at the end of the day, although in intra-day rally is likely as well. As to the dollar, if panic resumes, look for it to gain further. This is a risk situation, not an economic one for the time being.

Good luck
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Quite Dismaying

The bulls are all starting to fret
As rallies in stocks and bonds get
Their first taste of trouble
Were they in a bubble?
Perhaps, but we don’t know quite yet

Thus pundits all over are saying
Last week, while it was quite dismaying
Is likely to be
A hiccup, you’ll see
Meanwhile, everyone is out praying

If there is one notable thing from the press this weekend and this morning it is that almost universally, reactions to last week’s asset price declines have been, ‘don’t worry, it’s nothing.’ Now I will be the first to say that just because stocks fell 2.5% on Friday is not a sufficient signal that the end of the bull run is nigh. However, I do think it is important to remember what seemed to be the trigger of the move, and why the potential exists for further declines. And given the extremely high correlations amongst asset classes these days, declines in one asset are likely to lead to declines in all assets!

As I’m sure you recall, last week was a rocky one for asset prices before we got to Friday. While stock prices seemed to be stabilizing on Wednesday and Thursday after a rough beginning of the week, Treasury prices never slowed in their descent. Ironically, it was the AHE number on Friday, showing a 2.9% annual rise in earnings in January, that seemed to be the catalyst for the much sharper fall in Treasury prices and the collapse in stock prices. This is ironic because for the past five years at least, the Fed has lamented that wage gains have lagged so badly and they were working hard to push those wages higher. And yet, as soon as there was any inkling that they may finally be having some success in their endeavors, investors turned tail. The point is, if you needed proof that the key driver behind the asset market rallies of the past eight years was the extraordinary monetary policies of the central banks, then here it is. The chain of thought is that if inflation is finally starting to pick up, especially if it is picking up faster than expected, the central bank community will collectively stop adding liquidity to the system, and will in fact, withdraw some of the excess liquidity that already exists. Without that excess liquidity floating around, investments are going to have to stand on their merits. And that is a much tougher thing for anyone or anything to do!

Now it is entirely possible that we have already seen the worst of what is coming, and the idea that global growth will continue apace means that equity prices should never fall again, but I have to say that there are some ominous signals. First, the FOMC statement was clearly a bit more hawkish than anticipated, which implies that the Fed is ready to respond to rising inflation. Second is that in terms of experience on the Fed, in 2018 there will only be two voters, Powell and Brainerd, who have a history of voting for the past twelve months. This matters because so much of the recent financial market experience has been a complex dance between the Fed and investors/traders, with the communication strategy a critical aspect. However, now we have a Fed with extremely limited experience in terms of that communications dance, and so more likely to make a statement that doesn’t fit the meme. (Consider the Mnuchin weak-dollar comments from two weeks ago and the uproar they caused not only in the FX market but in the central bank community as well.) The point is that the perception of a policy error has grown dramatically. Finally, given the way inflation is calculated, the idiosyncrasies that drove it lower last year (remember unlimited cell-phone data plans?) are going to fade from the data, which means that the base effects are going to allow for higher readings going forward. Now, there is a large contingent of (Keynesian) economists who have started arguing to allow inflation to run hotter than the 2% target as they want to delay the Fed from raising rates further. However, one of the key things to remember about Chairman Powell is that he is not an economist, which means he is not necessarily Keynesian in his views. In fact, as a former banker, he is likely well aware of the damage that inflation does to the economy. My read is there is every chance he leans more hawkish than Yellen ever did, and that the consequence will be more declines in asset prices. Certainly, if inflation continues to tick higher, the back end of the yield curve will continue to steepen regardless of what the Fed does.

Now tying it all to the dollar is simple. The changing rate structure in the US is going to ultimately be seen as an attractive place to park funds. While the dollar could well show some further weakness in the near term, I continue to see it benefitting by the end of the year. The bigger risk, in my mind, is that the asset price decline gains serious traction and stocks fall 20% in the next month or two, at which point a general risk-off sentiment will be taking hold and the dollar should benefit sooner.

Now that I’m finished with last week, the week ahead seems much less interesting on its face. Overnight, the dollar has had a mixed performance with no significant movers in either direction. We did see Services PMI data from the UK (weaker than expected at 53.0), which pushed the pound a bit lower as well as from the Eurozone (stronger than expected at 58.0), which was unable to move the euro at all. It seems to me that the FX market is looking to the US equity markets for its cues right now, and while futures are pointing lower, the losses aren’t that large, hence the dollar’s indecision.

As to data this week, it is a pretty light calendar overall as follows:

Today ISM non-Manufacturing 56.5
Tuesday RBA Rate Decision 1.50% (unchanged)
  Trade Balance -$52.0B
  JOLTS Job Openings 5.90M
Wednesday Consumer Credit $20.0B
Thursday BOE Rate Decision 0.50% (unchanged)
  Initial Claims 232K

We do hear from seven Fed members this week, ranging across the spectrum from doves to hawks. It will be interesting to see if Friday’s data has moved the needle a bit further to the hawkish side and if they are going to start leading the market in that direction. We shall see. Overall, I feel like the dollar will remain rangebound this week as there are too many conflicting issues to allow significant movement in either direction. So for now, keep an eye on Treasuries and stocks, they will be key to everything.

Good luck
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Except JGB’s

All government bonds
Are under pressure today…
Except JGB’s

While markets are now anxiously awaiting the payroll report, a key underlying feature of markets this morning has been the virtual global rout in government bond markets. Yields are higher throughout Europe; with German bunds trading at their highest yields in almost three years while UK gilts are back to their highest yield since before the Brexit vote in June 2016. Of course, you are well aware of the ongoing rise in US yields, with the 10-year touching 2.80% yesterday and hovering just below there as I type. Which brings us to Japan, where JGB yields bucked the trend of rising yields. Of course, the reason is because the BOJ was actively intervening in the market overnight, buying JGB’s as part of their yield curve management program. So just when traders were thinking that even the BOJ was going to lean toward tighter monetary policy, the reality shows that there has been no such shift in view from Tokyo. This matters to our view of currencies because the widening yield premium of Treasuries over JGB’s has been enough to underpin USDJPY’s move higher by more than 0.5% this morning. This has been the biggest mover in the G10 space, although the dollar is firmer against all of its counterparts here. Perhaps what is most interesting about this market movement has been the sudden increase in articles describing all the reasons why the bond market rout may continue. By now I’m sure you all know that I believe yields around the world are going to rise, its just that I believe that US yields will be rising faster than others, and more importantly for the dollar, faster than currently priced by the market.

But at this point, all eyes are turning toward the US payroll report. Here are the current forecasts:

Nonfarm Payrolls 175K
Private Payrolls 172K
Manufacturing Payrolls 18K
Unemployment Rate 4.1%
Participation Rate 62.7%
Average Hourly Earnings (AHE) 0.3% (2.6% Y/Y)
Average Weekly Hours 34.5
Michigan Sentiment 95.0

This report includes benchmark revisions so can get a bit messy sometimes, but forecasts for revisions to 2017’s data have been quite small, just 95K in the NFP data for the entire year.

So what can we expect? Arguably there are only three potential outcomes here; weak, strong or as expected. In the event the forecasts are on the money, I would look for the recent market trends to continue. That means equities will remain beholden to earnings, bonds will continue to fall, and the dollar will probably give up some of its overnight gains. This would play into the idea that the market pricing for the Fed is on the money and therefore the dollar would have further to decline.

How about a weak report? Well, weakness in NFP, or perhaps more importantly for the Fed in AHE, would cause some serious recalibrating throughout the market. In fact, if the data was weak enough, say 125K for NFP or 2.3% for AHE, it would likely be enough to halt the bond market decline in its tracks. This would be the type of data signal that would get the doves on the Fed crowing (cooing?) again and force the bond bears to rethink how aggressive the Fed will be this year. And the dollar? Ugh, it would not fare well in this case, likely giving up all its overnight gains and then some. In fact, I would expect a weak report to send the euro to new highs for the move, breeching the 1.2550 level and beyond before the end of the day.

Finally, what if the data is strong? NFP above 200K or a decline in the Unemployment rate to 4.0%, or even more interestingly for the Fed, AHE jumping to 2.9%, would play to the bond and stock bears and the dollar bulls. Remember, bond market momentum is already strongly toward a sell-off, and this would exacerbate that trend. At the same time, while US equity markets have spent the past two sessions little changed, equity markets around the world have been under consistent pressure alongside their bond markets. A strong report here and the ensuing bond market sell-off would likely undermine the stock market as well. As to the dollar, this would be nirvana. Positioning in the dollar is extremely short according to futures market indicators and those positions have been broadly profitable to date. However, strength in this report, especially with a new Fed chair coming in, will likely result in a bout of profit-taking at the very least, and I think we could see the dollar close the week far stronger than it started.

And that’s really it for the session. My sense is that strength is in our future and that we are going to see the bond market sell-off continue along with equity market declines and a stronger dollar. Will this be enough to change the trend by itself? Not likely. But it will be one more piece of evidence that the trend is going to change.

Good luck and good weekend
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Further Than That

The FOMC stayed on hold
The outcome most thought would unfold
But ‘further’ than that
What they hinted at
Was on future hikes they were sold

Yesterday played out much as expected with first a strong ADP number (234K) having virtually no impact on the dollar, although it did seem to underpin the equity market in the morning. As I wrote then, given the previous strong print which was followed by a weaker than expected NFP number, pundits put less stock into a beat this month. Then the FOMC released their statement in the afternoon and the universal reading was of a slightly more hawkish stance going forward. The proximate cause of this view was the insertion of the word ‘further’ into the statement at two different points, highlighting a potentially more aggressive stance than previously expected. The key phrase was the following: “The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate.” So it is pretty clear that they are going to be continuing down this path for a while yet, and while they remain somewhat data dependent, they continue to express confidence that the inflation rate will gradually rise toward their target of 2.0%. The FX market response to this was to see the dollar recoup its early session losses and close essentially unchanged on the day. Equity markets, meanwhile, gave back their early gains, also closing essentially unchanged on the day.

But now as we look at markets this morning, we see a mixed session in FX for the first time in more than a week. What had been entirely a dollar story has now evolved into more specific currency discussions. For example, the euro is slightly higher this morning, up 0.25%, after PMI data showed continuing strength in the Eurozone economy. While the reading was unchanged at 59.6, that remains in strong growth territory. The pound has also benefitted this morning from data with Nationwide House prices rising a more than expected 3.2% on a Y/Y basis. While it seems it was more due to a lack of supply rather than an increase in demand, the pound has nonetheless benefitted by roughly 0.15%. However, the yen is finding itself under pressure this morning, down 0.4%, despite a better than expected PMI reading of 54.8. Perhaps it was the significant outflow of foreign equity investment that accompanied the Nikkei’s recent week-long streak of declines. Ironically, the weaker yen supported the Nikkei which itself rallied 1.7% overnight. The one other noteworthy aspect of G10 currencies is the Skandies, where both SEK and NOK have been performing well. Fresh comments from a Riksbank governor describing comfort with the recent rise in Swedish inflation to target levels has the market looking for the first rate hikes in years.

Pivoting to the EMG bloc, it is ZAR which is underperforming today, down 0.5% despite an ongoing wave of positive news. The market seems to be taking profits after a better than expected PMI release of 49.9, much closer to the growth line than expected. However, given the rand has been the best performing currency for the past three months on the back of the politics involving Cyril Ramaphosa’s election to party leader, I guess a little profit-taking cannot be surprising. The dollar has had a solid day against its APAC counterparts after equity markets throughout the region (except in Japan) all continued their recent slide. My sense is that if US equity markets are able to rally today, the fears engendered earlier this week about a correction are likely to fade and we will head back to the narrative of stronger stocks and a weaker dollar.

Data this morning brings Initial Claims (exp 238K); Unit Labor Costs (0.9%); Nonfarm Productivity (0.8%) and ISM Manufacturing (58.8). While the ISM number could be meaningful, with the payroll report on tomorrow’s slate, I would be surprised if traders responded too aggressively to anything but a wild miss, something like 54.0. In fact, I think today’s most likely outcome is one of limited activity as all eyes turn their focus to tomorrow morning. The only caveat is the equity market, which if it fails to hold after some mixed earnings data overnight, could result in the first inklings of a risk-off scenario. After all, Treasury yields continue to rise (currently 2.74%) and that cannot be good for stocks, but should be good for the dollar. At some point, investors will not be able to resist the significantly higher yield on offer from the US compared to its G10 counterparts. However, it’s not clear today will be the day of change. Tomorrow, however, has possibilities.

Good luck
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