Is Everyone Scared?

There’s no question fear is pervasive
But which argument is persuasive?
Is everyone scared
‘Cause Donald Trump dared
To tweet something highly abrasive?

As we have seen for much of the past eighteen months, the tech sector continues to lead the overall equity markets around the world. Alas for most investors, these days the direction is lower. Continuing concerns over the potential government response to privacy on social media have been a hallmark of recent sessions. But there is plenty more that is taking the shine off of markets these days. For example, the president has been lambasting a leading tech company on a regular basis, and while it doesn’t yet appear that the government will take any actions, it is clearly in the forefront of investor’s minds. In addition, the trade situation continues to deteriorate with the Chinese imposing their tariff response to the US’s Steel and Aluminum tariffs announced several weeks ago. In addition, they stand ready to impose more when the Section 301 tariffs get finalized in coming weeks. (As an aside, arguably the Fed should be cheering on the impending trade war, as the one thing it will certainly do is cause inflation. And after all, hasn’t that been their stated goal since the financial crisis? While that is said with tongue partly in cheek, what it does highlight is either the absurdity of their position, or the incredible nuance they need to try to communicate and their failure to do so effectively. But either way, inflation is clearly heading higher and along with it, so are US short-term rates. That much is clear.)

But let us not forget the economy. Thursday’s data showed Core PCE rising more than expected at 1.6%. Yesterday’s data showed a slightly weaker than expected ISM print at a, still robust, 59.3, but more ominously a jump in the prices paid index to 78.1, its highest level since 2011, and a clear harbinger of rising prices. Here are two more indicators that the inflation story is starting to get ahead of the Fed. Arguably, one of the biggest equity market concerns is that inflation data starts to rise more sharply and the Fed feels it is necessary to quicken the pace of rate hikes. It seems to me that we are seeing just that scenario playing out. After all, virtually every price indicator in the past month has been higher than expected. I assure you if Friday’s AHE number prints above current estimates, the response will be dramatic.

The upshot of all this has been a clear flight to safety, and so it should be no surprise that the dollar has continued to hold its own during this period. While the yen continues to be the primary currency haven of choice right now, the dollar is a close second.

FX traders find themselves in an uncomfortable position because there are two very conflicting ideas making the rounds. The prevailing narrative remains that the dollar will weaken further this year on the back of tighter policy by other central banks while the market has already accounted for the Fed’s tightening. The problem with this is twofold. First, as LIBOR continues to rise daily, the carrying cost of maintaining a short dollar position is growing every day and becoming quite significant. As I wrote yesterday, in a negative carry short position, not falling is the same as rising over time. It is a loser. Combining this idea with the recent data showing rising inflation in the US and increasing odds that the Fed gets more aggressive has made life tough for the narrative.

But that’s not all! The idea that both the ECB and BOJ are going to be tightening soon also has to be called into question based on the recent data from both places. For example, last night’s Eurozone PMI data showed continued slowing in the pace of growth, with the 56.6 reading the lowest level in a year. This is the third consecutive decline in the reading and is starting to seem like a trend. (Remember, Japanese data is also tipping over.) Perhaps, the evidence is showing that Eurozone growth may be slowing down a bit. The difference between this and the US situation is the inflation question. Thus far, Eurozone inflation data has shown no penchant to increase unlike in the US. If this is so, please explain why the ECB will be so quick to tighten policy. Rather, I would argue that Signor Draghi will be quite happy to continue his gradualism by reducing, but still extending, QE to €15 billion per month for Q4 of this year before stopping in 2019. And at that point, it will still be at least six to nine months before they actually begin raising rates. I continue to believe that the prevailing narrative will be proven wrong as the year progresses which means the dollar still has upside.

As to the BOJ, the growth story there seems to be the same as elsewhere, with Q4 2017 the pinnacle and a slow erosion since then. Japanese inflation remains far below the targeted 2.0%, and although Kuroda-san continues to discuss the idea that the BOJ will raise rates at some point, that point is clearly a long ways off. The BOJ’s biggest problem is that if the equity markets continue to correct (and they have plenty of room left to do so) and it continues to drive a flight to safety, the yen will strengthen without any help from tighter BOJ policy. In fact, that will serve to put further downward pressure on inflation, and by extension likely undermine any USDJPY strength. At the beginning of the year my expectation was for the dollar to broadly gain against all comers except the yen. That still looks like a good bet to me.

As for today’s session, the dollar has had a mixed overnight session with both gainers and losers but neither side showing a clear advantage. Aussie and Kiwi are showing a little strength, but that seems odd given the dovish RBA comments when they left rates on hold at 1.50%. USDJPY is actually higher this morning, but that seems more like a trading bounce than based on fundamentals. In fact, the biggest mover today is NOK (+0.7%), which seems to be responding to the rebound in the price of oil. Emerging market currencies have done virtually nothing of note, which is interesting in that I would have expected more general weakness given the risk situation.

There is no data of note released today so FX is likely to be driven by the ongoing equity market gyrations. While futures in the US are pointing slightly higher as I type, European markets are lower across the board. It strikes me that we will continue to see equity markets pressured without a new catalyst. This is especially so since the technicians will be jumping on board now that the three major indices have all closed below their 200-day moving averages, a key technical selling signal. With that in mind, I like the dollar and yen to edge higher during the day.

Good luck