Quite Consequential

My friends, this is quite consequential
In fact it could be existential
When asked about trade
Mnuchin portrayed
A trade war as having potential

But Sunday when pressed on the subject
His softer tone saying that in effect
He just didn’t think
We were on the brink
Of a trade war with China in retrospect

Trade continues to be the primary focus of markets as Friday’s jitters have abated somewhat over the weekend. In what can only be described as the norm in this administration, there are conflicting views amongst not only different spokespeople, but seemingly, as Mnuchin demonstrated, amongst individuals themselves. If pressed, I would say that it is certainly not the president’s intention to initiate a trade war, but that he is quite focused on adjusting the terms of trade with China, as well as the rest of the world. After all, it was a key campaign promise. The problem for markets is that the volatility that accompanies the various statements and interpretations of those statements is significantly greater than we have seen for a number of years and is likely to continue to be so. Interestingly, comments from Fed Chair Powell on Friday were notable in their complete lack of concern over the current situation regarding trade. It remains clear to me that Mr Powell is unlikely to demonstrate concern if equity markets fall further, barring a complete, October 87 like crash. This may, in fact, be the biggest change in the Powell Fed compared to the previous three iterations, the expiration of the Fed put.

Speaking of Powell’s comments, his message Friday was that a steady pace of rate increases was appropriate policy in order to prevent inflation from building up too large a head of steam. These comments were echoed by both Chicago’s Evans and the NY president-select Williams, which is pretty good evidence that the core of the Fed remains on track to continue raising rates, with the next move to come in June.

The other feature of Friday’s markets was the payroll report, where the headline NFP number was a quite disappointing 103K and the previous two months saw downward revisions totaling 50K. However, that still leaves the 3-month average at ~200K, a very healthy clip. In addition, the AHE number was right on the button at 2.7%, so wages continue to edge higher, although are certainly not running away. The recent economic story in the US, as well as elsewhere in the developed world, is one of moderating economic activity. I have pointed out several times that the ISM/PMI survey data appeared to peak back in December and has been trending lower since. German IP fell a surprising 1.6% on Friday and this morning’s data from the Eurozone showed their trade balance shrinking as well. Economists and policymakers have grown to believe that growth potential in the Eurozone tops out at 2.0%, assuming it can even maintain that pace over time. The fact that last year saw output grow at 2.4%, well above potential has resulted in a greater likelihood of a slowing pace of growth, and with it, the removal of any inflationary impulse, assuming there was one to begin with. This is Signor Draghi’s problem, that despite a year with very positive tidings, that things may be sliding back toward a more lackluster economy, with a reducing in inflation pressure. Under this circumstance, it is awfully difficult to make the case that tightening policy is the appropriate response. And while the hawkish wing of the ECB, led by Germany’s Jens Weidmann, are quite keen to not only end QE but raise rates, there is still a sizable contingent, notably from the peripheral nations, that see no reason for that at all. I continue to believe that the ECB’s actions this year willl be far less hawkish than the narrative.

Of course it is the combination of these views that helps inform my sense that the dollar has further to rebound. That and the policy mix of US loose fiscal and (relatively) tight monetary policy. But there is another side to the dollar, one that I have not addressed, but one that ought to be an important part of the discussion, namely the budget/trade deficits. In the world of capital flows, the fact remains that as the US sees both its budget deficit increase and its trade deficit increase, the money has to come from somewhere to fund it. This is why the US capital account is in such large surplus (all those funds flowing in to buy Treasuries). But the point that dollar bears make is that as both those deficits grow, the US is going to need to offer more attractive terms to get the rest of the world to finance them. That means that not only do rates need to rise, but that the dollar needs to fall.

Here’s a thought experiment. Consider that you are a foreign investor with a euro functional balance sheet. In order to be attracted to Treasuries, you would want not only a higher coupon, which of course you clearly have at this time, but also to have confidence that the dollar would at least not decline, if it doesn’t increase. However, given the recent trend, with the dollar falling for the past fifteen months, it is hard to remain sanguine about its near-term prospects. I would describe this as the transitional phase, where the dollar may not yet have adjusted to a level sufficient to attract that critical inward capital flow. If that is the case, then a further downward adjustment in the dollar may be required before foreign buyers feel confident that the risks are outweighed by the coupon advantage. In other words, as long as the twin deficits continue to climb, the US will effectively have to offer better terms to the buyers of their debt, and that means higher rates and a weaker dollar. In fact, it is a compelling argument and a key part of many forecasts for a weaker dollar. However, when I consider all the evidence, I continue to believe that the dollar is unlikely to fall further, or at least much further, and will begin to rebound when the market understands the change in tone from the ECB. Remember that the entire FX market is a relative one, with important information from both sides of the trade.

A look at this morning’s price action shows that the dollar has edged slightly higher, but in truth, other than against the RUB (which has fallen nearly 3% due to new sanctions on the oligarchs), most of the movement has been relatively muted. In fact, if you consider the past three months, the dollar really has done very little overall.

Looking ahead to this week, the data flow is significantly lighter, with the highlight certainly Wednesday’s CPI print.

Tuesday NFIB Small Biz Optimism 106.5
  PPI 0.1% (2.9% Y/Y)
  -ex food & energy 0.2% (2.6% Y/Y)
Wednesday CPI 0.2% (2.4% Y/Y)
  -ex food & energy 0.2% (2.0% Y/Y)
  FOMC Minutes  
Thursday Initial Claims 230K
Friday Michigan Sentiment 100.8
  JOLTS Jobs Report 6.15M

So Wednesday is clearly the big day, with both CPI and the FOMC Minutes. At this point, it seems pretty clear that inflation indicators continue to slowly grind higher, but the risk to markets will be for a bigger jump. Given the consistent Fed stance that rates are going to only rise gradually, any data that indicates the Fed are falling behind the curve will likely see a reaction. As to the Minutes, given how much we have already heard from Fed speakers, it doesn’t seem like there can be much new information there. And we have four more Fed speakers this week as well, all likely to reinforce the message save Neel Kashkari, the confirmed uber-dove.

In the end, the market is still beholden to the trade rhetoric, and so choppy markets are the most likely outcome for the week. The one thing of which I am sure is that the trade story is nowhere near over.

Good luck