Her Prospects Go Thudd

This morning the pound is a dudd
Responding to news Amber Rudd
Has stepped down today
Now poor PM May
Is watching her prospects go thudd

As the new week begins, the FX market’s biggest mover has been the British pound, which has fallen a further 0.6% after news that Home Secretary, Amber Rudd, has resigned. Ms Rudd had been a staunch supporter of PM May as well as firmly in the Bremain camp and so has acted as a counterweight to other ministers like Boris Johnson and Michael Gove, who are hardliners regarding Brexit and have been seeking a complete repudiation of the EU. Adding to the mix, Rudd’s replacement, Sajid Javid, is a euroskeptic himself, perhaps tipping the balance a bit further for that side of the discussion. In the end, what we have learned over the past week from the UK is that growth continues to ebb, prospects for a rate hike this week have disappeared, and for a hike this year at all have receded greatly, and the possibility of a harder Brexit has increased. It can be no surprise that the pound continues to decline in this environment. In fact, since it peaked two weeks’ ago at 1.4370, amid the hype that the BOE would be getting aggressive in its tightening stature, it has fallen nearly 5% and there is no reason to believe this decline has ended. While some of the movement is certainly due to the dollar’s more recent strong performance, the pound is falling of its own accord as markets grow increasingly skeptical about the near term growth prospects for the UK.

But the dollar is not just firmer against the pound; it continues to perform well across the board. Arguably the key reason is because the market has been forced to re-evaluate its previous forecasts regarding the Fed. Why is that you ask? Well, Friday’s GDP data was stronger than expected at 2.3% indicating that the growth impulse in the US is more sustained than that anywhere else in the world. But perhaps more importantly, the inflation impulse in the US is also much stronger. The GDP based price index, confusingly also called PCE, printed at 2.7% and the Employment Cost Index printed at a firmer than expected 0.8%, with the wages subcomponent rising 0.9%. The latter two are exactly the type of data that has the Fed on edge regarding rising prices. This morning, their key inflation data point, Core PCE, will be released and is expected to be 1.9%, awfully close to their 2.0% target. And as I wrote last week, it is quite conceivable that it prints at 2.0%. The real question is just how far above that level will it need to go before the Fed starts to get nervous. Recent comments by several Fed governors, Dudley, Bostic and Kashkari, indicate that when Core PCE reaches 2.3%, there will be little concern, but at 2.5% it is a bit trickier. With oil prices continuing to climb despite growth in US production, and with some tariffs due to be enacted, it is hard to make a case for a reduction in inflation anytime soon. As I have been writing all year, the Fed is going to continue to tighten policy more aggressively than the narrative has been willing to accept, while the rest of the world will be less aggressive.

And looking around the rest of the world, we see that data from China (PMI at 51.4) continues to ease lower. Given recent activities by the PBOC, cutting the RRR by 100bps last week, it is clear that there is concern about slowing growth there. Last night also brought us much weaker than expected German Retail Sales (-0.6% vs. +0.8% expected) as well as an ebbing Italian CPI (0.5%). Once again, after last week’s disappointing French and Spanish GDP data, it has to be getting harder for the ECB hawks to make their case. At this point, it would be shocking if the ECB did anything before July and I will say that there is at least a 33% chance that come September, they do not reduce QE at all if the current growth trajectory remains in place.

In the meantime, Emerging markets are feeling the stress of higher USD interest rates on two fronts. First, many, if not most, emerging market companies are forced to borrow in USD because their domestic markets cannot support the practice effectively, and so higher US rates are a direct negative on those companies’ earnings and prospects. Second, the higher US rates have been boosting the dollar and so repaying the dollar debt outstanding is more expensive locally. And what we are seeing is EMG currencies generally depreciating vs. the dollar and so these trends are set to continue. There has been one exception to this rule, KRW, which appreciated a further 0.5% overnight on the news that North Korea has offered to close its nuclear weapons facility and is seeking a nuclear free Korean Peninsula. That is a remarkable turn of events and one that ought to continue to benefit the Korean economy and corresponding sentiment toward the won.

Looking ahead we have a great deal of important information due this week as follows:

Today Personal Income 0.4%
  Personal Spending 0.4%
  PCE 0.1% (2.0% Y/Y)
  Core PCE 0.2% (1.9% Y/Y)
  Chicago PMI 57.8
Tuesday ISM Manufacturing 58.8
  ISM Prices Paid 78.6
  Construction Spending 0.5%
Wednesday ADP Employment 193K
  FOMC Rate Decision 1.75% (unchanged)
Thursday Initial Claims 220K
  Trade Balance -$50.0B
  Nonfarm Productivity 0.9%
  Unit Labor Costs 3.0%
  ISM Non-Manufacturing 58.5
  Factory Orders 1.3%
Friday Nonfarm Payrolls 190K
  Private Payrolls 190K
  Manufacturing Payrolls 19K
  Unemployment Rate 4.0%
  Participation Rate 62.9%
  Average Hourly Earnings 0.2% (2.7% Y/Y)
  Average Weekly Hours 34.5

So as you can see, this week is huge on the data front. Almost everyone has dismissed the FOMC meeting as being a non-event but I am not willing to do so. Rather, given the recent trajectory of inflation readings, notably Friday’s data, I think there is a decent chance that the statement comes out quite a bit more hawkish than we have been seeing lately. In fact, it would not surprise if they cemented the idea that there will be three more rate hikes in 2018. But really, every day has something that matters, so my take is markets are going to be highly focused on each release as they try to divine the future. If the recent pattern of positive US data continues, I believe we will continue to see the dollar perform well. The combination of still massive short USD positions in the FX markets as well as rising US interest rates will serve to force further short covering and a strong performance. Of course, if the data disappoints and indicates that the US economy is starting to suffer in the manner of the rest of the world that would necessitate a change of view. But for now, my money is still on strength in the US economy, on higher inflation and a higher dollar.

Good luck