Mario’s Tune

Inflation in Europe returned
At least for last month, so we learned
Does that mean in June
That Mario’s tune
Will change and QE’s overturned?

Markets continue to relax after Tuesday’s panic over the situation in Italy. Yields on Italian debt have fallen sharply, although not yet nearly to their pre-crisis levels. US Treasury yields are climbing again as investors are no longer desperately seeking safety, although yields here remain below levels seen last week. While the political situation in Italy remains ‘fluid’, it appears, as of now, that the Five-Star / League coalition is going to return to President Matarella with a new government proposal, rather than trying to force a new election. Of course, until Matarella approves the list, the potential for a repeat of Tuesday’s price action remains. However, the market has moved on for now.

Instead, this morning the surprising news has been the inflation data from the Eurozone, where the May data showed a much larger than expected increase to 1.9% with the core level rising to 1.1%. While expectations were for both rates to rise, it appears that rising energy prices had a much bigger impact than forecast. And that is really the crux of the matter as the ECB will be loath to react to inflation that is solely driven by changes in gasoline prices. This begs the question as to what the ECB will do when they meet in two weeks’ time.

If you recall the beginning of the year, the narrative had described a situation where synchronous global growth would push the ECB to announce by the June meeting that they would be ending QE completely in September, and then raising rates sometime in Q2 2019. Of course reality intervened and as it became increasingly clear that global growth remained US led, with the Eurozone starting to lag, that story changed. The latest iteration has been that the ECB will wait until its July meeting to announce its plans, and that a reduction in, though not elimination of, QE was likely to be revealed. Estimates are for QE to decline to either €10 billion or €15 billion per month for the final three months of 2018, with an option to continue if deemed necessary. This altered timeline also pushed the first potential rate hikes back until the second half of 2019. And of course, as this process evolved, the euro declined.

But now the ECB has a different problem, politics is intervening again. Not only is the situation in Italy disruptive, but Spain is also looking at a modest upheaval, where PM Mariano Rajoy, a pro-market, center-right leader is about to face a vote of no confidence from parliament there. The ECB’s problem is that he appears likely to lose the vote, as he leads a minority government with limited support. This opens the way for a more radical left-leaning leadership with designs on increasing government spending and worsening the country’s fiscal outlook. If both Italy and Spain see political shifts to the left, where fiscal rectitude (not that Italy ever had any) is ignored, and market turmoil increases, it will become that much more difficult for the ECB to contemplate tighter monetary policy in the near term. With the July meeting only two months away, Signor Draghi is going to find that he will be unable to please any constituents no matter his actions. The German bloc remains uber hawkish and is very keen to see QE end and higher rates return. The peripheral nations could be devastated if that policy is followed.

It is with this in mind that I continue to look for the ECB to err on the side of easier policy. My contention is that the ECB will not even reduce QE in September, but extend it at €30 billion/month through the end of the year as they await further data to see if inflation is actually beginning to take hold, and to see how things play out in both Italy and Spain. And given that expectation, I continue to look for the euro to decline further as the year progresses. While this morning it has continued its rebound from its Tuesday lows, it is only higher by 0.3%, and trading at 1.1700 as I type. While I don’t doubt we could see a little more upside, I strongly believe it is limited.

In fact, the dollar is softer overall this morning, as the panic attack from Tuesday continues to abate. G10 currencies are all performing well, with a number of others (GBP, CAD, CHF) all rising similar amounts to the euro. Of these, CAD is of interest as it had a much larger move yesterday, jumping 1% in the immediate aftermath of the Bank of Canada announcement yesterday. While they left rates on hold, as universally expected, they removed dovish language from their statement and hinted strongly that they would be raising rates twice more this year, with the next move coming in August. That is a more hawkish stance than the market had expected as there continue to be concerns over the housing market in Canada and the fact that the entire nation seems to be somewhat overleveraged. However, the BOC is looking at the overall growth picture as well as the fact that inflation there is running at 2.3% according to the latest data, and concluding that the economy can withstand modestly higher rates. Consider, that even if they raise rates twice more, their base rate will still only be 1.75%, hardly restrictive. However, given the change in perception, the CAD rally is not surprising.

Turning to the EMG bloc, while APAC currencies all performed well, led by IDR (+0.7%) after the central bank there raised rates for a second time in two weeks, the story in EEMEA is a bit different, with the CE4 all rising, but both TRY and ZAR down a bit. TRY remains extremely volatile as President Erdogan continues to roil markets with his unorthodox economic views, but ZAR appears to be more technical in nature, with profit taking driving the market right now. Finally, both BRL and MXN remain under broad pressure as the issues of elections in both nations and NAFTA for Mexico add to uncertainty in investors’ eyes.

This morning brings a bunch more data as follows: Initial Claims (exp 224K); Personal Income (0.3%); Personal Spending (0.4%); PCE (0.2%, 2.0% Y/Y); Core PCE (0.1%, 1.8% Y/Y) and finally Chicago PMI (58.4). Given the Fed’s utilization of PCE in their models, all eyes will be there at 8:30. But in reality, unless the number is surprisingly different, investors will start to focus on tomorrow’s payroll report. Yesterday’s ADP number was a touch softer than expected, but still a robust 178K. The problem seems to be more about finding workers than job openings available. In the Fed’s eyes, they will be searching for more evidence that wages are rising, as Powell and company will assume that will feed into the general inflation level and encourage continuing policy tightening.

So while the dollar is under pressure today, I expect that this modest correction is coming to an end soon, and that we are far more likely to see it resume its strengthening trend, perhaps as soon as this morning if the data warrants. But the trend remains in place for the dollar to go higher in the medium term.

Good luck

Turned and Tossed

Apparently all is not lost
No Maginot line has been crossed
But Italy’s still
Devoid of goodwill
And markets will be turned and tossed

The acute fears felt in markets yesterday morning have abated somewhat today. While nothing has really changed in Italy, which has been the epicenter of the current crisis, the tone of the commentary has been softened. As in all politics, the initial disagreement is always loud and abrupt as each side tries to rally its supporters, but in the end, a compromise is usually reached. At least that has been the pattern during the post WWII era. Of course, during the past two years, arguably ever since the Brexit vote, that pattern has been called into question.

My contention is that during the past 75ish years, there has been a tacit bargain between politicians of all stripes and their constituent populations as follows: most people don’t really care that much about politics, nor about who leads their country. They are far more concerned with their personal situation seeking mostly to earn a decent living, take care of their family, go on vacation periodically, and perhaps most importantly, believe that their children’s lives will be as good or better than theirs. While there are certainly single issue voters, who care deeply about a particular subject (think pro or anti-abortion, pro or anti–gun restrictions, etc.), the bulk of the population just doesn’t care that much. This situation is why it is rare, at least in the US, for one political party to win more than two presidential elections in a row; people just get tired of one party trying to do too much and are willing to change things around. And while there have been recessions during this period, they tended to be pretty short-lived and so were not sufficient to alter the big bargain, which could be stated as: we don’t care who wins political office as long as our lives are reasonable. Don’t take too much in taxes and give us a chance to believe things will get better and we are ok.

But then came the financial crisis in 2008-9. The subsequent recovery has been so anemic around the world that after six or seven years, broad sentiment started to change. People looked around and saw that the political classes were not doing simply ok, but were thriving, yet their own circumstances were not improving much at all. At least that was the perception. And it is this change in view that has led to the upheavals in politics that we have witnessed since June 2016, when the UK voted to exit the EU. Antiestablishment candidates and parties have performed extremely well since then, with the Italian elections in March simply the latest manifestation of that situation. The question, at this point, is really about just how far each of these parties is willing or able to push their agenda. And it will differ in each country. So is Italy going to be the straw that breaks the camel’s back? Is this the time when one of the major post WWII institutions, which have been under attack before, finally succumbs to the populist vote?

My view is that the odds are much higher than ever before. Remember, even though the UK left the EU, the EU remains intact and is fighting fiercely to show why it is still relevant. But if Italy were to become Quitaly and leave the Eurozone, it is not clear that the euro would be able to survive the blow. And given that a new election in Italy seems destined by September, and the antiestablishment parties now command ~60% support in the polls, it is entirely possible that bigger things are coming.

Consider the financial repercussions that would occur in this event. Redenomination of Italian euro debt to lire debt would have a devastating impact on the entire Eurozone banking sector, as well as the ECB, which is the largest holder of that debt. All the money that Italy has borrowed from the rest of the Eurozone, its so-called Target2 balances, would be called into question as to its likely repayment. While Italian yields would skyrocket, they would almost certainly repudiate a large chunk of debt (they’ve done it multiple times in their history). The new lire would certainly tumble, but that would have the salutary effect of supporting their export industries. And while inflation would surely rise sharply, it is not hard to believe that the country would be able to recover relatively quickly without the strictures of German fiscal prudence holding them back.

Meanwhile, the euro would likely fall sharply to begin with, but eventually, it should recover. After all, if one of its weakest links were to leave, the remaining countries would represent a stronger bloc. But the one thing that is certain is that markets would be disrupted across the board for at least a few weeks, and possibly longer, as investors tried to figure out what would come next. Yesterday was a little foretaste of what might happen in the event of Quitaly. But it would be a much bigger impact.

However, they are not leaving today, and in fact, the market is far more sanguine that they will not do so at all. Italian bonds have recovered some of yesterday’s losses, while Treasuries and Bunds have both sold off a bit. The dollar has fallen pretty substantially against most currencies, with SEK (+1.35%) actually leading the way in the G10 while the euro has rebounded 0.8%. EMG currencies have also performed well this morning, led by ZAR (+1.1%) and HUF (+1.25%). Given the enormous volatility we have seen in TRY lately, its 1.8% rise seems merely ordinary. Equity markets have rebounded somewhat, with Italy’s MIB leading the way at +2.2%, but the DAX (+0.5%) also showing some spirit. (US futures are little changed at this point.) In other words, yesterday’s risk-off scenario has been unwound to some extent. It seems that the ‘buy the dip’ mentality continues to be a key driver in markets.

While there are many other things that ordinarily would have had an impact on markets (increased discussion of US tariffs, a rate hike in Indonesia, oil’s sharp price decline to name just three), that is not the market’s focus right now. That information will need to be assimilated going forward, but seems unlikely to drive a large price move. Of course, that is until those tariffs are imposed, or OPEC announces a change in policy, or something else happens and Italy drifts into the background. But that, too, is unlikely today.

Rather, looking ahead to this morning we see ADP Employment (exp 187K) and the second estimate for Q1 GDP (exp 2.2%, down from 2.3% initially). Later this afternoon comes the Fed’s Beige Book, which seems likely to continue to show US economic strength. Yesterday saw Case-Shiller Housing prices continuing to advance at a 6.7% clip while Consumer Confidence remains buoyant with a reading of 128.0, up from 125.6 last month. The point is that the data is not driving markets, the story is. If the story continues to evolve where 5-Star and the League in Italy moderate their demands, then we will head back to a data focused market, but that will take a few more days to get market participants to believe it, so my guess is that we remain hostage to Luigi De Maio and Matteo Salvini, the leaders of those two parties for the time being.

Good luck


Newfound Headaches

Remember “whatever it takes”?
When Draghi addressed old mistakes?
Now all that he’s done
Is under the gun
With Italy’s newfound headaches

But it’s not just Europe’s unrest
That has traders clearly depressed
The EMG bloc
Too’s feeling the shock
And assets there are now distressed

While we enjoyed our Memorial Day holiday in the US, and the UK celebrated (?) its Spring Bank Holiday, the rest of the world decided it was a good time to create some trouble, at least from investors’ perspectives.

Italy is the locus of the primary issue, where the constitution there requires that the winning party in an election propose a cabinet to be approved by the President. Usually this is a mere formality in the process, and any cabinet proposed becomes the new government. But these are not usual times. This time, President Sergio Mattarella has rejected the cabinet, or more specifically, the appointment of 81-year old Paolo Savona as Economics Minister. Savona, a former Bank of Italy official, is a known euroskeptic and given the rhetoric that we have heard from the coalition of the League and 5-Star, both of which have discussed leaving the euro in the past, Mattarella decided that it was too risky to allow someone like Savona into the government. Instead, Mattarella appointed a former IMF official, Carlo Cottarelli, to be PM and form a government. The last phase before a government is seated is that parliament must vote to approve it, and generally this, too, is a mere formality because the winning party, with the majority in parliament is forming the government. But not this time. It is almost certain that Cottarelli will not gather enough support and that will force new elections. The thing is, according to the polls, the antiestablishment coalition is likely to win an even larger share of the vote in the new election, which will ratchet up the pressure further.

It can be no surprise given this unfolding situation that Italian markets are under severe pressure. Italian yields have exploded higher, with 2-year yields rising 169bps, to 2.59% and 10-year yields jumping a further 56bps to 3.31%. Spreads vs. German bunds have blown out and the euro has taken another leg lower, now trading at 1.1550, down 0.6%, to its lowest level since last July. But it is not just Italy that is causing stress in Europe, Spain is also under pressure as PM Mariano Rajoy is due to face a vote of no-confidence, which given he is running a minority government, could well force another election there. Both Portuguese and Greek debt are feeling the pressure as well, with the entire Eurozone periphery seemingly looking to recreate the debt crisis of 2011-2012.

And so, the result this morning is the classic risk-off scenario. Equity markets are getting drubbed, with Italian stocks leading the way lower, -2.7%, but the Spanish close behind at -2.6%, and even Germany down -1.4%. (S&P futures are currently pointing to a 1% decline on the open in the US.) Treasuries, meanwhile, have jumped a full point and the 10-year yield is back down to 2.85% having touched as low as 2.80% earlier in the session. Bunds have also rallied with yields down to 0.27%, as have Gilts. In the FX markets, it can be no surprise that the yen has firmed, rising 0.5% as a haven, but the big winner is the dollar, which has rallied against every other currency. And it is the continued dollar strength that is causing the second set of ructions in the market, specifically in emerging markets.

I have written in the past about the issues with a stronger dollar regarding emerging markets. During the seven-year period when US rates were effectively 0.0%, both emerging market companies and sovereigns availed themselves of the cheap financing. And as long as the dollar remained stable or softened and US rates remained low, everything was grand. But you may have heard that US rates have been rising lately, with the Fed having raised rates six times already and pretty certain to push them another 25bps higher next month, and of course the dollar has been anything but weak. So now, these EMG players are finding that all their plans have been disrupted. The stronger dollar has forced both sets of borrowers to pay up in local currency terms in order to pay interest and repay principal of those loans. And the higher US interest rates have forced them to pay higher rates when it comes time for refinancing. So you can see that this has created a vicious cycle where higher US rates beget a higher US dollar which forces EMG companies to use more local currency to pay their interest, which weakens their currencies causing the dollar to firm up even more.

We have already seen the problems in Argentina and in Turkey and in Malaysia and in Brazil and in Indonesia and in South Africa… The thing is we are likely to see these same problems manifest themselves in a wider array of countries going forward, with a major concern being India, where they are running a significant current account deficit, a harbinger of future problems. And then there is China, which controls things more than most, but which is currently trying to address its own problems regarding over leverage and the shadow banking system. Going forward Chinese room for maneuver is likely to be less robust than it has in the past because of the impressive build-up of leverage there. As I have written in the past, one of the release valves for economic pressure there is the renminbi, and it would not be surprising to see USDCNY head back toward 6.75 if things in the emerging markets continue along this path.

With that as a backdrop, let’s take a quick look at the array of data coming this week:

Today Case-Shiller Home Prices 6.4%
  Consumer Confidence 128.1
Wednesday ADP Employment 186K
  Q1 GDP (2ndestimate) 2.2%
  Intl Trade in Goods -$71.0B
  Fed’s beige Book  
Thursday Initial Claims 224K
  Personal Income 0.3%
  Personal Spending 0.3%
  Core PCE 0.1% (1.8% Y/Y)
  Chicago PMI 58.1
Friday Nonfarm Payrolls 185K
  Private Payrolls 185K
  Manufacturing Payrolls 18K
  Unemployment Rate 3.9%
  Participation Rate 62.8%
  Average Hourly Earnings 0.2% (2.7% Y/Y)
  Average Weekly Hours 34.5
  ISM Manufacturing 58.4
  Construction Spending 0.8%

As you can see, we have a very big data week to add to the mix of market information. Obviously, the payroll data is the big one, but quite frankly, Core PCE cannot be ignored.  And this will all happen with the problems in Europe continuing to unfold and risk likely to be shunned further.

The biggest concern for most central bankers is that it appears a new crisis is unfolding and most of them have very little room for maneuver when it comes to adjusting policy.  If rates are already negative, it’s hard to cut them further.  QE programs are ongoing, and the talk is that they will be winding down.  But ask yourself how can Mario Draghi end QE if Italy is about to collapse in chaos? Meanwhile, the Germans will object strenuously to the continuation of QE if that is the decision.  Ultimately, as I have written in the past, the reality remains that the ECB will find itself in no position to end monetary accommodation for quite a while yet, and the euro will suffer accordingly. In fact, while I was beginning to think that the dollar’s run might be coming to an end, these latest issues have simply reaffirmed that the dollar has further to run.  At this point, regaining all the ground it lost in 2017 seems to be a conservative bet.

For now, markets will react directly to every pronouncement from Italy, so watch the tape for those, but the trend remains your friend, and the trend is for the dollar to continue higher.

Good luck





Wholly Absurd

The summit betwixt Trump and Kim
Was called off by Trump on a whim
Thus risk was disposed
And when markets closed
The future had looked mighty grim

But last night the news that we heard
Was Kim would still meet, undeterred
Thus buyers returned
And seemed unconcerned
The process was wholly absurd

Yesterday saw risk reduction in the form of softer equity prices and firmer Treasury prices as the ongoing saga of the proposed summit between President Trump and North Korean leader, Kim Jong-Un, was called off by Mr Trump due to the increasingly antagonistic rhetoric by the Koreans. It seems that many investors were basing their decisions on the idea that détente between the two nations would help alleviate one of the thorniest geopolitical issues currently percolating (arguably, Iran is the other right now). So calling off the talks was seen as a distinct negative for markets. But at this point, my take is this is all part of President Trump’s negotiating tactics, based on the fact that the North Koreans responded quite quickly that they were still willing to meet. And perhaps those tactics are working as it makes the Koreans seem more desperate to get a deal done. The upshot is that what had been a mild risk off session before the Korean response, turned around to a mild risk on session. The lesson to be learned here is that basing any financial market decisions on the twists and turns of the current geopolitical process is a hazardous way to act.

As I write this morning, equity markets around the world have edged up from yesterday’s declines, but remain largely within recent trading ranges. The bigger signal is from the Treasury market, where even this morning yields on the 10-year continue to decline, now down to 2.96%, and an indication that bond traders and stock traders see the world differently right now, with the bond boys and girls far more risk averse. Finally, pivoting to the FX universe, after a down and up day yesterday (falling early before rallying into the close), the dollar is extending its late day gains, albeit mildly. The thing is today’s dollar price action seems far less about the dollar per se, and more about the broad swath of negative news we’ve seen from elsewhere.

Data from the Eurozone showed that the German economy has yet to show any signs of a rebound from its much weaker than expected first quarter. The IFO survey printed at 102.2, unchanged, but still continuing its six-month declining trend. The euro edged lower by 0.2% upon the release and has basically remained there since, hovering right around 1.1700. Based on its recent price action, it certainly seems like the euro has further to decline.

The UK gave us the second reading of Q1 GDP, which reconfirmed that growth there was just 0.1%, a mild disappointment to those who have been trying to argue that the first print overstated the problems. The pound also suffered on the release and is down 0.3% on the session, falling to its lowest level in six months. From Japan, Tokyo CPI data, which is seen as a harbinger for the nation as a whole, fell to just 0.4%, weaker than expected and an indication that talk of the BOJ changing its policy anytime soon is foolish. In fact, I think it is more likely that they expand their QQE program than curtail it. The yen, which had benefitted from the recent risk aversion, has backed off slightly today, falling 0.2%.

But that is my point, none of these are dollar stories, rather today is a session of idiosyncratic market reactions. Another great example is SEK, where the Swedish debt office has decided to take a large long krone position, SEK 7 billion ($800M) as part of their management program. This is directly at odds with the Riksbank, who has been working hard to weaken the currency to stoke inflation. The result is that SEK is stronger by 0.3% against the dollar and 0.6% vs. the euro. But again, that is not a dollar situation.

The emerging markets offer the same tale, with Turkey, the current poster child for economic mismanagement, offering to allow banks to repay certain dollar borrowings from the central bank with Turkish lira. That will certainly have a short-term positive impact, but it does nothing to address the underlying fundamentals within the Turkish economy, and is likely to be a temporary benefit at best.

It is difficult to look around the markets today and come away with a consistent theme. Instead, it appears that investors and traders are looking ahead to the long weekend in both the US and the UK and have decided to moderate positions so they can enjoy the beach. Nothing has changed in the background stories, whether it is the Fed’s ongoing policy tightening, or the lack of a compelling case for the ECB to begin to tighten further. Inflation is not evident in Japan, Turkey, Argentina, Indonesia and Brazil are still under significant pressure and the dollar’s recent strength continues to undermine many previous investment memes. Now, none of this has addressed the US fiscal imbalances nor the idea that the dollar is likely to suffer in the long run. But as Lord Keynes reminded us, in the long run we are all dead. It could be a very long time between now and when the market starts to actually take those big structural issues into account. As such, my advice remains to manage your risk based on the current cyclicals and that still points to the dollar advancing for the foreseeable future.

Ahead of the holiday weekend we get one piece of data, Durable Goods (exp 2.6%, 0.0% ex transport) and we get to hear from Chairman Powell at 9:00. I’m confident that the market is far more interested in what he has to say than in the data print. However, it is inconceivable to me that he will change his tune at all. Look for him to continue to dismiss global volatility and to say policy is on the right path for now. In other words, US rates will continue to rise and the dollar along with them.

Good luck and good weekend

Probably June

It’s likely appropriate soon
That rates will be raised, prob’ly June
Or so said the Fed
When Minutes were read
By traders Wednesday afternoon

But also, that self-same report
Explained that the Fed would not thwart
A rise in inflation
Unless the formation
Of bubbles caused them to abort

Yesterday’s price action was a study in contrast. The morning was dominated by the growing fear of contagion as the ongoing rout in the Turkish lira led to a decidedly risk-off tone in markets. Equity markets fell around the world and the dollar, yen and Treasuries all rallied. This was even in the wake of the Turkish central bank finally responding to the lira’s sharp decline and raising a key interest rate 300bps. While that had a temporarily positive impact on TRY, it was not nearly enough to turn broader market sentiment around.

But when the FOMC Minutes were released yesterday afternoon, the market gained a new, happier perspective on the world. While the Minutes made clear that the Fed was going to raise rates in June, it remained circumspect on whether there will be one or two more additional rate hikes coming. But what really turned things around was when traders and investors saw the following words, [a period of inflation] “modestly above 2 percent would be consistent with the committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations.” In other words, the discussion about the symmetry of the 2.0% inflation target was reaffirmed.

The implication is that even as inflation continues to print higher over the coming months, and that seems almost baked into the cake given the arithmetic behind the calculation, the Fed is telling us that they are not going to overreact and raise rates more aggressively than currently forecast. I guess the new debate will be on just what defines ‘modestly.’ Is 2.2% modestly above their target? What about 2.5%? Is there even a number that the FOMC members have in mind? However, the one thing that is clear is that the market has reduced the expected trajectory of Fed rate hikes, and that led to very predictable outcomes. The first was that the US equity markets, which had been under pressure prior to the Minutes, all rebounded and closed higher on the day. The second was the dollar, which has been a huge beneficiary of the evolving theme that the Fed was going to get more aggressive, gave back some recent gains. And finally, Treasury yields fell further as the fear over inflation in the long run was overwhelmed by the idea that the Fed would not be in the business of driving the short end of the yield curve up to inversion.

Which brings us to today’s session. The dollar has continued to cede ground, down broadly, although not universally. For example, the most notable data from the Eurozone was a softer than expected German GfK Consumer Confidence print at 10.7, but the euro is still higher by 0.2%. On the positive side, UK Retail Sales in April were much firmer than expected, rising 1.6% in the month, and helping instill some confidence in the prognosis for the UK economy. It can be no surprise that the pound is the leading gainer today, up 0.4%.

But arguably, the most notable news after the Minutes was the new threat of tariffs of up to 25% on imported automobiles into the US on national security grounds. It should be no surprise that car manufacturers’ stock prices have all suffered, or that the equity markets in both Tokyo and Seoul fell after the news was reported. My sense is that this may also be a tacit way for the administration to signal it wants to see the dollar retreat a bit. Remember, back in February both President Trump and Treasury Secretary Mnuchin discussed how a weaker dollar was beneficial to the US manufacturing sector. While we haven’t heard much on that front lately, I’m confident they are not unhappy that their comments are having this effect. But in the end, barring actual activity by the Treasury on the subject, which I think is an extremely remote probability, the market will continue to focus on the Fed, the ECB, the BOE and their brethren central banks. In other words, FX markets will continue to be driven by central bank activity and expectations thereof.

Putting it all together, the implication is that markets are going to be watching the data even more closely as the central banks are truly becoming data dependent. For the Fed, clearly the PCE data is going to be the primary data point, although CPI will still affect market movement. In the UK and Eurozone, I think the growth story will be the driver, as the ECB has made clear they want to remove QE but need justification to do so, and that justification will come from an end to the recent down trend in economic statistics. Japan is still on the inflation train, so higher prints there will offer the opportunity for the BOJ to back away from some of their QQE. And generally, every G10 central bank will be even more focused than usual on the data results.

The dollar has had an awfully good run for the past six weeks, regaining all of its lost ground from earlier this year and starting to cut into last year’s losses. My take is that the Minutes are going to bring a halt to that run for the time being. I don’t expect the dollar to fall sharply, simply to consolidate its recent gains. However, despite the Fed’s clear willingness to allow inflation to rise above their target, I think that is a limited resource, and one that will be used up before the end of the summer. If pressed, while 2.2% is probably not going to raise any hackles on the FOMC, I think that anything above 2.3% will be seen as courting danger and draw out a completely different tone from the Fed. For now, though, it is a waiting game. Better than expected US data will see the dollar benefit somewhat, and worse than expected data will see it fall. Of course, this all presumes that some emerging market doesn’t go pear-shaped, and cause a broader risk-off meme. In that event, the dollar will benefit just like in the old days!

Today brings the weekly Initial Claims data (exp 220K) and Existing Home Sales (5.60M), neither of which seems likely to drive markets. We continue to hear Fed speakers, as well as other central bank speakers, and until the PCE data gets released next week, I expect that will be the most interesting thing to market participants. Early this morning, BOE Governor Carney and NY Fed President Dudley both spoke at a conference and discussed the replacement of LIBOR, not monetary policy. But we hear from both Bostic and Harker later today, and much more importantly, Chairman Powell tomorrow morning. So there is still plenty that can happen.

Good luck


Signs of Decay

According to data today
From Europe and from the UK
Those stories ‘bout growth
Depicted by both
Are now showing signs of decay

Remember when the Eurozone was growing above potential? Yeah, me neither! But in fairness, in 2017, the bloc did have a (relatively) blockbuster year, where GDP in the Eurozone grew 2.4%, which is well above most economists’ estimates of how fast it can grow over time. And it was faster than US growth as well, which of course was one of the reasons that the euro rallied 11% vs. the dollar last year. You might remember the meme that arose from that story, ‘global synchronous growth,’ which was going to be the key behind the ECB exiting QE and starting to normalize monetary policy. That was also the rationale behind the UK preparing to raise rates despite Brexit, and the main argument as to why the dollar was destined to fall much further.

But that is so last year. We are now five months into 2018, a pretty good chunk of the way, and the data we continue to see from both the Eurozone and the UK has basically demonstrated that 2017’s growth meme seems to have ended. Thus far, the euro bulls have relied on the idea that the slowdown in Q1 was a result of extremely cold weather, a flu epidemic and some labor strife. But now we are two-thirds of the way through Q2 and the data is simply continuing to trend lower with no sign of slowing down. (For example, German manufacturing PMI fell to 56.8, its lowest level since February 2017, with all the major subcomponents falling.) The point is that Mario Draghi and his compatriots at the ECB have to be looking at the data and starting to ask themselves just how anxious they are to change their current monetary policy settings. Continuing down the path of reducing accommodation amid slowing growth will be very difficult to explain to both the markets, and perhaps more importantly for them, to the politicians across the Eurozone. Ask yourself how the new antiestablishment government in Italy will respond given that nation’s desperate need for both NIRP and QE to continue.

In fact, the breadth of disappointing data today was impressive. From the Eurozone, we saw weaker than expected flash PMI data from Germany, France and the Eurozone as a whole, most of it the weakest since the beginning of 2017. We also saw French Unemployment tick higher to 9.2%, above expectations although not yet sufficient to describe as reversing a trend. From the UK we got both disappointing PMI data and lower than expected inflation data, with CPI falling to 2.4%, continuing its retreat from the November highs of 3.1%, and reducing the probability that the BOE will feel compelled to raise rates this year. Two things seem to be driving the inflation data, and both seem likely to continue. First is the fact that in the immediate wake of the Brexit vote nearly two years ago, the pound sold off sharply and remained there for quite a while. That led to higher import prices, which pushed up inflation. However, since then, the pound has rebounded quite smartly and as time has passed, that initial wave of price increases has passed out of the data. The second is that the overall growth rate in the UK economy is very clearly slowing down, thus undermining the idea that higher demand will drive prices up.

It can be no surprise that given the data releases, both the euro and the pound are sharply lower this morning (EUR -0.7%, GBP -0.9%) and plumbing depths not seen since December. In fact, both currencies are now lower YTD, and as I’m sure you must be aware by now, in my view have further to fall.

But today’s story is more than simply poor data from Europe; it really has the feel of an old-fashioned risk –off session. For example, the yen has rallied more than 1%, US Treasuries are up nearly half a point with the yield back down to 3.03%, and equity markets around the world are falling, with most down 1% or more. It seems that adding to the poor data story are some broader issues, things like a less sanguine attitude by markets regarding the trade situation between the US and China, the sudden sense that the meeting between President Trump and North Korea’s Kim Jong-Un may not occur after all, thus unwinding so much good will that the market had embraced, and the ongoing collapse of the Turkish Lira, which has fallen another 4% this morning and is working hard to catch up to Argentina for the title of worst-performing currency this year.

It is with all this in mind that we look forward to today’s session, where the FOMC will release the Minutes from its meeting back on May 1st and 2nd. If you recall, the big story then was the use of the word symmetric twice with regard to the inflation target of 2.0%. Pundits read that to mean there was a growing willingness by the FOMC to allow the inflation rate to run above target for a while before tightening too aggressively. Now, everyone is looking for a deeper explanation as to the rationale behind the change in language, and to see if we can get a clearer view of the future rate path. Remember, the market is currently pricing in rate hikes in both June and September, with a ~50% chance of one in December. Given that the data we have seen since the meeting has continued to show solid economic growth, I continue to look for that fourth rate hike, and for the markets to continue to favor the dollar as the year progresses. While I understand that long term questions about fiscal sustainability and its impact on the currency, which are decidedly negative in the dollar’s case, we are going through a period where cyclical relationships dominate the structural, and where long-established relationships, like the dollar following the path of US rates, have resumed their trends. This morning’s New Home Sales data (exp 677K) seems unlikely to change any views. Rather, the market is likely to remain in thrall to the ongoing deterioration of Europe and assorted emerging markets while it awaits those Minutes. In other words, look for the dollar to continue to perform well today.

Good luck

Lacking Coherence

The nation that’s shaped like a boot
Is causing some problems acute
Their fiscal adherence
Is lacking coherence
And frankly it does not compute

Once again the euro is under pressure this morning, although it has recently rebounded from its worst levels of the day, as the Italian political saga has taken another lurch forward. It appears that the anti-establishment coalition of Five Star and the League have agreed on a neutral party to be prime minister, Giuseppe Conte, a law professor from Florence University with no previous political experience. And while it is bad enough that the third largest economy in Europe is going to be led by a political neophyte, I think of much greater concern is the story about Italy issuing BOT’s as a means of financing the new government’s spending plans.

While there is not much information on this yet, these BOT’s are seen as potentially quite destabilizing to the euro with the possibility that they become a parallel currency in Italy. The last thing that the euro needs is another structural question. I assure you that Signor Draghi has not forgotten just how close the euro came to breaking up back in 2012 amid the Euro government bond crisis (remember “whatever it takes”?). Unfortunately for him, his home country has never been able to regain the ground it lost during that crisis and the economy there remains more than 5% smaller than it was prior to the crisis unfolding. Issuance of this new paper will be strongly opposed by virtually all the members of the Eurozone, but at this stage, it seems unlikely that the new Italian government will care. After all, their hallmark is that they are anti-establishment! While nothing has been agreed at this stage, and it may simply be another trial balloon similar to the story about the ECB writing off €250billion that circulated at the beginning of last week, the fact that it is even under consideration is testimony to just how difficult things are in Italy, and just how difficult it will be to bring that nation back into the Eurozone fiscal fold. While this process continues to unfold, I believe the euro will remain under significant pressure. Hedgers, keep that in mind.

While that was a new twist in the Italian story, the reality is that there has been very little else in the market narrative that is new. Trade talks between the US and China were inconclusive when they ended on Friday, but Secretary Mnuchin’s comment that ‘the trade war is on hold for now’ seems to have allayed fears within the equity investor community as stock markets around the world have rallied modestly.

Otherwise, there has been virtually no data of note released anywhere in the world. This morning’s pattern shows that the idiosyncratic stories from the EMG space, (Turkey, Argentina, Malaysia, Hong Kong, Brazil) have all continued along their previously determined paths. Perhaps the biggest news is that the IMF and Argentina have finally sat down to begin to negotiate the stand-by loan that the country desperately needs. But otherwise, today’s price action is simply an extension of what we have been seeing for the past several weeks.

Looking ahead to the rest of this week, data is sparse with Wednesday’s FOMC Minutes the clear highlight.

Wednesday New Home Sales 677K
  FOMC Minutes  
Thursday Initial Claims 220K
  Existing Home Sales 5.60M
Friday Durable Goods Orders -1.3%
  -ex transport +0.6%

And that’s all on the data front. We do, however, hear from seven Fed speakers in a total of ten speeches with Friday’s comments from Chairman Powell likely to be the ones that everybody watches most closely. Of course, remember that Friday is the day before the Memorial Day holiday weekend here in the US, and so trading desks are likely to be lightly staffed then. That just means that if he were to say anything surprising (which I doubt) there would be the opportunity for more movement than usual given the likely reduced amount of liquidity that will be available.

All told, while things appear quiet for now, it is critical to remember that there are several important stories that continue in the background and that market liquidity is going to diminish as we hit the summer vacation season. That means that volatility is likely to resume its uptrend, especially if any one of these background stories comes to the fore. Nothing has occurred to change my view that the dollar has further to rally vs. all its counterparts, and until we see weak US data or a distinct change in tone from the Fed, things are likely to remain that way.

Good luck

Perhaps They’ll Secede!

The League and Five Star have agreed
That looking ahead what they need
Is tax rates to fall
Plus income for all
And who knows, perhaps they’ll secede!

It’s official; the coalition between the two anti-establishment parties in Italy has been signed. While they haven’t yet named a PM, they are heading to President Matterella for official sanctioning and then will be presenting their government to parliament. The key platforms are the creation of a Universal Basic Income (UBI) for everyone below a certain level of earnings, and the imposition of a relatively flat tax structure, with just two rates, 15% and 20%. Given the way that fiscal policy is ‘scored’ by central banks and analysts, both of these proposals imply that Italy’s fiscal situation is going to deteriorate sharply. The combination of higher spending on the UBI with reduced income from the lower tax rates is a direct rebuke of Eurozone fiscal rules. And I understand that concern. But one thing that is important to remember is that Italians are notorious for not paying their taxes now, with much higher tax rates. They are almost Greek in their disdain for the process. Perhaps by cutting tax rates so dramatically, it will change some behaviors and, at least, maintain the current revenue stream, if not actually increase it. This would not be unprecedented. In Russia in 2010, tax revenues increased substantially after they changed the tax rates to a remarkably low 13% flat tax, as compliance improved significantly. The thing is the current scorecards don’t take into account human behavioral changes, and so it is entirely possible that the situation will not be as bad as some fear.

However, for now the situation has increased market uncertainty significantly. This is clearest in the Italian government bond market, where BTP’s have seen their spread to German bunds rise significantly in the past two weeks, from below 100bps to more than 150 today. It has also been felt in the Italian stock market, where the MIB Index has fallen 3% since Tuesday when the prospects for this outcome started to crystallize. And naturally, the euro has also been under pressure, with many pointing to Italy as one of the key reasons for the single currencies recent weakness. Of course, there are other reasons for the euro’s decline, notably the weakening growth and inflation data that we keep seeing, but Italy is not helping the cause. This morning, the euro is extending its losses, albeit slightly, as it remains anchored below 1.18 and is down a further 0.1%. I see no reason for this trend to end without a change in the data metrics. So if Eurozone data does not start to improve, look for a continued slide in the euro.

Poor Kuroda-san
Despite all he tries to do
Inflation’s absent

The other news of note overnight was the Japanese inflation data, where it once again disappointed, rising only 0.6% on a headline basis and 0.4% ex fresh food & energy. Not only was that below forecasts, but it also remains miles away from the 2.0% target. And there doesn’t seem to be any reason to expect that Japanese inflation is going to rise soon. Interestingly, with unemployment in Japan down to 2.5%, wages are rising more rapidly, with the latest reading showing a 3.1% gain. It seems to me that if I were PM Abe or BOJ Governor Kuroda I would be touting just how good things are for the country, with real wages rising sharply and prices remaining stable for those on a fixed income. But central bank orthodoxy won’t allow that type of thinking. Damn it, we need inflation to be at 2.0%!!!

The yen fell further after the news, now down 0.25% on the day, and trading back above 111.00 again. For now, it appears that this trend, too, will remain in tact. After all, it is abundantly clear that the BOJ is in no position to begin normalizing monetary policy given the inflation readings, while the Fed is not going to be deterred from its current path. I think we will continue to see Japanese investors looking at the dollar’s trend and the 300bp spread between 10-year Treasuries and JGB’s and decide that it is too good to miss, especially on an unhedged basis. Look for outbound Japanese flows to continue and the dollar to keep rising here as well.

In fact, the dollar is broadly higher this morning, although in most instances the movement has been modest. In the emerging markets we continue to see TRY crumble slowly (-3.7% this week), ARS crumble swiftly (-7.0% this week) and the other problem currencies (IDR, BRL, ZAR) all under pressure. Despite the fact that Brent crude pushed to $80/bbl, MXN is under pressure, as it appears the NAFTA story (No deal is imminent) is weighing on the peso. In fact, while each country has its own idiosyncrasies, right now the story is plainly based on the dollar. And until we start to see the data story change, with either US data missing or other nations showing better than expected outcomes, the dollar will continue to rule. A simple example was yesterday’s Philly Fed release jumping back up to 34.4, it’s highest reading in a year and putting paid to any idea that the US economy is slowing like the rest of the world. The sequence, for now, remains stronger US growth leading to higher US interest rates and a stronger US dollar.

There is no US data today although we will hear from two more Fed speakers, Brainerd and Kaplan. Thus far, we continue to hear that some FOMC members are thinking two more rate hikes this year while others see three. However, the big changes will come when it becomes clear that the ECB and BOJ, who have been touted to start reducing stimulus, have to admit that process will be delayed further. The week of June 11 should be quite interesting as on Wednesday, the Fed will have raised rates by 25bps, and on Thursday, both the ECB and BOJ meet. The divergence will be extraordinarily clear at that time, and we could well see the next leg higher in the dollar at that point. For today, however, given it is Friday and traders tend to square positions into the weekend, and given the dollar has performed quite well recently, I expect we could see a little profit taking and the dollar ease off a bit. But the long-term story remains clearly for a stronger dollar.

Good luck and good weekend

A Partner Betrayed

Perhaps today’s story is trade
Where NAFTA fans now are dismayed
Meanwhile ‘cross the pond
The EU has donned
The cloak of a partner betrayed

Some days, there is very little to discuss regarding the big picture, and even less to discuss regarding specific issues. Today appears to be one of those days, so I will be brief as I touch on the few things that seem to matter.

The Asia session revealed only two new data points of note, Australian jobs and Japanese outbound investment. The former showed an increase in full-time jobs of 32.7K that was larger than expected, and even though the Unemployment Rate rose to 5.6%, up 0.1%, the market looked at the jobs data and pushed the Aussie dollar up 0.5% at its peak, although it has since drifted back a smidge. However, it remains the best performing G10 currency vs. the dollar this morning. Meanwhile, Japanese investors increased the pace of foreign bond investment substantially, buying ¥827 billion last week as US yields are obviously becoming too attractive to ignore. The yen fell 0.25% on the news, trading back to its lowest levels since late January. One cannot be surprised at this given the BOJ’s ongoing efforts at yield curve control as they maintain 10-year JGB yields near 0.0%. When looking at that in comparison to US 10-year’s at 3.10%, the trade is pretty straightforward. This is especially true if investors are less concerned that the dollar is going to fall sharply, which of late seems to be the case.

Moving on to Europe, there was a distinct lack of data released and the only noteworthy comments came in the wake of an EU meeting in Sofia, Bulgaria, where the leadership coalesced around a position on trade. Essentially they said they were happy to negotiate a free trade deal, but would not do so with the threat of US steel and aluminum sanctions hanging over their head. In fact, they have a slate of retaliatory tariffs prepared to go in the event that the US tariffs go into effect next month. Interestingly, the euro, which had edged higher earlier in the session, fell after the news. Now it is possible that there was some other rationale for the euro’s decline, but I have not been able to find one. The single currency’s earlier strength had been predicated on the latest news from Italy, where yesterday’s story about seeking a write-off of €250 billion of debt has been walked back to where the Italians now want to be able to simply exclude debt held by the ECB from debt/GDP calculations. I guess that would help them move back toward previously agreed targets, but it certainly wouldn’t change the reality.

And finally, the news from the Western Hemisphere consisted of a surprise ‘no change’ by the Brazilian central bank, as they left the SELIC rate at 6.50% and appear to have abruptly come to the end of their easing cycle. Given the fact that the BRL has fallen 10% in the past month, their lack of a cut ought not be that surprising. And while Argentina continues to be a disaster, with no IMF agreement yet complete, more attention was paid to Mexico and Canada, where it appears that any completion of a new NAFTA deal will not be happening soon. Today marks the deadline discussed by House Speaker Ryan regarding the ability of the House to take up new legislation before the election season begins. And with the Mexican presidential election also looming in July, it seems like these talks will be on hold for a while. It is not clear to me if that means NAFTA will die, or if the status quo will remain until they resume. I am assuming the latter situation will prevail given the certain disruption a collapse of the agreement would bring to all three economies.

Taking all of this into account, markets are clearly undecided as to what to do next. Equity markets around the world are mixed with limited movement and the same is true with government bond markets and the dollar. In other words, traders are biding their time for the next potential catalyst. This morning’s US data brings only Initial Claims (exp 215K) and Philly Fed (21.0). Traders will be far more focused on the latter than the former as a strong number, like we saw from the Empire Manufacturing Survey, would likely serve as a reinforcement to the view that the Fed is not going to change its tack anytime soon. And given the Treasury market response to the Retail Sales and Empire data on Tuesday, a move that has not been retraced at all, I expect that a strong print could see another leg lower in Treasuries and another leg higher in the dollar. The narrative is slowly evolving from synchronous global growth to the US leading the way, and as data corroborates that view, the Treasury and dollar trends should extend further. I guess the real question is how long that can go on without equity markets coming under more renewed pressure. As to today, I expect the dollar to maintain its upward momentum barring an extremely weak Philly Fed print.

Good luck

Some Concern

Apparently there’s some concern
Investors will soon start to spurn
New Treasury debt
Which could be a threat
To equity prices in turn

It seems that we could be heading back to the ‘good news is bad’ situation that existed several years ago. Yesterday’s Retail Sales data printed pretty much as expected at 0.3% although there were revisions higher to the previous data making the report, on the whole, seem quite robust. The immediate market reaction was a sharp sell-off in Treasury bonds with the 10-year yield touching as high as 3.09% before settling up 8bps at 3.077% at the end of the day. This is the highest level since March 2011 and has reignited the conversation about just how high yields will go. This morning’s punditry has seen an increase in the number of stories talking about a move to 3.25% or 3.50% before long and what might be the potential consequences of such a move. This cannot be that surprising as it has become increasingly clear that inflationary pressures in the US continue to point higher. Another tidbit is the fact that the Fed Funds futures market is now pricing in a 55% chance of a fourth Fed hike this year, its highest level to date.

The market impact beyond Treasuries was quite clear as the dollar surged to new highs for the move while equity prices suffered, albeit less than they might have. Interest rate spreads between the US and the rest of the G10 continue to widen in the US’ favor and as long as this continues you can expect to see the dollar supported. The historic link between rates and the dollar is firmly back in place at this stage, and I see no reason for it to break in the near future. As such, with US rates looking very much like they have further to rise, I’m confident the dollar will come along for the ride.

But that is not the only thing helping the dollar this morning, there are two other stories that have helped feed the evolving narrative of US growth leading the pack. First, Japanese GDP in Q1 shrank -0.2%, its first decline since Q4 2015, and a surprise to most forecasters. While the discussion is that this is a temporary phenomenon having to do with bad weather and uncertainty over the global trade situation, the reality is that while the US continues to see data at or better than expectations, the rest of the world is lagging. Interestingly, while the yen did fall during yesterday’s session, it has actually rebounded slightly, just 0.15%, this morning. The other story that is getting some press, although not as much as I expect it will eventually, is from Italy, where the League and Five-Star parties continue their negotiations to form an anti-establishment government, and have discussed the idea of writing off €250 billion of Italian government bonds! Given that Italy’s debt/GDP ratio is an unhealthy 132%, it can be no surprise that a completely new and reactionary government doesn’t want to be held back by their predecessors’ profligacy (after all, they have their own profligacy to consider!) However, if this actually moves into the Italian government platform, it is going to be devastating to government bond markets throughout the world, and I assure you that the euro will not fare well either. In fact, this morning the euro is down a further 0.4%, trading below 1.18 for the first time since December 2017. The trend here remains very clear and I continue to believe the euro has further to fall.

I have written before about the idea of a debt jubilee, where central banks tear up maturing bonds and leave the cash in the system thus reducing government debt outstanding and expanding the money supply. This would be highly inflationary. When looking around the world at record high debt levels, it is something that has to be considered possible. While I have always believed that Japan with its 230% debt/GDP ratio would be the first country to consider it, Italy had to be a candidate. And since it is evident that the new government is willing to consider radical changes in the way things are done there, I guess it shouldn’t be a big surprise. But it would have a monumental impact on financial markets if they were to do this, with risk being shunned everywhere and haven assets exploding higher. I’m not saying this is going to happen, just that the probability has clearly turned non-zero. Watch this space!

With all that in mind, the dollar continues to power ahead vs. both G10 and EMG currencies although most of the individual stories are less interesting. The one outlier this morning is ARS, which actually rallied nearly 4% yesterday after the government was able to roll over $26 billion equivalent of local currency debt, albeit paying between 38% and 40% to do so. While the market did take the news well, I don’t have to remind you that paying 40% interest is not really sustainable. If the IMF deal isn’t closed soon, I fear things there will really get out of hand. But that was the only bright spot on the day. We continue to see TRY (-1.8%), BRL (-0.9%), IDR (-0.5%) and KRW (-0.9%) lead the way lower across the board. And here, too, there is no reason to expect that the situation will change. In fact, the ongoing issue with the emerging market currencies is that higher US interest rates are beginning to compete effectively with investment opportunities in those countries. As such, investors are looking at 3.0% in the 10-year Treasury, a riskless yield, and it is starting to compare favorably to everything else available. Complicating the cycle for EMG economies is that they have been on a USD borrowing binge for the past eight years and it is becoming increasingly more expensive to service and repay that debt, weakening those economies. Here too, I think the dollar has further room to run.

Looking ahead to this morning’s data we see Housing Starts (exp 1.325M) and Building Permits (1.35M) along with IP (0.6%) and Capacity Utilization (78.4%). What we have learned from the inflation data is that the housing market remains robust. And given the tax changes, there is a clear expectation for gains in Capex, which should help the other data this morning. In other words, it is difficult to look at the data and come away with a rationale for either Treasuries or the dollar to reverse course. In fact, my take is that we could see the dollar continue to rally through the end of the week, whereupon traders are more likely to start taking profits before they go home for the weekend.

Good luck