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