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