Birds of a Feather

The crisis in Rome has abated
As two parties have been mandated
To govern together
Like birds of a feather
The League and Five Star are now mated

So markets have turned their attention
To trade, or perhaps its prevention
New tariffs in place
Have started a race
By nations to show their dissension

Political ructions in Italy have calmed down with the appointment of a new government. President Mattarella has approved the latest cabinet of the coalition government, which is set to win a parliamentary vote and begin governing right away. While its policy mix is unorthodox, and there are still many things that can go wrong, at least the immediacy of a major political problem seems to have been eliminated. Italian bonds rallied although they remain well below prices (yields are higher) than seen this time last week. We have not heard the last of this problem.

Meanwhile, Spanish PM Rajoy just lost a confidence vote and has been replaced by Socialist Party leader Pedro Sanchez, who is heading a coalition including Podemos, a radical leftist party and the Catalan nationalists who want to secede. It seems that this is a marriage of convenience and is unlikely to last for a long time. However, while I expect that things may get messy periodically in Spain, there is no indication that the vibe is anything like in Italy, where the question of EU membership remains a serious topic.

With politics out of the way, we can look at economics. Well, I guess this is politics too. At any rate, as of today, the US has imposed tariffs on steel and aluminum imports from Mexico, Canada and European nations, which has resulted in an immediate response by all three. Each nation has implemented its own tariffs in return taking the world another step away from the idea of free trade. Interestingly the market response to this news was extremely muted. It appears that this may have fallen under the category of old news. Either that or nobody really knows how to respond yet. If pressed, I would suggest that a reduction in global trade will be a dollar negative over time simply because most trade is denominated in dollars. This means there is always a bid for them as countries need to pay their import bills. Reducing those bills will reduce the demand for dollars. Will that be enough to offset the interest rate impacts we have been feeling lately? Probably not yet, but if we see the tariff story increase in scope, then it is a good bet that the structural dollar weakness story will start to dominate the narrative, and we could well see the dollar fall at that point.

One other interesting piece of news overnight was the reduction of JGB purchases by the BOJ in their most recent operation. This continues their process of stealth tapering…or does it? The market response was muted, with the yen actually falling after the news (-0.45%), and my take is that the BOJ already owns so many JGB’s, and there is so little liquidity left in that market, that they just don’t need to purchase so many in order to achieve their rate objective. Remember, their current goal is to keep 10-year JGB yields at 0.0%, and they are comfortable as long as it remains below 0.10%. Well, last night the yield closed at 0.048%, well within its range. This looks like a technical adjustment, not a policy shift, and I would not read anything into the change.

A quick look around the market shows that the dollar, despite its strength against the yen, is having a mixed session. Both the euro and pound are modestly higher (~0.1% each) as PMI data across the Eurozone showed stability, which was better than the declining trend we had been seeing, and the same data from the UK actually ticked higher, albeit to still well below Q4 levels. The rest of the G10 is a mixed bag with AUD and NZD weaker while CAD and CHF are both stronger. The point is that there is no defining dollar story here, each currency seems to be responding to its own catalysts. CAD, for example, continues to benefit from the growing belief that the BOC is going to raise rates in August. EMG currencies have also had a mixed performance with the standout movement coming from TRY again, as the lira has fallen 2% this morning. But we saw strength in INR (+0.4%), IDR (+0.7%), TWD (+0.4%) and KRW (+0.2%) last night. LATAM currencies are little changed this morning and the CE4 have barely edged higher. My point is that there is no rhyme or reason to today’s movement.

Which brings us to the last big data point of the week, this morning’s payroll report. Here are the current expectations:

Nonfarm Payrolls 190K
Private Payrolls 184K
Manufacturing Payrolls 18K
Unemployment Rate 3.9%
Participation Rate 62.8%
Average Hourly Earnings (AHE) 0.2% (2.7% Y/Y)
Average Workweek 34.5
ISM Manufacturing 58.5

Yesterday’s Chicago PMI was quite robust at 62.7 and Personal Spending rose a more than expected 0.6%, both data points helping to underpin the idea that the US growth story remains the strongest amongst developed nations. In fact, the Atlanta Fed updated its GDP Now forecast for Q2 to 4.7%, although that seems pretty high. However, considering this news as well as comments from Fed Governor Lael Brainerd yesterday that further gradual rate hikes were appropriate and likely to continue until the Fed Funds rate was above the neutral rate (meaning policy would actually be tightening) has simply reconfirmed the idea that the Fed is going to raise rates at least two more times this year, regardless of the ongoing questions about other currencies. The Fed is on a mission, my friends, and that mission is to normalize policy while they can. There is a clear realization that the economic expansion will not last forever, and they are very keen to have some policy ammunition when the next downturn arrives. While the Fed is far ahead of every other central bank on the planet, they are still inadequately armed. With this in mind, it is easier to understand my strong belief that the dollar is due to continue climbing for the time being. And in fact, unless we see a significant escalation in the brewing trade war, I see no reason for that trend to end.

Good luck