Perhaps, Has Been Quelled

In Europe the powers that be
At last got around to agree
On policy specs
That are quite complex
But take pressure off Italy

So immigrants now will be held
Off shore, and some will be expelled
Frau Merkel survived
The euro? It thrived
This problem, perhaps, has been quelled

The dollar is under pressure this morning, largely led by the gains in the euro, which has rebounded 0.75%. The proximate cause of this rise was news from the EU summit that they agreed on a new immigration plan designed to reduce the pressure on Italy, a key staging point for African immigrants to the EU, as well as create a series of camps in North Africa to detain asylum seekers and refugees while they are processed. This has been a huge issue in Europe, with significant divisions amongst the various players, and has been a key driver of the rise of right wing populism on the continent. While it remains to be seen if the agreement actually comes in to force, and if it is effective in its stated goals, at least for now the market is giving it the benefit of the doubt. One critical feature is the belief that German Chancellor Merkel has now removed the threat of her governing coalition partner, the Christian Social Union, leaving the government and thus CDU/CSU/SPD coalition will continue with Merkel at the helm. Given Germany’s preeminent role in Europe, there has been significant concern that if Merkel is pushed out, ensuing EU leadership will be unable to maintain the growth momentum that currently exists. And remember, data continues to show that growth momentum in Europe is slowing anyway.

There was one bright spot on the data front, though, as Eurozone headline CPI printed at 2.0%, exactly as expected, but a positive nonetheless. Of course, the rise was entirely attributed to oil prices, as core CPI actually disappointed, falling to 1.0%, still very far from the target of “just below 2.0%”. It is by no means obvious that a more genuine inflation impulse is brewing on the Continent just yet, and so I continue to believe that the ECB, while it seems likely to end QE in December, will still not be raising interest rates for quite a long time in the future. In fact, my sense now is that Eurozone rates remain at -0.4% until Q1 2020 at the earliest.

Speaking of rates, we did hear from two Fed speakers yesterday, with both commenting on the brewing trade war situation. Bostic and Bullard remain on the dovish side of the spectrum, with each of them explaining that they were quite concerned over the possibility of a yield curve inversion occurring, and both of them remarking that their conversations with businesses in their respective regions highlighted those businesses’ concerns over the trade situation and the impacts it could have going forward. Bullard, in fact, continues to maintain that the Fed needn’t hike rates any further this year, while Bostic seems in the one more time camp.

I think it is time to have a brief discussion on the yield curve inversion situation. To be clear, I am looking at the yield spread between 2-year Treasuries and 10-year Treasuries, which in more normal times, has traded in a range of 75bps-125bps. This means that the 10-year Treasury’s yield was that much higher than the 2-year Treasury’s yield. This morning, however, that spread is just 32bps, and has been trending lower ever since the Fed started tightening policy. When the spread turns negative, it is called an inverted yield curve, and the concern arises from the fact that every time we have seen an inverted yield curve in the past fifty years, a recession has followed within a fairly short period of time.

Now I greatly respect this historical indicator and it makes sense economically that an inverted curve would lead to a slowdown in economic growth, but I think it is critical that we remember one thing that is truly different this time. In the past, the Fed’s balance sheet represented a much smaller proportion of the economy, generally less than 10%, and so any bonds they owned had only a minor impact on market pricing. Therefore it was reasonable to believe that the 10-year yield was an accurate reflection of what the market demanded for that risk. However, that is not today’s situation. Even though the Fed has begun to reduce the size of its balance sheet ever so slowly, it still remains as ~22% of the economy. And if you recall what QE was all about, it was a price insensitive bid for Treasury bonds that was designed to drive long-term rates lower, and it succeeded in doing so.

My concern is that those long-term rates are still a reflection of the Fed’s buying activity during QE, rather than an accurate reflection of investor demands regarding the risk of holding 10-year debt. In other words, they are likely much lower than they otherwise would be, in the absence of QE ever happening, and thus despite the fact that short term rates have been rising and a curve inversion seems possible soon, it may not be giving us the same type of signal. Given the strength of the US economy, and the current US inflation rate, it would not be hard to make the case that 10-year Treasury yields should be 4.5%-5.0%. After all, that would equate to real rates of just 1.7%-2.2% based on the current CPI readings of 2.8%. And real rates of 2% + or – have been the long run historical average. So if the Fed buying has resulted in 10-year Treasury yields being 170bps lower than the historical record for the economy, perhaps the angst over an inverted yield curve is misplaced at current levels. This could well be the first time that the curve inverts and no recession follows. Food for thought.

Anyway, back to the markets. As I mentioned above, the dollar is broadly weaker, which is not only the result of the European situation, but also seems a simple price correction heading into the weekend. Japanese data showed Unemployment falling sharply, as well as the BOJ able to reduce the amount of JGB purchases necessary to maintain stability in rates in that market. Indonesia surprised the punditry by raising overnight rates by 50bps, to 5.25%, which helped support the rupiyah. And in general, the dollar is on its back foot today.

I have been expecting a correction, so this price action is no surprise. Meanwhile, this morning we get the latest Core PCE number, the critical inflation data point that the Fed uses in their sorcery modeling (exp 0.2%, 1.9% Y/Y). We also see Personal Income (0.4%), Personal Spending (0.4%), Chicago PMI (60.0) and Michigan Confidence (99.1) as the month and quarter come to a close. In the end, while the dollar is under pressure today, I continue to look for the Fed to maintain its tightening cycle and the rest of the world to lag, thus the dollar remains more likely to rise going forward.

Good luck and good weekend
Adf