Monthly Archives: August 2018

More Concerned

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More pressure has lately been felt
In China, despite Road and Belt
As growth there is slowing
And Xi Jinping’s knowing
He must change the cards he’s been dealt

So last night, the news that we learned
Was both sides have grown more concerned
Thus trade talks would start
While traders took heart
And short-sellers of yuan got burned

While the Turkey situation has not disappeared completely, the central bank there appears to be regaining some control over the lira through surreptitious rate hikes. Cagily, they have stopped offering one-week liquidity, which theoretically could be had for ‘just’ 17.75% and instead are forcing banks to fund at the more expensive overnight window. This amounts to an effective 300bp rate rise and has been a key reason, along with yesterday’s announced moves regarding short positions, as to why the Turkish lira has rebounded so sharply from its worst levels. This hasn’t changed the macroeconomic picture, nor can it address the ongoing political row between the US and Turkey, but it has been effective in cooling the ardor of traders to short the lira. We will continue to monitor the situation, but it appears, that for now, TRY will no longer be the primary topic in FX markets.

Which allows us to turn our attention to China, where last night it was announced that low level trade talks between the US and China would start later this month in Washington. That is clearly the best news we have heard on the trade front in months, and although the process for further tariffs continues apace in the US, and it seems highly likely that next weeks imposition of tariffs on $16 billion of Chinese goods would go ahead, traders took the news very positively. The FX response was to reverse the renminbi’s recent decline, which prior to the news had seen it trade above 6.95 and perilously close to the 7.00 level many analysts have targeted as critical in PBOC deliberations. But this morning, USDCNY has fallen 0.75%, quite a large move for the currency pair, as fears of further escalation in the trade war seem to have abated slightly. There is certainly no guarantee that these talks will amount to anything or bring about further discussions, let alone a solution, but for now, they have been extremely well received by markets. Not only did the yuan rally, but also the Shanghai Composite reversed its early weakness, having fallen 1.8% at the open, and closed lower by only 0.65%. Hong Kong shares, too, rebounded from early weakness to close only marginally lower. It is important to remember that one of the drivers of the Shanghai market had been much weaker than expected earnings from Tencent, the Chinese internet firm that owns WeChat, China’s answer to Facebook. But there is no question that the news about trade talks was a critical factor in the rebound.

With these two stories as the lead, it is not surprising that the dollar has ceded some of its recent gains and is a touch softer overall this morning. Other EMG currencies that had seen significant pressure like ZAR (+0.1%), MXN (+0.5%), and RUB (+0.3%) have at least stabilized, if not reversed course. Fear of contagion remains rampant amongst emerging market investors and I expect that they will only return to markets slowly. And of course, it is entirely possible that the measures taken by the various authorities will turn out to be insufficient to address what in many cases are structural problems, and the currency rout will resume. But for now, it feels like a modicum of calm has been restored.

Meanwhile, G10 currencies are also mildly firmer this morning, although the dollar remains near its recent highs. For example, while the euro is higher by 0.3%, it is still trading with a 1.13 handle. There has been very little Eurozone data to drive markets, but there have been several articles discussing the ongoing trauma in Italy and how concerns over the new government’s fiscal policies may still turn disastrous.

Looking toward the UK, Retail Sales data there was quite strong, rising 0.7% in July, well above expectations for a 0.2% rise. However, the benefit to the pound has been minimal, with it rising just 0.1% on the news. Brexit remains a huge cloud over the currency (and the economy) and every day there is no positive news means that there is that much less time to create a solution. You all know I foresee a hard Brexit, not so much on principle as much as because I fear the May government simply cannot decide how to proceed and is not strong enough to impose a decision.

The last noteworthy piece of news in this space comes from Oslo, where the Norgesbank left rates on hold, as expected, but also essentially cemented the idea that they will be raising rates in September, joining the growing list of countries that are beginning to remove the excess accommodation put in place as a response to the financial crisis. After all, the tenth anniversary of the Lehman bankruptcy, the time many hold as the starting point to the crisis, is coming up in less than a month!

This morning’s US data brings Housing Starts (exp 1.2M), Building Permits (1.28M), Initial Claims (217K) and Philly Fed (22). Yesterday’s data was pretty strong, with the Empire Mfg print higher than expected and productivity growth showing its highest outcome since Q1 2015. In all, there is nothing in the data that suggests the Fed is going to change its tune, and if the trade situation eases, it is even more likely the Fed remains steady. All in all, despite modest softness this morning, the dollar remains the best bet going forward.

Good luck
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Myriad Flaws

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The Turkish are starting to act
As dollars they try to attract
Restrictions imposed
Effectively closed
The method short-sellers had backed

But problems in Turkey remain
And although we’ve seen lira gain
The myriad flaws
In Turkey still cause
A major league capital drain

Much to my chagrin, I am forced to continue the discussion on the Turkish lira as it remains the driving force in FX conversations. Despite the fact that Turkey is a bit player on the world stage economically, the fear engendered by its recent policy actions and subsequent market gyrations continues to have spillover effects elsewhere around the world. The latest example is that the Indonesian central bank surprised most analysts last night and raised their policy rate by 25bps to 5.50% specifically to help fight further IDR weakness. The rupiah finds itself weaker by 1.2% this week, despite the rate hike, and nearly 5% since late June, which has included two rate hikes. Clearly, the market has evaluated the macroeconomic situation in Indonesia and sees too many similarities to Turkey, notably the significant amount of USD debt outstanding there. As long as the Fed continues to tighten policy, and there is no hint that they will be slowing down anytime soon, every emerging market with significant USD debt outstanding (besides Turkey and Indonesia, Malaysia, South Africa and Argentina come to mind) will continue to see their currency under pressure.

The question of whether the Turkey situation is a harbinger of others remains the hottest topic in FX markets. Last night, the Bank of Turkey took a page from China’s activity book and attacked the forward FX market by reducing the limit on banks’ swap transactions to 25% of shareholder equity, down from the previous level of 50%. This had the effect of driving up short-term lira rates substantially, with the overnight rate touching 34.5%. It should be no surprise that the lira has continued yesterday’s rebound, rising a further 3% this morning, but that is well off the highs for the session, when it traded back below 6.00 briefly. The point is that despite not raising the base rate, the central bank there does have some tools to help address the situation, at least in the short term. However, there is very limited confidence that President Erdogan will allow the central bank the leeway deemed necessary to address the lira’s problems in the long run. This story is nowhere near over, although several days into it, the story is starting to get a little tired.

Turning away from Turkey, the dollar is having quite a good session. Versus its G10 counterparts, we have seen consistent strength to the tune of 0.2%-0.3%. Data has not been the driver as the only notable release has been UK inflation, where the headline came out at 2.5%, 0.1% higher than last month, but right on analysts forecasts. There has been a modest amount of Brexit conversation, but none of it has been positive, and at this point, every day without positive news is likely to weigh further on the pound. Meanwhile the euro is making a run at 1.1300, a level not traded since late June 2017, and unless we see some policy adjustments, it is hard to believe that the data is going to turn things in the near future.

Regarding the rest of the emerging markets, there has been some substantial weakness in ZAR (-3.3%), MXN (-1.2%), KRW (-1.3%) and RUB (-1.4%), none of which have released any economic data of note. This feels much more like contagion as traders seek proxies to short while the Turkish authorities use up their ammunition. But of more interest to me is CNY, which has fallen 0.4% this morning to 6.9250 or so. Many analysts have been confident that the PBOC would not allow the renminbi to weaken past the 6.90 level, as they are concerned over potential capital outflows. However, I have maintained that the renminbi has much further to fall. I believe the PBOC will continue to see the renminbi as the most effective release valve for the pressures that continue to build in the economy there. Remember, too, that the government imposed much stricter capital controls earlier this year and so they are feeling more and more confident that they will not have a repeat of the 2015-6 situation. In fact, the most recent data showed that FX reserves in China actually rose last month, surprising every analyst. The upshot is that there is further room for CNY to decline, and a move past 7.00 is merely a matter of time. In fact, it would not surprise me if it occurred before the end of August.

Turning to today’s data releases, we actually receive a great deal of new information as follows: Empire State Manufacturing (exp 20); Retail Sales (0.1%, 0.3% ex autos); Nonfarm Productivity (2.3%); Unit Labor Costs (0.3%); IP (0.3%); Capacity Utilization (78.2%); and finally Business Inventories (0.1%). While Retail Sales will garner the most attention, I will be watching ULC carefully as wage growth remains the watchword at the Fed. If that number surprises on the high side, that will serve to reinforce the idea that Chairman Powell is going to ignore the screams of the emerging markets for quite a while yet. In the end, nothing has changed with regard to the broad macroeconomic picture and the dollar ought to continue to see support across the board. Don’t say I didn’t warn you.

Good luck
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Somewhat Misguided

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The story in Turkey remains
One loaded with stresses and strains
While Erdogan dithers
The lira, it withers
And everything points to more pains

It seems, though, most traders decided
Their fears turned out somewhat misguided
So havens they’ve sold
From Swiss francs to gold
As safety’s now soundly derided.

The crisis in Turkey is, literally, yesterday’s news! This morning, while there have been no policy changes announced by the Turkish government, it seems that markets are feeling a bit less stressed. In fact, the Turkish lira has rebounded 5.5% as I type, although it is still lower by 25% in the past week. There has been no indication that President Erdogan is going to allow interest rates to rise nor has there been any hint that the Turkish government is going to heed calls to address its fundamental economic problems. Rather, it appears that in the manner of autocrats everywhere facing economic stress, Erdogan is blaming foreign influences for his domestic problems. It makes no sense to me that this crisis in Turkey has ended, but it is not that surprising that after a market move of the magnitude we have just seen in TRY, it should pause. Remember, too,
a key stressor has been the US-Turkish dustup over the detention of an American pastor and the tariffs imposed by President Trump in an effort to force Erdogan to comply with the US request to release him. And that shows no signs of ending either. The point is that while things today have calmed down, my sense is this is a temporary lull.

Moving on from Turkey, we see that China released a passel of data last night, none of which impressed. Fixed Asset Investment fell to 5.5%, the smallest gain in this series since it began in 1996. Retail Sales fell to 8.8%, below expectations and continuing the downward trend that has been evident for the past two years, while Industrial Production rose 6.0%, also below expectations, and continuing the gradual decline in the pace of this statistic. Taking it all together demonstrates that China’s efforts to reel in excessive debt growth earlier this year is starting to pay dividends. The problem for President Xi is that combining that effort with a trade fight with the US is starting to have a bigger nationwide impact than he would like to see. This is why we will continue to see the PBOC ease policy further this year, and why I continue to expect further pressure on the renminbi going forward. There have been many analysts who claim that the PBOC will prevent the currency from weakening beyond 6.90 or 7.00 as they fear the potential effects on capital flows. I disagree with that assessment and expect we can see a further decline in CNY as long as the dollar continues its broad based rally.

As to other emerging markets that had been severely impacted yesterday, we have seen most of those currencies rebound this morning. For instance, ZAR has rallied 2.5%, RUB is +1.5% and MXN is +0.9%. The point is that with TRY taking a breather, the same has been true elsewhere in this space.

Turning to the G10, we received a significant amount of data this morning with most of it better than expected. For example, UK Unemployment fell to 4.0% while Eurozone GDP grew at a 0.4% rate in Q2, a tick higher than expected. We also saw the German ZEW Sentiment Index rise to -13.7, up significantly from last month and a full 7 points better than expected. There were myriad individual national prints regarding GDP, employment and inflation, most of which showed that Q2 growth in the Eurozone was better than Q1. However, none of that has had much of an impact on the euro, which continues to hover unchanged on the day around 1.1400. While this level is a few pips better than the lows seen yesterday, there is no indication that traders have changed their collective minds regarding the euro’s eventual strength. The pound, meanwhile, has rebounded a touch this morning, +0.15%, but that seems more to do with the fact that Brexit has been off the front page than with any specific data releases. Ultimately, unless the Brits figure out a fudge and can get the Europeans to go along, I fear the pound will test the post Brexit vote lows seen two years ago.

As to today’s session, the only data point in the US is NFIB Small Business confidence (exp 106.9). This could actually be quite important in telling us how the trade saga is playing out amongst small companies. Thus far, corporate America seems to have weathered the storm, although if the President does go through with his threatened 25% tariffs on $200 billion of Chinese goods, I expect that will have a larger negative impact on the economy. But for now, it remains full speed ahead in the US, and that includes for the Fed, which is almost certainly going to raise rates in September and again in December. In fact, I think the real risk is that they hike more than three times in 2019, and they do it sooner than the market is expecting. And that, my friends, will continue to support the dollar.

Good luck
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Quite Foreboding

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In this, the eighth month of the year
The market’s succumbing to fear
With Turkey imploding
It feels quite foreboding
And folks, it can get more severe!

On Friday I discussed the Turkey situation as one beginning to spiral out of control. Well, this morning it has lived up to that billing with the lira falling an additional 7.5% as I type, although that includes a substantial recovery from its worst levels today. Now, the central bank there has finally reacted by loosening reserve requirements and offering foreign currency loans to local banks in unlimited size, but those moves have had only a limited positive impact on the currency. And since President Erdogan refuses to countenance higher interest rates, it seems that the next move is going to be capital controls, and it is likely to come pretty soon. In fact, if the recent pace of the lira’s decline continues unchecked, and I see no reason for it to stop yet, I expect that we will see capital controls before the week is out, and maybe as soon as tomorrow.

Here’s the thing. Turkey’s growth over the past decade has largely been debt driven (after all, who’s hasn’t?) but the Turks have been one of the most aggressive in using USD funding such that dollar debt represents >50% of the total debt in the economy. When the Fed turned from ultra easy monetary policy to begin tightening, it really began to hurt them. And as Chairman Powell has not only continued the process begun under Yellen, but increased the pace, the pain has become unbearable for Turkey’s economy. So it is fair to say that Turkey’s problems are self-inflicted (had they taken a more local and gradual path toward growth they arguably wouldn’t be in this bind), but those problems are not unique within the emerging markets, and at a certain point to investors, it doesn’t matter.

As I mentioned Friday, herd behavior amongst investors is the rule, not the exception. And as liquidity in Turkish asset markets dries up, and it has, investment managers will be looking to sell other risky assets in order to manage their overall portfolios. That is a key reason why ZAR has fallen by 2.5% this morning. Too, the Mexican peso has fallen 2% and even the Korean won, which is nobody’s idea of an emerging market (per capita GDP ranks ahead of Spain, Italy and New Zealand according to the CIA) has fallen 1.0%. The point is, if an asset manager cannot sell what he wants to sell to reduce risk, then he will sell what he can sell in order to limit portfolio damage. And this is how contagion starts!

So does Turkey really matter? In the FX markets, prior to the recent situation, the Turkish lira was a favored carry trade component, with investors seeking to earn what had been very high yields with a relatively stable currency. But that trade is over, and by all appearances, Turkey is going to be facing a recession pretty soon, which means that real trade flows are likely to diminish as well. In that sense, Turkey doesn’t matter too much.

But when you put this situation in the context of what else is happening in the world, this could well be the proverbial last straw. We have already been dealing with escalating trade tensions that show no sign of ebbing; a seeming stalemate in the Brexit talks opening the door to the UK crashing out of the EU with no deal; a populist government in Italy threatening to challenge Eurozone fiscal rules; and not least, a Federal Reserve that, despite everything else going on, is hell-bent and determined to continue raising interest rates. It should be no surprise that a number of equity markets around the world have struggled so far this year, but there is still a lot more green than red on screens. However, market sentiment can only take so much stress before investors decide that the risk is no longer worth the reward. I fear that we may be approaching that point. Market sentiment can be fleeting, and right now, we seem to be watching it flee!

With that in mind, a look at the G10 currency space confirms everything we have seen for the past several sessions. The dollar is broadly higher, with the euro -0.3% and the pound -0.2% although the yen, as is its wont in a crisis, has rallied 0.5%. Equity markets around the world are bathed in red, with the Nikkei falling 2% overnight and European shares, on average, down about 0.5%. US equity futures are pointing to a -0.3% opening in New York as well. Treasuries and Bunds have continued their modest rally, with yields falling another 1-2bps, and commodity prices are under pressure again. In other words, this is a classic risk off performance.

What can stop this? Historically, it has been the IMF that would step in and help support a country and its currency when stressed in this manner (remember Argentina a few months ago getting a $50 billion line of credit), but I am skeptical of that happening this time around. There are two things likely to prevent the IMF from getting involved: first, President Erdogan has been extremely vocal in his disdain for orthodox economic policies like raising interest rates in to help combat rising inflation, but the IMF will demand tighter monetary and tighter fiscal policy, neither of which Erdogan is likely to embrace; and second, for the IMF to act, the US has to be on sides, and the current situation has been partly aggravated by the diplomatic row between the US and Turkey. It seems hard to believe that President Trump will give the IMF the leeway to extend help. Unfortunately, I fear that there is more turmoil in our future.

Turning to the data review this week, there is a modest uptick in the volume of data, but it is not clear any of it will be critical to the Fed’s view of the world.

Tuesday NFIB Small Business 106.9
Wednesday Nonfarm Productivity 2.3%
  Unit Labor Costs 0.3%
  Empire State Mfg 20
  Retail Sales 0.1%
  -ex Autos 0.3%
  IP 0.3%
  Capacity Utilization 78.2%
Thursday Housing Starts 1.26M
  Building Permits 1.31M
  Initial Claims 215K
  Philly Fed 22
Friday Michigan Sentiment 98

Arguably, Retail Sales will be the most watched number, but everything we have heard from Fed speakers of late has been full speed ahead, so we will need to see much weaker data to change that perspective. Either that or a total collapse in the emerging market space, with the latter situation seemingly far more likely than the former. In the end, I see no reason to change my views on the dollar’s broad trajectory, which remains higher for the foreseeable future.

Good luck
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Somewhat Restrictive

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Said Evans, if I were predictive
A setting that’s somewhat restrictive
Might be just the thing
To slightly hamstring
This growth that’s become quite addictive

Chicago Fed president Charles Evans, a reliable dovish voice on the FOMC, spoke yesterday and made news because of his more hawkish tone. “If inflation [PCE] continues to be on the order of 2, 2.2 (percent) — I’m not expecting it to get as high as 2.5 — that suggests only a modest amount of restrictiveness above our neutral rate might be called for in 2020,” he said and continued, “ It would not surprise me at all if we make a judgment to move to a somewhat restrictive setting.” For a dove, that is a remarkable admission of the strength of the economy and the growing belief that monetary policy is now sending the wrong signals.

Remember, despite the fact that the Fed has raised rates seven times for a total of 175bps since December 2015, Fed funds remain well below the inflation rate so real interest rates remain negative. In fact, this morning we will see just how far below as CPI is due to be released at 8:30 and expected to print at 3.0% with the core rate at 2.3%. Historically, real interest rates have been positive to the tune of 2.0% and while there have clearly been fundamental changes in the economy that may warrant a lower real interest rate (e.g. technological advances driving efficiencies, globalization), negative real rates are only called for during a recession or worse. If the doves are now on board the rate raising train, and these comments seem to suggest that they are, the Fed could become even more aggressive in 2019, with a press conference after every meeting, and therefore the opportunity to explain their actions. Don’t be surprised if they raise rates in January 2019 especially if the emerging markets don’t completely crater. And if you want a hint of how this will impact the dollar, last night’s price action, with the DXY rising 0.5% and the euro finally breaking out of its recent trading range, falling by a similar amount, are very good prognosticators.

But the caveat is, if the emerging markets don’t crater, and that is an important caveat. Last night, the Turkish lira saw a significant escalation in the recent market tension as it fell nearly 10% at one point and though it has recovered slightly, remains down by 7% as I type. The thing is, nothing new has been revealed. It appears that as the week is drawing to a close, traders and investors are simply coming to the conclusion that President Erdogan is not going to allow the central bank the leeway it needs to manage the economy in an orthodox manner, and that things could well spiral out of control. The fact that Turkey and the US remain at odds over the arrest of an American pastor by Istanbul, and that sanctions are being imposed, is just adding fuel to the fire. This is the proverbial falling knife. Don’t try to catch it. Until the politics changes, the currency is likely to continue in freefall.

The question is, will this infect other emerging markets, and by extension developed country markets? If last night is any indication, it may just be starting to do so. Equity markets throughout Europe are lower, some pretty sharply (Germany -1.5%, Italy -1.7%) as concerns have been raised over some of the large European banks’ exposures to Turkey. We saw weakness in Japanese equities (-1.3%) despite the fact that GDP growth there in Q2 was shown to be a better than expected 1.9% annualized. US equity futures are also softer, down about 0.5% at this point, and Treasury yields are falling (10yr -4bps) as investors are fleeing to safe havens. In other words, it is beginning to look like that infection is starting to spread.

As is often the case, these concerns make themselves known in almost random fashion. Certain currencies respond to the news in a negative way, while others that you may assume would see the same type of response don’t move. It is also important to watch the movement over a week or two, rather than on a given day, as those trends can be more revealing. For example, RUB is barely softer this morning, down just 0.3%, despite increased sanctions imposed by the US because of the poisoning of an ex Russian spy in London earlier this year. But this week it has fallen 5.6%, a pretty hefty move, and indicative of the fact that there is growing concern there. Another currency feeling the pressure this morning is ZAR, which has fallen 1.1% and 4% on the week. But as it had strengthened sharply through Q1, it is only down 2% in the past year. However, the recent trend is ominous and it certainly appears that ZAR has further to fall. MXN is another interesting case, where it has fallen 1.25% overnight and 2.6% this week, but remains far stronger than its levels earlier this summer in the run up to the presidential election there. However, regardless of the market’s relief that AMLO does not seem to be as radical as initially feared, emerging market disease can be quite contagious, and it would not surprise me at all to see the peso fall another 5% or even more if we see additional pressure elsewhere.

The key to remember here is that there is a great deal of herd behavior demonstrated by investors, especially emerging market investors, and if they start to leave one market because there is fear of a serious problem, it can easily spread to other markets, especially if liquidity in that first market dries up. We have been witnessing individual market problems all year, and each one seemed isolated due to specific local events. But I am getting the feeling that we may have reached a tipping point, where there have been enough individual events to cause a re-evaluation of the general trend. If this is indeed the case, then the Fed may well slow the pace of its rate hikes, but the dollar should benefit anyway as the safest haven of all.

Do not be surprised if we see wider spread weakness across emerging market currencies going forward, and by extension, the G10 as well. There are likely to be two exceptions to this rule, JPY and CHF, but otherwise, I fear thin summer markets may lead us to some larger moves across the board. So stay alert and maintain those hedge ratios.

Good luck and good weekend
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Up To New Tricks

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The nation that first tried to fix
Its price target’s up to new tricks
Last night it explained
That rates would remain
Unchanged til growth, up, finally ticks

You know it has been a relatively uneventful session when the most interesting story is about New Zealand! For those with a bent toward history, it was then-RBNZ Governor Donald Brash, who in 1988 set the first inflation target for a nation, 3.0% at that time, and who was able to maintain the RBNZ’s independence from government meddling ( a new philosophy then) to help achieve that target and eventually bring interest rates down from more than 15% to low single digits. Well, last night when the RBNZ met, they left rates on hold at a record low level of 1.75%, as was universally expected, but they added a sentence to their policy statement “…that rates will remain at this level through 2019 and into 2020”, adding forward guidance to the mix and surprising markets completely. The result was that the NZD fell a bit more than 1% instantly and has continued lower to currently trade down 1.4% on the session and back to its lowest level since March 2016.

This action simply underscores the policy divergence that we have seen over the past two and a half years. Since the Fed’s first, tentative steps towards tightening in December 2015, it has been clear that the US remains ahead of the global growth cycle. And now we find ourselves in a world where several countries are trending higher (US, Canada, India, Sweden) in growth and inflation, while others are seeing the opposite outcome (China, New Zealand, Australia). Of course there are those who are in between, like the Eurozone and Japan, where they want to believe that things are getting better so they can normalize policy, but just don’t quite have the confidence yet. Maybe soon. And it is these policy differences, as well as expectations for their evolution, that will continue to be the key drivers of currencies going forward.

However, away from New Zealand, the G10 has been a dull affair. There has been limited data released and currency movement has been extremely modest, generally less than 0.1% since yesterday’s closing levels.

Emerging markets, though, have been a different story, with several of them really taking a tumble. Starting with Turkey, which has, of course, been under pressure for the past several months, last night saw yet another significant decline of 2.2%, which makes 6.5% this week and more than 50% in the past year. Additional US sanctions driven by the arrest of a US pastor in Turkey have been the recent catalyst, but the reality is that there is an increasing sense of doom attached to President Erdogan’s economic management theories, which include the idea that high interest rates cause inflation; they don’t fight it. But high inflation is what they have there, with the annual rate now running above 16% and rising. The lira has further to fall, mark my words.

Next on the list is the Russian ruble, which has recovered as I write to only be down by 0.6%, after having been lower by as much as 1.3% earlier in the session. However, this week it is lower by 4.2% and nearly 7% this month. The story here is a combination of both new US sanctions as the latest response to the poisoning of an ex Russian agent in the UK earlier this year, as well as the sharp decline in oil prices yesterday, WTI fell 3.2% after storage data indicated there was much more oil and products around than expected. The Russian economy is definitely feeling the squeeze of US sanctions and I expect that the ruble will continue to be pressured lower for a while yet.

But once we get past those currencies, there is precious little to discuss in this space as well. Which takes us to the upcoming data releases. This morning we see Initial Claims (exp 220K) and PPI (3.4%, 2.8% core) at 8:30 and then we hear from Chicago Fed president Evans at 9:30. Evans is a known dove, so the only possibility of a newsworthy event would be if he sounded hawkish. Yesterday, Richmond Fed president Barkin said it was time to get rates back to ‘normal’ and that two more hikes this year seem reasonable. While the futures market is not yet pricing in great confidence in a December move by the Fed, it seems a foregone conclusion to me.

In the end, nothing has happened to alter my views that the Fed will continue to lead the way in tighter monetary policy and that the dollar will be the main beneficiary of that action.

Good luck
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A Torch Song

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As summer meanders along
Two stories are still going strong
In China the yuan
Is just hanging on
While Brexit’s become a torch song

Last night was yet another session of modest activity in foreign exchange as market participants’ focused on the same two stories that have been hogging the headlines for months; Brexit and its fallout on the pound; and China and the deteriorating trade situation. In fact, there is one other story that gets some press, the collapsing Turkish lira, but given the fact that TRY is a relatively inconsequential currency in the broad scheme of things, it is sufficient to know that the problems there are unlikely to get better soon, but also unlikely to have a wider impact on markets.

Let’s start with China today. Last night’s trade data showed that their surplus shrank substantially, to $28B, as imports surged more than 27% while export growth was a more modest 12%. At the same time, their surplus with the US fell only slightly, from $28.9B to $28.1B. It is the latter data that has been driving the current US trade policy, and the modest improvement seems unlikely to change anything. Already, tariffs on the next $16B are set to be put in place in two weeks’ time, and the list of products for the following grouping of $200B is being finalized and tariffs could be imposed as soon as September 6th. The Chinese have not yet blinked, but by all accounts, the situation in the Chinese economy is starting to get a bit more concerning.

The PBOC has flooded the market there with liquidity as evidenced by the fact that Chinese interest rates across the curve have fallen to the lowest levels seen in more than three years. (If you recall three years ago was when the PBOC instituted their ‘mini-devaluation’ in the yuan, which led to massive capital outflows and forced them to spend in excess of $1 trillion of reserves defending the yuan.) Regardless of the fact that those capital controls remain in place, it is pretty clear that money is flowing out of China right now. The question is, will those flows increase to a more troubling level forcing more aggressive PBOC action? Interestingly, a recent survey of traders and economists showed a strong belief that the PBOC will be able to contain CNY weakness and there is limited expectation for the currency to weaken beyond 7.00. Adding to this view, last night the PBOC called the major banks into a meeting and ‘encouraged’ them to insure their clients don’t become caught up in the “herd behavior” of selling yuan. This verbal suasion is in addition to their recent re-imposition of excess capital requirements for short CNY forward positions as well as the PBOC’s significantly increased activity in the FX swaps market, where they have sold so many dollars forward that the points have fallen to a discount, despite the fact that a pure interest rate calculation would put them at a substantial premium. As powerful as the PBOC is, and as much control as they exert over the currency, the market is still bigger than they are. If the Chinese population fears that the yuan is going to weaken further, they will find ways to get their money out of China, and it will be a self-fulfilling event. The benefit for hedgers is that with one-year USDCNY forwards at a discount, hedging assets and receivables is now very cost effective.

Turning to the UK and the ongoing Brexit story, there actually seems to have been little new in the way of news overnight. However, just before NY walked in, the pound extended its losses and is now down more than 0.5% on the day and trading at one year lows. The problem for the pound is that as the timeline leading to Brexit shrinks, no news is no longer good news. The lack of activity is an indication that the probability of a no-deal Brexit is growing, and as I have written several times recently, if there is no deal, the pound is likely to fall sharply. In fact, at this point in time, there is probably a short-term risk that the pound can move sharply higher in response to something positive in this process. For example, if the EU were to soften its stance, or make a serious accommodation, the pound could easily rise a few percent on the news. However, that doesn’t seem very likely, at least based on anything that has been reported in the past several weeks.

Beyond those stories, though, there is precious little to discuss. Yesterday, as expected, the JOLTs report showed that there are many jobs available in the US, 6.66M to be exact, which is simply in line with the strong employment situation that we all know exists. Today, however, there is no new data to absorb, and really, until Friday’s CPI, the FX market will be looking elsewhere for catalysts. My sense is that the trade story will remain the single biggest driver, and that it still points to a stronger dollar for now. Keep that in mind as you look ahead.

Good luck
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Ere Brexit’s Birthday

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The UK Prime Minister May
Is seeking an outcome one day
Where Europe realizes
That some compromises
Are needed ere Brexit’s birthday

It has been a painfully quiet FX market overnight with very limited new information crossing the tapes. Lately, the biggest market moves have been seen in the Turkish lira, which after falling nearly 5% yesterday has rebounded just under 2% today. The thing is that Turkey’s importance in the broad scheme of the market is so marginal, it is tiresome to mention too frequently. And let’s face it; as long as President Erdogan is running things, this situation is unlikely to improve.

Arguably the only other noteworthy story overnight is the continued angst in the UK over International Trade Secretary, Liam Fox’s comments about the increasing probability of a hard Brexit. Certainly the analyst community all jumped on the bandwagon yesterday with regard to the discussion, but in the end, there is still precious little movement in the negotiations. There was a Bloomberg article this morning that was quite disconcerting, at least if you want to see a deal put in place. It basically hypothesized that PM May was counting on an increased willingness by the EU to compromise in order that the bloc may show a unified stance to President Trump at the G20 meeting scheduled for November in Buenos Aires. That seems pretty thin gruel for negotiating tactics and doesn’t sound like a winning play to me, but then I’m not a politician.

Reviewing the key issues outstanding, I still don’t see how the Irish border situation can be resolved effectively. Northern Ireland demands that there is no ‘hard’ border between themselves and Ireland, but as that will now be the only land border between the UK and the EU, something will be necessary to insure the proper movement of people and goods between nations. (Perhaps they can use the Shrodinger’s Cat model, where the border simultaneously does and doesn’t exist until someone looks to cross it.) In effect, one side is going to have to cave in, and right now, neither side is willing to do so. As long as this remains the case, I maintain that a hard Brexit is the most likely outcome and that the pound has further to fall.

But away from that, there is just not much to discuss. The dollar, overall, is slightly softer, giving back some of its recent gains, but that remains trading activity not news driven movement. Data has been sparse with soft German IP offset by ongoing strong trade data the most noteworthy Eurozone prints. The RBA left rates on hold, as universally expected, although perhaps the statement was seen as a bit more hawkish than anticipated as the Aussie dollar is actually today’s top performer in the G10, rising 0.6%. But after that, there is nothing to note.

And quite frankly, the only thing on the calendar this morning in the US is the JOLTs Jobs Report, which is simply going to show that the employment situation in the US remains quite strong. But we know that already and it was reconfirmed last Friday with the payroll report.

All told, it is shaping up to be an uninspiring day in the FX markets. Given we have seen some pretty steady strength in the dollar for the past week, I wouldn’t be surprised to see this morning’s mild weakness extend further. But I wouldn’t read any long-term thoughts into a day with low volumes where prices are correcting.

Good luck
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Turning To Fearing

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The deadline for Brexit is nearing
And hoping is turning to fearing
No deal’s yet in sight
But both sides delight
In claiming that they’re persevering

This morning, the two stories that have captured the FX market’s attention are Brexit and its impact on the pound and Chinese policy changes and their impact on the yuan.

Starting in the UK, the pound is under pressure this morning, down 0.55%, as comments from International Trade Secretary, Liam Fox, have rattled traders. According to Fox, the odds that there is no Brexit deal have now risen to 60%, certainly enough to qualify as “uncomfortably high”, Governor Carney’s description last week in his comments following the BOE meeting. It appears that both sides remain committed to their positions and there has been very little movement from either London or Brussels of late. Meanwhile, in the UK, the politics of the situation has resulted in the new favorite pastime of guessing who will replace PM May when she finally loses a no-confidence vote. And while March 31 is the technical deadline, the reality is that if there is no agreement in place by October, it is likely to be too late. Remember that once an agreement is reached, it needs to be enacted into law by all the nations in the EU as well as the UK, with any one of them able to derail the process. Last year I posited that the odds of reaching a deal were extremely low. I believe this is exactly what is playing out now.

The consequences for the pound are unlikely to be pretty. I expect that we will see pressure continue to increase as it becomes clear that there is no deal forthcoming. So unlike the market action right after the initial Brexit vote in June 2016, where the pound fell more than 10% overnight, and shed another 10% in the ensuing four months, I expect that this will be steady downward pressure, although the net 20% decline cannot be ruled out. After all, there will be no announcement that talks have ended, merely a lack of progress to be seen. Consider that a further 20% decline from here will put the historic low level of 1.06, set back in 1985, on the radar. And while that may well be too pessimistic, it remains extremely difficult to make a bullish pound case at this time. Unless we see a negotiating breakthrough in the next month or so, hedgers need to be prepared for a much lower pound over time.

Turning to China, late Friday night the PBOC imposed a new restriction on FX trading by reinstituting a 20% reserve requirement against short yuan forward positions. The idea here is that Chinese banks will not be willing to allocate the funds necessary to maintain those positions, and therefore will not allow clients to sell CNY forward. In 2015, during the last CNY devaluation, when capital outflows really gathered pace, this was one of the tools that the PBOC employed to stem the yuan’s weakness. What this tells me is that despite the rhetoric from the government about the trade situation and their willingness to tough it out, there is growing concern that if USDCNY reaches 7.00, citizens will start to become much more aggressive in their efforts to reduce their exposure to the yuan, and flee to other, safer currencies. Ironically, given what has started this process, this includes the dollar as well as the yen and Swiss franc. As is typical of the Chinese, they announced this change late Friday night when markets were closed. And while the initial market reaction to the news in China’s morning was for the yuan to strengthen a bit, that strength has reversed and USDCNY is now higher by 0.25%. If 7.00 is truly the pain point, I fear we are going to see some fireworks before the end of the summer.

Beyond those two stories, the dollar is firmer overall, but there is less specificity than it simply being a strong dollar day. The euro is lower by 0.25% after German Factory Orders fell a much worse than expected -4.0%, taking the Y/Y level negative for the first time in two years. But given the breadth of the dollar’s strength this morning, I would argue the euro would have declined no matter the number. As the trade rhetoric continues apace, I expect the dollar to remain well bid against all comers.

Turning to the data this week, it is far less interesting than last week’s onslaught, but we do end the week with CPI.

Tuesday JOLT’s Job Openings 6.646M
  Consumer Credit $16.0B
Thursday Initial Claims 220K
  PPI 0.2% (3.4% Y/Y)
  -ex food & energy 0.2% (2.8% Y/Y)
Friday CPI 0.2% (3.0% Y/Y)
  -ex food & energy 0.2% (2.3% Y/Y)

Beyond the inflation data, we have only two Fed Speakers, and given the continued strong run of data, it remains hard to believe that we will hear any new dovishness by anyone. I am hard-pressed to derive a scenario that leads to significant dollar weakness in the short run. Until the US data turns, I believe that the Fed will continue to tighten policy and that the dollar will benefit. And that seems likely to last through at least the end of the year.

Good luck
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Uncomfortably High

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Said Carney, exhaling a sigh
The odds are “uncomfortably high”
More pain will we feel
If there is no deal
When England waves Europe bye-bye

Yesterday the BOE, in a unanimous decision, raised its base rate by 25bps. This outcome was widely expected by the markets and resulted in a very short-term boost for the pound. However, after the meeting, Governor Carney described the odds of the UK leaving the EU next March with no transition deal in hand as “uncomfortably high.” That was enough to spook markets and the pound sold off pretty aggressively afterwards, closing the day lower by 0.9%. And this morning, it has continued that trend, falling a further 0.2% and is now trading back below 1.30 again.

By this time, you are all well aware that I believe there will be no deal, and that the market response, as that becomes increasingly clear, will be to drive the pound still lower. In the months after the Brexit vote, January 2017 to be precise, the pound touched a low of 1.1986, but had risen fairly steadily since then until it peaked well above 1.40 in April of this year. However, we have been falling back since that time, as the prospects for a deal seem to have receded. The thing is, there is no evidence that points to any willingness to compromise among the Tory faithful and so it appears increasingly likely that no deal will be agreed by next March. Carney put the odds at 20%, personally I see them as at least 50% and probably higher than that. In the meantime, the combination of ongoing tightening by the Fed and Brexit uncertainty impacting the UK economy points to the pound falling further. Do not be surprised if we test those lows below 1.20 seen eighteen months ago.

This morning also brought news about the continuing slowdown in Eurozone growth as PMI data was released slightly softer than expected. French, German and therefore, not surprisingly, Eurozone Services data was all softer than expected, and in each case has continued the trend in evidence all year long. It is very clear that Eurozone growth peaked in Q4 2017 and despite Signor Draghi’s confidence that steady growth will lead inflation to rise to the ECB target of just below 2.0%, the evidence is pointing in the opposite direction. While the ECB may well stop QE by the end of the year, it appears that there will be no ability to raise rates at all in 2019, and if the current growth trajectory continues, perhaps in 2020 as well. Yesterday saw the euro decline 0.7%, amid a broad-based dollar rally. So far this morning, after an early extension of that move, it has rebounded slightly and now sits +0.1% on the day. But in the end, the euro, too, will remain under pressure from the combination of tighter Fed policy and a decreasing probability of the ECB ever matching that activity. We remain in the 1.1500-1.1800 trading range, which has existed since April, but as we push toward the lower end of that range, be prepared for a breakout.

Finally, the other mover of note overnight was CNY, with the renminbi falling to new lows for the move and testing 6.90. The currency has declined more than 8% since the middle of June as it has become increasingly clear that the PBOC is willing to allow it to adjust along with most other emerging market currencies. While the movement has been steady, it has not been disorderly, and as yet, there is no evidence that capital outflows are ramping up quickly, so it is hard to make the case the PBOC will step in anytime soon. And that is really the key; increases in capital outflows will be the issue that triggers any intervention. But while many pundits point to 7.00 as the level where that is expected to occur, given the still restrictive capital controls that exist there, it may take a much bigger decline to drive the process. With the Chinese economy slowing as well (last night’s Caixin Services PMI fell to 52.8, below expectations and continuing the declining trend this year) a weaker yuan remains one of China’s most important and effective policy tools. There is no reason for this trend to end soon and accordingly, I believe 7.50 is reasonable as a target in the medium term.

Turning to this morning’s payroll report, here are the current expectations:

Nonfarm Payrolls 190K
Private Payrolls 189K
Manufacturing Payrolls 22K
Unemployment Rate 3.9%
Average Hourly Earnings (AHE) 0.3% (2.7% Y/Y)
Average Weekly Hours 34.5
Trade Balance -$46.5B
ISM Non-Manufacturing 58.6

Wednesday’s ADP number was much stronger than expected at 213K, and the whisper number is now 205K for this morning. As long as this data set continues to show a strong labor market, and there is every indication it will do so, the only question regarding the Fed is how quickly they will be raising rates. All of this points to continued dollar strength going forward as the divergence between the US economy and the rest of the world continues. While increasing angst over trade may have a modest impact, we will need to see an actual increase in tariffs, like the mooted 25% on $200 billion in Chinese imports, to really affect the economy and perhaps change the Fed’s thinking. Until then, it is still a green light for dollar buyers.

Good luck and good weekend
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