When Tax Cuts Arrive

The euro has taken a dive
As Italy tries to revive
Its still quite weak growth
By managing both
More spending when tax cuts arrive

It was just earlier this week that pundits were sounding the death knell for the dollar, as they explained the market has already fully priced in Fed rate hikes while other markets, both developed and emerging, were just beginning their turn towards tighter policy. In fact, the convergence trade was becoming all the rage; the idea that as the dollar started to slide, emerging market economies would see reduced pressure on their fundamentals (it would become easier to repay dollar debt) while commodity prices could rebound (most emerging markets are commodity exporters) and so both stock and bond prices in those markets would benefit. At the same time, other developed markets would see a similar, albeit lesser, impact and so market sentiment would get markedly better. Or not.

Yesterday, the market learned that the Italian budget question, something that had been set aside as not really impactful, has become impactful. The announcement by the ruling coalition that they would be targeting a 2.4% budget deficit next year, well above earlier estimates of 1.8% but still below the EU’s 3.0% target, has raised numerous red flags for investors. First, the new budget will do nothing to address Italy’s debt/GDP ratio, which at 131% is second only to Greece within the EU. One of the reasons that the EU wanted that lower target was to help address that situation. The potential consequence of that issue, a larger debt/GDP ratio, is that the ratings agencies may lower their country credit ratings for Italy, which currently stand at Baa2 by Moody’s and BBB by S&P. And given that those ratings are just two notches above junk, it could put the country in a precarious position of having a much more difficult time funding its deficit. It should be no surprise that Italian government bond yields jumped, with 2-year yields spiking 46bps and 10-year yields up 31bps. It should also be no surprise that the Italian stock markets fell sharply, with the FTSE-MIB down 4.1% as I type. And finally, it should be no surprise that the euro is lower, having fallen more than 1.5% since this news first trickled into the market yesterday morning NY time. While this could still play out where the coalition government backs off its demands and markets revert, what is clear is that dismissing Italian budget risk as insignificant is no longer a viable option.

But it’s not just the euro that is under pressure; the dollar is generally stronger against most of its counterparts. For example, the pound is down 0.3% this morning and 1% since yesterday morning after UK data showed weakening confidence and slowing business investment. Both of these seem to be directly related to growing Brexit concerns. And on that subject, there has been no movement with regard to the latest stance by either the UK or the EU. Politicians being what they are, I still feel like they will have something signed when the time comes, but it will be short on specifics and not actually address the issues. But every day that passes increases the odds that the UK just leaves with no deal, and that will be, at least in the short term, a huge pound Sterling negative.

Meanwhile, the yen has fallen to its lowest level vs. the dollar this year, trading through 113.60 before consolidating, after the BOJ once again tweaked its concept of how to manage QE there. Surprisingly (to me at least) the movement away from buying 30-year bonds was seen as a currency negative, despite the fact that it drove yields higher at the back of the curve. If anything, I would have expected that move to encourage Japanese investors to repatriate funds and invest locally, but that is not the market reaction. What I will say is that the yen’s trend is clearly downward and there is every indication that it will continue.

Looking at the data story, yesterday we saw US GDP for Q2 confirmed at 4.2%, while Durable Goods soared at a 4.5% pace in August on the back of strong aircraft orders. For this morning, we are looking for Personal Income (exp 0.4%); Personal Spending (0.3%); PCE (0.2%, 2.3% Y/Y); Core PCE (0.1%, 2.0% Y/Y); and Michigan Sentiment (100.8). All eyes should be on the Core PCE data given it is the number the Fed puts into their models. In addition, we hear from two Fed speakers, Barkin and Williams, although at this stage they are likely to just reiterate Wednesday’s message. Speaking of which, yesterday Chairman Powell spoke and when asked about the flattening yield curve explained that it was something they watched, but it was not seen as a game changer.

In the end, barring much weaker PCE data, there is no reason to believe that the Fed is going to slow down, and if anything, it appears they could fall behind the curve, especially if the tariff situation starts to impact prices more quickly than currently assumed. There is still a tug of war between the structural issues, which undoubtedly remain dollar negative, and the cyclical issues, which are undoubtedly dollar positive, but for now, it appears the cyclicals are winning.

Good luck and good weekend

Too Arcane

The Fed took the time to explain
Why ‘Neutral’ they’ll never attain
Though theories suppose
O’er that rate, growth slows
Its measurement is too arcane

If one needed proof that Fed watching was an arcane pastime, there is no need to look beyond yesterday’s activities. As universally expected, the FOMC raised the Fed funds rate by 25bps to a range of 2.00% – 2.25%. But in the accompanying statement, they left out the sentence that described their policy as ‘accommodative’. Initially this was seen as both surprising and dovish as it implied the Fed thought that rates were now neutral and therefore wouldn’t need to be raised much further. However, that was not at all their intention, as Chairman Powell made clear at the press conference. Instead, because there is an ongoing debate about where the neutral rate actually lies, he wanted to remove the concept from the Fed’s communications.

The neutral rate, or r-star (r*) is the theoretical interest rate that neither supports nor impedes growth in an economy. And while it makes a great theory, and has been a linchpin of Fed models for the past decade at least, Chairman Powell takes a more pragmatic view of things. Namely, he recognizes that since r* cannot be observed or measured in anything like real-time, it is pretty useless as a policy tool. His point in removing the accommodative language was to say that they don’t really know if current policy is accommodative or not, at least with any precision. However, given that their published forecasts, the dot plot, showed an increase in the number of FOMC members that are looking for another rate hike this year and at least three rate hikes next year, it certainly doesn’t seem the Fed believes they have reached neutral.

The market response was pretty much as you would expect it to be. When the statement was released, and initially seen as dovish, the dollar suffered, stocks rallied and Treasury prices fell in a classic risk-on move. However, once Powell started speaking and explained the rationale for the change, the market reversed those moves and the dollar actually edged higher on the day, equity markets closed lower and Treasury yields fell as bids flooded the market.

In the end, there is no indication that the Fed is slowing down its current trajectory of policy tightening. While they have explicitly recognized the potential risks due to growing trade friction, they made clear that they have not seen any evidence in the data that it was yet having an impact. And given that things remain fluid in that arena, it would be a mistake to base policy on something that may not occur. All told, if anything, I would characterize the Fed message as leaning more hawkish than dovish.

So looking beyond the Fed, we need to look at everything else that is ongoing. Remember, the trade situation remains fraught, with the US and China still at loggerheads over how to proceed, Canada unwilling to accede to US demands, and the ongoing threat of US tariffs on European auto manufacturers still in the air. As well, oil prices have been rallying lately amid the belief that increased sanctions on Iran are going to reduce global supply. There is the ongoing Brexit situation, which appears no closer to resolution, although we did have French President Macron’s refreshingly honest comments that he believes the UK should suffer greatly in the process to insure that nobody else in the EU will even consider the same rash act as leaving the bloc. And the Italian budget spectacle remains an ongoing risk within the Eurozone as failure to present an acceptable budget could well trigger another bout of fear in Italian government bonds and put pressure on the ECB to back off their plans to remove accommodation. In other words, there is still plenty to watch, although none of it has been meaningful to markets for more than a brief period yet.

Keeping all that in mind, let’s take a look at the market. As I type (which by the way is much earlier than usual as I am currently in London) the dollar is showing some modest strength with the Dollar Index up about 0.25% at this point. The thing is, there has been no additional news of note since yesterday to drive things, which implies that either a large order is going through the market, or that short dollar positions are being covered. Quite frankly, I would expect the latter reason is more compelling. But stepping back, the euro has traded within a one big figure range since last Thursday, meaning that nothing is really going on. The same is true for most of the G10, as despite both data and the Fed, it is clear very few opinions have really changed. My take is that we are going to need to see material changes in the data stream in order to alter views, and that will take time.

In the emerging markets, we have two key interest rate decisions shortly, Indonesia is forecasts to raise their base rate by 25bps to 5.75% and the Philippines are expected to raise their base rate by 50bps to 4.50%. Both nations have seen their currencies remain under pressure due to the dollar’s overall strength and their own current account deficits. They have been two of the worst three performing APAC currencies this year, with India the other member of that ignominious group. Meanwhile, rising oil prices have lately helped the Russian ruble rebound with today’s 0.2% rally adding to the nearly 7% gains seen in the past two plus weeks. And look for the Argentine peso to have a solid day today after the IMF increased its assistance to $57 billion with faster disbursement times. Otherwise, it is tough to get very excited about this bloc either.

On the data front, this morning brings the weekly Initial Claims data (exp 210K), Durable Goods (2.0%, 0.5% ex transport) and our last look at Q2 GDP (4.2%). I think tomorrow’s PCE data will be of far more interest to the markets, although a big revision in GDP could have an impact. But overall, things remain on the same general trajectory, solid US growth, slightly softer growth elsewhere, and a Federal Reserve that is continually tightening monetary policy. I still believe they will go tighter than the market has priced, and that the dollar will benefit accordingly. But for now, we remain stuck with the opposing cyclical and structural issues offsetting. It will be a little while before the outcome of that battle is determined, and in the meantime, a drifting currency market is the most likely outcome.

Good luck


Doves Will Despise

Come two o’clock later today
The Fed will attempt to convey
How high rates may rise
Though doves will despise
The idea that more’s on the way

Ahead of the conclusion of the FOMC meeting today, very little has happened in the FX markets, and in fact, in most markets. At this point, given the fact that the Fed remains one of the key drivers to global monetary policy, and the still significant concern that the ongoing divergence in Fed policy with that of the rest of the world can have negative consequences, pretty much every investor is awaiting the Fed statement and Chairman Powell’s press conference. It is a foregone conclusion that they will raise the Fed Funds rate by 25bps to 2.00% – 2.25%.

So the big question is just what the dot plot will look like, especially since today is the first time we will see their 2021 forecasts. Economists and analysts have slowly accepted that the Chairman is on a mission here, and that rates are going to continue to rise by 25bps every quarter at least through June 2019. That would put Fed Funds at 2.75% – 3.00%, a level that is currently seen as ‘neutral’. But what is still uncertain is how the Fed itself expects the economy to evolve beyond the end of the previous forecast period. Any indication that their models point to faster growth would be quite surprising and have a market impact. In fact, the most recent Fed forecasts have been for the economy to peak soon and begin to slow back to a 2.0% GDP growth rate by 2020. It is changes in this trajectory that will be of the most interest. That and Chairman Powell’s comments and answers at the press conference. But at this point, all we can do is wait.

Looking around the rest of the world, we see that central banks everywhere continue to have their policy dictated by the Fed. Two examples are Indonesia and the Philippines, both of whom are expected to raise rates this week (Indonesia by 25bps, Philippines by 50bps) as both of these nations continue to run current account deficits and have seen their currencies erode in value faster than any of their Asian peers other than India. The nature of these two countries, which is quite common in the emerging market sphere, is that currency weakness passes through quickly to higher inflation, and so the dollar strength that we have seen since the beginning of Q2 has already had a significant impact. It is this issue that has prompted a number of emerging market central bankers to caution Chairman Powell of the negative consequences of the current Fed policy trajectory. However, Powell has dismissed these out of hand and the Fed continues on its course.

The other notable movement in the EMG bloc was in Argentina, where the central bank president resigned after just three months on the job. Luis Caputo was both liked and respected by markets and the FX market responded by pushing the peso lower by 2.5% on the news. Of course, in the broad scheme of things, this is not very much compared to the currency’s 50% decline this year.

Pivoting to the G10, FX movement has been modest overall, with the biggest movers AUD and NZD, both of which seem to be benefitting from the recent revival in commodity prices. There has been no new Brexit news and so the pound remains relatively unscathed. Meanwhile, after Monday’s excitement in the euro following Signor Draghi’s “relatively vigorous” comments, it seems that ECB member Peter Prâet was trotted out to explain that there was no change in the committee’s view and that rates would not be rising until much later next year. Ultimately, however, the euro is essentially unchanged on the day, with the market having drawn that conclusion shortly after the comments were made.

Yesterday’s US data showed that Consumer Confidence was approaching all time highs but House prices seemed to display some weakness. This is the perfect mix for the Fed, lessening price pressures along with optimism on economic growth. I assure you this will not deter the Fed from continuing on its path. Before the FOMC meeting ends this afternoon, New Home Sales data will print, expected to be 630K, which looks right about in line with the longer term trend, albeit showing some softness from the situation earlier this year.

I see no reason to expect that the market will move significantly before the FOMC, and of course, can only watch with the rest of the market to see what actually comes from the meeting as well as what the Chairman says. Until then, look for a quiet session.

Good luck


Watching With Rigor

Though Draghi said data of late
May not have appeared all that great
We’re watching with rigor
Inflation that’s vigor-
Ously rising at a high rate

After a multi week decline, the dollar is showing further signs of stabilizing this morning. And that includes its response to yesterday’s surprising comments by ECB President Mario Draghi, who indicated that despite the ECB lowering its forecasts for growth this year and next, and that despite the fact that recent data has been falling short of expectations, he still described the underlying inflation impulse as “relatively vigorous” and reconfirmed that QE would be ending in December with rates rising next year. In fact, several of his top lieutenants, including Peter Praet and Ewald Nowotny, indicated that rates ought to rise even sooner than that. Draghi, however, has remained consistent in his views that gradual removal of the current policy accommodation is the best way forward. But as soon as the words “relatively vigorous” hit the tape, the euro jumped more than 0.5% and touched an intraday high of 1.1815, its richest point since June. The thing is, that since that time yesterday morning, it has been a one-way trip lower, with the euro ultimately rising only slightly yesterday and actually drifting lower this morning.

But away from the excitement there, the dollar has continued to consolidate Friday’s gains, and is actually edging higher on a broad basis. It should be no surprise that the pound remains beholden to the Brexit story, and in truth I am surprised it is not lower this morning after news that the Labour party would definitively not support a Brexit deal based on the current discussions. This means that PM May will need to convince everyone in her tenuous majority coalition to vote her way, assuming they actually get a deal agreed. And while one should never underestimate the ability of politicians to paint nothing as something, it does seem as though the UK is going to be leaving the EU with no exit deal in place. While the pound is only down 0.15% this morning, I continue to see a very real probability of a much sharper decline over the next few months as it becomes increasingly clear that no deal will appear.

There was one big winner overnight, though, the Korean won, which rallied 4.2% on two bits of news. Arguably the biggest positive was the word that the US and Korea had agreed a new trade deal, the first of the Trump era, which was widely hailed by both sides. But let us not forget the news that there would be a second round of talks between President Trump and Kim Jong-Un to further the denuclearization discussion. This news is also a significant positive for the won.

The trade situation remains fascinating in that while Mr Trump continues to lambaste the Chinese regarding trade, he is aggressively pursuing deals elsewhere. In fact, it seems that one of the reasons yesterday’s imposition of the newest round of tariffs on Chinese goods had so little market impact is that there is no indication that the president is seeking isolationism, but rather simply new terms of trade. For all the bluster that is included in the process, he does have a very real success to hang his hat on now that South Korea is on board. Signing a new NAFTA deal might just cause a re-evaluation of his tactics in a more positive light. We shall see. But in the end, the China situation does not appear any closer to resolution, and that will almost certainly outweigh all the other deals, especially if the final threatened round of $267 billion of goods sees tariffs. The punditry has come around to the view that this is all election posturing and that there will be active negotiations after the mid-term elections are concluded in November. Personally, I am not so sanguine about the process and see a real chance that the trade war situation will extend much longer.

If the tariffs remain in place for an extended period of time, look for inflation prints to start to pick up much faster and for the Fed to start to lean more hawkishly than they have been to date. The one thing that is clear about tariffs is that they are inflationary. With the FOMC starting their meeting this morning, all eyes will be on the statement tomorrow afternoon, and then, of course, all will be tuned in to Chairman Powell’s press conference. At this point, there seems to be a large market contingent (although not a majority) that is looking for a more dovish slant in the statement. Powell must be happy that the dollar has given back some of its recent gains, and will want to see that continue. But in the end, there is not yet any evidence that the Fed is going to slow down the tightening process. In fact, the recent rebound in oil prices will only serve to put further upward pressure on inflation, and most likely keep the doves cooped up.

With that in mind, the two data points to be released today are unlikely to have much market impact with Case-Shiller Home Prices (exp 6.2%) at 9:00am and Consumer Confidence (132.0) due at 10:00. So barring any new comments from other central bankers, I expect the dollar to remain range bound ahead of tomorrow’s FOMC action.

Good luck


Just How He Feels

On Wednesday the Chairman reveals
To all of us, just how he feels
If dovish expect
Bulls to genuflect
If hawkish, prepare for some squeals

This is an early note as I will be in transit during my normal time tomorrow.

On Friday, the dollar continued its early morning rebound and was generally firmer all day long. The worst performer was the British pound, which fell more than 1.0% after Friday’s note was sent. It seems that the Brexit story is seen as increasingly tendentious, and much of the optimism that we had seen develop during the past three weeks has dissipated. While the pound remains above its lowest levels from earlier in the month, it certainly appears that those levels, and lower ones, are within reach if there is not some new, positive news on the topic. This appears to be an enormous game of chicken, and at this point, it is not clear who is going to blink first. But every indication is that the pound’s value will remain closely tied to the perceptions of movement on a daily basis. Hedgers need to be vigilant in maintaining appropriate hedge levels as one cannot rule out a significant move in either direction depending on the next piece of news.

But away from the pound, the story was much more about lightening positions ahead of the weekend, and arguably ahead of this week’s FOMC meeting. The pattern from earlier in the week; a weaker dollar along with higher equity prices around the world and higher government bond yields, was reversed in a modest way. US equity markets closed slightly softer, the dollar, net, edged higher, and 10-year Treasury yields fell 2bps.

The big question remains was the dollar’s recent weakness simply a small correction that led to the other market moves, or are we at the beginning of a new, more significant trend of dollar weakness? And there is no easy answer to that one.

Looking ahead to this week shows the following data will be released:

Tuesday Case-Shiller House Prices 6.2%
  Consumer Confidence 312.2
Wednesday New Home Sales 630K
  FOMC Decision 2.25%
Thursday Initial Claims 208K
  Goods Trade Balance -$70.6B
  Q2 GDP 4.2%
Friday PCE 0.2% (2.3% Y/Y)
  Core PCE 0.1% (2.0% Y/Y)
  Personal Income 0.4%
  Personal Spending 0.3%
  Chicago PMI 62.5
  Michigan Sentiment 100.8

So clearly, the FOMC is the big issue. It is universally expected that they will raise the Fed funds rate by 25bps to 2.25%. The real question will be with the dot plot, and the analysis as to whether the sentiment in the room is getting even more hawkish, or if the CPI data from two weeks ago was enough to take some of the edge off their collective thinking, and perhaps even change the median expectations of the path of rate hikes. I can virtually guarantee you that if the dot plot shows a lower median, even if it is because of a change by just one FOMC member, equity markets will explode higher around the world, the dollar will fall and government bond yields will rise. However, my own view is that the data since we have last heard from any Fed speaker has not been nearly soft enough to consider changing one’s view. Instead, I expect a neutral to hawkish statement, and a little pressure on equities.

But the big picture narrative does seem to be starting to change, and so any dollar benefit is likely to be short lived. Be ready to hear a great deal more about the structural deficits and how that will force the dollar lower. One last thing, tariffs on $200 billion of Chinese imports go into effect on Monday, which will only serve to add upward pressure to inflation data, and ultimately keep the FOMC quite vigilant. I remain committed to the idea that the cyclical factors will regain their preeminence, but it just may take a few weeks or months for that to be apparent. In the meantime, look for the dollar to slowly slide lower.

Good luck

A Terrible Day

The UK’s Prime Minister May
Last night had a terrible day
Her plans for a deal
Were seen as unreal
As hawks in the EU held sway

But elsewhere the market’s embraced
The concept that fear was misplaced
Instead, stocks they’re buying
And so, fortifying
The idea, for risk, they have taste

Arguably, the key headline this morning was the extremely poor reception British PM May received from her 27 dinner companions at the EU dinner last night. She continues to proffer the so-called Chequers deal (named for the PM’s summer residence where the deal was agreed amongst Tory members several weeks ago), which essentially says the UK will toe the EU line when it comes to manufactured and agricultural goods, but wants a free hand in services and immigration. French President Macron was quick to dismiss the notion as he remains adamant that leaving the EU should be seen as a disaster, lest any other nations (Italy are you watching?) consider the idea. At any rate, while the pound had been rallying for the past week, reaching its highest level since early July, that all came a cropper last night. The growing hope that a Brexit deal would be found has been shattered, at least for now, and it should be no surprise that the pound has suffered for it. This morning, it is leading the way lower, having fallen 0.6% from yesterday’s closing levels.

However, while the dollar is modestly firmer this morning across the board, my strong dollar thesis is being severely tested of late. We have seen the dollar fall broadly all week despite the resumption of the march higher in US yields. Or is it because of that movement that the dollar is falling? Let’s consider the alternatives.

Several months ago I wrote about the conflicting cyclical and structural aspects of the market that were impacting the dollar’s value. The cyclical factors were US growth outpacing the rest of the world and the Fed tightening monetary policy faster than any other central bank. This combination led to higher US rates and a better investment environment in the US than elsewhere, and consequently, an increase in dollar buying for global investors to take advantage of the opportunities. Thus higher short-term interest rates led to a higher US dollar, along with a flatter yield curve.

On the other hand, the structural questions that hang over the US economy consist of the impact of late cycle fiscal stimulus in the form of both tax cuts and increased spending. The fact that this was occurring at the same time the Fed was reducing the size of its balance sheet meant that at some point, it seemed likely that increased Treasury supply would find decreased demand. The growing budget and current account deficits would in turn pressure the dollar lower while the excess Treasury supply would push long-term yields higher ending up with a weaker dollar and a steeper yield curve.

Starting in April, it became clear that the cyclical story was the primary market driver, with strong US growth pushing up short-term rates as well as US corporate earnings. Investors flocked to the US to take advantage with the dollar rallying sharply while US equity markets significantly outperformed their foreign counterparts. This was especially notable in the EMG space, where a decade of QE had forced funds to the highest yielding assets they could find, which happened to be those EMG markets. But now that there was an alternative, those funds were quick to return to the US, driving EMG equity markets lower and hammering those currencies as well. There was also a great deal of concern that if the divergence in markets continued, it could result in much more significant losses elsewhere that would eventually come back to haunt US markets.

But a funny thing happened last week, US CPI printed lower than expected. Now you might not think that a 0.1% miss on a number would be that important, but essentially what that signaled to markets was that the Fed would be more likely to ease back on the pace of tightening, thereby slowing the rise in the short-term interest rate structure. It also indicated that US growth may not be as robust as had been previously thought, and therefore, opportunities here, while still excellent, needed to be weighed against what was going on elsewhere in the world. At the same time, elsewhere in the world we have seen continued central bank rhetoric about removing policy accommodation, with ECB President Draghi’s press conference seen as mildly hawkish, while the BOJ seems to be in stealth taper mode. We have also seen the trade situation get pushed to the back of the collective market’s mind as the US imposed a lower tariff rate than expected on Chinese goods, and has not yet moved forward on any other tariffs.

But wait, there’s more!, after four months of selling off, EMG assets have suddenly started to look like they represent a ‘value’ play, with the first buyers tentatively dipping their toes back into those markets. And finally, remember that the speculative long dollar position has been building for months and reaching near record levels. Adding it all up leads to the following conclusion: there is room for the dollar to continue this decline in the medium term. Continued fund movement into EMG markets combined with the reduction of the long dollar positions will be more than sufficient to continue to drive the dollar lower.

That combination is what has taken place this week, and despite the break today, it seems quite viable that we will continue to see this pattern for a bit longer. In the end, I don’t think that the market will completely ignore the cyclical dollar prospects, but for now, the broad structural story is holding sway. Add to this the idea that market technicians are going to get excited about selling dollars because it has reached levels below the 50-day and 100-day moving averages, and thus is ‘breaking out lower’, and we could be in for a couple of months of dollar weakness. If this is true, while individual currencies could still underperform, like the pound if the Brexit situation collapses, it is entirely possible that Chairman Powell could find himself in the best position he could imagine, continuing to remove policy ease while the dollar falls, thus ameliorating the President’s concerns. But it’s not clear to me that is such a good thing overall. We shall see.

Good luck and good weekend

Money More Dear

Next week, though it’s certainly clear
The Fed will price money more dear
The dollar’s incurred
Some selling and spurred
More weakness than seen since last year

The dollar remains under pressure this morning with a number of stories having a separate, but a cumulative impact on the buck. For example, overnight we learned that New Zealand’s GDP grew 1.0% in Q2, higher than the expected 0.7% outcome, and sufficient to get investors and traders to consider that the RBNZ, which just last month promised to maintain record low interest rates until at least 2020, may wind up raising rates sooner than that. A surprise of this nature usually leads to currency strength and so it is this morning with NZD higher by 0.8%.

Or consider the UK, where Retail Sales data surprised one and all by rising 0.3% in August (3.3% Y/Y), a much better performance than expected. This was enough to overcome the ongoing Brexit malaise and drive the pound higher by 0.7% and back to its highest level in two months. In truth, this is somewhat surprising given the quite disappointing outcome from the EU meeting Wednesday night in Brussels. Rather than more positive remarks about the viability of a deal being completed, we heard more of the hard-core negativity from the French and Irish, basically saying if the UK doesn’t cave, then there will be no deal. This is certainly not a welcome outcome, especially since there are only 190 days until Brexit will occur, deal or no. Meanwhile, PM May continues to fight a rearguard action against the avid pro-Brexiters in her party in order to retain her position.

Logically, I look at the situation and believe there is no real chance of a satisfactory deal being agreed on time. Frankly, the Irish border issue is intractable in my view. But given that this is entirely about politics, and the Europeans and British are both famous for kicking the can down the road, I suspect that something along the lines of a pure fudge, with neither side agreeing anything, will be achieved in order to prevent a complete disaster. However, there is a very real probability that the UK will simply leave the EU with no deal of any sort, and if that is the case, the initial market reaction will be for a sharp sell-off in the pound.

Interestingly, despite the fact that the little Eurozone data released was on the soft side, the euro has managed to continue its recent rally and is higher by 0.4% as I type. This seems more of a piece with the general dollar weakness that we have witnessed the past two sessions than anything else.

Another potential conundrum is US interest rates, where 10-year Treasury yields jumped to 3.08% yesterday, their highest level since early May, and now gathering momentum for the breakout that many pundits have been expecting for a while. Remember, short Treasury futures are one of the largest positions in the market. This thought process has been led by two concurrent features; the Fed continues to raise short term rates while the Treasury, due to increased fiscal policy stimulus and a growing budget deficit, will be forced to increase the amount of debt issued. When this is wrapped up with the fact that the Fed is reducing the size of its balance sheet, thus removing the one true price-insensitive bid from the market, it seemed a recipe for much higher 10-year yields. The fact that we remain at 3.08% nine months into the year is quite surprising, at least to me. But it is entirely possible that we see a much more aggressive sell-off in Treasuries going forward, especially if the Fed tweaks their message next week to one that is more hawkish.

In this context, let me give a concrete example of just how important the central bank message really is. This morning, Norgesbank raised interest rates in Norway by 25bps, as was universally expected. This was the first time in 7 years they raised rates, and are doing so because the economy there is expanding rapidly while inflation moves closer to their target. But in their policy discussion, they reduced the forecast pace of future interest rate hikes, surprising everyone, and the result was a sharp decline in NOK. Versus the euro it fell more than 1%, which translated into a 0.7% decline vs. the dollar. The point is the market is highly focused on the policy statements as well as the actual moves.

This is equally true, if not more so, with regard to the Fed. Current expectations are that the Fed will raise rates 25bps next week and another 25bps in December. Where things get cloudier is what next year will look like, and how fast they will continue to tighten policy. It is for this reason that next week’s meeting is so widely anticipated, because the Fed will release its updated dot plot, the effective forecasts of each Fed member as to where Fed funds will be at various points in the future. If the dot plot implies higher rates than the last iteration in June, you can expect the dollar to benefit from the outcome. Any implication of a slower pace of rate hikes will certainly undermine the dollar.

In the end, the mixture of new information has been sufficient to push the dollar lower by 0.3% when looking at the broad dollar index. Interestingly, despite its recent weakness, it remains within the trading range that has defined its movement since it stopped appreciating in April. Frankly, I expect this range trading to continue unless the Fed significantly changes its tune.

This morning brings a bit more data with Initial Claims (exp 210K) and Philly Fed (17.0) due at 8:30 while Existing Home Sales (5.35M) are released at 10:00. Yesterday’s housing data was mixed with New Home Sales rising more than expected, but Building Permits plunging. And remember that both of those data points tend to have a great deal of volatility. With that in mind, looking at the longer term trend shows that while Housing Starts seem to be rebounding from a bad spot, the trend in Permits is clearly downward, which doesn’t speak well for the housing market in the medium term.

In the end, as I wrote yesterday, continued modest dollar weakness seems the most likely outcome for now, but I suspect that we are coming to the end of this soft patch, and that the dollar will find its legs soon. I remain confused as to why there is so much bullishness attached to the Eurozone economy given the data continues to underperform. And there is no indication that the ECB is going to suddenly turn truly hawkish. Current levels strike me as attractive for dollar buyers.

Good luck