Monthly Archives: October 2018

More Trouble is Brewing

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The PMI data last night
From China highlighted their plight
More trouble is brewing
While Xi keeps pursuing
The policies to get things right

Any questions about whether the trade conflict between the US and China was having an impact on the Chinese economy were answered last night when the latest PMI readings were released. The Manufacturing PMI fell to 50.2, it’s lowest level in more than two years and barely above the expansion/contraction level of 50.0. Even more disconcertingly for the Chinese, a number of the sub-indices notably export sales and employment, fell further below that 50.0 level (to 46.9 and 48.1 respectively), pointing to a limited probability of a rebound any time soon. At the same time, the Services PMI was also released lower than expected, falling to 53.9, its lowest level since last summer. Here, too, export orders and employment numbers fell (to 47.8 and 48.9 respectively), indicating that the economic weakness is quite broad based.

Summing up, it seems safe to say that growth in China continues to slow. One question I have is how is it possible that when the Chinese release their GDP estimates, the quarter-to-quarter movement is restricted to 0.1% increments? After all, elsewhere in the world, despite much lower headline numbers (remember China is allegedly growing at 6.5% while Europe is growing at 2.0% and the US at 3.5%), the month-to-month variability is much greater. Simple probability would anticipate that the variance in China’s data would be higher than in the rest of the world. My point is that, as in most things to do with China, we don’t really know what is happening there other than what they tell us and that is like relying on a pharmaceutical salesman to prescribe your medicine. There are several independent attempts ongoing to get a more accurate reading of GDP growth in China, with measures of electricity utilization or copper imports seen as key data that is difficult to manipulate, but they all remain incomplete. And it seems highly unlikely that President Xi, who has been focused on improving the economic lot of his country, will ever admit that the growth figures are being manipulated. But I remain skeptical of pretty much all the data that they provide.

At any rate, the impact on the renminbi continues to be modestly negative, with the dollar touching another new high for the move, just below 6.9800, in the overnight session. This very gradual weakening trend seems to be the PBOC’s plan for now, perhaps in order to make a move through 7.00 appear less frightening if it happens very slowly. I expect that it will continue for the foreseeable future especially as long as the Fed remains on track to tighten policy further while the PBOC searches for more ways to ease policy without actually cutting interest rates. Look for another reserve requirement ratio cut before the end of the year as well as a 7 handle on USDCNY.

Turning to the euro, data this morning showed that Signor Draghi has a bit of a challenge ahead of him. Eurozone inflation rose to 2.2% with the core reading rising to 1.1%, both slightly firmer than expected. The difference continues to be driven by energy prices, but the concern comes from the fact that GDP growth in the Eurozone slowed more than expected last quarter. Facing a situation where growth is slowing and inflation rising is every central banker’s nightmare scenario, as the traditional remedies for each are exactly opposite policies. And while the fluctuations are hardly the stuff of a disaster, the implication is that Europe may be reaching its growth potential at a time when interest rates remain negative and QE is still extant. The risk is that the removal of those policies will drive the Eurozone back into a much slower growth scenario, if not a recession, while inflation continues to creep higher. It is data of this nature, as well as the ongoing political dramas, that inform my views that the ECB will maintain easier policy for far longer than the market currently believes. And this is why I remain bearish on the euro.

Yesterday the pound managed to trade to its lowest level since the post-Brexit vote period, but it has bounced a bit this morning, +0.35%. That said, the trend remains lower for the pound. We are now exactly five months away from Brexit and there is still no resolution for the Irish border issue. Every day that passes increases the risk that there will be no deal, which will certainly have a decidedly negative impact on the UK economy and the pound by extension. Remember, too, that even if the negotiators agree a deal, it still must be ratified by 28 separate parliaments, which will be no easy task in the space of a few months. As long as this is the trajectory, the risk of a sharp decline in the pound remains quite real. Hedgers take note.

Elsewhere, the BOJ met last night and left policy unchanged as they remain no closer to achieving their 2.0% inflation goal today than they were five years ago when they started this process. However, the market has become quite accustomed to the process and as such, the yen is unchanged this morning. At this time, yen movement will be dictated by the interplay between risk scenarios and the Fed’s rate hike trajectory. Yen remains a haven asset, and in periods of extreme market stress is likely to perform well, but at the same time, as the interest rate differential increasingly favors the dollar, yen strength is likely to be moderated. In other words, it is hard to make a case for a large move in either direction in the near term.

Away from those three currencies, the dollar appears generally firmer, but movement has not been large. Turning to the data front, yesterday’s releases showed that home prices continue to ebb slightly in the US while Consumer Confidence remains high. This morning brings the first inklings of the employment situation with the ADP report (exp 189K) and then Chicago PMI (60.0) coming at 9:45. Equity futures are pointing higher as the market looks to build on yesterday’s modest rally. All the talk remains about how October has been the worst month in equity markets all year, but in the broad scheme of things, I would contend that, at least in the US, prices remain elevated compared to traditional valuation benchmarks like P/E ratios. At any rate, it seems unlikely that either of today’s data points will drive much FX activity, meaning that the big trend of a higher dollar is likely to dominate, albeit in a gradual fashion.

Good luck
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A Narrative Challenge

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From Europe, the data released
Showed growth there has clearly decreased
For Draghi this poses
(What everyone knows is)
A narrative challenge, at least

Once upon a time there was a group of nations that came together in an effort to reap the theoretical benefits of closely adhering to the same types of economic policies. They believed that by linking together, they would create a much larger ‘domestic’ market, and therefore would be able to compete more effectively on the global stage. They even threw away their own currencies and created a single currency on which to depend. Under the guidance of their largest and most successful member, this currency was managed by a completely independent central bank, so they could never be accused of printing money recklessly. And after a few initial hiccups, this group generally thrived.

But then one day, clouds arose on the horizon, where from across the great ocean, a storm (now known as the Great financial crisis) blew in from the west. At first it appeared that this group of nations would weather the storm pretty well. But quickly these nations found out that their own banks had substantial exposure to the key problem that precipitated the storm, real estate investment in the US. Suddenly they were dragged into the maelstrom and their economies all weakened dramatically. The after effects of this included questions about whether a number of these countries would be able to continue to repay their outstanding debt. This precipitated the next crisis, where the weakest members of the club, the PIIGS, all saw their financing costs skyrocket as investors no longer wanted to accept the risk of repayment. This had the added detriment of weakening those nations’ banks further, as they had allocated a significant portion of their own balance sheets to buying home country debt. (The very debt investors were loath to own because of the repayment risks.)

Just when things reached their nadir, and the very weakest piggy looked like it was about to leave the group, a knight in shining armor rode to the rescue, promising to do “whatever it takes” to prevent the system from collapsing and the currency from breaking up. Being a knight in good standing, he lived up to those words and used every monetary policy trick known to mankind in order to save the day. These included cutting interest rates not just to zero, but below; force-feeding interest-free loans to the banks so that that they could on lend that money to companies throughout the group; and finally buying up as much sovereign, and then corporate, debt as they could, regardless of the price.

Time passed (five years) and that shining knight was still doing all those same things which helped avoid the worst possible outcomes, but didn’t really get the group’s economy growing as much as hoped. In fact, it seems that last year was the best it was going to get, where growth reached 2.5%. But now there are new storm clouds brewing, both from the West as well as from within, and the growth narrative has changed. And it appears this new narrative may not have a happy ending.

Data released this morning showed that GDP growth in Italy was nil, matching Germany’s performance, and helping to drag Eurozone growth down to 0.2% for Q3, half the expected rate. French growth, while weaker than expected at 0.4%, was at least positive. In addition, a series of confidence and sentiment indicators all demonstrated weakness describing a situation where not only has the recent performance been slipping, but expectations for the future are weakening as well. It can be no surprise that the euro has slipped further on the news, down 0.2% this morning and continuing its recent trend. During the month of October, the single currency has fallen more than 2.2%, and quite frankly, there doesn’t appear to be any reason in the short run for that to change.

What may change, though, is Signor Draghi’s tune if Eurozone growth data continues to weaken. It will be increasingly difficult for Draghi to justify ending QE and eventually raising rates if the economy is truly slowing. Right now, most analysts are saying this is a temporary thing, and that growth will rebound in Q4, but with the ongoing trade fight between the US and China weakening the Chinese economy, as well as the Fed continuing to raise interest rates and reduce dollar liquidity in global markets, it is quite realistic to believe that there will be no reprieve. And none of that includes the still fragile Italian budget situation as well as the potential for a ‘hard’ Brexit, both of which are likely to negatively impact the euro. And don’t get me started about German politics and how the end of the Merkel era could be an even bigger problem.

The point is, there is still no good reason to believe the dollar’s rally has ended. Speaking of Brexit, the pound is under pressure this morning, down -0.35%, as the market absorbs the most recent UK budget, where austerity has ended while growth is slowing. Of course, everything in the UK is still subject to change depending on the Brexit outcome, but as yet, there has been no breakthrough on the Irish border issue.

As to the rest of the G10, Aussie and Kiwi both benefitted from a bounce in the Chinese stock market, at least that’s what people are talking about. However, it makes little sense to me that a tiny bounce there would have such a big impact. Rather, I expect that both currencies will cede at least some of those gains before the day is done. Meanwhile, the yen has softened, which has been attributed to a risk-on sentiment there, and in fairness, Treasury yields have risen as well, but the rest of the risk clues are far less clear.

Speaking of China, the PBOC fixed the renminbi at a new low for the move, 6.9724, which promptly saw it trade even closer to 7.00, although it is now essentially unchanged on the day. The market talk is that traders are waiting for the meeting between Presidents Trump and Xi, later this mornth, to see if a further trade war can be averted. If tensions ease in the wake of the meeting, look for USDCNY to slowly head lower, but if there is no breakthrough, a move through 7.00 would seem imminent.

And that’s really it for this morning. Yesterday’s US data showed PCE right at 2.0% for both headline and core, while Personal Spending rose 0.4%, as expected. Today’s data brings only the Case-Shiller Home Price Index (exp 5.8%) and Consumer Confidence (136.0), neither of which is likely to move markets. In addition, the Fed is now in its quiet period, so no more Fed speak until the meeting next week. Equity futures are pointing slightly higher, but that is no guarantee of how the day proceeds. In the end, it is hard to make a case for a weaker dollar quite yet.

Good luck
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New Standard-Bearers

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The largest of all Latin nations
This weekend confirmed its frustrations
Electing a man
Whose stated game plan
Is changing the country’s foundations

Meanwhile in a key German state
Frau Merkel and friends felt the weight
Of policy errors
So new standard-bearers
Like AfD now resonate

This weekend brought two key elections internationally, with Brazil voting in Jair Bolsonaro, the right-wing firebrand and nationalist who has promised to clean up the corruption rampant in the country. Not unlike New Jersey and Illinois, Brazil has several former politicians imprisoned for corruption. Bolsonaro represented a change from the status quo of the past fifteen years, and in similar fashion to people throughout the Western world, Brazilians were willing to take a chance to see a change. Markets have been cheering Bolsonaro on, as he has a free-market oriented FinMin in mind, and both Brazilian equities and the real have rallied more than 10% during the past month. The early price action this morning has BRL rising by another 1.65%, continuing its recent rally, and that seems likely to continue until Bolsonaro changes tack to a more populist stance, something I imagine we will see within the first year of his presidency.

Just prior to those results, the German elections in the state of Hesse, one of the wealthiest states in Germany and the home of Frankfurt and the financial industry, showed disdain for the ruling coalition of Chancellor Merkel’s CDU and the Social Democrats, with their combined share of the vote falling to just 39%, from well above 50% at the last election. The big winners were the far left Green Party and the far right AfD, both of whom saw significant gains in the state house there, and both of whom will make it difficult to find a ruling coalition. But more importantly, it is yet another sign that Frau Merkel may be on her last legs. This was confirmed this morning when Merkel announced she was stepping down as leader of her party, the CDU, but claimed she will serve out her term as Chancellor, which runs until 2021.

One other Eurozone story came out Friday afternoon as Standard & Poors released their updated ratings on Italy’s sovereign debt, leaving the rating intact but cutting the outlook to negative. This was slightly better than expected as there were many who worried that S&P would follow Moody’s and cut the rating as well. Italian debt markets rallied on the opening with 10-year yields falling 10bps and the spread with German Bunds narrowing accordingly. So net, there was a euro negative, with Merkel stepping down, and a euro positive, from S&P, and not surprisingly, the euro wound up little changed so far, although that reflects a rebound from the early price action. My concern is that the positive story was really the absence of a more negative story, and one that could well be simply a timing delay, rather than an endorsement of the current situation in Italy. The budget situation remains uncertain there, and if the government chooses to ignore the EU and implement their proposed budget, I expect there will be more pressure on the euro. After all, what good are rules if they are ignored by those required to follow them? None of this bodes well for the euro going forward.

Two other key stories have impacted markets, first from Mexico, the government canceled the construction of a new airport for Mexico City. This was part of the departing administration’s infrastructure program, but, not surprisingly, it has seen its cost explode over time and the incoming president has determined the money is better spent elsewhere. The upshot is that the peso has fallen a bit more than 1% on the news, and I would be wary going forward as we approach AMLO’s inauguration. By cutting the investment spending, not only will the country’s infrastructure remain substandard, but its growth potential will suffer as well. I think this is a very negative sign for the peso.

The other story comes from China, where early Q4 data continues to show the economy slowing further. The government there, ever willing to do anything necessary to achieve their growth target, has proposed a 50% cut in auto sales taxes in order to spur the market. Auto sales are on track for their first annual decline ever this year, as growth slows throughout the country. Interestingly, the market impact was seen by rallies in auto shares throughout Europe and the US, but Chinese equity markets continued to slide, with the Shanghai Index falling another 2.2% overnight. This also has put further pressure on the renminbi with CNY falling another 0.2% early in the session before recently paring some of those losses. USDCNY continues to hover just below 7.00, the level deemed critical by the PBOC as they struggle to prevent an increase in capital outflows. The last time the currency traded at this level, it cost China more than $1 trillion to staunch the outflow, so they are really working to prevent that from happening again.

And those are the big stories from the weekend. Overall, the dollar is actually little changed as you can see that there have been individual issues across specific currencies rather than a broad dollar theme today. Looking ahead to the US session, we get the first of a number of important data points this morning with the full list here:

Today Personal Income 0.4%
  Personal Spending 0.4%
  PCE 0.1% (2.2% Y/Y)
  Core PCE 0.1% (2.0% Y/Y)
Tuesday Case-Shlller Home Prices 5.8%
Wednesday ADP Employment 189K
  Chicago PMI 60.0
Thursday Initial Claims 213K
  Nonfarm Productivity 2.2%
  Unit Labor Costs 1.1%
  ISM Manufacturing 59.0
  ISM Prices Paid 65.0
  Construction Spending 0.1%
Friday Nonfarm Payrolls 190K
  Private Payrolls 184K
  Manufacturing Payrolls 15K
  Unemployment Rate 3.7%
  Average Hourly Earnings 0.2% (3.1% Y/Y)
  Average Weekly Hours 34.5
  Trade Balance -$53.6B
  Factory Orders 0.4%

So there is a ton of data upcoming, with this morning’s PCE and Friday’s Payrolls the key numbers. Last week’s GDP data had a better than expected headline print but the entire weekend press was a discussion as to why the harbingers of weaker future growth were evident. And one other thing we have seen is the equity market dismiss better than expected Q3 earnings data from many companies, selling those stocks after the release, as the benefits from the tax cut at the beginning of the year are starting to get priced out of the future.

The market structure is changing, that much is clear. The combination of central bank actions to reduce accommodation, and an expansion that is exceedingly long in the tooth, as well as increased political uncertainty throughout the world has made investors nervous. It is these investors who will continue to support US Treasuries, the dollar, the yen and perhaps, gold,; the traditional safe havens. At this point, there is nothing evident that will change that theme.

Good luck
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The Doves’ Greatest Friend

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Despite signs that growth is now slowing
Said Draghi, he would keep on going
With plans to soon end
The doves’ greatest friend
QE, which has kept Europe growing

While all eyes have been focused on the recent equity market gyrations, which in fairness have been impressive, there are other things ongoing that continue to have medium and long-term ramifications. One of the most important is the ECB and its future path of monetary policy. Yesterday, to no one’s surprise they left policy on hold, but of more interest were the comments Signor Draghi made during his press conference following the meeting. Notably, he continued to characterize the risks to the Eurozone economy as “balanced” despite the fact that virtually every piece of data we have seen in the past two months has indicated growth is slowing there more rapidly than previously anticipated.

If you recall, the declared rationale for the ending of QE was that Eurozone growth had been running above its potential throughout 2017 and it was expected to continue to do so this year. Alas, that no longer seems to be the case. Instead, recent data indicates that the growth impulse there is back at potential, if not slightly below. Recent PMI and IP data have all shown weakness, which when added to the stresses induced by Brexit uncertainty and slowing growth in China make for a substandard future. But not according to Draghi, who indicated that the ECB is going to end QE in December regardless, and that rate hikes are still slated to start next year. Perhaps he is correct and this is simply a temporary rough patch. The problem is the message from recent equity market performance is that there is a growing widespread concern that trouble is brewing everywhere around the world. Of course Draghi’s biggest problem is that if the Eurozone tips into a recession in 2019, they will have a serious problem trying to add monetary stimulus to the economy given the current, still ultra easy, settings. As I have written frequently in the past, this is why I continue to expect the dollar to outperform going forward. Yesterday saw the early morning rally in the euro reverse completely and the single currency closed -0.2%, and this morning it is a further 0.25% lower. The trend is your friend, and this trend is still for a lower euro.

In the meantime, we continue to see Brexit uncertainty plague the pound, which after a 0.5% decline yesterday has continued to fall this morning (-0.2%) as there is no indication that a compromise is in the offing. With the pound back to its lowest levels since late summer, and the trend decidedly lower, it will take a significant breakthrough in the Brexit negotiations to change things. This morning, the NIESR (a well-regarded British economic research institute) published a report that a hard Brexit will result in GDP growth being 1.6% lower than it otherwise would have been in 2019. That’s a pretty big hit, and simply adds to the Brexit concerns going forward. But the clock is still ticking and there is no indication that a solution can be found for the Irish border situation. One side will have to cave, and at this point, my money is on the UK.

As to the rest of the G10 space, the commodity bloc (AUD, CAD and NZD) has had a rough go of it overnight, with all three falling 0.5% or more in the session. It seems that concerns over slowing Chinese and global growth is being recognized as commodity prices continue to slide. With that, these currencies are also taking a beating with Aussie falling back near 0.7000, its lowest level since January 2016. Keep in mind that the more questions that are raised about the global growth trajectory, the more these currencies are likely to suffer.

Turning to our favorite EMG currency, CNY, it traded to a new low for the move overnight, although has since recouped some of those losses. The PBOC fixed the yuan at another new low (6.9510), and that saw both the offshore and onshore markets push the currency down below (dollar above) 6.9700. This is the weakest that the renminbi has been since December 2016 when the PBOC was forced to intervene more aggressively to prevent a rout. Remember they remain extremely concerned that if it trades above 7.00 that will be seen as a trigger for an increase in capital outflows from the country, and lead to a spiraling lower currency and greater domestic issues. Last time the market reached these levels, the PBOC withdrew liquidity from the offshore market, driving interest rates there massively higher, and forcing speculators with short positions to cover. That could well be what we will see next week, but as of now, there has been no activity like that observed. Speculators will only be deterred if the cost of speculation is high, which is not yet the case. Given that, I expect that we will see a run at 7.00 before long, likely next week, unless the PBOC acts. Words will not be sufficient to stop the move.

Away from CNY, other EMG currencies are almost universally weaker with declines ranging between 0.1% and 0.6%. The point is that this is a wide and shallow move, not one driven by specific national idiosyncrasies.

Yesterday’s data showed that defense spending was propping up the US manufacturing sector, with Durable Goods surprising to the high side although the ex-Defense number was soft. This morning, however, brings the most important data of the week, Q3 GDP. The median forecast is for growth of 3.3% and there will be a great deal of scrutiny on any revisions to Q2. A strong number ought to help support the dollar, as it will back up the Fed’s contention that strong growth demands higher interest rates. A soft number, or a big revision lower to Q2, seems likely to have a bigger impact though, as positions are still long dollars, and that would be a chink in its armor. Later this morning we see the Michigan Consumer Sentiment data (exp 99.0) and we also hear from Signor Draghi again, perhaps to try to clarify his message. But as it stands, if data is as expected, the dollar remains the best bet. This is even more likely if we continue to see equity markets decline. Spoiler alert, they have been doing that in Asia and Europe, and US futures are pointing in the same direction!

Good luck and good weekend
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Trembling With Fear

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The one thing increasingly clear
Is markets are trembling with fear
As stock markets tumble
Most central banks fumble
Their message, then get a Bronx cheer

Being a central banker has become much more difficult recently, especially in the wake of yesterday’s global equity market rout. It seems that policies that they have collectively promulgated, QE and ZIRP/NIRP are now quite long in the tooth, and no longer having the positive impact desired. Let’s recap quickly.

The Great recession in 2008 called for an extraordinary monetary response by central banks around the world, and rightly so. The deepest recession since the Great Depression saw liquidity across many markets completely dry up. Even FX, arguably the most liquid market of them all, had structural problems. So the combination of QE and USD swap lines offered by the Fed to the rest of the world’s central banks was an appropriate response to help untangle the mess. Alas, fiscal policy never chipped in to the recovery and central banks took it upon themselves to do all the lifting, thus relieving governments of the need to make hard decisions. In hindsight, this was a key mistake!

Fast forward ten years to today and the situation, remarkably, is that most of that extraordinary monetary stimulus is still sloshing around the world as other than the Fed and the Bank of Canada (who raised rates yesterday and indicated they would be quickening the pace of doing so in the future), no other major central bank has done anything of note. The ECB, the BOJ and the PBOC are all still adding liquidity to their systems, while the BOE has raised rates just 25bps, net, from the lows established after the crisis. And the same is true of peripheral nations like Switzerland, Sweden and Australia, where interest rates remain at their post crisis nadirs (-0.75%, -0.50% and 1.50% respectively).

The problem for these central banks is that growth is starting to slow on a global basis. Whether it is the increased trade friction between the US and China, concerns over Brexit or simply that the US recovery (which still arguably drives most of the global economy) is now the longest on record and due to end, the situation is increasingly fraught. And that’s the rub. If interest rates are already negative, what can central banks do to stimulate the economy in the event of a recession? The answer, of course, is not much. More QE and even deeper negative interest rates are unlikely to have the same positive impact the first efforts had, in fact they could have the opposite effect by generating greater concern amongst investors and causing a more severe sell-off in markets. But politically, no central bank will be able to sit by and do nothing if a recession does appear. As I said, central banking has become much more difficult lately.

That is all a preamble to discuss what is going on in markets right now. FX is a backburner issue with equities front and center around the world. While European markets have stabilized at this time, one session of stability is not sufficient to declare an end to the rout. In the end, markets remain beholden to broad sentiment, the narrative if you will, and for the past ten years that narrative was that continued low inflation combined with steady growth would allow the central banks to maintain ultra easy monetary policy with no negative side effects. But in the past year, the cracks in that narrative have grown to the point where it is no longer seen as viable. First, inflation has begun to creep higher in certain areas around the world, notably the US and China. At the same time, growth data appears to have peaked last quarter. Tomorrow we will see the first estimate of Q3 GDP growth in the US (exp 3.3%), which is already considerably lower than Q2. In addition, we have seen Chinese growth slow more than expected and German growth fall to 0.0% in Q3. The combination of rising inflation and slower growth has put central banks in a bind forcing them to choose which issue to address first. The problem is by addressing one they are likely to exacerbate the other. So as the Fed fights threats of higher inflation, it impedes growth. Meanwhile, China has opted to support growth, thus feeding faster inflation. In the end, as the next recession looms closer, central banks will find themselves with fewer policy arrows in their quiver.

But this is an FX note, so let’s take a quick look at the market this morning. The dollar is a touch softer, with both the euro and the pound higher by 0.15% while we are seeing similar moves in most emerging market currencies. Activity in the market seems muted relative to the excitement in equities, but my sense is this will not last. Rather, if the equity sell-off continues, the dollar should find itself in a much stronger position. As to the stories that have been driving things in FX, the Italian budget, Brexit, central bank policies, there have been no real changes in the past twenty-four hours. The possible exception is that the interest rate futures market in the US has removed one price hike from the Fed’s expected path as concern grows that a continues slide in the stock market will lead to weaker growth and less need to keep driving rates higher. It seems that the Fed realizes that it began its tightening process far too late (thank you Chair Yellen!) and is now desperately trying to catch up so they can respond to the next downturn. But hey, the ECB is MUCH further behind.

Looking forward to today’s session, we start with the ECB meeting, where they announced no change in policy rates, but we still await Signor Draghi’s press conference at 8:30. It will be interesting if he continues to characterize the Eurozone economy risks as balanced, or if the downside risks are now elevated. If the latter, look for the euro to decline sharply! We also get US data including Durable Goods (exp -1.0%, ex transport +0.5%) and the Goods Trade Balance (-$74.9B). Yesterday’s New Home Sales data was awful, just 553K, well below expectations, and another sign that parts of the economy here are rolling over. I still don’t believe that the data turn has been enough to change the Fed’s mind about a December rate hike, but if numbers start to fall, watch out. Tomorrow’s GDP print will be quite important to the market. But today, I think the ECB dominates the story.

Good luck
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Just Let It Go

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Said Brussels to Italy, No
Your budget is not apropos
Go fix it and then
Come back here again
Said Italy, just let it go

In England, meanwhile, PM May
Is finding she can’t get her way
A challenge is forming
With more Tories warming
Up to the thought she shouldn’t stay

The world seems to be getting messier by the day. Despite the ongoing vitriol in the US election process, the dollar continues to benefit from the fact that problems elsewhere seem to be worse. For example, the euro is under pressure this morning with two key stories driving the market. First, in an unprecedented move, the EU rejected Italy’s draft budget by claiming that it’s deficit targets were not in line with EU directives of reducing debt. Not surprisingly, the populist government in Italy simply said that fiscal stimulus was required to get the economy growing again, and they were going to enact it anyway. There are two issues here impacting the euro, the first being that markets are likely to drive Italian interest rates higher and add significant pressure to the Italian economy, notably the banking sector, which is tightly tied to those rates. The second is that if a major country is willing to ignore EU guidance on an important issue like this, what does that say about the credibility of the entire EU construct and the euro by default.

The other key issue was the release of much weaker than expected Flash PMI data for Germany, France and the entire Eurozone. Remember yesterday the Bundesbank indicated that GDP growth in Q3 would be flat in Germany, undermining markets there. Well, today, we learned that growth in Q4 isn’t exactly shining either, with the Manufacturing PMI printing at 52.3, its lowest level since early 2016. This data added to the pressure on the euro, which has fallen 0.6% on the day and is now touching 1.1400 for the first time since mid-August. It appears that regardless of the ongoing structural concerns in the US, the cyclical growth and interest rate story remains the market’s driver for now.

Turning to the UK, yesterday saw a rally in the pound after a story circulated that the EU was going to offer a compromise on how to treat the UK after Brexit, allowing them to stay within the customs union. However, this morning, there appears to be a growing insurgency within the Tory party and a challenge to PM May appears to be coming. If she were ousted, that would become quite problematic with regards to the ongoing negotiations as Cabinet members would change, and policy direction would likely as well. Given the late date, just five months left before the split is finalized, it would speak to a much higher probability of a hard Brexit with no deal, and a much lower pound. With this in mind, it is not surprising that the pound has ceded yesterday’s gains and is down 0.6% as well this morning.

Away from those two stories, the dollar is generally, but not universally, stronger. It is noteworthy that USDCNY is higher by 0.2%, pushing back to the top of its recent range just above 6.95, and starting to move into the area where many are counting on the PBOC to intervene. There are a number of analysts who continue to believe that a move above 7.00 will lead to a significant increase in capital outflows from China, and a much bigger risk-off movement. This is something about which the Chinese are extremely concerned. However, looking around APAC currencies overnight, both INR (+0.5%) and KRW (+0.25%), arguably the next most important ones, showed strength vs. the dollar as yesterday’s sharp decline in oil prices was seen as a positive for both of these large oil importers.

On the rate front, the Riksbank in Stockholm left interest rates on hold, as expected, but basically promised to raise them in either December or February. SEK is modestly weaker vs. the dollar, but almost unchanged vs. the euro, perhaps a better measure of the impact. This morning, the Bank of Canada will also announce its rate decision with expectations nearly universal that they will raise rates by 25bps to 1.75%. Ahead of the announcement, the Loonie is flat.

And those are really the FX stories of the day. Equity markets around the world seem to be rebounding from yesterday’s US led sell-off, although US equity futures are still pointing lower as I type. Treasury yields have fallen from yesterday’s closing levels, but remain in the vicinity of 3.15%. As mentioned, oil prices tumbled yesterday by more than 4% after Saudi Arabia indicated they would make up for any reduction in Iranian crude exports due to the US sanctions that are to begin in earnest next week. And gold, the traditional safe haven, is basically flat on the day, although about 1% lower than the peak of $1240/oz it reached during the nadir of yesterday’s equity market movement.

This morning we see our first real data of the week, with New Home Sales expected to print at 625K. We also get the Fed’s Beige Book at 2:00pm. Speaking of the Fed, yesterday Atlanta Fed President Bostic reiterated that the Fed was on the right path and that gradual rate increases were appropriate. Today we hear from Bullard, Mester and Bostic again. While the housing data has softened lately, and even some of the earnings data has been a bit softer than expected, there is no strong rationale for any of these regional presidents to change their views. In fact the one thing I would mention about earnings is how many companies are raising prices to cover increased materials costs or tariff impacts. If anything, that sounds pretty inflationary to me, and I would guess to the Fed as well.

If US equity markets follow through on the opening and continue to decline, the dollar should remain well bid overall. But my sense is that we are going to see some bargain hunters coming in here, help the stock markets bounce and see the dollar decline by the time NY goes home.

Good luck
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Some Whiplash

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It seems that the pumping of cash
By China was good for a flash
Of higher stock prices
But there’s still a crisis
So traders there felt some whiplash

In Europe, the same might be said
As traders, Italian debt fled
The EU today
Rome’s budget will weigh
With portents of more strife ahead

Remember how the officially induced rally in the Chinese equity market was going to stabilize markets? Yeah, me neither. It seems that, last night, despite lots more talk and promises of more funding, investors in those equity markets were decidedly unimpressed with the prospects and have resumed their active share selling. Overnight saw the Shanghai composite decline 2.25% and drag the rest of Asian markets lower alongside (Nikkei -2.7%, Hang Seng -2.9%). The impact on the CNY was very much as would be expected, a modest decline of 0.25% as traders test the PBOC resolve of preventing a move to 7.00.

This has also impacted European markets, which are lower across the board, none more so than Germany’s DAX which has fallen 2.0%. Given the ongoing angst over the Italian budget situation, one might have expected the Italian markets to be the worst performers, but Germany revealed its own little secret this morning, Q3 GDP growth there is expected to be 0.0%! That’s right, Europe’s strongest economy is going to suffer a stagnant quarter, and so equity markets have responded accordingly. This is not to imply that all is rosy in Rome, just that the Germans had a bigger surprise today.

Before moving on to the Italian story, let me note that the situation in China needs to be watched carefully going forward for another reason. For the past ten years, central banks around the world have controlled the price action in markets. Whether it was the first QE implementation by Benny the Beard, or Signor Draghi’s “whatever it takes” comments, when central bankers spoke, markets responded as the bankers desired. But lately, those same central banks seem to have lost a little bit of their mojo, as comments they make in an effort to sway markets have a shorter and shorter half-life. The fact that despite a concerted effort by every senior financial official in China, including President Xi, to talk up equity markets, and by reference the health of the Chinese economy, has had such a short lived impact, may well imply that the meme of central banks controlling markets is coming to an end.

And to my mind, that would be a good thing. Ten years of unprecedented monetary policy actions have dramatically distorted price signals in virtually every market. Whether it is the abnormally low spread between high-yield debt and government bonds, or the idea that P/E ratios of 100 are the signs of a good investment, markets no longer offer price discovery. Or perhaps they no longer offer the opportunity to discern value in a price. Keep in mind that there are still more than €5 trillion of debt outstanding that have negative interest rates. But while I may see this as a positive step toward markets regaining their functionality, the central banks are likely to feel very differently. If their words are no longer effective tools to manage markets, they will be forced to enact actual policies, some of which may be contrary to fiscal considerations. ‘Forward guidance’ is much easier to implement (and comes with much less political fallout) than actual policy changes. Just remember, if this thesis is correct, market volatility in every market is going to increase going forward.

Now back to our regularly scheduled programming. The Italian budget continues to be topic number one in terms of current risks to market stability. Thus far the Italian government has been unwilling to change its plans and the EU is studying them closely to determine if the budget breaks the rules. The problem for the EU is that if they crack down hard, reject the budget and tell Rome what to do, it is likely to further inflame the anti-establishment forces in Italy, and potentially have a bigger detrimental impact on the European Parliament elections to be held early next year. However, if they do nothing, the risk is that Italy finds itself in a situation where it has increased difficulty in refinancing its debt, and that could stress the entire Eurozone project. It was much easier for the EU to act tough with Greece, whose economy was so tiny. Italy has the third largest economy in the Eurozone , and if they have financing troubles it could quickly lead to problems throughout the continent, and directly impact the euro. In other words, there is no good answer.

The market impact of this ongoing situation has been a gradual erosion in the euro’s value, which fell about 0.7% yesterday, although it has stabilized this morning. While the German GDP story is obviously a negative for the currency, the reality is that the euro, for now, is beholden to the Italian budget story. If Italy remains recalcitrant, look for further weakness. Meanwhile, the pound, too, suffered yesterday, falling a penny alongside the euro, as the ongoing Brexit story continues to weigh on the currency. Consider that there are essentially five months left to find a compromise and that the problem has not gotten any easier. Despite the lack of progress, I still expect some sort of face-saving deal at the end of the process, but the risk situation is highly skewed. If there is no deal, look for the pound to fall very sharply, maybe another 5% right away, whereas any deal will likely only see a relief rally of 2% or so. Hedgers beware.

And those are really the only stories that matter today. There is a great deal of discussion regarding the US midterm elections, and how any given result may impact markets, but that is well beyond the purview of this note. Generally, risk was tossed overboard yesterday as 10-year Treasury yields fell 5bps, gold rallied and so did the dollar, the yen and the Swiss franc. This morning, there has been less movement in that group of havens, although risk assets remain under pressure. My sense is that given the absence of any US data, the broad risk profile will drive the dollar. To me, all signs point to further equity weakness and therefore more haven buying. I like the dollar in that scenario.

Good luck
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Unwavering

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Said Xi, our support is “unwavering”
For stocks, which of late have been quavering
A rally ensued
The result, which imbued
A feeling the bulls have been savoring

Make no mistake about it, while President Xi Jinping is ‘president-for-life’ in China, and the most powerful leader since Deng Xiaoping, it turns out that the stock market is more powerful still. Despite last night’s 4% rally by the Shanghai Index, the market remains 25% lower than the highs seen in January. On Friday, we heard from a number of Chinese financial officials, each of them explaining how the government would support the market, and saw quasi-official purchases by Chinese brokerage firms. Over the weekend, President Xi, in a speech, promised a cut in personal income taxes as well as “unwavering” support for state owned enterprises. In other words, the combination of the trade spat with the US and the government’s previous efforts to deflate the real estate bubble by tightening liquidity and cracking down on non-bank financing seems to have been too much for Xi to bear. The equity market there has become too important to Chinese consumer sentiment to be ignored by the government, and a nearly 30% decline during the past nine months has really increased the pressure on Xi and his comrades. Since a key underpinning of Xi’s power is continued strong economic growth, the market signals had become too great to ignore. Hence the weekend actions, which also included promises of further tax cuts in the VAT rate, and the all-out effort to not merely halt the equity market decline, but reverse it.

For the moment, it has worked, with global equity markets responding favorably to the Chinese lead and risk being more warmly embraced by traders, if not long-term investors. European equity markets are higher, Treasury prices are falling, except in Italy (a truly high risk asset these days) where yields on the 10-year BTP have fallen 17bps today. Meanwhile, the dollar is little changed, having been slightly softer earlier in the session but now showing signs of life. The renminbi is also little changed this morning, continuing to hover near 6.94, while the PBOC looks on nervously. It has become increasingly apparent that regardless of the trade situation, there is very limited appetite to allow USDCNY to trade to 7.00 or beyond right now, as the fear of an uptick in capital outflows remains palpable. Although, eventually, I think that is exactly what will happen, it appears that the PBOC is going to allow only a very slow movement in that direction.

Away from China, the other ‘good’ news of the day was from Italy, where Moody’s cut the sovereign debt rating one notch to Baa3, its lowest investment grade, and adjusted the outlook to stable. This downgrade had been widely expected, but fears had been growing that it could actually be a two notch downgrade, into junk status, which would have resulted in forced selling of Italian debt by funds with mandates to only invest in investment grade bonds. The confirmation of a stable outlook has resulted in widespread relief by the market, although Standard & Poors will release their newest report next week, also slated to be a downgrade, but also expected (hoped?) to be a single notch and to remain in investment grade territory. For now, the result has been a huge rally in Italian bonds, with yields falling 14bps to 3.44% and the spread over German bunds declining to 298bps, its first time below 300 in two weeks. The thing is, there has been no indication that the Italians are going to alter their budget to meet EU requirements, and that is what started this latest round of problems.

Elsewhere in Europe Brexit remains the biggest unknown, with a deal still far from concluded. The key issue is still the Ireland situation and the competing demands for no hard Irish/Northern Irish border vs. the willingness to allow Northern Ireland to have a completely different set of trading rules than the rest of the UK. Over the weekend, PM May seemed to signal some willingness to move toward an EU suggested solution, but that is likely to imperil her tenure as PM given the strong resistance by hard-line Brexiteers. The pound is the worst performing G10 currency this morning, down 0.3%, but my sense is that for a substantive move to occur we will need to get a clear signal one way or the other, and that does not look imminent.

Another issue, which is in the background right now, but will start to become more interesting as we head into 2019, is the funding status of Eurozone banks that took advantage of the TLTRO financing during the Eurozone bond crisis. That cheap funding is set to mature beginning next year, and given the ECB’s stated goals of ending QE and eventually returning interest rates back to a more normal level, it means that bank funding costs throughout Europe are set to rise, and rise sharply. This will impact regulatory issues enacted in the wake of the financial crisis, as once those loans have less than 1-year remaining in them, they no longer count as long term capital. The point is that while the Eurozone economy has been recovering, a sharp rise in bank financing costs could easily undermine recent strength and force the ECB to reconsider the trajectory of tighter policy. Easier than expected ECB monetary policy would definitely weaken the single currency. This is not an issue for today, but we need to keep an eye out for potential concerns going forward.

Turning to the data story, this week doesn’t have much, but it does include the first look of Q3 GDP growth in the US, which could be critical for both markets and the upcoming elections. We also see New Home Sales, the last of the housing data, which thus far, has been quite weak.

Wednesday New Home Sales 625K
  Fed’s Beige Book  
Thursday Initial Claims 214K
  Durable Goods -1.0%
  -ex Transport +0.5%
  Goods Trade Balance -$74.9B
Friday Q3 GDP 3.3%
  Michigan Sentiment 99

On top of the GDP we have six Fed speakers, but there seems to be a pretty uniform set of expectations that they are on the right path with gradual rate increases the correct policy for now. In other words, don’t look for any new information there.

That sets us up for a week dependent on any changes in several ongoing stories, notably the Brexit negotiations, the Italian budget situation and Chinese market intervention. For now the signs are that the Chinese will continue to support things while Brexit will go nowhere. In the end, Italy has the best chance to rock the boat further, although I doubt that will occur this week. So look for a fairly quiet FX market, with the dollar remaining in its trading range waiting the next catalyst of note.

Good luck
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From Brussels

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From Brussels, the word is stop spending
Your budget, you must start amending
But Rome has replied
Get off our backside
And stop being so condescending

The fight between Rome and Brussels is intensifying as the EU has prepared to formally reject Italy’s 2019 budget. Explaining that the forecast budget deficit was too large and potentially destabilizing, EU FinMin’s are trying to apply pressure to prevent any further flouting of their rules. The problem is that the EU has only limited power, other than persuasion, to force change. There is a rule that allows them to impose a penalty of 0.2% of GDP on the offending nation if the situation gets out of control, but it has never been enacted in the entire history of the EU. And just getting to that point would require numerous meetings, lawsuits and hysterics, all of which will take a great deal of time. As well, the precedent is that when both France and Germany ran above target budget deficits for nearly a decade each in the 1980’s and 1990’s, a fine was never imposed. One other thing is that technically, Italy is within the rules, which call for a budget deficit of no more than 3.0%. Meanwhile, Italy is forecasting a 2.4% deficit. In the end, however, the market is growing increasingly concerned that this situation will get worse, not better, as can be seen from the sharp price decline in Italian government debt. In the past two days, the 10-year yield there has risen nearly 30bps and is now 328bps higher than German Bunds, the widest spread since 2013, just before the Greek crisis began.

With this in mind, it should be no surprise that the euro has come under renewed pressure. Yesterday it declined 0.45% and it is now pushing back toward the lows for the year seen in mid August. Recently I highlighted that the structural issues in the US seemed to be starting to exert more influence in the FX markets, which would help weaken the greenback. However, I didn’t really discuss the structural (existential?) issues in the euro, which also have the potential to cause significant damage to the currency. The difference is that the European issues are headline news every day, (the ongoing Italian budget fight and the ongoing Brexit negotiations), neither of which are likely to add value to the single currency. Whereas, the US structural issues, the twin deficits, don’t get nearly as much airtime, and tend to be at the back of traders’ minds. Even the trade issue, which is obvious and acute, does not lead in the US press, as the focus has turned to the mid-term elections here. In the end, it is quite reasonable that we may see yet another leg lower in the euro, testing, and breaking, the August lows. This is self-inflicted by Europe, not a product of Fed policy.

This morning, however, the dollar is actually underperforming slightly. Despite the ongoing Brexit question, the pound has rebounded slightly from yesterday’s decline on the strength of better than expected public finance data that showed the government borrowed less than expected. Meanwhile, the commodity bloc is rebounding on the strength of better performance in both base metal and agricultural markets. And finally, the yen is slightly softer as equity markets seem to have halted their slide, for now, and inflation data continues to disappoint encouraging traders to believe that the BOJ will not be ending their ultra easy monetary policy anytime soon.

Turning to China, we see that the renminbi is little changed this morning, hovering near the 6.94 level despite weaker than expected economic data last night. In fact, GDP in Q2 rose only 6.5%, below the expected 6.6% level, and indicating that the Chinese economy is clearly feeling the strains of the trade conflict with the US. This was made manifest in two ways; first components of the data like Fixed Asset Investment and Retail Sales were both softer than expected (although surprisingly the trade figures remain solid), but second, and more importantly, there was a concerted effort by Chinese financial mandarins to talk up the economy. Statements from PBOC Governor Yi Gang, CSRC head Liu Shiyu and vice premier Liu He were all released within minutes of the opening of the Shanghai stock market and focused on explaining how good things were and that there were no reasons to worry. At this point I must note that the Shanghai index opened lower by more than 1%, following yesterdays 2.9% decline, so the timing was not coincidental. In the end, the Chinese stock markets rallied in the afternoon, closing up by 2.6%, although the move appeared to be completely driven by official buying, rather than ordinary investors.

Stepping back, the overriding theme of late has been increased uncertainty over the economy due to political machinations. Whether it is Brexit, the Italian budget, the US mid-term elections or weakening Chinese growth, key market drivers are nonmarket events. For equities, earnings results have had less impact. In currencies, rate moves don’t seem to be the driver either. When markets reach a point where movement is driven entirely by outside actors, it becomes extremely difficult to manage risk effectively as nobody knows where the next tape bomb is coming from. It was much easier when all eyes were on the Fed and the ECB, as at least there was some consistency. In other words, look for more volatility across markets going forward.

As to the data story today, the only release is Existing Home Sales (exp 5.30M), where it wouldn’t be a great surprise to see a weak number given the weakness we saw in Wednesday’s Housing Starts data. We also hear from Atlanta Fed President Bostic. Yesterday’s two Fed speakers did exactly what was expected, with vice chairman Quarles saying the Fed was on the right course, and uberdove Bullard explaining that there was no reason to raise rates further. Neither one seemed to have a market impact.

I think the weight of evidence is that the dollar is likely to continue to creep higher today as the US rate picture continues to support it, the Italian budget story continues to undermine the euro, and the unlikelihood of positive news from a host of other nations seems set to keep investors focused on higher US yields. Unless the Italians capitulate, which I think is highly unlikely, I think the dollar edges up more before the weekend comes.

Good luck and good weekend
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Propense to Inveigh

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The Minutes released yesterday
Had not very much new to say
Rates will keep on rising
And assets downsizing
Despite Trump’s propense to inveigh

The market reaction was swift
With 10-years receiving short shrift
The stock market fell
(Was this its death knell?)
While dollars received quite a lift!

And here I thought the FOMC Minutes would be dull and boring with limited market impact. I couldn’t have been more wrong. While the text itself was as dry as usual, it seems the market read between the lines and gleaned the following: interest rates are going to go higher for a while yet, a longer time than previously considered.

Arguably the biggest change in the September FOMC statement was the removal of the sentence regarding policy being accommodative. Chairman Powell focused on this at the ensuing press conference, and has commented on it since then as well. The gist of his message has been that since the dividing line between accommodative and not accommodative is so uncertain (r* is immeasurable) and that it is not likely to be stationary either, there is no way the Fed can be certain they have reached that target. Given that premise, describing their policy as accommodative seemed to express too much precision in something that is extremely uncertain.

However, the compilation of views from the Minutes seemingly showed a larger group of members sounding hawkish. In the end, the market read this to mean that the Fed was going to be raising rates at least another 100bps before they stop. Consider that if they act every quarter through the end of 2019, raising rates 25bps each time, Fed Funds is going to be in a range of 3.25%-3.50% at the end of next year. And while that is still low on a historic basis, it is much higher than markets have seen in more than a decade. Based on what we have heard from the ECB and BOJ, it is also much higher than their cash rates are going to be at that time. In fact, it is quite possible that in both those cases, cash rates will still be 0.00% or negative at the end of next year.

If you play out that scenario, it cannot be very surprising that the dollar was a beneficiary of the release of the Minutes. So yesterday’s 0.6% decline in the euro makes a great deal of sense. In fact, the dollar index performed in exactly the same manner, rising 0.6% on the day. And one thing to keep in mind is that Fed funds futures markets are still pricing in only a 25% probability that rates will be that high at the end of next year. If the Fed stays the course, and there is no reason yet to believe they won’t, that market will need to adjust, and other markets will adjust accordingly.

So a quick recap of the G10 currencies showed that the dollar performed will against all of them yesterday, but has since ceded some of that ground in what appears to be a short-term trading effect. So this morning’s 0.15% rise in the euro, or 0.1% rise in the pound hardly seems compelling.

But there was another story of note yesterday as well, the US Treasury issued its semiannual report on currencies and, once again, did not find China a currency manipulator by its legal definition. This cannot be a real surprise because despite the President’s constant complaints, according to the law, a country can only be designated a manipulator if three conditions are met; consistent currency intervention, running a large trade surplus with the US and running a large current account surplus overall. In fact, China has not been actively intervening on a net basis in the FX markets, and its overall current account surplus has actually fallen to near flat, although obviously it continues to run a large surplus with the US.

Recent price action in USDCNY had been extremely stable, with the PBOC seeking to maintain very modest volatility and expressly saying that they would not be using the exchange rate as a ‘weapon’ in trade. But interestingly, last night, after the release of the Treasury report, the PBOC fixed CNY at its weakest level in nearly two years and the renminbi fell 0.25%. As well, Chinese stock markets continued their recent declines, with Shanghai falling another 2.9% and now trading at its lowest point since December 2014. Concerns are growing that the Chinese economy may be slowing faster than anticipated and this is also being reflected in commodity prices, where base metals have been falling along with oil. (Oil also suffered because of the ongoing inventory build in the US, which when combined with fears over slowing global growth have been sufficient to add a little caution to all those claims that $100 oil was returning soon.)

And those were the big stories yesterday. The US data was surprisingly weak, with both Housing Starts and Building Permits falling and coming in well short of expectations. But this market is far more focused on the Fed and its perceived intentions than on a piece of data. That tells me that this morning’s Initial Claims (exp 212K) and Philly Fed (20.0) are unlikely to move markets. Of more interest may be speeches by two Fed speakers, Bullard and Quarles, especially if they delve into more detail of their policy expectations.

Equity futures are pointing lower, and Treasury yields have maintained yesterday’s gains and are back at 3.20%. My sense is that risk is being reduced across the board here, thus driving both stocks and bonds lower at the same time. If that is true, then look for further commodity price weakness and the dollar to retain its recent gains.

Good luck
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