From Brussels

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