Most Are Afraid

Since pundits have often asserted
A yield curve that’s truly inverted
Will lead to recession
The recent compression
Of rates has investors alerted

Meanwhile the concerns over trade
Have not really started to fade
Twixt trade and those yields
Investors need shields
Explaining why most are afraid

It got ugly in the equity markets yesterday, with significant declines in the US followed by weakness overnight in Asia and continuing into today’s European session. With US markets closed today in observance of a day of mourning for ex-president George Herbert Walker Bush, the news cycle has the potential to increase recent volatility. Driving the market activity were two key stories, ongoing uncertainty over the US-China trade situation and, more importantly, further flattening of the US yield curve toward inversion.

At this point, unless you have been hiding under a rock for the past year (although given market activity, that may not have been a bad idea!) you are aware of the relationship between the shape of the US yield curve and the potential for a recession in the US. Every recession since 1975 has been preceded by an inverted yield curve (one where short-term rates are higher than long-term ones). In each of those cases, the driving force raising short-term rates was the Fed, which is no different than today’s situation. What is different is both the level of yields, on both a nominal and real basis, and the size of the Fed’s balance sheet.

From 1963 up to the Financial Crisis, the average of nominal 10-year Treasury yields had been 7.11%. Since the crisis, that number has fallen to 2.62%! Of course that was driven by the Fed’s policy actions of ZIRP and QE, the second of which was explicitly designed to drive longer-term rates lower. Clearly they were successful on that score. However, ten years on from the crisis, rates remain exceptionally low on a historical basis, despite the fact that the economy has been expanding since the middle of 2009. The reasons for this are twofold; first the Fed had maintained ZIRP for an exceptionally long time, and while they have been raising rates since December 2015, the pace at which they have done so has been extremely slow by historical standards. Secondly, although the Fed has begun to reduce the size of their balance sheet, it remains significantly larger, relative to the size of the economy, than it was prior to the crisis. This means that there is less supply of bonds available for other investors, and so prices continue to be artificially high.

This combination of the Fed’s rate hikes, as slow as they have been, and their ownership of a significant portion of available Treasuries has resulted in a much flatter yield curve. Adding to this mixture is the fact that the economy’s performance is now beginning to show signs of slowing down. This has been evident in the recent weakness in both the housing market and the auto sector. Meanwhile, falling equity prices have encouraged more demand for the safety of Treasuries. Put it all together and you have a recipe for a yield curve inversion, which will simply help fulfill the prophesy of an inverted yield curve leading to recession.

The other pressure point in markets has been the ongoing trade drama between the US and China. The weekend’s G20 news was quickly embraced by investors everywhere in the hope that further tariffs had been avoided and the current ones might be reduced or removed. However, China’s interpretation of the weekend discussions and those of President Trump appear to be somewhat different, and now there is concern that the delay in tariff increases may not result in their eventual removal.

Recapping the two stories, fears over a resumption of the trade war have helped undermine views of future economic growth. This has led investors to seek safety in longer dated Treasury securities helping to flatten the US yield curve. That signal is seen as a harbinger of future recession, which has led investors to sell equities, further increasing demand for Treasuries. It is easy to see how this cycle can get out of hand, and may well lead to much weaker equity prices, lower US yields and slower US growth.

That trifecta would be a cogent reason for the dollar to suffer. But remember, the FX market is a relative one, not an absolute one. And if the US is seeing declining growth, you can be certain that the rest of the world is suffering from the same affliction. In fact, the data from Europe this morning showed that Eurozone Services PMI fell to 52.7, its lowest level since September 2016 and further evidence that the Eurozone economy is quickly slowing. While Italy has garnered the headlines, and appears set to enter yet another recession, the data from Germany has also been soft, which bodes ill for the future. If the slowdown in the Eurozone economy continues its recent trend, it will be that much harder for Signor Draghi to begin tightening policy. So once again, despite the fact that the Fed may be slowing down, signs are pointing to the fact that the ECB will be in the same boat. In that case, the euro is unlikely to be seen as terribly attractive, and the dollar still has potential to rise, despite the recent US softness.

The point is that although the long-term structural issues remain quite concerning in the US, the short-term cyclical factors continue to favor the dollar over its G10 and EMG counterparts. We will need to see wholesale changes within the policy mixes around the world for this to change.

With markets closed today, there is no US data to be released, and I expect a subdued session overall. However, nothing has changed my medium term view of dollar strength.

Good luck
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Progress Was Made

The Presidents, Trump and Xi, met
Attempting, trade talks, to reset
Some progress was made
Though China downplayed
Reductions in tariffs as yet

Risk is back! At least it is for today, with the news that there has been a truce, if not an end, to the trade war between the US and China seen as a huge positive for risky assets. And rightly so, given that the trade contretemps has been one of the key drivers of recent investor anxiety. In addition, the G20 managed to release a statement endorsed by all parties, albeit one that was a shadow of its former self. There remain significant disagreements on the value of the G20 with the Trump administration still convinced that these gatherings seek to institutionalize rules and regulations that are contra to the US best interests.

At any rate, equity markets around the world have rallied sharply with Shanghai jumping 2.5%, the Nikkei up 1.25% and the South Korean KOSPI rising by 1.75%. In Europe, the FTSE is higher by 1.75%, the DAX by 2.2% and the CAC, despite ongoing riots in Paris and throughout France, higher by 1.0%. Ahead of the opening here, futures are pointing to an opening on the order of 2.0% higher as well. It should be no surprise that Treasury bonds have fallen somewhat, although the 2bp rise in 10-year yields is dwarfed relative to the equity movements. And finally, the dollar is lower, not quite across the board, but against many of its counterparts. Today, EMG currencies are leading the way, with CNY rising 0.9%, MXN rising 1.7% and RUB up 0.75% indicative of the type of price movement we have seen.

However, the trade story is not the only market driver today, with news in the oil market impacting currencies as well. The story that OPEC and Russia have agreed to extend production cuts into 2019, as well as the news that Alberta’s Premier has ordered a reduction of production, and finally, the news that Qatar is leaving OPEC all combining to help oil jump by more than 3% this morning. The FX impact from oil, however, was mixed. While the RUB and MXN both rallied sharply, as did CAD (+0.9%) and BRL (+0.9%), those nations that are major energy importers, notably India (INR -1.1%), have seen their currencies suffer. I would be remiss not to mention the fact that the euro, which is a large energy importer, has actually moved very little as the two main stories, trade war truce and oil price rise, have offsetting impacts in FX terms on the Continent.

But through it all, there is one currency that is universally underperforming, the British pound, which has fallen 0.3% vs. the dollar and much further against most others. Brexit continues to cast a long shadow over the pound with today’s story that the DUP, the small Northern Irish party that has been key for PM May’s ability to run a coalition government, is very unhappy with the Brexit deal and prepared to not only vote against it in Parliament next week, but to agree a vote of no confidence against PM May as well. This news was far too much for the pound, overwhelming even much better than expected Manufacturing PMI data from the UK (53.1 vs. exp 51.5). So the poor pound is likely to remain under pressure until that vote has been recorded next Tuesday. As of now, it continues to appear that the Brexit deal will fail in its current form, and that the UK will be leaving the EU with no framework for the future in place. This has been the market’s collective fear since the beginning of this process, and the pound will almost certainly suffer further in the event Parliament votes down the deal.

While all this has been fun, the week ahead brings us much more news and
information, as it is Payrolls week in the US.

Today ISM Manufacturing 57.6
  ISM Prices Paid 70.0
  Construction Spending 0.4%
Wednesday ADP Employment 197K
  Nonfarm Productivity 2.3%
  Unit Labor Costs 1.2%
  ISM Non-Manufacturing 59.2
  Fed’s Beige Book  
Thursday Initial Claims 220K
  Trade Balance -$54.9B
  Factory Orders -2.0%
Friday Nonfarm Payrolls 200K
  Private Payrolls 200K
  Manufacturing Payrolls 19K
  Unemployment Rate 3.7%
  Average Hourly Earnings 0.3% (3.1% Y/Y)
  Average Weekly Hours 34.5
  Michigan Sentiment 97.0

So a lot of data, and even more Fed speakers, with a total of 11 speeches, including congressional testimony by Chairman Powell on Wednesday, from six different Fed Governors and Presidents. Now we have heard an awful lot from the Fed lately and it has been interpreted as being somewhat less hawkish than the commentary from September and October. In fact, Minneapolis President Kashkari was out on Friday calling for an end to rate hikes, although he is arguably the most dovish member of the FOMC. Interestingly, the trade truce is likely to lead to one less problem the Fed has highlighted as an economic headwind, and may result in some more hawkish commentary, but my guess is that the current mindset at the Eccles Building is one of moderation. I continue to believe that a December hike is a done deal, but I challenge anyone who claims they have a good idea for what 2019 will bring. The arguments on both sides are viable, and the proponents are fierce in their defense. While the Fed continues to be a key driver of FX activity, my sense is that longer term FX views are much less certain these days, and will continue down to be that way as the Fed strives to remove Forward Guidance from the tool kit. Or at least put it away for a while. I still like the dollar, but I will admit my conviction is a bit less robust than before.

Good luck
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