On Friday the President tweeted
Unless immigration, unneeded,
Is stopped at the border
I will give the order
To raise tariffs til it’s defeated

Friday’s big market news was President Trump’s threat of new tariffs, this time on Mexico, if they don’t address the illegal immigration issue domestically. This is a novel approach to a non-economic problem, but given the President’s embrace of the tariff process, perhaps it is not that surprising. The impact across markets, however, was substantial, with equities suffering while haven assets, notably Treasuries and Bunds, both rallied sharply. In fact, those moves have continued through the overnight session and we now see the 10-year US Treasury yielding just 2.10%, its lowest since September 2017, while 10-year Bunds are yielding a record low -0.21%! In other words, fear is rife that the future is going to be less amenable to investors than the recent past.

Meanwhile, equity markets have also suffered with Friday’s global sell-off continuing this morning in Europe after a mostly negative day in Asia. As to the dollar, it has been a bit more mixed, falling sharply against the yen (JPY +1.1% Friday, flat today), rising sharply against emerging market currencies (MXN -2.5% Friday, -0.3% today), but actually sliding slightly vs. its other G10 counterparts.

It is instructive to consider why the dollar is not maintaining its full status as a haven. Ultimately, the reason is that expectations for aggressive rate cuts by the Fed are becoming the default market expectation. This compares to a much less aggressive adjustment by other central banks, and so the relative forecasts point to a narrowing interest rate differential. Consider that the futures market has now priced in three rate cuts by Q1 2020 in Fed funds. Six months ago, they were pricing in three rate hikes! That is a huge sentiment change, and yet the dollar is actually stronger today than it was at the beginning of the year by about 2%. The point is that while recent economic estimates in the US continue to be downgraded, estimates for the rest of the world are being downgraded equally. In fact, there is substantially greater concern that China’s GDP growth could slow far more than that of the US adding to knock-on effects elsewhere in the world.

One of the things I have consistently maintained is that a slowdown in the US will not happen in isolation, and if the US is slowing, so will be the rest of the world. This means there is virtually no probability that the Fed will cut rates without essentially every other country easing policy as well, and that all important (at least for FX traders) interest rate differential is not likely to shrink nearly as much as reflected by simply looking at the Fed’s activities. A perfect example is Australia, where tomorrow’s RBA meeting is expected to see a 25bp rate cut, with the market pricing between two and three more during the next several quarters. Aussie has been suffering lately and is likely to continue to do so going forward, especially as pressure remains on China’s economy.

The Fed’s done a year-long review
Of policies they might turn to
They’re hoping to find
A new frame of mind
In order to reach a breakthrough

The other story about which you will hear a great deal this week is the gathering at the Chicago Fed of the FOMC and academics as they try to find a better way to effect policy. The positive aspect of this process is that they recognize they are not really doing a very good job. The negative aspect is that they continue to believe inflation remains too low and are extremely frustrated by their impotence to change the situation. We have already heard a number of the ideas; ranging from choosing a higher inflation target to allowing inflation to run hot (if it ever gets there based on their measurements). Alas, there seems little chance that the fundamental issue, the fact that their models are no longer reasonable representations of the real world, will be addressed. To a (wo)man, they all continue to strongly believe in a Keynesian world where more stimulus equals more economic activity. I would contend that, not dissimilar to the differences between Newtonian physics and particle physics, interest rates at the zero bound (and below) no longer have the same impact as they do at higher levels. And it is this failure by all central bankers to recognize the non-linearity of results which will prevent a viable solution from being found until a crisis materializes. And even then I’m not optimistic.

Turning to this weeks’ data dump, there is a ton of stuff coming, culminating in Friday’s NFP report:

There are also eleven Fed speakers including Chairman Powell on Tuesday morning as well as the aforementioned Fed conclave regarding new policy tools. In other words, there is plenty available to move markets this week. And that doesn’t even take into consideration the ongoing trade situation, where fears are extremely high, but both China and Mexico have said they want to sit down and discuss things again.

At this point, given how much new information will be added to the mix, it is impossible to say how markets will perform. However, with that in mind, we will need to see some extraordinarily weak US data to change the idea that the US is still the ‘cleanest dirty shirt in the laundry’, to use a terrible metaphor. As well, do not be surprised to see Mexico, at least, agree to implement new policies to address the immigration issue and reduce pressure on the peso. In the end, I continue to look for the dollar to maintain its overall strength, but a modest drift lower against G10 counterparts is well within reason.

Good luck
Adf