A Truly Momentous Event

The ten-year has breached three percent
A truly momentous event
The dollar is gaining
While stocks take a caning
For bulls now there’s much discontent

Does a 3.00% yield in the 10-year Treasury really matter that much? While a cursory look at the market reaction yesterday would indicate it does, it is not clear to me this is the case.

Ten-year Treasury yields traded through 3.00% for the first time since January 2014 in yesterday’s session, and coincidentally the US equity market fell pretty sharply. However, upon closer inspection the proximate cause of the equity decline seems to have been a comment from a bellwether US manufacturing company on their earnings call, where the CFO indicated that Q1 earnings were likely to be the “high-water mark for the year.” Despite very strong results, that stock fell sharply. Markets that are priced for perfection, similar to the US equity market overall, cannot accept that type of information without repricing, and so that is what we saw. The key concern seems to be that despite the widely touted global growth environment, this company feels the future is less bright than had been expected. Part of the reason is that input prices continue to rise rapidly and are cutting into margins. And part of the reason seems to be a concern that perhaps the global growth story is not as robust as had been expected earlier in the year. In the end, the combination of events was too much for the US stock market and we saw some pretty sharp declines that have carried over around the world.

Interestingly, the dollar, which had been benefitting for the past week as US yields rose, also fell slightly in the session. This is a bit of a head scratcher, as it appeared that the historic cyclical relationship between the dollar and US rates was reasserting itself. And while the decline was modest, just 0.3%, it was strange nonetheless. However, this morning things are back on track with the dollar recouping yesterday’s entire decline and, quite frankly, looking like it has further to run.

So what are we to make of these new milestones in the market? Regarding the Treasury story, 3.00% represents a big psychological point, but probably not a key economic one. Traders and investors tend to over emphasize round numbers (recall when the Dow was approaching 25,000, or USDJPY at 100.00) but it is not clear that a round number is actually significant in the workings of the economy. When it comes to financing operations, it is the rare company where a 10bp change is the difference between making it and failing. And quite frankly if that is the case, the company is going to fail anyway. But the psychology does matter as it helps inform confidence in the market and the economy overall. So I wouldn’t dismiss this as unimportant, but it’s probably not the most important thing happening. Rather, that would be the ongoing economic story and how the data that we continue to see plays out.

In that vein, the relative data releases between the US and the rest of the world are far more interesting. And those continue to point to the US outperforming for the time being. Even though recent US data has been mixed (e.g. Retail Sales soft, housing strong) that has been a far better result than the consistently soft data coming from the Eurozone, the UK, Japan and most of the rest of the developed world. This is especially true regarding inflation, where the trajectory in the US is unambiguously pointing higher while we continue to see misses to the downside elsewhere. And it is this point that is likely to inform policy actions going forward.

There is one other spin to note of late, and that is the commentary I read has highlighted relatively hawkish comments made by ECB, BOE and BOJ members, even though they were made last month before the latest set of data added to the impression of slowing growth momentum. At the same time, I keep reading that the Fedspeak we have been hearing is actually NOT that hawkish, despite a near universal discussion of the need to keep ahead of the inflation situation and not allow the economy to run too hot. If I didn’t know better, I might think that the journalists who are writing the articles were trying to drive the narrative themselves rather than report the news. But then that could never happen, could it?

At any rate, my read continues to be that the Fed will remain on course to tighten policy further this year, with at least three more rate hikes coming, and that we will continue to see a more dovish policy response elsewhere as the growth story falters.

As to the overnight session, the dollar, as mentioned above, has recouped all of yesterday’s losses and currently sits higher by 0.35% vs. the euro, 0.25% vs. the pound and 0.35% vs. the yen. In fact, the entire G10 is down by similar amounts. We are also seeing that price action throughout the EMG bloc, where the notably movers are MXN (-1.4%), RUB (-0.75%) and ZAR (-1.3%). In Mexico, not only have oil prices ebbed, but there is increasing concern that AMLO is going to win the presidential election in July and that with him, policies are going to become far less business friendly. He is, after all, a far left wing populist firebrand, and while he may have moderated his tone on renationalizing assets, he is still focused on unwinding labor and energy investment policies that have been very beneficial to the country. One other currency of note has continued its recent decline, the Chinese renminbi, which is down 0.5% overnight and 1.5% from its nadir at the end of March. The word out of Beijing has altered to include additional policy support while ceasing to discuss excess leverage. This was always going to be an issue there, as the idea of reducing leverage without tightening policy and slowing economic growth held some key contradictions. Apparently, despite President Xi being the supreme ruler in China, the laws of economics are too great for even his powers to repeal.

And that’s really it for the day. Equity futures are currently pointing lower, Treasuries remain under pressure with the 10-year yield now at 3.03%, and commodities are under the gun as well. All of that points to continued strength in the dollar and I see no reason why that shouldn’t continue. As I have mentioned before, I expect the euro to test the bottom of its trading range, which at 1.2155 is a scant 20 pips from the current level. Typically it won’t break on the first test, but by the end of the month, don’t be surprised to see 1.2000 on a screen near you.

Good luck
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A QE Encore

The data from Europe once more
Showed slowing one cannot ignore
I’m starting to think
That Draghi will blink
And promote a QE encore

It is always interesting to watch the evolution of a narrative. For the longest time it was absolutely obvious to one and all that the dollar was going to decline sharply this year just like it did last year. The structural case was clear, but more importantly, it was also widely assumed that every other G10 central bank was going to begin to normalize its own monetary policy and narrow the gap with the Fed. Another key point was that the market had already priced in the Fed tightening while the best was yet to come from the ECB, BOJ, BOE et al. Well, let’s be clear here. There is only one central bank that is actually normalizing monetary policy at this point, the Federal Reserve. To date there has been no ambiguity from the Powell Fed, rates are going to rise consistently this year unless something shocking occurs. Even the futures market is starting to buy the story with a 48% probability of four rate hikes now priced in for this year.

Meanwhile, the data last night simply highlighted the reasons why the Fed is the only bank normalizing policy, because the spurt of growth seen elsewhere around the world in 2017 has clearly been ebbing ever since New Year’s Day. The latest examples showed the German IFO survey falling to 102.1, its lowest level since March 2017 and extending a pattern that has clearly rolled over and is now trending lower. Adding to the mix were declines in both French and Italian Business Confidence, with both of them heading back to one-year lows. In fact, the pattern in all three nations is identical, December marked the top and the deceleration is picking up speed. Given this apparent slowing in Eurozone growth, it remains a mystery to me why so many market pundits expect the ECB to end QE in September. While I understand that there are hawks on the Governing Council, they are not even close to the majority, and we have heard nothing from Signor Draghi except cautionary words about patience and prudence in their actions going forward. The ECB meets on Thursday and there are limited expectations of any action. However, the prevailing wisdom is that come the June meeting, they will announce their plans for policy after September. Given the current trajectory of growth in the Eurozone, it appears to me that QE will continue beyond September, perhaps at a reduced rate, but that it will not end. And raising rates? That is still eighteen months away at the earliest and a case for 2020 cannot be ruled out.

Meanwhile, the story in Japan is quite similar, with economic growth there showing signs of faltering compared to 2017 as survey data continue to disappoint on a regular basis. Adding to the mix is the fact that the Goods and Services Tax (VAT) is going to be raised by two percentage points, to 10%, come next April 1st. This has been part of the Japanese fiscal plan for the past five years, but it has been postponed twice already because in each of the first two stages, the economy slowed sharply in the immediate aftermath of the tax hike. Of course, PM Abe, who is currently dogged by some domestic scandals, is desperate to prevent an economic downswing, as that would further undermine his political strength. And so, the idea that the BOJ is going to begin to normalize monetary policy is actually laughable at this stage. They are not going to do anything of the sort. Rather a much more interesting story has been the increased interest of Japanese insurers to buy US Treasuries on an unhedged basis with the 10-year yield now nearing 3.00%. It is flows of this nature that are going to help underpin the dollar (and the Treasury market) for the time being.

Concomitant with the slowing growth is the lack of inflationary pressure elsewhere around the world, with Australia the latest data point. Inflation there remained at 1.9%, failing to rise as expected and still well below the midpoint of the RBA’s target of 2.0%-3.0%. The implication is that the RBA will remain on the sidelines of policy for a considerable while yet. Slowing growth and low inflation are not the backdrop for tighter monetary policy. Folks, the dollar is not about to collapse. And while it remains in the relatively narrow trading range of the past three months, I am becoming more confident that we will break that range with a stronger dollar rather than a weaker one!

With that rant out of the way, let’s take a look at the markets this morning. Actually, the dollar is essentially unchanged today, holding onto its gains of the past week. In fact, in the G10 only Kiwi has moved more than a few pips, and its 0.3% decline is hardly significant. At the same time, something that we are continuing to see is weakness in the EMG currency bloc. And while it is not universal this morning, with the rebound in oil prices this morning underpinning both the RUB and MXN somewhat, those nations that are running current account deficits (Indonesia, India, Philippines, Brazil, etc.) have seen their currencies continue to fall amid rising USD rates. Many nations borrow in dollars and the combination of increased debt and higher rates usually reflects itself in a weaker currency. As an example, BRL has fallen 10% during the past three months. It is very hard to make the case that any of this class of currency will rebound unless US rates begin to decline, and given the Powell Fed, that doesn’t seem very likely. So hedgers, as expensive as it may be to manage these asset risks, I believe that hedging will be the least expensive way to keep things in check.

There is one last thing to note in the EMG bloc, and that is China. Despite an almost mythical acceptance that President Xi can create any outcome he wants, economic reality often intrudes on those dreams. While there is no question that Xi is keen to reduce overall leverage in the economy and deflate the housing bubbles that exist around the country, apparently he is not willing to do so if it results in slowing growth. So we have been getting simultaneous policy adjustments that both tighten and ease conditions, with things like the surprise RRR cut from last week a clear easing, but a crackdown on WMP’s and local government debt a clear tightening. At the end of the day it appears (to me at least) that with the rest of the world seeing a slowdown in the growth trajectory, China will see the same thing. After all, they remain a highly mercantilist economy reliant on international trade, so if growth is slowing elsewhere, it will have an immediate impact. The point is that easier monetary policy seems like one of the few tools they have available to help manage things, and part of that will be a slowly depreciating renminbi, at least to my mind. Food for thought.

As for today, we follow up yesterday’s solid Existing Home Sales report of 5.6M with a look at New Home Sales (exp 630K) along with Consumer Confidence (126.1), however neither of these is typically a market-moving event. Instead, I expect that the trends that we have seen for the past week are likely to remain in motion, although at a moderated pace. The bottom of the trading range in the euro has been 1.2155; so don’t be surprised if we make a run at it, although I believe we will need new information in order to break through. Friday’s GDP maybe? Or next week’s FOMC or payroll report all come to mind as potential catalysts. But nothing today.

Good luck
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All That Surprising

As Treasury yields keep on rising
It shouldn’t be all that surprising
The dollar is stronger
And will be for longer
Than most traders are yet realizing

We begin a new week in the markets with the dollar flexing its muscles. The proximate cause seems to be the 10-year yield, which has traded up to 2.99%, a new high for the move, and which certainly seems like it is going to breech the psychologically important 3.00% level pretty soon. The Treasury move is based on a combination of two factors, namely continuing strength in commodity prices and an increased supply of new paper. And quite frankly, it is hard to see a reason for either of those to change in the short run. (As an aside, you may recall last week’s anxious discussions regarding an inverted yield curve in the US and its potential to be a harbinger for a recession. Funnily enough, that conversation has gone quiet!)

Oil continues to lead the commodity sector as recent data indicates the glut overhanging the market for the past several years has finally been absorbed. With WTI approaching $70/bbl (and Brent well above that already), I’m sure you have all noticed the rise in prices at the pump. And oil prices tend to be one of the most important factors in inflation expectations, so higher oil today, higher inflation expected in the future. As to the supply of Treasuries, just this week the Treasury is going to auction $181 billion in new debt, of which $96 billion is comprised of 2, 5 and 7-year notes. And remember, too, the Fed has reduced its presence at auctions as it allows its balance sheet to shrink via lessened reinvestment of maturing proceeds. All this leads to the thought that Treasury yields have further to rise.

The one thing that can stop it would be a significant risk-off type of event, but even on this front things seem to be abating. After all, the weekend was replete with articles about Treasury Secretary Mnuchin’s likely trip to China to discuss trade issues, and we continue to hear about the upcoming summit between President Trump and North Korea’s Kim Jong-un, a clear de-escalation of the nuclear war rhetoric. With the US economy still showing decent growth, at this point all signs point to the dollar regaining some of the ground lost earlier this year. At least for now, the question of cyclical dollar factors vs. structural dollar factors seems to be pointing in favor of the cyclical driving things.

But it’s not just the US side of the equation that is helping the dollar. Data released elsewhere continues to point to a slowing growth trajectory in both Europe and Japan (PMI data continues to ebb from Q4’s results) and no sign of inflation making a comeback in either place. In fact, despite the fact that measured inflation in the US seems to be modest, the reality is that it is far more robust here than elsewhere around the world. All told, the dollar is looking pretty good for now.

To be specific, we have seen the euro slip a further 0.4% this morning, which makes 1.4% since last Tuesday’s peak. The pound, too, has been suffering, down another 0.3% this morning (and 2.8% from last Tuesday.) And things wouldn’t be complete without discussing the yen, down 0.5% this morning which actually represents almost half the 1.1% decline since the dollar’s nadir. In all these cases, PMI data has disappointed and US yields seem more attractive.

We have seen some larger moves in the EMG space, which is to be expected, with ZAR falling more than 1.1% and MXN down 0.9%. In neither case is there a specific story driving things, rather both of these have been among the best performers in the bloc over the past several weeks and simply have more room to decline. In the end, today is a dollar story day, not a currency specific one.

Looking ahead, we have our first look at Q1 GDP in the US on Friday, but prior to that the data doesn’t excite.

Today Existing Home Sales 5.513M
Tuesday New Home Sales 630K
Thursday Initial Claims 230K
  Durable Goods 1.7%
  -ex transport 0.5%
  Goods Trade Balance -$74.5B
Friday Q1 GDP 2.0%
  Chicago PMI 57.9
  Michigan Sentiment 98.0

So all eyes will really be on Friday’s GDP data, with the question just how much things have slowed since Q4. As I have written before, it appears that the global growth story peaked in Q4 of last year, and we are just starting to get the harder data that is going to bear that out. While the Fed is in their quiet period ahead of next week’s meeting, the last we heard from them was Cleveland president Mester’s call for continued higher rates in order to prevent an overheating economy and financial imbalances. She is clearly not in the camp of letting things run ‘hot’ for very long. However, as she is one of the avowed hawks on the FOMC, this is no real surprise. In addition, the BOJ meets on Friday, but it is hard to believe that there will be anything new to discuss from that. For the time being, central banks remain on hold, with the only truly uncertain outcome being next week’s BOE meeting.

At this point, I see no reason for the dollar to give up its gains, as the cyclical features appear ascendant. That said, we have already seen a pretty good move, so I imagine that any further strength today will be quite minimal.

Good luck
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There’s Not Just One Meeting

Of late the pound’s taken a beating
Not only is data retreating
But Carney explained
No May hike’s ordained
Remember, there’s not just one meeting

The pound is lower by more than 2% (0.2% overnight) since Wednesday’s high with yesterday’s decline directly attributed to Governor Carney’s most recent comments. While the market had been convinced that the BOE would be raising rates at their May meeting, having priced in a more than 80% probability despite the recently softening data, that all changed when Carney was interviewed yesterday at the IMF meetings by the BBC. He said that the BOE would make decisions “conscious that there are other meetings” at which they could act this year. The market response was immediate, with that rate hike probability falling below 50% in short order. The clear implication was that he no longer feels compelled to act in May. Rather, given the combination of the recently softer data as well as the ongoing Brexit uncertainties (questions about the Irish border issue have resurfaced and are not close to being solved), the BOE is going to be very deliberate in its actions. If you recall, inflation data released earlier this week fell much more sharply than expected and possibly signaled that the impact of the much weaker pound in the immediate aftermath of the Brexit vote may now have passed. At the same time, while the employment situation (a lagging indicator) remains robust, the production and consumption data have continued to disappoint. You know that I have always been skeptical of a May rate hike, which I based on the ongoing Brexit issues, and now it appears that Governor Carney is having second thoughts as well. It seems to me that unless there is a broad based dollar retreat, the pound will have difficulty rallying in the near term.

But the pound is not the only currency under pressure this morning, in fact the dollar is having quite a good day, rallying 0.35% vs. the euro and 0.45% vs. the Australian dollar. Even the yen is lower by 0.25%. It seems that the past week has highlighted some of the impending differences between the US and the rest of the G10, at least with regard to monetary policy. All week the US data has been pretty much on expectations, albeit with a few softer readings. But the commentary from the Fed speakers has done nothing to change the view that they will be raising rates at least twice more this year with a good chance at three more hikes. At the same time, the data we have seen from elsewhere in the G10 has been consistently disappointing, notably the inflation data from the Eurozone, but also IP data, Retail Sales data and survey data. In fact, Bloomberg had an article this morning directly discussing changing perceptions about the ECB’s activities going forward, where they highlighted that a number of economists have delayed their anticipated timing of policy actions. While this is no surprise to me, it is indicative that the market may be beginning to shift the narrative slightly. While the ECB hawks are still keen to end QE and start raising rates as soon as possible, they remain in a minority. Instead, it appears that the ECB will continue to move extremely slowly, even in their commentary, which is likely to delay the first rate hikes further. My personal view is they won’t raise rates before Q4 2019, although most economists are looking for Q2.

What about the inverting yield curve? Well, given the ongoing rise in commodity prices, which are exploding higher across both energy and metals, the back end of the Treasury curve is seeing much greater selling pressure. In fact, this morning the 10-year yield is up to 2.92% and the 2’s-10’s spread has widened out to 49bps. As I wrote yesterday, if inflation continues to perk up, which given the rise in commodity prices seems like an even better bet, there will be limited concerns about an inverting yield curve. Rather, the Fed is likely to sound even more hawkish as they realize that they are falling behind the curve. The upshot is that as US rates consistently outpace those in the rest of the world, I continue to see scope for the dollar to outperform. I understand that there are structural impediments, but in the short run, I would still look to relative monetary policy actions and expectations.

However, one thing to remember is that despite the dollar’s solid performance today, we remain right in the middle of the trading range seen since late January. In order to break from this malaise we will need to see something completely new to the market. Quite frankly, my concern is that the most likely candidate for this type of news would be a re-escalation of the trade war rhetoric, and more damaging, actual imposition of those tariffs on $150 billion of Chinese goods. That would clearly undermine the dollar in the short run, and probably in the long run as well. But that is a story for another day, or at least potentially so. Today there is no such issue.

There is no US data today although we hear from two Fed speakers, Evans and Williams, both of whom appear to be relative centrists on the FOMC. We also have the IMF meetings in Washington, although I don’t believe any statement will be released until after the close. The last piece of data to be released of any import is Canadian inflation, where the market is looking for a 2.4% headline and 1.5% core reading. If you recall earlier this week, the BOC cited the lessening inflation pressures along with moderating growth and production data as reasons to slow their pace of tightening. Today we will learn if their concerns were valid. But otherwise I have to look toward the energy markets, where WTI is testing $70/BBL, for market cues. If commodity prices continue to rally as they have been, inflationary concerns are going to rise quickly which means that we are likely to see Treasuries continue to sell off, equities continue to sell off and the dollar to remain well bid on the idea that the Fed will become even more aggressive. And I see nothing to stop that price action for now.

Good luck and good weekend
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They’re All On Alert

Concerns the yield curve could invert
Has prompted the Fed to assert
That none of them think
The growth rate will sink
Regardless, they’re all on alert!

As the Treasury market curve continues to flatten, with the 2’s-10’s spread closing Wednesday at 42bps, a new low for the move, we have now heard four Fed speakers (Williams, Dudley, Evans and Kashkari) discuss the fact that they are aware of the history of inverted yield curves and ensuing recessions, and that they continue to believe that their actions will not trigger either inversion or recession. In fairness, Kashkari was a little less convinced than the others, but then he is one of the most dovish members of the FOMC. I guess a lot depends on just how inflation actually behaves going forward because if we start to see CPI tick up to 2.5% or higher, I think the fear of an inverted yield curve will quickly dissipate. That is because investors will be quick to sell the back end of the curve and wait for yields to rise to more attractive levels that take into account a higher inflationary environment. However, if inflation were to stall again, like we saw last year, then it is very possible the Fed, assuming they continue raising rates as currently expected, could invert the curve. At this point, there is no way to know how it will play out, which is just another reason that the most important data points these days are the inflation readings, not employment readings.

So what will happen to the dollar if the curve inverts? The last two times the yield curve inverted were in 2006, presaging the recession of 2007-8 and the financial crisis, and in 2000, presaging the tech crash and recession of 2001. In 2006, the dollar fell sharply during the inversion and only rallied after the crisis blossomed into the mother of all risk-off events. But in 2000, the dollar actually rallied modestly until after the recession ended and the series of Fed rate cuts seemed to finally unhinge the FX market so the dollar subsequently fell. The point is there is no clear precedent for the dollar to move in either direction simply due to the fact of the inversion. Rather, other circumstances are going to be critical to determining what may occur this time.

First let me say that as the curve has not yet inverted, none of this may matter. But second, if we assume that it does invert then my sense is it will be because the current inflation trajectory stalls and expectations for future growth moderate. In that event, and given the structural issues I discussed yesterday and which are not going to change any time soon, I would expect this situation to more closely resemble 2006 and that the dollar would lose ground rapidly. In fact, in this scenario a euro move toward 1.40 or beyond would be quite viable. Given the extended period that the dollar has been range trading, my take is that a convincing break of the range, so in the euro consider above 1.26-1.27 can lead to a very sharp additional move. Now I am not forecasting this outcome, merely trying to estimate what might happen in the event that the yield curve does invert. So a hypothetical based on a different hypothetical is hardly a strong position. Please take that for what it is worth! However, the one thing of which I am increasingly certain is that we are going to continue to hear a great deal about the shape of the yield curve for foreseeable future. On that you can bank!

The other notable news from yesterday was the Bank of Canada sounding somewhat dovish while leaving rates on hold. Although there was only very limited expectation of a rate hike, the fact that Governor Poloz sounded concerned about the future rather than upbeat was seen as a distinct negative for the Loonie. In the end, CAD fell 0.4% and has maintained those losses overnight.

Turning to the overnight session, things have been generally quiet on the FX front ( a theme that has been evident for quite some time now) with only two data releases of note. First, Australian employment data was a tad soft, with just 4900 net new jobs, far less than the 21K expected, but interestingly, AUD has managed to rally slightly, 0.2%, after the release. This looks more like a ‘sell the rumor, buy the news’ rally and I wouldn’t put much stock in it as a harbinger of the future. The other data was UK Retail Sales, which also disappointed, falling a greater than expected -1.2% in March. While this was largely attributed to the extremely cold weather during the month, it nonetheless resulted in an initial decline in the pound of about -0.3%. However, in the ensuing market activity, the pound has clawed back most of those losses and is essentially flat on the day now.

In the EMG bloc, KRW continues to benefit from two political stories related to North Korea. Not only is President Trump due to meet with Kim Jong-Un next month and ostensibly discuss denuclearization of the Korean Peninsula, but the North and South are in preliminary discussions to try to officially end the Korean War. The point is that if North Korea were actually to change its pugnacious stance, the market would likely imbue greater opportunities to South Korea. This would be analogous to when the two Germanies merged in the late 1980’s and the Deutschemark rallied sharply.

The other noteworthy story in this bloc is Turkey, where President Erdogan has called a snap election for June and the market has responded by aggressively buying Turkish assets including the lira. Yesterday saw TRY rally 2% on the news and it has largely maintained those gains as of this morning. The idea is that with a new term, Erdogan can stop pressuring the central bank to leave interest rates lower than they probably ought to be, and in the process rebuilding support for the currency based on a higher yield. Otherwise, there has been little of interest in emerging FX markets.

This morning brings two data points, Initial Claims (exp 230K) and Philly Fed (20.1) as well as several more Fed speakers including Brainerd, Quarles and Mester. Quarles continues his testimony to Congress on regulations, so is unlikely to delve into monetary policy, but Brainerd and Mester represent opposite ends of the spectrum in views, so it will be interesting to hear what they have to say. On the whole, the dollar is little changed as I write, as are both Treasuries and equity futures. In fact the one market that has been truly performing well, commodities, would indicate that we could see further pressure on the dollar. However, the dollar has actually gained while commodities have rallied, a highly unusual outcome. Arguably, this relationship will reassert itself soon, and given the weight of evidence, I suspect that we will see the dollar suffer somewhat in the near term, although not aggressively so.

Good luck
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Cant’ Seem to Decide

The market can’t seem to decide
If buying the buck’s justified
While rates are entrancing
The issue’s financing
Those deficits, which won’t subside

So cyclical forces point higher
But structurally there is a fire
Destroying its base
Which bears will embrace
Thus dollars they just won’t acquire

The overnight session has resulted in the dollar continuing to recoup the losses seen Monday after the President’s tweet regarding China and Russia’s alleged currency manipulation. If you recall, the market seemed to expand that into a generic sign that the US was seeking a weaker dollar. But since then, the dollar has performed ably, benefitting from ongoing data softness elsewhere and reasonably solid data at home.

The biggest mover overnight was the pound, which fell 0.65% after CPI was released at just 2.5% with the core printing at 2.3%. Both those outcomes were 0.2% below expectations and continue the trend of inflation heading back toward the BOE’s target of 2.0%. While that is clearly good news for the UK, the market has been forced to reprice the probability of future rate hikes. Although the probability is still high for next month’s meeting, at 84%, it has fallen significantly for the November meeting, from well above a 50% probability to now around 40%. And after all, if inflation is, in fact, under control and heading back to target already and the economy’s growth trajectory is flattening, it doesn’t seem that higher rates are necessarily the right prescription. The euro is also edging lower this morning after the final reading of CPI data there disappointed at 1.3% (exp 1.4%) highlighting the fact that the ongoing narrative regarding the ECB withdrawing stimulus seems to be ahead of itself.

It is with this in mind that I wanted to discuss the big picture for the dollar. There was an excellent short article on the Bloomberg service yesterday (“Time Is Running Out on the Bull Case for the Dollar”) which succinctly made the case for both sides of the argument regarding the dollar’s future path. In a nutshell, the cyclical case for the dollar (interest rates and economic activity) remains quite bullish while the structural case for the dollar (the US fiscal situation with significant budget and trade deficits) arguably points to further dollar weakness. And so the question is, which one will dominate.

As you know, my view has been the cyclical case is what drives the bulk of the market’s activity and it is why I continue to look for the dollar to rebound further from last year’s declines. Interest rate differentials remain quite attractive with, for example, the two-year spread between Treasuries and Bunds at 2.99% this morning (US rate 2.40%, German rate -0.59%) and so when it comes to the search for yield, the clear choice is dollars. Given that US rates are the highest in the developed world, that rate advantage exists against all of the other G10 currencies as well, albeit at various different levels. A potential dampener of that effect occurs if the investor is seeking to hedge the trade’s FX risk. The flattening of the yield curve in the US means that hedgers are forced to pay away much of that yield advantage to prevent FX movement from undermining their investment. But not every investor hedges, and in fact, many are seeking to maintain a USD exposure overall.

The second part of this case is the economic performance of each nation. Here, too, the US continues to outperform its G10 counterparts. While the overall global growth trajectory seems to have peaked, the data we have seen so far this year points to a more rapid slowing elsewhere in the world than in the US. Remember, too, that US fiscal policy has just been significantly eased between the tax reform and budget bills that were enacted in the past several months. Arguably, these ought to underpin a better growth story here than elsewhere. One way to characterize this is that the US is currently running tightening monetary policy (Fed rate hikes, balance sheet runoff) and loose fiscal policy (tax cuts, budget deficits). Historically, this combination of policy settings has always led to a stronger currency. I continue to believe this will be the case going forward, but there is another side.

The structural story is based on long-term capital flows and trends in a nation’s fiscal position. It is here where dollar bears make their case. By virtue of the fact that the US is back to running both a large budget deficit and a large trade deficit, the funding for these deficits needs to come from somewhere. That somewhere is the rest of the world. On the trade side, we send dollars to other nations to buy their wares and then they need to do something with those dollars. What they do is buy US securities, either Treasuries or equities or sometimes property. At the same time, by running a large budget deficit, we issue plenty of Treasuries for them to buy. So the bargain is we borrow from our suppliers of goods to buy those goods, kind of like vendor financing. Now since WWII, when the dollar became the world’s reserve currency, we have basically been able to do this with impunity, as essentially everyone would accept dollars. Lately, however, some have questioned the ability for this process to continue.

Finance professors will point to the idea that in order to make this equation work the dollar needs to decline to a point where it appears stable in a new equilibrium. As I have pointed out numerous times in the past, the dollar is currently right in the middle of its long-term range, so this is arguably not that new equilibrium. Rather, the dollar bears argue that the dollar needs to decline much closer to its historical low levels (think of the euro at 1.40-1.50 and the yen back at 85) in order to find a new equilibrium level. And that is the crux of their case, the dollar must head lower in order to reach a point where foreign investors are comfortable buying US assets on an unhedged basis.

In the end, the dollar’s future will depend on all of these things and the relative timing of changes in each variable. A saying in markets is that nothing matters until it matters. This means that while particular issues may be outstanding for a long time, until the market focuses on the issue, it is not going to drive trading or investment decisions. The long-term dollar bearish case is quite viable, it is just a question of what will cause it to ‘matter’. My view remains that the cyclical case will continue to dominate as US rates continue to rise and it becomes clearer that the rest of the world is going to continue to lag. And that should help the dollar overall.

At any rate, hopefully this helps make clear both sides of the argument ongoing in markets. As to today, the only data is the Fed’s Beige Book, which has consistently shown the robust aspects of the US economy and highlighted the ongoing price pressures most businesses are feeling. But until that is released this afternoon, FX is likely to take its cues from other markets and with Treasury yields continuing to edge higher and equities doing the same, I like the dollar to continue its two-day rebound.

Good luck
Adf

 

Hold the Line – a

Said Trump about Russia and China
While we raise rates they hold the line – a
So rubles and yuan
Both fall further down
Thus new trade rules we will enshrine – a

The dollar fell pretty sharply during yesterday’s session (-0.4%) as President Trump weighed in on the currency markets with an early morning tweet calling out both Russia and China for devaluing their currencies. It is, of course, ironic since the reason the ruble has fallen so far is because of the latest US sanctions that were imposed on specific Russian individuals and companies, as well as the threat of imposing additional sanctions on Russian government bonds. The upshot is that the ruble’s recent trauma was directly caused by US actions. It seems pretty harsh to call them out for weakening their own currency when we did the dirty work.

At the same time, the yuan has not really been weakening at all lately; in fact it is within spitting distance of multi-year highs. The last time the yuan was this strong was the day before China devalued it by 2% back in August 2015. If you remember that scenario it led to a mini crisis in markets with equities falling sharply around the world and the Chinese ultimately being forced to impose capital controls as locals sought to get their money out as rapidly as possible into a safer setting. So with this as a backdrop, the dollar fell pretty sharply on the tweet and maintained those losses all day long. Arguably, the market’s broader concern is that the US is going to start to use the dollar as a negotiating tool in the ongoing trade fight. After all, we have already heard Trump himself mention the negatives of a strong dollar, and remember, Treasury Secretary Mnuchin was clear in some comments at Davos in February that a weak dollar was beneficial for US trade. So the market was already on edge before the latest comments from the President.

Adding to the dollar’s malaise was the ongoing mediocre US data with Empire Manufacturing slipping further than expected to 15.8, clearly coming off the boil from Q4’s activity. We also saw continued lackluster Retail Sales data, which rose just 0.2% ex autos, hardly the stuff of a robust economy and finally the NAHB housing index fell to 69, its fifth consecutive decline and seemingly indicating that the top of the housing market is behind us. Given the trajectory of interest rates in the US, that cannot be a real surprise. In summary, ongoing soft data along with an administration that seems to be talking the dollar down are more than enough to offset the growing interest rate differential in the dollar’s favor.

As to the overnight session, very little has occurred since the NY close. The dollar is virtually unchanged overnight, with the entire G10 space trading within pips of their closing prices. But it was not only quiet in the G10 bloc; EMG currencies have also been extremely sluggish in their price action. It appears that traders are waiting for the next big piece of news and quite frankly, all eyes are turned toward Washington as that seems to be the source of most market moving information these days. Given the unpredictability of that source, it is fruitless to try to anticipate anything in particular.

So heading down more traditional lines of inquiry, the overnight data showed that China’s GDP continues to grow strongly, with Q1 coming in at 6.8%, above analysts expectations. However, some of the underlying data, like IP and Fixed Asset Investment were both a bit softer than expected, perhaps pointing to a somewhat moderating future there. And while this data includes the solar panel and washing machine tariffs, those were small potatoes in the grand scheme of things, so almost certainly had no impact on the broad data. Staying in Asia, Japanese IP also disappointed, printing at 0.0% rather than the 4.1% monthly expansion expected. This is of a piece with the data that we have been seeing for the past three months, where the vaunted synchronized global expansion is feeling a great deal of pressure.

Turning to the Eurozone, there were two pieces of noteworthy data, Italian inflation, which disappointed at 0.9% Y/Y, well below the 1.1% forecast, and the German ZEW index, which fell to -8.2, its first negative reading since the immediate aftermath of the Brexit vote in 2016 and its lowest level since the Eurozone bond crisis in 2013. Once again I will point out that it is very clear the global economy has lost some zest. From the UK, however, we saw labor data that showed wages rising at their fastest pace, 2.8%, since 2015 and continuing to trend higher. At the same time the Unemployment rate fell to 4.0% for the month taking the three-monthly average rate to 4.2%, its lowest reading since the mid-1970’s! Obviously that is good news, but it seems the FX market presaged the data with yesterday’s rally, as this morning the pound is actually a touch softer. In the end it is important to remember that Unemployment is a lagging economic indicator, meaning it takes a backward looking picture. This actually becomes clear when looking at the ongoing dichotomy between softening production and consumption data we have seen alongside the still robust employment and inflation data that is being released. To my eye, as I have repeatedly said, economic growth for the cycle peaked back in Q4 and we are going to see a steady erosion in the data going forward.

Looking ahead, we have our most active data day of the week with both Housing Starts (exp 1.264M) and Building Permits (1.315M) to be released at 8:30 and then our own IP (0.4%) and Capacity Utilization (78.0%) data coming at 9:15. We also hear from five Fed speakers, Williams, Quarles, Harker, Evans and Bostic, so there will be plenty of opportunity for some new views. In fairness, Quarles is testifying before Congress on banking regulation so is unlikely to touch on policy, but the other four are clearly available for additional nuance and information.

I actually find it quite interesting that the dollar stopped declining after yesterday’s fall. I think what we are witnessing is the level at which the continued widening of interest rate differentials offsets perceptions of future extra-monetary policy action (things like tariffs and jawboning). And in the end, despite all of the angst about the falling dollar, the reality is it remains well within its recent trading range, and in fact, has not even threatened the bottom of that range. All my years of experience lead me to believe that the interest rate differentials remain the most critical factor in currency values, and to my eye, especially given the apparent easing of the global growth trajectory while the Fed is clearly on track to continue tightening, the dollar will be the beneficiary. Maybe not today, but certainly by the end of the year.

Good luck
Adf