This week all investors will learn
Not only how much yield they’ll earn
But also they’ll hear
If later this year
A fourth hike is cause for concern

FX markets are opening the week in a subdued fashion, with the dollar under mild pressure, but the same cannot be said for equity markets, which have seen a clear trend lower. Japanese markets led the way down in Asia while in Europe; it is the UK falling the most. US equity futures are also pointing lower, most notably on the NASDAQ, where there seems to be growing concern that the FANG group might be running into trouble. But ultimately, this week is going to be about policy discussions with the key being Wednesday’s FOMC meeting and the ensuing press conference. However, we also have the G20 meeting today and tomorrow in Buenos Aires, a BOE meeting on Thursday and the EU meeting to discuss the next steps in Brexit on Friday. In many ways, it is a positive that there is virtually no data of note to be released, as it would almost certainly be overshadowed anyway.

Generally speaking, the G20 is likely to be ignored by most market participants as the reality with any of the G# meetings are that nothing ever gets resolved. However, in this case, given the Trump administration’s tariff proposals, there is some possibility that we could hear negative news from the gathering. I am certain every other member of the group is weighing in with the reasons that tariffs make no sense and should be avoided, but it seems unlikely to me that this particular group will have much impact on the eventual decisions. Headline risk, however, remains real, especially if the US sounds more aggressive in its stance.

But the real treat this week is the Fed. It is virtually certain that they will raise the Fed Funds rate by 25bps to 1.50%-1.75% with the market completely priced for that outcome. The question of note is will they signal that there will be four rate hikes this year rather than the three that they indicated back in December. Certainly, the last rhetoric we heard from any speakers, Powell’s Humphrey-Hawkins testimony and a following speech by Governor Lael Brainerd, indicated that the hawks were in command now. In fact, there are a number of Wall Street analysts who believe that the latest dot plot will show that the median expectation for this year will be four rate hikes, up from three in the previous several iterations. The latest futures data shows that there is currently a 35% probability of a fourth rate hike priced in which means that there is certainly opportunity for the market to adjust further if the dot plot shifts.

Of course, the idea of four rate hikes is not without controversy, as there are many who believe that inflation will remain subdued and that the yield curve will invert if the Fed follows through. After all, though 10-year yields rallied sharply through February, they have basically stagnated since then and remain well below 3.0% (currently 2.86%), never having even touched that level during the peak of inflationary concern. And an inverted yield curve has been a harbinger of a recession for the past fifty years.

Here’s the problem: with rates still so low on a historical basis, the Fed also realizes that they need to have a more normalized rate structure (read, higher rates) in order to have enough ammunition to fight the next downturn, whenever it comes. The fact is that during the past eight cyclical downturns, the Fed has cut rates, on average, by 500 bps. However, in the current situation, even if they raise rates four times this year, Fed funds will not yet be 3.00% when they are done. If a recession appears by the end of this year, something that is currently seen as highly unlikely, but certainly not impossible, what are they going to do? In that situation, are negative rates likely? QE4? Something else? Remember that we are already in the midst of a significant fiscal expansion, so if things slow down despite that, it seems policymakers may find themselves with few appealing options. I’m not forecasting this is the situation; I’m merely pointing out the risks that the Fed needs to consider as they make policy. In a terrible metaphor I would ask, will reloading the policy gun cause it to be fired? At any rate, this is why the FOMC meeting on Wednesday is so critical. With some luck, Chairman Powell will be able to give us some guidance. We’ll see.

Turning back to FX the question is, what will all this do to the dollar? At this point, the dollar remains largely unloved. Certainly positioning indicates that we are approaching the largest short dollar positions seen in the past ten years. Analysts hate the buck, pointing to the idea that markets have yet to price in sufficient policy tightness from other central banks and have already done so for the Fed. They also point to the growing twin deficits and massive increase in bond issuance as rationales for the dollar to decline further. After all, to attract investors, the dollar needs to be weaker so that it can eventually appreciate. At least that is the theory. I have not changed my view that the dollar will rebound this year, as I continue to look for the Fed to be more hawkish than anticipated, but I remain in the minority.

As to the overnight session, the pound has been the biggest winner, rising 0.65% on what seems to be hope that there will be progress on the Brexit situation and that trade talks between the UK and the EU will begin soon. Personally, my take is that they have not adequately addressed the Ireland border issue and that all the so-called progress to date has been smoke and mirrors with nothing substantive yet agreed. And while the market is showing a great deal of confidence that the BOE is going to raise rates in May, I disagree. It seems far more likely to me that the Brexit talks show little progress by then and the BOE reconsiders that move. But for now, traders are getting bullish the pound and we are back above the 1.40 level. My view is it is a great sale. But away from the pound, the rest of the G10 has done very little overnight, wiggling just a few basis points from Friday’s closing levels.

In the EMG bloc, the story has actually been one of more general dollar strength. In fact, the biggest moves have been MXN (-0.7%), ZAR (-0.75%) and KRW (-0.5%), with the rest trailing along mostly little changed. The Korea story has to do with an investigation into some Kia and Hyundai airbags and a potential recall. Both companies’ stocks were lower as was the Kospi, and the currency. South Africa has suffered due to concerns that Moody’s is about to cut their credit rating to junk thus forcing them out of key emerging market bond indices and likely leading to liquidation of as much as $6 billion of local bonds by international investors. Finally, the peso seems to be under the gun from the trade situation with no help yet coming from the G20.

As to data this week, as I said before it is light:

We also hear from a few Fed speakers after the meeting, but it is hard to believe that they will have changed any views in the interim, so are likely to be mostly ignored. My gut tells me that Powell is committed to turning the Fed ship toward a more hawkish view, and that we are going to see that reflected in Wednesday’s activities. In the end, I like the dollar to finish the week a bit stronger than it is starting it.

Good luck
Adf

Amid growing market disorder
The currency north of the border
Is feeling the strain
As traders abstain
From anything but getting shorter

While US dollar bears continue to drive the bulk of the discussion, there is at least one currency bucking the trend, the Canadian dollar. A combination of increasingly negative trade rhetoric on NAFTA from the Trump administration and a slowing in economic data pushing the BOC into a more dovish stance than before has resulted in a YTD loss of more than 3% (-0.3% overnight). Consider, yesterday we discussed the yen, which has been rocking all year (+0.65% overnight) and is now nearly 7% stronger YTD. What to make of this move? I think, in fact, it is quite healthy. The first thing it demonstrates is that some currencies are trading on fundamentals, or at least market perceptions of the data. Rather than a broad based risk-on/risk-off framework, there is actual consideration given to positioning. This is a good thing. The second thing it demonstrates is that as monetary policies around the world change, market volatility is growing and not just in equities. Rather, market volatility appears to be undergoing a paradigm shift.

Arguably, since Alan Greenspan first created the “Greenspan put” in 1987, we have seen a steady decline in both volatility across markets, and if you look at the long term trend, in interest rates. While there were certainly periods of movement over the past thirty years, with volatility spikes and some higher rate moves, the trend has been quite clear. I would argue that the causality runs from lower rates to lower volatility and has been doing so during that entire period. And what is different about now? Well, interest rates have pretty clearly bottomed and are no longer in their downtrend. Rather as monetary policy around the world tightens, we are going to see more market volatility across every product. This means that hedging is going to become a more important part of the discussion for every corporate risk manager as well as every investor. Low volatility environments are conducive to passive trades, things like index funds and carry trades, where a single feature of the markets is exploited and performance is positive. But within the new paradigm, those strategies, and others that rely on low volatility are going to perform far less well. In fact, I expect that actively managing risk is going to be the only way to mitigate it for the next 5-10 years.

But I have another bone to pick with the pundits, and that is about the strength (or weakness) of the dollar at any given point in time. As I have written before, I would argue that the dollar right now is neither strong nor weak; rather it is very close to the middle of its long term trading range. Versus the euro, for example, with a historic range of 0.86 – 1.60, the dollar this morning at 1.2328 is almost exactly in the middle of the range. That certainly doesn’t sound like a weak dollar to me, nor like a strong one. But beyond that, I am keen to understand why when Mario Draghi highlights the recent strength of the euro as an issue, nobody takes exception to him trying to talk down the euro, or when the Swiss National Bank creates an unlimited intervention plan to weaken the franc, that is acceptable, but when Steve Mnuchin mentions that a weaker dollar helps the trade account, which it clearly does, that is seen as out of bounds. Every country is going to act in accordance with what they perceive is in their own best interest. In fact, if the dollar were to weaken significantly and the trade accounts improved accordingly, I would wager that there would be no talk of tariffs in the US, there would be no need.

In the end, as I wrote yesterday, policies are what drive markets, and relative monetary policy is arguably the biggest driver in the FX markets. So if the Fed continues to tighten faster than everybody else, the dollar is going to benefit. In fact, every study done shows that there are two clear policy settings that impact a currency. Loose fiscal and tight monetary policies tend to strengthen a currency, while the opposite, tight fiscal and loose monetary policies tend to weaken it. Certainly we are looking at the loosest fiscal policy in the US in decades, between the tax cuts and increased budget deficits, and we are watching the Fed lead the way toward tighter money as QE is actually ending here with the balance sheet roll-off, rather than merely being discussed as elsewhere. It all points to a stronger dollar.

Enough ranting. On the day, the dollar is broadly softer despite the weakness in the Loonie. Yen is the leading gainer, but we are seeing strength in the euro (+0.2%) and the pound (+0.2%) as well. Funnily enough, the EMG space is actually feeling pressure this morning, with things like ZAR, TRY, and almost all of LATAM falling. So while the dollar index, which is weighted toward the G10 is down, there are actually more currencies falling than rising.

Looking at the overnight data, the surprise was Eurozone inflation, which printed at a softer than expected 1.1% annualized gain in February. Once again, the absence of an inflationary pulse continues to dominate the data there highlighting my view that the ECB is not going to be nearly as aggressive as many traders believe. Meanwhile, in the US this morning we see Housing Starts (exp 1.285M) and Building Permits (1.322M) early, then IP (0.4%) and Capacity Utilization (77.7%) at 9:15 followed by Michigan Sentiment (98.8) at 10:00. Once again I will highlight that the focus is growing on next week’s FOMC and that this data doesn’t feel like the type that will move markets, at least not the FX market. So, we will need to look elsewhere for catalysts, like equity markets where Europe has edged very slightly higher while US futures are little changed to slightly lower, and Treasuries, where despite headlines about the Chinese having reduced their holdings, and significantly increased auction sizes, yields have been softening pretty steadily for the past week. It is hard to get excited about dollar movement today, or in truth until we hear from Chairman Powell next Wednesday.

Good luck and good weekend
Adf

Though Abe rejects
Calls for his resignation
Traders are less sure

Amidst another dull FX session, where the dollar is overall little changed, the drumbeat of scandal continues to get louder in Tokyo. Pressure is clearly increasing on FinMin Taro Aso to resign over the scandal where he is alleged to have altered documents involving a sweetheart real estate deal for one of the PM’s friends. And while Aso has been in the cross hairs for the past week, yesterday, the PM’s own party legislators were demanding answers from Abe himself! This matters because there is a small but growing belief that Abe may be forced to step down over the scandal, and in so doing, take the reflationist mindset with him. The upshot is there is a growing risk of a more significant strengthening of the yen. Having already appreciated more than 6% this year (including 0.35% overnight), the yen is the strongest performer in the G10. And this is with an administration and central bank that are consciously trying to undermine the currency. If there is a forced change at the top, and the new PM and administration is evenly modestly less forceful in their views regarding the ongoing efforts to address what has become a national mindset on deflation, the yen will have much further to rally.

As an aside, there was another interesting tidbit out of Japan this week; one that I think bodes ill for the ongoing efforts to weaken the yen. On Tuesday, there were exactly zero trades of the key 10-year JGB in the Tokyo market. None, nada, zip! This is unprecedented. Never before has the bond market in a major economy actually seen no volume during a session. Ultimately, the BOJ’s QQE program has succeeded in completely undermining the value of the marketplace in JGB’s. Remember, a market is designed to give price signals to both buyers and sellers, but if it doesn’t trade, no signals are forthcoming. So what is the proper price of 10-year money in Japan? The answer is that since the BOJ started its yield curve control program, there is no way to know. I guess you could say they are doing a good job of controlling the rate as it is whatever they say it is. But that is not a healthy situation for the world’s third largest economy. And of course, how can they continue to pump money into the economy if nobody is willing to sell them the bonds?

My point is that there are significant troubles in Japan and therefore a growing potential for an outsized market impact, especially on the yen. Don’t be surprised if you hear in the next months that the BOJ is buying US Treasuries or even US equities as part of their reflationary efforts. Both of those would serve to weaken the yen as the BOJ explicitly buys dollars for the purchases. In the back of my mind, I also see a growing probability of actual debt monetization in Japan, where the BOJ ultimately tears up JGB’s when they mature and leaves the money in the economy. That is an inherently inflationary action, but one which will be extremely difficult to control. However, given the decades of failure surrounding Japanese efforts to halt deflation as well as the diminishing toolkit available to the BOJ, don’t be shocked if something like this happens.

In the meantime, all signs point to further yen strength. The combination of events and market circumstances seems to be overwhelming any current reflationary strategy. And that is before a situation where Abe is forced out. If he goes, then things happen much faster. In fact, it could trigger a more widespread market disruption, negatively impacting equity markets everywhere and driving investors to perceived safe havens, ironically including the yen. I am not saying this is the future, merely that it is not a zero probability event.

And with that joyousness out of the way, let’s look at the rest of the market. Overall, the dollar is a touch stronger today, although it remains mired in its recent trading range with no sharp movements anywhere. It is becoming increasingly clear that traders are looking to next week’s FOMC for the next big clues. Yesterday’s data proved disappointing with regard to Retail Sales, as despite a seemingly robust economy, sales actually fell. PPI demonstrated price pressures are slowly building, but overall it is hard to believe the data would have changed any views at the Fed. This morning brings some more information including Initial Claims (exp 226K), Empire Manufacturing (15.2) and Philly Fed (23.0). However, it is difficult to see how these will be significant enough to drive markets.

After a down day yesterday, equity futures are pointing slightly higher in the US which is in synch with the price action seen in Asia and Europe, modest gains. Absent another key political surprise, it is hard to see a compelling reason for the dollar to move too far in either direction ahead of the FOMC next week. As such, while I do believe the pressure for the yen to strengthen will keep up, I don’t see much activity elsewhere.

Good luck
Adf

The news out of Europe implied
That Draghi could quickly backslide
On ending QE
Though most still foresee
The hawks there will not be denied

Data surprises overnight are the talk this morning with Eurozone IP falling the most in more than a year, down -1.0%, while inflation readings from various Eurozone countries continue to point to a distinct lack of impetus there. In addition to the underwhelming data performance, Signor Draghi was on the tape reiterating that it is still too soon to declare victory in their long-running battle to reflate the Eurozone economy. He continued to counsel patience in the pace of removal of accommodation, but one of his key lieutenants, Peter Praet, did discuss how guidance would be changing over time to give a clearer view of future policy actions. Net however, Draghi’s dovishness added to the soft data and so it cannot be a surprise that after the euro rallied during yesterday’s session, it has given back a portion of those gains.

Quickly touching on yesterday’s rally, the proximate cause was the US CPI data, which came in right on expectations thus indicating that inflation pressures continue to increase gradually, but that they are not yet showing signs of accelerating. This resulted in a bit less enthusiasm by market participants over the idea of a fourth Fed rate hike this year, and the result was some dollar weakness. Of course, yesterday also saw the firing of Secretary of State, Rex Tillerson, and the appointment of Mike Pompeo, erstwhile head of the CIA as his replacement. There are those who claim the ongoing turmoil within the Trump Administration is yet another factor in the dollar’s persistent weakness but I am less confident that is a viable explanation. My observation is that markets tend to react to policies, not politics, and despite all the sturm und drang, its still policies driving things. Of more interest to me was the very solid 30-year Treasury auction and modest bull-flattening of the yield curve. So despite some doomsday discussion about massive increases in Treasury supplies and reduced demand, something I touched on yesterday, it’s not happening yet.

The other data surprise came from China overnight, where IP jumped a full percent, printing at 7.2% and much higher than the expected 6.1% forecast. Fixed Asset Investment was also quite robust at 7.9%, almost a full percent higher than expected there. Finally, Retail Sales remain strong, printing at 9.7%, up slightly from last month. The point is that despite a universal belief that the Chinese economy is set to slow further this year, it remains quite robust. The market impact of this data was strength in the commodity sector, which has fed into higher equity markets in Europe and higher US equity futures as I type.

Looking across the FX spectrum, the dollar is arguably a bit softer overall, despite the euro’s modest decline. The biggest gainer has been AUD, (+0.6%) which seems to have benefitted from the strong Chinese data and commodity prices as well as an uptick in its own consumer confidence data. But away from the Aussie, movement in the G10 space has been rather limited. Once again, I believe that market participants are unwilling to position for significant policy changes, as uncertainty remains high, especially with the threat of a trade war hanging over us all. Meanwhile, in the EMG bloc, there has certainly been more currency strength than weakness, but the magnitude is not sufficient to make a strong case of a thematic driver. Rather, it feels like the dollar is feeling a little stress based on mildly softer interest rates from yesterday’s trading rather than anything else.

This morning brings a bit more data, starting with PPI (exp 0.2% both headline and core) then Retail Sales (0.4%, 0.4% ex autos) and finally Business Inventories (0.5%). Clearly it is the Retail Sales number with the best opportunity to move markets, and a big miss in either direction will likely have an impact on the dollar, as well as equity markets. But any impact will remain short term as the market slowly turns it attention to next week’s FOMC meeting. So all told, I anticipate a pretty lackluster session barring any further surprises on the trade front.

Good luck
Adf

Inflation continues to be
The data that folks want to see
While recent releases
Have shown some increases
Investors remain quite carefree

After a period of weeks where there seemed to be something of real import in virtually every session, the overnight market has seen very little of interest across the board. At this point, it appears that most market participants are simply waiting for this morning’s CPI data to see if the Fed will continue to show increasing concern over the trajectory of prices in the US. Expectations are for a headline increase of 0.2% (2.2% Y/Y) and a core increase of 0.2% (1.9% Y/Y). Both of those annualized numbers represent an uptick from last month and are likely to be the beginning of a trend higher, at least through the early autumn. The question, as always, is how will the Fed respond to data showing rising inflation. Thus far, we have heard from both hawks and doves that “headwinds are turning into tailwinds” which is Fedspeak for expectations are growing that rates may need to rise more quickly still. At this point, it is a virtual certainty that when the FOMC meets next week they will raise the Fed Funds rate by 25bps. The key unknowns are whether they will continue their hawkish rhetoric, and whether the dot plot will reflect a more aggressive tightening cycle. At this point, I see no reason to believe they will back off from recent comments. This is especially true if this morning’s data surprises to the high side. But even a low print is unlikely to change things yet. They will need a series of low inflation prints to change their tune.

So what does this mean for markets? In the FX world, the reality is that the dollar has done very little over the past two months, trading in a range while consolidating its declines from last year. FX traders continue to try to parse the information from the ECB, where the default view remains that they will be tightening soon; from the BOJ, where the default view remains that they will be forced to reduce accommodation because it has become completely ineffective; and from the Fed, where the default view seems to be that even if they raise rates four times this year, it is still completely priced in and dovish. While I disagree with the default views, the reality is that we will need to see some very new information, likely in the way of data surprises, in order to change those views at all. At the same time, bigger picture issues like the increasing US budget deficit, the significant increase in US Treasury issuance, the prospect of a trade war and the ongoing Fed reduction in its balance sheet will only play out over a much longer timeframe.

Of these, I remain most concerned over the impact of the shrinkage of the balance sheet. In fact, there is one scenario where I could see a much weaker dollar, and that is as follows: increased supply of Treasuries to fund the deficit alongside decreased demand for Treasuries (by the only price insensitive buyer) as the Fed stops replacing maturing securities could lead to both a sharp decline in Treasury prices and a coincident decline in the dollar as investors shun the greenback amid sharply rising rates and a weak fiscal position. After a more substantial dollar decline, perhaps another 10%-15%, and with higher yields available (think 4.0% in the 10-year) to investors, I would expect to see flows return, but that still implies a sharp movement between here and there. And while that is not my base case, it is certainly a scenario that is finding adherents. Time will tell.

Looking at today’s FX movement, the dollar is modestly stronger with the yen being the biggest underperformer, falling 0.75%. Looking at the data released there overnight, it didn’t appear to be of a market-moving sort, with the Tertiary Index falling slightly more than expected and PPI there softening as well. Rather, it appears that the ongoing elementary school scandal regarding FinMin Taro Aso is the driver, as he refused to step down and has continued to receive support from both Kuroda and Abe. It seems that traders expect if he is forced out it will result in a less dovish Abe administration and even serve as a catalyst for USDJPY to head to par. I’m not sure I buy that story, but there is no question that yen sellers were out in force overnight. But in truth, away from the yen, the rest of the G10 is trading within a few basis points of yesterday’s closing prices.

Meanwhile, in the EMG markets there has been a bit more currency weakness as concerns grow over the significant size of outstanding USD debt held by EMG companies and countries. With US rates continuing to rise, repayment risk remains a serious concern, and it should be no surprise that this bloc is feeling a little pressure. But all told, the dollar’s overall rally has only been about 0.15%, hardly enough to really change things.

Aside from the CPI data, the only other release has been the NFIB Small Business Optimism Index which printed at a better than expected 107.6, demonstrating that there is still a great deal of confidence in the economy. Equity markets, which had a mixed session in the US yesterday, are edging higher ahead of CPI, but the movement is quite limited. Treasury yields continue to hover either side of 2.90% as the market looks forward to the new 30-year Treasury Bond after a good performance yesterday in both the 3-year and 10-year auctions. So fears over indigestion of too much supply are not yet rampant. And that’s really it for the day. If pressed, I continue to expect inflation data to print slightly higher rather than lower, but that will need to happen for several more months in a row before the Fed starts to get nervous. All told, I expect that the dollar will be able to maintain its modest overnight gains, but see no reason for significant movement until the FOMC next week.

Good luck
Adf

On Friday the rally in stocks
Resulted from word Goldilocks
Was not really dead
Because now the Fed
Would not need to sound like such hawks

After a great deal of new information last week, markets are opening this week in a far more subdued manner, arguably with far lower expectations. A quick look around shows that Asian equity markets followed Friday’s US market performance with strong rallies across the board while European markets are just edging higher. Bond markets, meanwhile, have shown resilience, although 10-year Treasury yields have drifted back to 2.90% as I type. And finally, FX markets have not displayed any coherent story this morning, with Friday’s dollar weakness in the wake of the payroll data largely maintained but not extended.

So let’s recap Friday’s data as I think it is important to help construct the narrative. By now we all know that the NFP number was killer at 313K, more than 100K higher than expected. But the real surprise came in the fact that the Participation Rate rose to 63.0%, up from 62.7%, while the Unemployment Rate remained unchanged at 4.1%. What this implies is that the economy has been growing strongly enough to draw people who were previously on the sidelines, and ostensibly not seeking jobs according to the BLS measurements, back into the workforce. This had been one of the key concerns of former Fed Chair Yellen, that there was ‘hidden’ unemployment and so the headline rate that had fallen to multi decade lows was overstating the tightness of the labor market. That Participation Rate had fallen steadily since the financial crisis and has been a source of concern. Part of it is demographic, as baby boomers retire and the workforce shrinks, but Friday’s data indicates that with the proper incentives, it is possible to ameliorate that decline. But just as important to the Goldilocks narrative was the fact that AHE data fell back to 2.6% from the 2.9% print last month. This implies that incipient wage pressures are not as strong as they seemed last month, and therefore the Fed need not be as aggressive as many had started to consider they would become. Hence, Goldilocks is back with strong growth and low inflation highlighting less need for the Fed to tighten rapidly.

In this context, Friday’s market reactions made perfect sense. On the equity side, continued low rates would support further economic and profit growth and hence continue to inflate the equity bubble allow for additional multiple expansion. Meanwhile, the assumed more dovish slant for the Fed would undermine the dollar further, thus opening the way for a continuation in its year-long decline. Adding to the dollar’s woes was the confirmation that the ECB would be removing its own accommodation by the end of this year, or at least would stop adding to it. And so, the Goldilocks narrative is alive and well for now. In fact, the only thing that I can see to derail it in the near term would be surprisingly higher inflation readings, high enough to have the central bank set appear to get nervous that they are falling behind the curve. Interestingly, this week brings the next set of CPI data from the US and Europe, so who knows, maybe it will happen.

Looking more closely at the FX market, there is no currency that has shown movement in excess of 0.3% overnight. In fact, in the G10 space, movement has been largely +/- 0.10%. Let me say that there is nothing of interest in that price action. Perhaps the only excitement was in Tokyo where a growing scandal about fnding of a controversial elementary school seems to have the potential to force Abe-san’s FinMin, Taro Aso, to resign. This would be a blow to Abe, as Aso has been one of his staunchest supporters in their attempt to reflate the Japanese economy. The market reaction has been a modest yen rally of 0.2%, I guess the idea being that they will not be able to be as aggressively easy in policy if Aso is forced out. In the EMG space movement has been just as desultory, with a spate of both winners and losers, but no stories and no large adjustments.

Turning to the data this week, it is not nearly as exciting as last week’s output, but we do see CPI on Tuesday and a range of other things that might adjust some thoughts. However, the Fed is in its quiet period ahead of their meeting a week from Wednesday, so no commentary is on the cards.

We also see Eurozone CPI on Friday, as well as important data from China during the week. But in the end, it feels like the narrative is back in control and we will need to have a series of data outcomes pointing to faster inflation in order to change that for now. The one place where things have a chance to get unsettled is in the Treasury auctions this week. As US budget deficits grow, so grows the amount of securities auctioned and there has been a distinct decline in the bid-to-cover ratios seen over the past several auctions. Quite frankly, while I don’t actually expect it to be the case, you cannot rule out the 10-year yield trading up to 3.0% in the event that investors are too busy buying stocks to bid for Treasuries. And 3.0% could turn a few heads. In the meantime, the narrative points to further dollar weakness, so I’m not going to fight that for now.

Good luck
Adf

In Frankfurt the hawks stole the show
Declaring QE will ne’er grow
But Draghi the dove
Would not dispose of
His view QE’s still apropos

The market response was to buy
The euro up to the day’s high
But after he spoke
The hawks’ spirit broke
By day’s end the buck felt quite spry

There is much to discuss today as to what happened yesterday and what we might expect today. To begin, the ECB left policy on hold, as universally expected. However, they surprised one and all by removing the paragraph from their statement promising that they could increase QE if they thought it was appropriate. The initial market response was to take the euro higher by about 0.5% as the hawks were feeling quite smug. Alas for those who jumped on that news, when Draghi spoke at the press conference forty-five minutes later, it became clear that he was not really so hawkish after all. One of the key changes was in the staff economic update where the forecast for CPI in 2018 was decreased by 0.1% to 1.4%. Now it seems awfully hard to believe that the ECB is going to be aggressively withdrawing stimulus if they officially expect inflation to grow more slowly than previous expectations. In addition, a surprising twist was that the forecasts were based on QE of €30 billion/month continuing through the end of the year, rather than ending abruptly or tapering further in September as many had mooted. The upshot was that the euro reversed course and fell steadily all session, closing the day lower by some 0.8%. This morning it continues under pressure, falling another 0.1% and is back around the 1.23 level, which seems to have become a trading pivot.

Next up the BOJ, with their meeting concluding last night and again, no actual policy changes being revealed. Rather, Kuroda-san is still working to walk back the comments he made about the end of QE occurring next year and has thus extended his dovish rhetoric at the press conference as follows, “We’re not thinking at all about weakening the degree of easing, or changing the current monetary easing policy framework, before we achieve 2 percent.” So he has come full circle, after first saying that they would consider how to end QE when they achieve their target in 2019, they have now indicated that while their goal is to achieve that elusive 2.0% inflation rate by then, they have less confidence in doing so and will not act, in any case, before they have achieved the target. In other words…just kidding! Remember, CPI ex fresh food, the BOJ measure, is running at 0.9%. It astounds me that they are willing to continue to say they expect to reach that level so frequently while, except for the GST increases a few years ago, they haven’t sniffed that level in decades! Needless to say the market took heart that the BOJ would remain more dovish and sold the yen further after the meeting, with the dollar higher by 0.5% overnight and a solid 1.4% this week.

Which brings us to this morning and the US payroll report. No one has forgotten the market response to last month’s payroll report, where the jump in AHE to a 2.9% annualized rate completely spooked markets. The resulting decimation of the short volatility trade wound up reintroducing everyone to the idea that markets can go down as well as up. So it is not surprising that much commentary is focused on that number today, because if it were to tick up even slightly, to 3.0%, I think the market response would be quite large. However, there are many economists who point to the idea that last month’s number was a statistical anomaly because of the number of days in the period and how weather related issues impacted the weekly hours number. While I don’t have my own econometric models, my observation is that we have seen a broad swath of commentary and data showing that wages are, in fact, rising more rapidly than at any time in a number of years. My gut tells me that the number was no fluke. At any rate, here are the current expectations:

Remember, too, ADP Employment was a much stronger than expected 235K and that the Fed’s Beige Book highlighted that employers were raising wages. We have also seen that in the NFIB survey as well as in PMI data. The point is that while it has taken a long time to see the apparent tightness in the labor market lead to higher wages, that process has clearly begun. And there is one other thing to note, look at the Manufacturing payrolls expectation. For quite a while, growth in manufacturing payrolls was stagnant, and actually negative, but lately we have seen those numbers pick up quite nicely. And remember, manufacturing wages tend to be significantly higher than the average wage, so as that process continues, the average number should continue to see upward pressure. As always, I would contend that inflation is very real in the economy and that the data measurements will reflect that eventually. It is becoming clearer that eventually is now.

In the end, for the dollar I think the market response will be perfectly logical, with strong data resulting in a strong dollar on the basis of faster Fed tightening and vice versa. For equity markets I think we are in the good news is bad scenario, and a strong print will undermine equities, while for bonds it is a toss-up. The case could be made that higher inflation will drive yields higher, or that flight from risky assets could drive them lower. My own view is that we will see another set of robust data, with NFP something on the order of 225K, Unemployment at 4.0% and AHE at 3.0%. I like the dollar higher in that scenario.

Good luck and good weekend
Adf

With war drums of trade in the background
The ECB may find it’s now bound
To slow the retreat
Of their balance sheet
As gains in growth might now be unwound

Today is when the real onslaught of new news starts to arrive. Yesterday’s ADP Employment report was certainly better than expected at 235K, and I expect that has heightened expectations for tomorrow’s NFP report. Of course, that was largely overshadowed by the late report from the White House that the tariff measures would be signed into law today. The one concession seems to be that both Canada and Mexico will be exempt as long as the NAFTA negotiations continue. However, looking to this morning, we hear from the ECB at 7:45, where there is certainly no policy change expected, although there are those who believe that the policy statement may contain some important changes. Then, of course, at 8:30 Signor Draghi will hold his press conference and that is where things can get interesting.

To recap the narrative, continued above trend growth within the ECB has led many pundits to expect that the ECB will start to officially close off avenues of further QE at this meeting. So they will no longer include the line about possibly increasing QE again if necessary, and may even discuss a definitive finishing point. Certainly the hawks on the committee would like to see that. However, Draghi has a few valid reasons today to avoid any real changes. First, the US trade tariffs on steel and aluminum are a completely new event since they last met and one that cannot be seen as an economic positive in any light. While the Eurozone has highlighted the countermeasures they plan to take, that will not help growth there either. So increased uncertainty over the future trajectory of growth on this basis is certainly a valid reason to avoid tightening policy further. In addition, while growth in the Eurozone has been solid, the data is showing signs of rolling over which implies that further acceleration is no longer likely. In an economy with steady, but not accelerating growth, price pressures are not likely to become an issue. In the current situation, that means higher inflation may well be much further in the future than previously hoped expected. And one thing that has not gotten much play at all, but I believe could be quite important, was commentary from Bundesbank President Jens Weidmann a short while ago. He has been one of the most ardent hawks on the committee. However, in an interview he remarked that there was no reason to hurry on the tightening front, completely uncharacteristic of his previous views. I believe the explanation is that he is angling for Draghi’s job when it becomes available next year and if he is seen as too hawkish he will not get the votes of the peripheral nations who rely on low rates. In that calculation, a few extra months of low rates is worth the installation of the first German as head of the ECB. One can never discount politics in these situations.

At any rate, I would be extremely surprised if Draghi came across as anything other than dovish today, and I expect that he will do all he can to delay any changes in wording of the statement. As you all know, I continue to believe that the ECB will remain more dovish than the narrative all year and the euro will eventually suffer for it, so this is just part of that thought process.

In the end, the market has bid the dollar higher this morning, albeit not by very much, roughly 0.2% overall. However, it has been pretty universal. This has not been a data driven move, but rather it seems to be more positional as traders reduce risk ahead of the ECB. In fact, the euro, prior to the ECB statement, has been the worst performer in the G10, falling 0.3%. But we have seen lots of 0.15%-0.2% moves there overall. Even in the EMG bloc there have been few currency moves of note with the bulk of the bloc biding its time, I believe, for the next big shoe to drop. Now while today that is the ECB, I think there are far more EMG eyes on tomorrow’s payrolls report here in the US.

As to today’s session, likely Draghi and his comments will drive it. The only US data point is Initial Claims (exp 220K) but that is not going to have an impact. So it’s really all about Mario today and whatever he says. The initial reaction to the statement was mildly hawkish, but I’m still betting on a dovish slant.

Good luck
Adf

There once was a fellow named Cohn
Who markets thought stood all alone
‘Gainst forces quite set
To keep up the threat
Of tariffs. Now this bird has flown!

Apparently trade friction and tariffs ARE a problem in the market’s eyes. Who’d a thunk it? The announced resignation of President Trump’s chief economic advisor, Gary Cohn, was not well received by markets anywhere as he was seen as the last free trade voice in the White House. S&P futures fell 1% within minutes of the announcement and we have seen that follow through in equity markets around the world. The dollar has been a different story though. While the yen has rallied about 0.35% on its haven status, the euro is little changed, and the dollar has actually shown strength against many key US trade partners amid the escalating rhetoric on trade. For example, CAD has declined 0.45%, MXN is down 0.6% and KRW is lower by 0.5%. Of course, it should be no surprise the renminbi has suffered as well, down 0.15%. Net, the dollar is little changed on the day, at least as measured by the many indices that track it, but there has been some movement.

So what are we to make of all this? Quite frankly I would argue there is no way to know at this time. On the one hand, President Trump campaigned on this specific issue; countless times declaring he would get better deals for the US. Does this mean that he will follow through on these threats and actually impose the tariffs? I am not prepared to answer that question other than to say the probability is clearly non-zero. Will this lead to escalation and retaliation by other nations? Certainly they have made clear they are willing to do that, but a funny thing is given the size of the US trade deficit with the rest of the world, it just might be they have more to lose than the US. Now I’m not advocating for a trade war as history shows those can be quite destructive to all involved, but based on my observations of the President to date, I would not rule out that outcome. There is, however, a more likely thought process to these tariffs; they are the latest salvo in a trade negotiation. In fact, Administration members have been essentially saying that already, for example, pointing to NAFTA and saying if a new agreement is reached that is more to the US liking, tariffs won’t apply to either Mexico or Canada. And when looking at the largest exporters of steel and aluminum to the US, both Canada and Mexico are top of the list, well ahead of China in both cases.

So here’s my broad observation about what is happening in the US right now, at least from the perspective of markets and their investors. There is a significant transition in the tone and language that is emanating from the key power centers in the US: the White House, the Treasury and the Fed. For the past umpteen years, every comment has been carefully considered before being made public, as there was a great fear that speaking forthrightly would unleash market turmoil. Arguably this has been the case since at least the Clinton Administration when the term ‘bond vigilantes’ was invented.

But the current administration is quite different than all we have seen in the past, perhaps since Andrew Jackson in the 1860’s. Forthrightness has become a hallmark of the communication policy, as evidenced by Fed Chair Powell’s testimony, by Treasury Secretary Mnuchin’s comments at Davos, and by the daily commentary from the White House. And markets are having a tantrum because they seem to be losing the control they feel that they had. And in reality, they did have control. Thus the taper tantrum in 2013 was met with the Fed bending over backwards to deny that they would ever stop QE, and the entire concept of the Fed put is based on the idea that if policy changes aren’t met with market approval, a sell-off will result in a change in those policies. But as I have said before, the stock market is not the economy, and despite the fact that President Trump has been bragging about the stock market’s rally, he will drop that discussion in a heartbeat if he has something else to say. I assure you that if this is a negotiating tactic and Canada and Mexico cave on current outstanding issues in NAFTA, that will be the entire discussion, regardless of where equity prices go. I think the rest of the world is having trouble digesting this change as well, as circumspection in announcements has been the norm. It will become ever harder for Draghi or Carney or Merkel or any foreign leader to remain subtle in the face of straightforward comments from the US. Maybe that’s not such a bad thing!

Anyway, we are getting to watch a remarkable turn of events in communication, and I would look for market volatility to continue to rise accordingly. So what is in store for today? As another Nor’Easter bears down on NY, we get our first hint at the payroll data with ADP Payroll (exp 205K) and then Trade Data (-$55.1B). A little later comes Nonfarm Productivity (-0.1%) and Unit Labor Costs (+2.2%) and finally the Fed’s Beige book is released at 2:00. We also hear from Bill Dudley again, as well as Atlanta’s Raphael Bostic. One of the interesting things from yesterday was Governor Lael Brainerd, seen as one of the most dovish Fed members, turned quite bullish on the economy and seemingly hawkish in comments she made. She used the term headwinds turning into tailwinds just like we heard from Chair Powell at his testimony. I remain convinced that the Fed hikes four times this year. I remain convinced that the ECB remains far more dovish than currently anticipated, and I remain convinced that the dollar will end the year higher. For today, I like a modestly firmer dollar by the close.

Good luck
Adf

Apparently tariffs are not
The problem that people had thought
With nary a worry
Investors still scurry
To buy all the stocks that are hot

The dollar, however, ignored
The rally and looked rather bored
But later this week
We’ll hear Draghi speak
Then Friday’s employment’s explored

One has to be impressed with the speed with which tariffs went from ‘the worst thing ever’ to ‘no big deal’. If market activity at the end of last week was indeed due to the President’s announcement of tariffs on imported steel and aluminum, and that certainly seemed to be the case, then yesterday was all about the blowback that followed that announcement, not only from the nations directly impacted, but from the GOP congressional delegation as well as numerous major US companies. At this point, there is no way to know whether these tariffs are going to ultimately be emplaced or not, but the market has clearly decided that the answer is not. What that does is set us up for further volatility if they actually do come about.

But away from the tariff discussion, there was not much else of note to drive markets. Yesterday’s ISM Non-Manufacturing data showed continued strength in the US economy, printing at 59.5, slightly below the previous month but above expectations. However, in the current market, at least in the current FX market, data of that sort has limited impact. Rather, traders went back to their continuing bias for a weak dollar, and while yesterday saw little movement in the buck, since Europe opened this morning, we have seen it pressured lower. In fact, the euro has rallied in the past hour by 0.5%, although the only data released was third tier in nature. We have seen a similar rally in GBP, and there was no data on which to base the move. Even more impressively, AUD is higher by 0.7% in that time span. Now last night, the RBA left rates on hold at 1.5%, which was universally expected, and when looking at interest rate differentials, US 10-year yields are actually higher than those in Australia. The last time this was the case was in 2001, and AUD was trading below $0.50, as opposed to today’s levels around $0.78. Obviously, there were many other different things ongoing then, but it is an interesting point to be made. However, the market movement has been just in the past hour, long past the time of the RBA decision.

Interestingly, the yen has been lagging this move, but that is more likely because Kuroda-san was testifying for a second time at his confirmation hearings, and he walked back the discussion about ending QQE in 2019 when he expects inflation to achieve their 2.0% target. Now it was always silly to me that they could have such a precise forecast for something like inflation, especially given that over the past decade, the BOJ has proven it has no idea what drives the statistic. So the idea that they would change policy instantaneously at a time twelve months from now because of their inflation forecast was always unlikely. After all, they have been saying for the past five years that they would achieve their target within the next twelve to twenty-four months, and yet here we are with CPI there below 1.0% five years on! At any rate, the yen lost some of its impetus from those comments and has lagged other currencies, strengthening only 0.1% today.

Away from the G10, we have seen a more mixed picture, although the dollar is predominantly weaker here as well. For example, ZAR has rallied 0.75% after a better than expected GDP outcome as investors continue to favor the new Ramaphosa administration. Similarly, KRW is higher by 0.6% after news that North Korea would be willing to explore talks with the US leading toward denuclearization hit the tapes. But in general, it seems there doesn’t need to be a specific catalyst today, we are seeing risk being embraced, as evidenced by equity market rallies around the world, and the dollar is suffering as well.

As to the session here today, the only data point is Factory Orders (exp -1.2%), which is not typically a market mover. In addition, we hear from three Fed speakers, Dudley, Brainerd and Kaplan, which means things are likely to sound slightly more dovish than not. But really, that’s all we’ve got today. The background picture remains one where US growth continues apace, and the biggest question is just how aggressive the FOMC is going to be this year. Starting tomorrow, we get much more market information with both an ECB and BOJ meeting on Thursday and payroll data on Friday. If we continue to see AHE push higher, like last month, you can be sure that the equity markets will have a shaky time as expectations of four Fed hikes this year grow further. But that is still a few days away. For today, the dollar is under pressure and likely to remain so.

Good luck
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