There once was a time when inflation
Was cursed like hellfire and damnation
But these days it seems
Those were but bad dreams
Now central banks seek its creation

So this week the data has shown
That clearly their efforts have sewn
The seeds they desire
As prices catch fire
Soon high prices they will disown

Remember way back on Wednesday, when markets appeared to be concerned about rising inflation as a harbinger for higher rates and increased volatility which would cause the unwinding of so many trading strategies? Yeah, that was so 48-hours ago it’s not funny. Between then and now we have seen US CPI print much higher than expected, US PPI print higher than expected and the price indices for both the Philly Fed and Empire Manufacturing gauges rise to their highest levels in six years. And what has been the market response to this uptick in price pressures? It’s not even a collective yawn, but rather an aggressive embrasure of the data. Apparently any concerns that the Fed will become more aggressive in their policy tightening have completely disappeared. And my read is not that traders are dismissing the fact that tighter policy will occur, it’s that nobody seems to care anymore. After a very rocky week last week, the equity market has recouped 75% of those losses. While Treasury yields have touched their highest point (2.942%) since January 2014, it seems that higher yields are no longer seen as a concern regarding equities. And of course, yesterday I highlighted that higher yields were no longer seen as a benefit for the dollar, so it appears that the ‘narrative’ continues to be, whatever you do, make sure that you buy stocks and sell the dollar. And that is exactly what we are seeing in markets these days and I suppose for the foreseeable future. At some point, I’m pretty sure views will adjust to the negative realities that come along higher inflation, but right now, you have to go with the flow.

I don’t think there is anything else for me to say on that subject, so let’s take a look at the FX markets a bit more closely. Broadly, the dollar remains under pressure, although the overnight session has been fairly dull. In G10 space, the biggest mover has been the pound, which fell 0.4% after much weaker than expected Retail Sales data (actual 0.1%, exp 0.5%) was released. That seems to be weighing slightly on the euro, which is down about 0.25%, but in fairness, both of them were quite strong yesterday, so this seems to be a bit of position unwinding ahead of the weekend. The one constant in the space has been JPY, which continues to strengthen, and is now barely able to hold the 106 level. Last night we learned that Kuroda-san was reappointed as Governor of the BOJ, and the two Deputy Governors appointed are also strongly in the reflationist camp, so for the time being, it doesn’t seem like the BOJ is going to move away from its aggressive QQE policy. Interestingly, economists and traders continue to believe that they will be forced to do so as the BOJ balance sheet has already grown to be the same size as the Japanese economy, (for a comparison, the Fed balance sheet remains at about 22% of the US economy’s size) and there is a growing belief they will not be able to safely expand it any further. Of course, a couple of days ago there was a growing belief that quickly rising inflation in the US was going to be an issue for markets, and we can see how that was mistaken. I have a feeling that Kuroda and company will not be changing policy anytime soon, but that it won’t matter very much. I still see the yen strengthening from here despite the BOJ’s best efforts.

Turning to the emerging markets, South Africa continues to be in the spotlight, as President Zuma finally resigned and President Ramaphosa was sworn in. The rand, which has been the best performing currency for three months, actually sold off slightly, 0.4%, in what is clearly a profit-taking exercise. I expect that if Ramaphosa lives up to half of expectations, the rand has further to climb. Elsewhere, while MXN has barely moved overnight, it is worth pointing out that the current polls for this summer’s Presidential elections point to Andres Manuel Lopez Obrador (AMLO) well in the lead. Given that he is a leftist firebrand, talking about renationalization of energy assets, it is surprising that there is not more concern in evidence about an AMLO victory. But there has been no reaction and surveys of business leaders dismiss his chances despite the polls. I certainly have no idea whether or not he will win the election, but it seems to me that there is at least a fair probability that will be the case, and my impression is the market is not prepared for that outcome. As the election draws nearer, if he retains his lead in the polls, look for the peso to feel some pain.

As we wrap up the week, we have a bit more data to absorb, but this doesn’t seem like market moving stuff. We start with Housing Starts (exp 1.232M) and Building Permits (1.3M) at 8:30 alongside the final Inflation gauges, Import and Export prices (exp 0.6% and 0.3% respectively). Finally, at 10:00 is Michigan Sentiment (95.5). Given the lack of concern shown by markets over the data earlier this week, I can’t imagine today’s data will matter very much. And so, as we head into the weekend, it appears that the trends this week will remain intact, thus look for the dollar to remain under pressure, bonds as well, and the stock market to continue rebounding from the correction last week.

Good luck and good weekend
Adf

No nuance is needed to show
Price pressures are starting to grow
And as an aside
Poor Goldilocks died
For shareholders, look out below!

In the wake of yesterday’s surprisingly high CPI print, on both the headline and core measures, the immediate impact was equity futures sold off sharply. This made sense given the heightened concerns that the market has been showing with regard to inflation ever since the AHE number surprised on the high side two weeks ago. So the CPI was now the second piece of important inflation data that was pointing to the Fed being forced to raise rates faster than they currently assume (3x in 2018) and much faster than the market is currently pricing (~2x in 2018). In fact, a Bloomberg survey of economists now points to the median expectation of Fed rate hikes this year having moved up to four while the Fed Funds futures market has moved up to a 25% probability of a fourth rate hike this year.

However, by yesterdays close
The market, its fear did transpose
As rates keep on rising
It’s now emphasizing
How fast the economy grows

It seems, however, that the bulls will not be denied. By the time the equity markets closed yesterday afternoon, stock prices were up ~1%, the dollar had resumed its decline and commodity prices were rising; all while Treasury prices continued to fall. There seems to be a pretty big disconnect between the way asset markets are trading and the increasing probability that global QE is going to disappear sooner than expected. My friend Mike Ashton (follow him on Twitter at @inflation_guy), who really does seem to know everything about inflation, makes the point that because of the comparisons over the next six months, Core CPI is likely to be up to 2.5% or even higher come late summer. If that is the case, and it certainly seems reasonable based on the data, ask yourself how relaxed the FOMC will be about that gradual pace of rate increases. My view is that even the doves will be forced to admit that rates need to move higher if the data begins to show the Fed is truly behind the curve. And so, I continue to look at the current broad market price action and scratch my head. A perfect example is that the correlation between the yield on 2-year Treasuries and the dollar, which historically has run above 60%, has fallen to 23%. That is emblematic of the change in views we have seen. It is also ripe for a return to historical values as more stress builds in the market. After all, equity markets that have been built on unlimited free liquidity cannot sustain the same levels when liquidity shrinks and is no longer free. Last week was, I believe, just a taste of what we will see during the rest of the year.

But for now, the market continues to whistle past that graveyard and the narrative remains, gradual rate rises will not impact the synchronous global growth story, earnings will continue to be amazing, and equity prices, alongside commodity prices, will continue to rise.

And the dollar? Boy they hate the dollar. In fairness, there is a clear negative fundamental, the growing twin deficits (budget and current account), which ought to undermine the dollar’s value. And of course, given the recent breakdown in the correlation with interest rates, there is nothing to offset that right now. With this in mind, it is no surprise that the dollar remains under pressure and has fallen further overnight. Can it continue? My view remains that the dollar will find its footing as the year progresses, but right now that is a distinct minority position.

So let’s take a look at the overnight activity in FX. As mentioned, the dollar is down across the board. In the G10 space, the biggest gainer has been the pound, up 0.5% and back over 1.40, although the Swiss franc has had almost the same magnitude movement. Interestingly, there has been no specific news in either one, or comments from officials that would seem to drive things. In fact, the only comment of note overnight was from Japanese FinMin, Taro Aso, who said that recent yen movement has not been severe enough to consider intervention. Not surprisingly, the yen is firmer by 0.3% and is actually now at its strongest vs. the dollar in more than a year.

Moving to emerging markets, we have seen strength across the board here as well, with ZAR continuing to benefit from President Zuma’s finally having resigned, and the APAC bloc virtually all stronger vs. the dollar as they head into the Lunar New Year celebrations. Local equity markets have been rebounding from last week’s sell-off and it is clear that investors are actively buying those currencies to get back into the trade. With the holiday now upon us, I expect this bloc will see limited action for the next couple of days, but both EEMEA and LATAM are likely to continue to trade with the broad narrative. I’m not sure what will change this view, but I am increasingly confident that something will do so in the near future.

On the data front today, we have a bunch of stuff as follows: Initial Claims (exp 224K); Empire Mfg (17.2); Philly Fed (21.6); PPI (0.3%, 2.5% Y/Y); Capacity Utilization (78.0%); and IP (0.2%). Given the market response to yesterday’s data, I would think the only thing that can derail the bulls would be information that the economy is fading, so much weaker Empire or Philly data, or surprisingly weak IP. Of course, that would simply encourage the bulls to point to the lack of pressure for further rate hikes.

Chairman Powell has a challenging time ahead of him as the market seems almost to be daring him to raise rates more quickly than currently assessed. I have to say that we have not heard any concerns from the Fed that the recent increase in market volatility is an issue, and so my take is the Fed will pick up the pace as the data presents itself going forward, and that volatility will continue. And in the end, increased volatility equals risk-off equals a stronger dollar. It just may take a little more time to get there.

Good luck
Adf

The CPI data today
Could very well show us the way
The market will move
As things here improve
So strong data might cause dismay

It is remarkable to me that the CPI print today has garnered as much press as it has. For the past three decades, this attention has pretty much been entirely reserved for the payroll report. So perhaps this is a healthy turn of events, one signaling that investors are going to look more carefully at the entire economic data set rather than a single proxy. Of course, it’s early days to be making that claim, but one can be hopeful! At any rate, most markets have basically tread water for the past two sessions in anticipation of the print.

To reiterate, expectations are as follows: CPI (0.3%, 2.0% Y/Y) and CPI ex food & energy (0.2%, 1.7% Y/Y). One thing that is important to understand is that not all 0.3% rises are the same. While the release only has one decimal place showing, the actual calculation pushes to the second decimal place, so 0.26% and 0.34% both print at 0.3%. Street economists and analysts will be closely watching the more precise figure and markets will respond to that number. And there is one other thing to remember, CPI is an annual number, so it is comparing the current price index to last year’s data. If you recall, it was last February when the cell phone companies changed their pricing for unlimited data, which drove the March inflation number much lower. So starting next month, the comparisons are going to be with those lower numbers, therefore we are almost assured of higher numbers this year beginning in March. Of course, that says nothing about today. While I don’t know where this data is going to print, what seems quite likely is that any print on the high side of 0.3%, let alone a 0.4% print, will be seen as confirmation that the FOMC is going to pick up the pace of rate hikes, and is likely to see another wave of equity market turmoil.

Oh and there is one more thing about the Fed, a story this morning that the White House is considering Loretta Mester, currently Cleveland Fed president and one of the more hawkish members of the FOMC, for the role of Fed Vice-Chair. She is a well-respected economist, and if she becomes the highest-ranking economist on the Fed, I expect that the tone from the FOMC will turn even more hawkish. That, my friends, will have an immediate impact on markets if it is announced. In the end, what we are seeing is the ongoing dismantling of the ultra easy monetary policy of the past nine years. As that progresses, expect both equity and bond markets to underperform and volatility to head back toward more historic levels, which despite the past week’s activity, are still higher than currently seen.

How will the dollar fare through all this? For the past two sessions, it has clearly been under some pressure, albeit not excessively so. One interesting conundrum has been the yen, which is stronger again this morning by 0.4%. Despite the fact that equity markets have stabilized, and there are many calls that last week’s decline was overdone, a stronger yen has historically been a sign of removing risk. So the modestly higher equity prices this week don’t really fit with a much stronger yen. Now, it’s possible that FX traders were responding to the Japanese GDP data last night, which showed Q4 growth at a slower than expected 0.5% Y/Y. The Nikkei underperformed, falling 0.4%, but in a classic chicken and egg question, I’m not sure whether the weak data and Nikkei, in the guise of risk reduction, caused the yen to strengthen, or if the strong yen caused the Nikkei to weaken. What I do know is that there are more stories that PM Abe is set to reappoint Kuroda-san as BOJ Governor, which some take as proof that the BOJ is going to maintain its hyper aggressive monetary stance. But even he has questioned just how much more QQE (Japan’s terms for QE) can help the economy there. And there is one other thing to note. Japan’s population is actually shrinking, as well as aging rapidly. So any growth at all on a gross basis implies a much better rate of per capita growth. Quite frankly, I think Japan has been doing quite well, and I continue to expect the yen to strengthen further despite my views on the Fed. Par remains my year-end target.

Pivoting to Europe shows that Q4 GDP was released at the expected (0.6%, 2.7% Y/Y) level, with Germany and Italy coming in a bit weaker than expected, while the Netherlands, France and Spain all looked a bit better. However, given the overall pace of growth, traders continue to preach the narrative that the ECB is going to exit QE faster than Signor Draghi is willing to admit. While the euro is virtually unchanged overnight, it has been edging higher during the past week. Here, I continue to put more faith in the Fed to turn the tables and drive the dollar higher. Today will be a key input in that process I think.

In the emerging markets, once again South Africa remains the place with the most noise as the ANC voted to remove President Zuma, but he has not yet vacated the post. This vote, however, has been enough to encourage further active rand buying, and it is higher by another 1% this morning. The risk here is that given the delays in this transition, the economy remains under stress and there is no budget in place. Moody’s is on the cusp of downgrading South Africa to junk rating which would trigger a significant outflow by bond investors, and correspondingly, likely have a pretty negative impact on the rand. For those with hedging needs here, it is something to keep in mind.

Elsewhere in the EMG bloc, APAC currencies have been the best performers, following the yen higher with KRW higher by 0.65%, MYR by 0.5% and both INR and TWD by 0.3%. Overall, a strong performance ahead of a key US data point. But it appears that investors are getting set to shake off last week’s market action and dive back in to risk. Again, the conundrum is the yen showing strength while other markets seem to be embracing risk. One of these processes is going to change soon, so beware.

Alongside the CPI data we also get Retail Sales this morning (exp 0.3%, 0.5% ex autos) although with the focus on CPI, it will have to be a really big outlier to matter. There are no Fed speakers and no other news on the docket. With that in mind, it will be all about that CPI print. A strong number should lead to equity market declines alongside bond market declines and the dollar rallying. A weak number should see the opposite, and if it is right in line, I expect that we are likely to see a continued tentative rebound from last week’s price action.

Good luck
Adf

Economists shouting like Stentor*
Have put inflation front and center
Investors are edgy
And seeking a hedge-y
For new trades they’re now scared to enter

*Stentor – A mythic Greek herald whose voice was “as powerful as fifty voices of other men” according to Homer

You cannot read an article or listen to a commentator these days without the conversation turning toward inflation. With this in mind, let me recap the recent trajectory of that conversation. We all know that central banks have been (overly?) terrified of deflation ever since the Japanese economy was afflicted with it in the wake of their market crash back in the late 1980’s. Policy errors by the BOJ helped insure that prices couldn’t rise because they supported so many zombie-like companies and never allowed the requisite bankruptcies and losses that would have allowed the markets to clear. And don’t get me wrong; deflation can be difficult for central banks to address, certainly compared to inflation. At any rate, with the financial crisis of 2008-9, central banks, led by Benny the Beard, were hyper focused on deflation again and did all they could to prevent it from occurring. Hence, the creation of QE and ZIRP and NIRP. Of course, the problem with those policies was they didn’t directly address inflation as we know it, basically CPI, but rather served to inflate asset prices dramatically. This is how we had come to see both stock and bond markets at their most overvalued levels in history. And despite the impact those policies had on markets, central banks have all been singing from the same hymnal and doing everything they can think of to raise inflation. We have heard it from Yellen, Draghi, Kuroda, Carney, Poloz and every other central banker on the planet. Taken together, the lack of measured price inflation (and especially wage inflation) and the ongoing desires of central bankers to see it come about have been the keys to keeping monetary policy ultra accommodative.

Which brings us to the past few weeks. A look at price data more recently shows that there are finally signs that inflation is seeping into the economy. Clearly, the Fed has already begun to tighten policy, as has the BOE and BOC. The market narrative continues to expect the ECB to move in that direction and even though the BOJ denies any possibility of change soon, the market narrative has them starting to remove accommodation as well in the near future. But the market had been sanguine over the pace of this change, pricing a far flatter trajectory of rate rises than even the central banks themselves have been highlighting. So with this as a backgound (the shortest 30-year history you will ever read), we get to the US employment report a week and a half ago, where the Average Hourly Earnings data surprised sharply to the upside and printed at 2.9%. Suddenly, investors and traders figured out that perhaps things on the inflation front were moving more rapidly than they had been led to believe, and that the central banks would need to become more aggressive to fight inflation. With global growth synchronized and moving up, all the pieces were suddenly in place to allow central banks to roll back their extraordinary policies, and to do so more quickly than previously expected. You all know what happened to asset markets since then, and now the question is whether or not this was just a hiccup and long-overdue modest correction, or the beginning of something new, namely an unwinding of risk.

There are myriad arguments on both sides with the bulls pointing to the still strong economic growth and earnings data while the bears highlight the change in monetary policy as being sufficient to overwhelm that data. We shall see. But there is no question that the next chapter to the story will be Wednesday’s CPI print here. While the Fed targets PCE, which will be released at the end of the month, CPI remains the market perception of what inflation is all about. And so virtually every market commentary article, and this is no exception, has been focused on how that number will impact market sentiment, and by extension markets. It is a very simple equation, with a strong print, above 0.3% (1.9% Y/Y) having immediate negative consequences for both equities and bonds, and a weak number allowing the ‘buy the dip’ crowd to get back to business. Tomorrow should be fun.

But in the meantime, today is still ahead of us, and so we must look at what has been ongoing in FX markets so far. Broadly, the dollar is weak, significantly so against some currencies, as it appears market participants are ramping up their bets that the rest of the world will tighten faster than the Fed. Of course, if this is the case, you would expect equity markets to fall as well, and lo and behold, that has been the overnight price action, with APAC markets lower, EMEA markets lower and US futures pointing in the same direction. The most noteworthy data overnight was from the UK, where core CPI surprised on the high side (see a pattern here?) at 2.7%. This has served to encourage the rate hike story in the UK, with May now seen as a virtual certainty, and helped underpin the pound, which has rallied 0.5%. But the dollar’s decline is not really data based, I would argue, rather it is a sentimental move. Take a look at the yen, which despite no data or comments whatsoever, has rallied more than 1.0% overnight. This is more in line with a derisking rather than a rate story. As to the rest of the G10, the movement has been somewhat less aggressive than that of the pound, with modest strength in the 0.2% area the norm.

In the emerging markets, while the dollar is generally softer, the movement has also not been that significant. There is, however, one surprising outcome and that is the South African rand. A vote was taken by the ruling ANC party to remove President Zuma, something that the market has been clearly very keen to see, and something they have priced in as can be seen from the rand’s now 17% rally since mid-November. And the rand is firmer today by another 0.25%. BUT, President Zuma ignored the vote and did not step down! In fact, from what I have read he appears to be digging in his heels even deeper. I am no expert on the politics of South Africa, but one thing is certain, and that is that if Zuma somehow manages to remain in office for much longer, the rand is going to start to give up some of these gains. Markets and investors have already priced in a President Ramaphosa and are quite bullish on the idea. If that fails to come about, watch out!

But those are the only interesting currency stories of the day. Today’s only data point is the NFIB Small Business Optimism Index, which was just released at a slightly better than expected 106.9. This is a historically high level, and one that has indicated peak optimism in the past. We also here from Cleveland Fed President Mester this morning, but unless she is suddenly dovish, which I sincerely doubt, it will be difficult for her to change many opinions I think. So today will be another one where we follow the equity markets as we await tomorrow’s CPI data. If equity markets resume last week’s decline, I expect that the dollar will find support and likely rebound a bit. However, if the bulls regain the upper hand, then the dollar should suffer as well.

Good luck
Adf

There once was a banker named Jay
Who had a quite trying first day
A week has now passed
And he’s been steadfast
That rate hikes will see no delay

Investors, however, are sore
‘Cause most of the ten years before
Each time stocks would sink
The Fed Chair would blink
And open the taps even more

So what can we look for ahead?
Is this market bull really dead?
It’s still early days
But I think this phase
Has room to become more widespread

This morning’s market activity is far more subdued than what we saw last week, which is not that surprising. As I have written many times, periods of extreme volatility tend to be short-lived simply because traders don’t have the stamina to maintain the pace of activity. This is especially so these days since most traders have barely even seen this type of market movement and are uncertain how to respond. When all your trading models are predicated on markets rising forever, falling markets can be quite confusing.

Friday’s late day equity rally was quite interesting in both its timing and power. It appears that a research note from JPMorgan was released which essentially sounded the all-clear signal. The essence of the note was that they estimated the bulk of the risk-off selling had been completed, so no need to panic further. It is not often when somebody rings the proverbial bell and tells you the market has either topped or bottomed, but apparently, that is what we just saw. Personally, I remain skeptical that the volatility has ended and I make that case because a quick peek at the 10-year Treasury this morning, currently making new highs at 2.88%, highlights that the initial driver, rising yields in the US, are continuing on their merry way. Once again I will point out that we have had nine years of QE and extraordinary monetary policy and a nine-year equity and bond market rally (actually the bond market rally has been about thirty years). As monetary policy tightens, and there is no indication at this point that the Fed is changing their tune, those two rallies are certain to suffer. A one-week correction is not sufficient to offset a nine-year rally. I’m sorry, but there is more downside to come.

Turning our gaze to the FX market, the dollar is under very mild pressure this morning. While it is weaker against a majority of its major counterpart currencies, the magnitude of the decline is tiny, probably about 0.1% on average. In other words, I wouldn’t put much stock into stories describing the dollar’s decline as being significant. I find it interesting that the FX narrative revolves around tighter policy elsewhere in the world, hence the idea that the dollar has further to fall, but the equity narrative is that rising rates will have no impact on stock prices. This seems to be a conundrum given the historic relationship between interest rates and equity markets. In fact, the anomaly has been the fact that during a powerful equity market rally we saw declining yields, which is historically very rare. Normalization of monetary policy is very likely, in my view, to reinvigorate historical relationships. It is why I believe that Treasury yields will continue to rise; why I believe that the equity market will come under further pressure; and why I believe the dollar will find support. Until the Fed changes their current storyline of continuing to gradually raise rates and allow the balance sheet to shrink, we are going to be subject to ongoing downside activity and increased volatility. [A quick aside on this. The Fed is NOT selling any bonds in the market, although that has been widely reported. The change they have made has been that rather than take the proceeds of the bonds that are maturing in their portfolio and reinvesting them, thus buying more bonds; they are simply letting a portion of these maturities roll off without being replaced. These funds then disappear from the market in exactly the opposite manner as when the Fed ‘printed money’ from thin air and bought bonds. I assure you that if the Fed were actually selling bonds in the market, Treasury prices would already be much lower and so would stock prices!]

This week has a much more active data calendar but I think that all eyes will be on Wednesday’s CPI reading which, given the importance of the inflation debate, has the ability to be a market mover. Remember what happened with the AHE number two weeks ago. Here’s a listing of what is upcoming:

On the speaker front, only Cleveland’s Loretta Mester is on the schedule, and she is a known hawk, so unless she turns dovish, it is unlikely to have a major impact on markets.

For today, if the equity market picks up where Friday closed, and futures are pointing nicely higher right now, about 1%, then I expect the dollar will potentially edge a bit lower. However, if we experience the next wave of derisking, look for the dollar to find support.

Good luck
Adf

Most people just don’t understand
The reasons the flames have been fanned
For markets to fall
While growth doesn’t stall
And so, now relief, they demand

However, the Fed’s displayed phlegm
Amid the increasing mayhem
The moves must be bigger
If they are to trigger
Some comments, the fall to condemn

As we have seen all week, the equity markets remain the dominant discussion topic and continue to be the market driver. Arguably, the proximate cause of yesterday’s sharp decline was the lackluster 30-year treasury auction, which helped to extend the recent narrative of higher US rates undermining equity valuations and cause a repricing of risk. But at this point, with stocks closing yesterday down 10% from their recent peak, we are beginning to see an increasing amount of downward momentum in the stock market. That means that we may not need much in the way of continued bad market news to see this process continue. And it is important to remember that economic news is not necessarily market news. The stock market can continue to decline and we can see a significant uptick in volatility across all markets, while the economy performs well. In fact, I would contend that is a reasonably high probability outcome.

Consider the fact that one of the key drivers of all asset prices since the financial crisis has been the extraordinary monetary policies implemented by the major central banks around the world. The $15 trillion of liquidity that they created to purchase assets never found its way into the price of goods or services because it was too busy flowing into the price of assets. The result was the greatest simultaneous bull market in stocks and bonds ever seen. But now, as the central banks embark on the process of removing all that liquidity, it should be no surprise that asset prices are falling. In fact, it would be shocking if they didn’t. So perhaps, maybe it wasn’t only yesterday’s Treasury auction that caused problems, but also the comments from the BOE. If you recall, Governor Carney hinted at further rate hikes and the removal of accommodation from markets due to improving growth prospects and increasing price pressures. While the pound was the immediate beneficiary yesterday, it has since given back much of those gains as the bigger picture of asset price retreats overwhelms everything else. Markets remain very interconnected but more importantly, virtually all asset prices have been the beneficiaries of monetary policy for the past nine years. As that policy changes, all assets are going to be negatively impacted. And the one thing that will get those policies to change is strong GDP growth! So for the time being, we are likely to see good economic news lead to declining stock and bond markets around the world.

One other thing to remember is that I assure you the central banks will be looking at percentage movements, so the fact that the Dow has fallen more than 1000 points in two of the past four sessions is far less impressive given the level of the Dow. 4% declines are not life threatening. One-day declines of 8% or 10% are going to be required to increase central bank angst.

But on to FX. Actually, the biggest mover overnight has been the Norwegian Krone, falling more than 1.25% after data releases showed inflation pressures remain subdued despite ongoing growth. The market saw this and discounted the idea that the Norges bank would be tightening their policy any time soon, hence the NOK’s decline. The next biggest loser in the G10 space has been the pound, which despite yesterday’s BOE comments, has responded to a series of poor data. IP fell a more than expected -1.3% and the Trade Deficit grew dramatically to £4.9B (exp £2.4B). This has removed all of yesterday’s gains and then some. In fact, from the peak, it is lower by 1.7%, although from the close just 0.7%. At the end of the day, it remains difficult for me to foresee how Brexit is going to be a near-term positive for the currency, and I continue to believe that the BOE remains far more quiescent than the market expects. This idea has been bolstered by reports that PM May is encouraging her Brexit negotiators to remain firm on British commitments to free trade without sacrificing sovereignty. I don’t know how well that will end.

Pivoting to the emerging markets, ZAR has once again benefitted from the stories that President Zuma is going to be resigning soon, having rallied a further 0.5% this morning. The rest of EEMEA, though, has been far less interesting, with de minimis changes similar to the euro’s virtually unchanged stance. Interestingly, despite the ongoing rout in Chinese equity prices, CNY has actually strengthened overnight, gaining 0.4% and unwinding some of yesterday’s losses. This could be funds coming home to cover equity losses, or potentially funds coming home ahead of the Chinese New Year. Keep in mind that markets there will be closed for most of the next two weeks. I continue to believe the CNY will fall throughout this year, but thus far, I am on the wrong side of that trade.

There is no US data today nor any scheduled Fed speakers. The one consistent thing we have heard from the Fed has been that the recent equity market movement has been “healthy” and the magnitude, given how far we’ve come, has been “small potatoes”. One thing Dudley did say was that if the market fell far enough, it would impact his personal view on the timing of policy changes, which means that the Fed put still exists. But I continue to believe it is still far out of the money. Equity futures are pointing slightly higher this morning, but I see no reason for the downward momentum there to wane. I like the dollar to continue to hold its own overall amid another down day in the stock market.

Good luck and good weekend
Adf

For those in the stock market’s grip
A common plan was ‘buy the dip’
But for the past week
Which has been quite bleak
It’s lost some of its sponsorship

A sample of markets exposes
That China’s been no bed of roses
The yuan, late last night,
Caused many a fright
As that bubble now decomposes

The dollar is broadly stronger this morning as markets remains far more volatile than we had gotten used to over the past several years. Equity markets remain quite uncertain, as evidenced by yesterday’s 500 point range in the Dow. Consider this, the VIX index, which is a measure of S&P 500 volatility, had been trading around 10% prior to the recent activity. Meanwhile, a 2% daily move in the underlying market represents annualized volatility of ~32%. It should be no surprise that the short volatility trades are under pressure here, given what has actually occurred of late. If your position basis is 10%, then a 32% outcome is quite painful. Nowhere is that more evident than in China, where the Shanghai Composite has fallen more than 4% in the past week, and started to raise some red flags. Of direct interest to us is the Chinese yuan, which fell nearly 1.0% last night, its largest one-day loss since the PBOC devalued the currency in 2015. It seems that the combination of local stock market declines, weaker than expected trade data (Imports jumping 36.9% and the Trade Balance falling to a $20.3B surplus from $54.7B last month) and the approaching Chinese New Year (which has raised concerns over liquidity) has conspired to undermine some of the currencies recent gains. The cynic in me wonders whether the much reduced Trade Surplus is real or simply a more acceptable political outcome given the current angst between the US and China on the subject. But the market response to the data should be no surprise. Will the renminbi continue to fall? My view is that over time, that will be the case, but that is in the context of my view the dollar will continue to rally as the year progresses.

Elsewhere, however, the dollar’s rise overnight has, thus far, been far less robust, averaging something on the order of 0.3%. German trade data, which was essentially the only notable release, was right in line with expectations. As well, there have been no comments from ECB members, so the euro’s continuing slide is really a dollar rally. This is also in evidence vs. the yen, which has fallen despite the reduction in risk appetite that has become evident around the world. In other words, the dollar seems to be benefitting from other issues.

Arguably, the news about a budget agreement in the Senate is one of the key stories. If the House follows through, this will remove the prospect of a government shutdown as well as talk about the debt ceiling. When the headline hit yesterday afternoon, the euro fell almost 90 pips within minutes and has continued slowly lower since. But something else underpinning the dollar is likely US interest rates. Yesterday’s 10-year auction was lackluster and the yield has risen back to 2.84%, essentially its level Monday morning, before the real equity market fireworks went off. Nothing has changed my view that 10-year yields have further to climb, that inflation remains a growing problem and that the Fed is going to respond accordingly. It was heartening to hear yesterday’s Fed speakers Dudley and Kaplan both ignore the recent stock market gyrations with regard to their views on future rate hikes. It appears that the Fed’s reaction function toward equity market declines has been somewhat reduced, or in other words, the Fed put is much further out of the money than it has been in the past. What this means is that a further equity market corrections (which I believe is coming) will not be met with any change in rhetoric, let alone action, unless it becomes a real rout, something like a 25% or greater decline. And so, I continue to look for the dollar to benefit from this set of circumstances.

The last thing of note is the BOE, which has just released its statement, along with its updated growth and inflation forecasts. Ahead of the release, the pound was essentially unchanged on the day, but the remarkably hawkish sentiment put forth by the MPC inspired a nearly 1% gap higher with the pound touching 1.40 again. The essence of the statement was that growth was picking up in the UK, albeit at a somewhat slower level than the rest of the world. However, slack in the economy was shrinking and they explicitly said that rates would likely rise faster than had been expected in November when they last updated their forecast. Market expectations are growing for a 25bp rate hike at the May meeting, although I remain concerned that the ongoing Brexit story will prevent that action. However, for now, that is the scoop and the pound should benefit in the short term.

One other thing to take away from this is that a more aggressive BOE simply adds to the story of central banks taking away the proverbial punch bowl. The point is that asset valuations that have been so reliant on excess liquidity are going to find themselves with some ‘splaining to do when that liquidity dries up. In fact, this is the key reason I believe that recent equity market price action is just the beginning of the correction, and that dip buyers are going to need to be more discriminating in the near term.

As to the rest of the day, the only data here is Initial Claims (exp 232K) and we hear from two more Fed speakers, Philly’s Harker, and the uber-dove, Minneapolis’ Kashkari. There is also a 30-year Treasury auction, which if it disappoints is likely to add further downward pressure across the curve. In the end, I think the dollar will hold its own, and very likely edge higher from here.

Good luck
Adf

There once was a market condition
Where stock prices were on a mission
To rise ever higher
Like they were on fire
And bears were accused of sedition

Since Friday, however, we’ve learned
That thesis has been overturned
The question at hand
Will stocks now crash land?
Is one where no jury’s adjourned

I know this note is technically about FX markets, but sometimes other areas are the obvious drivers and so must be addressed. And clearly, all eyes remain on the equity markets right now, which means we can’t escape them when considering the dollar. With that as a prelude, yesterday saw another extremely volatile US equity session, with a substantially lower open and then a sharp rebound that resulted in stock prices here higher by more than 2% at the end of the day. As I had suggested yesterday, however, two of the short volatility contracts that had been among the most popular trading strategies for the past two years have now disintegrated after their values fell by more than 80%. Overnight, equity markets had a more mixed response, with not every market following the price action here. For instance, while Japanese stocks eked out a small gain, virtually every APAC market fell further led by China’s nearly 2% decline. Europe is faring a bit better, with most markets higher there, but the gains are modest, averaging around 0.5%, and hardly enough to offset recent declines. And as I type, US equity futures are pointing to another lower opening, something on the order of 1% right now. I highlight this because it is important to understand that markets have not yet found a new equilibrium. In fact, I would be surprised if we go back to that slow steady appreciation of prices any time soon. After all, if central bank behavior is changing, and clearly it is, then the rationale for constantly higher stock prices has likely ended as well. Rather, individual companies will need to demonstrate they are worth the investment, and I assure you, some won’t be able to do so.

So what does this have to do with FX? Well, it means that the FX markets are likely to be shaken out of their doldrums as well. At this point, it is quite clear that my view of dollar strength is in the tiny minority of global analysts. In fact, I read this morning that given the dollar’s early weakness this year, nearly two dozen of those analysts have raised their year-end target price for the euro, with the median expectation now 1.25, up from 1.22 just a month ago. I also know that long euro positions are near record levels on futures exchanges, which implies that the market is massively short dollars. Let me say that I feel much better about my dollar view when taking this new information into account. The combination of a higher volatility environment and an extreme short dollar position seems to me to be a perfect situation for the dollar to turn around and rally. One thing I have learned over the years is that the market is expert at finding the ‘pain trade’, which is defined as the one that will cause the most players the most losses. We saw that recently in the short volatility trade in stocks and I expect we will see it in the dollar as well. And to that end, the dollar, this morning, is higher vs. most of its counterparts.

In the G10, only the yen has outperformed the dollar overnight in what is clearly an ongoing risk-off sentiment. The worst performer in this space has been the pound, which has fallen back below 1.39 and is down nearly 3% in the past week. I have been particularly bearish on the pound relative to the Street and continue to be so. Its recent woes can be attributed to the weaker than expected Halifax Housing Price data (-0.6%, exp +0.2%) released this morning, as well as Monday’s much weaker than expected Services PMI data. But on top of the data has been the ongoing debacle of the Brexit process, where PM May continues to be unable to find a coherent voice with which to negotiate. I maintained early on, and continue to believe, that there will be no transitional deal, that the UK will simply exit the EU and its customs union next March, and that the idea that the BOE is going to raise rates ahead of this occurrence is daft. As it becomes clearer that there is no plan, the BOE will find itself completely unable to address what will almost certainly be rising inflation. The pound has further to fall.

As to the euro, the only notable data this morning was a widely expected decline in German IP in December, but given the volatility of that data, it doesn’t really take the shine off the economy there. The other German news of note was that Chancellor Merkel has reached a tentative deal with the center-left SPD to form a governing coalition, although that deal has yet to be approved by the SPD membership. I am confident it will be approved, but also expect that German leadership in the Eurozone is likely to be somewhat lacking going forward. I understand the hawks on the ECB have become more vocal, and that is certainly why the euro has performed well so far this year, but I continue to look for the Fed to be more aggressive than currently expected and the ECB to be less so, and the dollar to benefit accordingly. This morning’s 0.3% decline in the euro just means the euro has given back about 1.5% since its recent high at 1.2536. That is hardly enough to shake things up, and quite frankly, until we see the Fed actually acting in a more hawkish manner, the euro probably has a bit more upside. But come year-end, I remain confident in my view.

In the EMG bloc, the dollar’s performance has been more mixed. While EMEA currencies have all fallen vs. the dollar, following the euro lower, APAC saw a very different picture. In fact, the leader there has been CNY, which, after a 0.3% rise overnight, has appreciated 4% in the past month. In truth, this is an impressive performance, but one that I am not sure I can ascribe entirely to market forces. While it is possible that demand for renminbi is rising rapidly, it is also entirely possible that the central bank has pushed Chinese companies to repatriate funds in order to give the appearance of robust demand. As with all things China, it is always difficult to tell where the market impact is the driver as opposed to the government impact. But in fairness, most of the rest of APAC currencies also performed well overnight, with only INR falling after the RBI left rates on hold at 6.0%.

Turning to the day’s upcoming events, the only data point is Consumer Credit (exp $20.0B) and unlikely to move the needle. Of more importance is we have four Fed speakers; Kaplan, Dudley, Evans and Williams. Yesterday, Bullard maintained a dovish view by explaining that just because wages were rising, it didn’t mean inflation would follow. Of course, given that has been the entire Fed argument for the past four years, that seems a pretty ironic statement. But I guess when arguing your book, you make whatever case you can. If pushed, I would expect that the equity market has a far less rosy finish today than it did yesterday, and I expect that the dollar will cede some of its overnight gains. Treasury yields rebounded from Monday’s lows, and I expect that this will continue to be the underlying driver of everything for now.

Good luck
Adf

The question, Has Goldilocks died?
Has recently been asked worldwide
If this is the case
Prepare for the pace
Of selling to be amplified

OMG! Well, yesterday was certainly an interesting one in the markets. And to think, all that digital ink was spilled over Friday’s much smaller decline! Here’s the deal folks, markets can fall, and they can fall a long way without any obvious catalyst.

Remember Goldilocks and her economy? You know, strong global growth without inflation would allow central banks to continue to leave rates at rock bottom levels thus fostering further economic growth, spectacular earnings and a never-ending bull market in both stocks and bonds. Yeah, well not so much after all. She was always most likely to be slain by inflation and once again I will point to Friday’s AHE number as the sign that markets are getting a bit more nervous over future inflation readings. But when markets get going like this, they decouple from the underlying story and become the story themselves. That is classic market behavior and I see no reason for it to change now.

Funnily enough, I do think this time is different, just not different in a good way. This is because over the past three to five years, there has been a significant increase in the number of algorithmic strategies and the amount invested in them. As well, the idea that the retail investor was actively trading implied volatility movement is another true difference from previous bouts of market disruption. And the upshot is that all of those, and other, systematic strategies that have been instrumental in leading the great bull market higher are very likely to be what leads the market lower now that it has turned when it turns. The hallmarks of this type of behavior were seen just after 3:00pm yesterday, when the decline accelerated sharply and the Dow fell an additional 2.1% in just minutes before rebounding slightly into the close. That was very clearly machine algorithms being triggered by some signal like a moving average or a relative strength indicator or something else, and responding exactly as programmed. The thing is, this type of market behavior can be self-reinforcing, and so several more days of sell-offs is quite realistic. Being different in this case is a distinct negative. The magnitude of the ramifications of those strategies being unwound is hard to determine, although the direction is easy.

A moment about the volatility trading I mentioned above. Let me explain that trading volatility is extremely difficult. I spent some fifteen years trading and running options businesses and I know from whence I speak. In order to be effective, one needs to be deeply involved in the underlying market, which for me was mostly FX but also commodities and government bonds, as well as in the day-to-day activity in the options market. Understanding how the second derivatives impacted positions and profitability was critical to any level of success. The point is, the popular strategy of buying the XIV or SXVY (short volatility ETN’s) and leaving them in your account was never going to be a long run success. It appears that both of those ETN’s may actually disappear today, which means that despite closing at 99.00 yesterday, the XIV could actually be delisted today as its value approaches 0.00! I have not read the prospectus so am not certain that will be the case, but if you were counting on gains in that security as part of your portfolio, things just got a lot worse.

Back to the market. So we know that stocks fell sharply, and in what cannot be a great surprise, Treasury prices rallied alongside the dollar. That whole risk-off, flight to safety concept remains a fundamental part of the market, and as risk was being jettisoned yesterday, the true safe havens were highly sought after. So, 10-year Treasuries saw prices rise 1-½ points and the yield fall 15bps. The dollar rallied vs. most of its counterparts with only the yen, also a traditional haven currency, rallying further. On the flip side, aside from equity market declines, we saw commodity prices fall sharply too. And I would be remiss if I did not mention that Bitcoin, the erstwhile digital gold, fell sharply as well, on the order of 15%. Meanwhile, gold, as a traditional haven, rallied slightly, about 0.5%, showing that when it comes to a store of value, the barbarous relic has it all over the digital variety.

In this market environment, there is no room for a story about a particular currency or country. We continue in the midst of a significant readjustment and quite frankly, I believe there are only two things that can change this. The first is if we get central bank reaction such that the market believes that QE is not going to end. If, for example, the Fed halted its balance sheet roll-off, or Jens Weidmann started talking about the benefits of further QE, the decline would stop in its tracks. But I think we are a long way from that happening. The other thing is time. Essentially, sharp movements in the market tend to peter out not so much because anything has changed, but because time has passed and positions have finally been adjusted. That however, portends further pain for risk asset holders to come.

One last thing on bonds. It is somewhat ironic that Treasury prices rallied so far given that much of the blame for the equity market’s undoing can be laid at the feet of the fact that Treasury prices were falling so rapidly. Of course, the decline was based on changes in inflation expectations, while the rally was pure risk-off behavior. The thing is, if equity prices continue to fall, I expect that Treasuries will continue to rally. But when we finally settle down, inflation continues to be on an upward trajectory and Treasury prices are very likely to give back all these gains and then some.

Looking at today’s activity, we do get the Trade Balance (exp -$52.0B) and we hear from St Louis Fed President, and uber-dove, James Bullard just before 9:00. However, if Bullard is dovish, that is not news. On the other hand, if KC President Esther George is dovish when she speaks Thursday evening, the market would immediately take notice. Certainly equity markets are going to open lower again this morning. My guess is they maintain those losses at the end of the day, although in intra-day rally is likely as well. As to the dollar, if panic resumes, look for it to gain further. This is a risk situation, not an economic one for the time being.

Good luck
Adf

The bulls are all starting to fret
As rallies in stocks and bonds get
Their first taste of trouble
Were they in a bubble?
Perhaps, but we don’t know quite yet

Thus pundits all over are saying
Last week, while it was quite dismaying
Is likely to be
A hiccup, you’ll see
Meanwhile, everyone is out praying

If there is one notable thing from the press this weekend and this morning it is that almost universally, reactions to last week’s asset price declines have been, ‘don’t worry, it’s nothing.’ Now I will be the first to say that just because stocks fell 2.5% on Friday is not a sufficient signal that the end of the bull run is nigh. However, I do think it is important to remember what seemed to be the trigger of the move, and why the potential exists for further declines. And given the extremely high correlations amongst asset classes these days, declines in one asset are likely to lead to declines in all assets!

As I’m sure you recall, last week was a rocky one for asset prices before we got to Friday. While stock prices seemed to be stabilizing on Wednesday and Thursday after a rough beginning of the week, Treasury prices never slowed in their descent. Ironically, it was the AHE number on Friday, showing a 2.9% annual rise in earnings in January, that seemed to be the catalyst for the much sharper fall in Treasury prices and the collapse in stock prices. This is ironic because for the past five years at least, the Fed has lamented that wage gains have lagged so badly and they were working hard to push those wages higher. And yet, as soon as there was any inkling that they may finally be having some success in their endeavors, investors turned tail. The point is, if you needed proof that the key driver behind the asset market rallies of the past eight years was the extraordinary monetary policies of the central banks, then here it is. The chain of thought is that if inflation is finally starting to pick up, especially if it is picking up faster than expected, the central bank community will collectively stop adding liquidity to the system, and will in fact, withdraw some of the excess liquidity that already exists. Without that excess liquidity floating around, investments are going to have to stand on their merits. And that is a much tougher thing for anyone or anything to do!

Now it is entirely possible that we have already seen the worst of what is coming, and the idea that global growth will continue apace means that equity prices should never fall again, but I have to say that there are some ominous signals. First, the FOMC statement was clearly a bit more hawkish than anticipated, which implies that the Fed is ready to respond to rising inflation. Second is that in terms of experience on the Fed, in 2018 there will only be two voters, Powell and Brainerd, who have a history of voting for the past twelve months. This matters because so much of the recent financial market experience has been a complex dance between the Fed and investors/traders, with the communication strategy a critical aspect. However, now we have a Fed with extremely limited experience in terms of that communications dance, and so more likely to make a statement that doesn’t fit the meme. (Consider the Mnuchin weak-dollar comments from two weeks ago and the uproar they caused not only in the FX market but in the central bank community as well.) The point is that the perception of a policy error has grown dramatically. Finally, given the way inflation is calculated, the idiosyncrasies that drove it lower last year (remember unlimited cell-phone data plans?) are going to fade from the data, which means that the base effects are going to allow for higher readings going forward. Now, there is a large contingent of (Keynesian) economists who have started arguing to allow inflation to run hotter than the 2% target as they want to delay the Fed from raising rates further. However, one of the key things to remember about Chairman Powell is that he is not an economist, which means he is not necessarily Keynesian in his views. In fact, as a former banker, he is likely well aware of the damage that inflation does to the economy. My read is there is every chance he leans more hawkish than Yellen ever did, and that the consequence will be more declines in asset prices. Certainly, if inflation continues to tick higher, the back end of the yield curve will continue to steepen regardless of what the Fed does.

Now tying it all to the dollar is simple. The changing rate structure in the US is going to ultimately be seen as an attractive place to park funds. While the dollar could well show some further weakness in the near term, I continue to see it benefitting by the end of the year. The bigger risk, in my mind, is that the asset price decline gains serious traction and stocks fall 20% in the next month or two, at which point a general risk-off sentiment will be taking hold and the dollar should benefit sooner.

Now that I’m finished with last week, the week ahead seems much less interesting on its face. Overnight, the dollar has had a mixed performance with no significant movers in either direction. We did see Services PMI data from the UK (weaker than expected at 53.0), which pushed the pound a bit lower as well as from the Eurozone (stronger than expected at 58.0), which was unable to move the euro at all. It seems to me that the FX market is looking to the US equity markets for its cues right now, and while futures are pointing lower, the losses aren’t that large, hence the dollar’s indecision.

As to data this week, it is a pretty light calendar overall as follows:

We do hear from seven Fed members this week, ranging across the spectrum from doves to hawks. It will be interesting to see if Friday’s data has moved the needle a bit further to the hawkish side and if they are going to start leading the market in that direction. We shall see. Overall, I feel like the dollar will remain rangebound this week as there are too many conflicting issues to allow significant movement in either direction. So for now, keep an eye on Treasuries and stocks, they will be key to everything.

Good luck
Adf