Weakness is Fleeting

Posted on August 7, 2023 by fxpoet

Two narratives are now competing
Recession, the first, is retreating
No-landing is rising
As those analyzing
The data claim weakness is fleeting

But what of the curse of inflation
Which for two years has gripped the nation
Is it really past
Or are we too fast
To follow that interpretation?

Friday’s employment data was, for a second consecutive month, a bit lower than the median forecast of economists. However, it was still reasonable at 187K new jobs. One of the positive aspects was the decline in the Unemployment Rate to 3.5% although from an inflation perspective, Average Hourly Earnings (AHE) rose more than forecast. In a way, there was something for everyone in the report with the recessionistas highlighting the decline in average weekly hours and the fact that last month’s data was revised down for the 6^th consecutive month, typically a very negative signal. However, the no-landing crowd points to the AHE data as well as the Unemployment Rate and claim all is well.

Of course, ultimately, the opinion that matters the most is that of Chairman Powell and his acolytes at the Fed. Are they glass half full or glass half empty folks? I have been highlighting the importance of the NFP data as I believe it remains the fig leaf necessary for the Fed to continue to raise interest rates if they want to in their ongoing efforts to rein inflation back to their target level. My sense is that Friday’s data will not dissuade them from hiking rates in September if they decide it is still appropriate, but it could also be argued as a reason for another pause. Certainly, there is nothing about the data that would indicate a rate cut is on the table anytime soon. And remember, we will see the August report shortly after Labor Day, which comes before the next FOMC meeting, so still plenty of information yet to come.

Which brings us to this week’s numbers on Thursday and Friday when CPI and PPI are set to be released respectively. While we all understand that the Fed’s models use core PCE as their key inflation input, we also know that CPI, especially core -ex housing, has been a recent focus for Powell and that is the number that gets the press. You may recall that last month, the headline CPI number printed at 3.0%, it’s lowest since early 2021, and was widely touted as proof positive that the Fed was close to achieving their objective. Alas, energy prices have done nothing but rise in the ensuing month and given the ongoing reductions in production by OPEC+, it seems unlikely that we are done with this move. In fact, ironically for the no-landing crowd, if there is no landing and supply continues to shrink, energy prices, both oil and gasoline, will likely continue to rise as well, putting significant upward pressure on headline CPI. If CPI is rising it will be extremely difficult for Powell to consider anything but more rate hikes.

Currently, the market is pricing a very low probability of a September rate hike by the Fed, just 16%, so there is ample room for repricing if the data comes in hot. Surprisingly, the market is pricing in a higher probability of an ECB hike, 38% in September, despite the fact that Madame Lagarde essentially told us at the last meeting they were done. My suspicion is that there is room for a more negative outcome in the interest rate space going forward. One other tidbit this morning is the Cleveland Fed has an CPI Nowcast, similar to the Atlanta Fed’s GDPNow but for inflation, and that number is currently 0.41% for July, well above the market median forecast of 0.2%. The point is there is room for a negative inflation surprise and the knock-on effects of such a result would likely be risk negative. Just sayin’.

Meanwhile, Friday’s equity market reversal in the US has mostly been followed around the world with red the dominant color on screens in the major markets. In Asia, while the Nikkei managed to eke out a small gain, China and South Korea both saw renewed selling. As to Europe, all markets are lower on the order of -0.25% to -0.5% at this hour (7:30). However, US futures are currently edging higher on what seems to be a reflexive bounce rather than a fundamental opinion.

Bond markets, though, are reversing much of Friday’s rally with 10-yr Treasury yields higher by 7bps this morning and most European sovereign yields up a similar amount. Friday saw a sharp rally on the headline NFP number which served to force the hand of many short sellers in the Treasury market. Recall, heading into the release, there was a growing consensus, especially after a particularly strong ADP Employment number, that the no-landing scenario was the most likely and that would mean higher yields for longer. In addition, the market was informed of the extra $1.9 trillion in Treasury issuance that was coming the rest of the year, with the bulk of that coming out the curve, rather than in the T-bills that have been the focus to date. It feels like the short-selling crowd is getting back on board and the weight on prices of excessive issuance and the Fed’s ongoing QT program means higher yields should be expected.

As to oil prices, while they are lower this morning by -0.7%, they remain well above $80//bbl and appear to be consolidating ahead of the next attempt to break above key technical resistance at $85/bbl. Absent a very severe recession, which has not yet shown up, it is hard to make the case for a large decline in this sector of the market. Metals markets are far more benign this morning with tiny gains and losses as traders continue to try to figure out if there is a recession coming.

Lastly, the dollar’s demise, which is touted on a weekly basis by pundits everywhere, will have to wait at least one more day as the greenback is stronger vs. essentially every one of its major counterparts. There is still a strong relationship between US Treasury yields and the dollar, and with higher yields, it is no surprise the dollar is higher. Consider, too, the fact that the market is pricing such a small probability of a Fed funds hike next month. If (when?) that pricing changes, I expect the dollar to benefit greatly.

On the data front, there is a bit more than CPI and PPI, but not much:

Today	Consumer Credit	$13.55B
Tuesday	NFIB Small Biz Optimism	90.5
	Trade Balance	-$65.0B
Thursday	Initial Claims	230K
	Continuing Claims	1710K
	CPI	0.2% (3.3% Y/Y)
	-ex food & energy	0.2% (4.8% Y/Y)
Friday	PPI	0.2% (0.7% Y/Y)
	-ex food & energy	0.2% (2.3% Y/Y)
	Michigan Sentiment	71.5

Source: Bloomberg

In addition to the data, we have three Fed speakers, Bostic, Bowman and Harker, each speaking twice this week. Ultimately, my take is that Friday’s NFP data did nothing to change the current Fed calculus and higher for longer remains the operative thought process. As to the dollar, if we continue to see Treasury yields rise, which I think is the most likely scenario, then I suspect the dollar will find buyers. For those of you awaiting a sharp dollar pullback to establish hedges, you may be waiting quite a while.

Good luck

Adf

Demimonde

Posted on August 4, 2023 by fxpoet

There once was a government bond
About which investors were fond
Regardless of yield
Their safety appealed
But lately, they’ve turned demimonde

So, as we await Payroll data
Demand has just started to crate-a
As yield keeps on rising
More folks are downsizing
Positions today and not late-a

It’s Payrolls Day and market participants are all anxiously awaiting the news at 8:30. Recall, last month, for the first time in more than a year, the NFP number printed slightly lower than the median forecast and that was seen as proof positive that the soft landing was on its way. Subsequently, headline CPI fell to its lowest in two years as a confirmation of that process, and market participants decided, as one, that risk was the thing to own. Equities rallied, bond yields fell and there was joy around the ~~world~~ markets.

But lately, that story is having a rougher go of things as 10-year Treasury yields have jumped 43bps from their levels following the CPI release even though the PCE data was similarly soft. What gives? Arguably, part of this is because energy prices have rebounded sharply since last month, so it is increasingly clear that next week’s CPI data is going to higher than last month’s number. As well, the growing confidence in the soft-landing scenario, which is touted across mainstream media constantly, implies that rate cuts may not be necessary. After all, if Fed funds are at 5.5% and GDP is growing at 2.5% and Unemployment remains below 4.0%, why would the Fed change its policy rate? The answer is, they wouldn’t. At the same time, in the event the economy is clearly growing with positive future prospects, it is very likely that the yield curve will steepen back to a ‘normal’ shape with longer dated yields higher than short-dated yields. If the Fed is not going to cut, that means the back end of the curve must see yields rise. The current 2yr-10yr inversion is down to -74bps, so another 100bp rise in 10-year yields would seem realistic.

Of course, the question is, how would risk assets behave in that scenario? And the answer there is likely to be far less positive. After all, if risk free returns for 10 years were at 5+%, equities would need to offer a very good return opportunity to attract investors. While there will be some companies that offer that, I suspect there are many more that would be shunned and need to reprice substantially lower to become attractive. In other words, investors will want much lower entry prices to get involved and that could see a pretty big sell-off in the equity markets. Just one possible scenario, but one with a decent probability of occurring, I think.

But that is all future prognostication. In the meantime, let’s look at what the current consensus forecasts are for today:

Nonfarm Payrolls	200K
Private Payrolls	180K
Manufacturing Payrolls	5K
Unemployment Rate	3.6%
Average Hourly Earnings	0.3% (4.2% Y/Y)
Average Weekly Hours	34.4
Participation Rate	62.6%

Source: Bloomberg

Wednesday’s ADP number was much higher than expected at 324K although the prior blowout number, 497K in June, was revised lower by 42K. Still, 455K was much larger than the BLS report so there are many questions as to whether we will see a similar outcome today, a softer NFP number despite a very strong ADP number. Looking at other indicators, the Initial Claims data continues to improve, hovering around 225K. The JOLTS data was slightly softer than expected, but still right around 9.6 million and well above levels prior to the pandemic. And finally, if you look at the employment subsets of the ISM data, they were soft in manufacturing, but solid in services, and services is a much larger part of the economy.

My take is the market is going to behave very clearly based on the actual outcome. A strong number, anything over 225K, is likely to see the bond market sell off further and I wouldn’t be surprised to see 10-year yields, which have edged up another basis point this morning to 4.19%, trade back above the levels seen last October at 4.25% or more. That will not be a positive for the stock markets as it will reintroduce the idea the Fed is going to continue to raise rates, something the market has completely priced out at this point. Similarly, a soft number will open the door to a sharp equity rally and bond rally, with yields likely to even test the 4.0% level if the NFP number is soft enough. I think we need a 100K or less number for a reaction like that.

Ahead of the data, there seems to be a growing concern over the outcome. While Asian markets rebounded a bit, European bourses have started to fall across the board from earlier levels and are now all down by between -0.2% and -0.5%. US futures, too, are now back to unchanged having spent the bulk of the evening higher on the back of a strong earnings report from Amazon.

Bond markets are under pressure as energy prices around the world are rising, as are food prices, and so inflation prospects seem to be worsening. This is despite the very earnest efforts of central banks around the world to convince us all that inflation has peaked, and they are near the end of their hiking cycles. After the BOE raised rates by 25bps yesterday, the market has reduced the expected UK terminal rate down to 5.75%, two more hikes despite CPI running at 7.9% with Core at 6.9%. In the Eurozone, the ECB has released a new report claiming that inflation has peaked as well, and the market has priced out any further rate hikes. This all smacks of whistling past the graveyard in my view.

For instance, oil (+0.35%) is higher again, up more than 14% in the past month, and shows no signs of slowing down. Not only did Saudi Arabia extend their one million bbl/day production cut for another month, but Russia now claims it will cut production by 300K bbl/day in September as well. I haven’t discussed food prices in a while as they had eased off from the immediate post invasion highs, but the FAO Food price index rebounded last month and despite a sharp decline from its highest levels last year, is still at levels that have caused riots in the streets of African nations in the past. Metals prices are also under pressure today, but that seems more to do with the strong dollar than anything else.

Turning to the dollar, it is once again seeing demand as only NOK (+0.2%) has managed to gain on the greenback in the G10 space, although the other currencies’ losses are not large. The same cannot be said for the EMG space where the APAC bloc is under real pressure led by KRW (-0.8%) and THB (-0.4%) on the dual concern of a slower growing China and broad risk-off sentiment. One thing that seems likely is the dollar will benefit from a strong NFP print and suffer from a weak one.

And that’s really it for the day. No Fed speakers are on the docket, but do not be surprised to hear some interviews if the number is very different from the forecasts. In the end, nothing has changed my view that inflation will remain stickier than forecast and the Fed will hold tight thus supporting the dollar. Remember, the combination of tight monetary and loose fiscal policy is the recipe for a strong currency. And the US is running that in spades!

Good luck and good weekend

Adf

Like Goldilocks?

Posted on August 3, 2023 by fxpoet

For assets so safe and secure
It seems bonds have lost their allure
Yields worldwide are rising
And it’s not surprising
Since ‘flation, we all must endure

The question is, what about stocks?
Are they set to soon hit the rocks?
Or will they remain
Resistant to pain
If growth behaves like goldilocks?

Certainly, yesterday was a pretty bad day for risk assets as equity markets in the US sold off aggressively along with commodities. The thing is it was a pretty bad day for haven assets as well with Treasury yields rising sharply. And right now, just before 7:00am in NY, those trends remain intact. In fact, the only thing that seemed to perform well yesterday was the dollar.

So, what gives? Many will point to the downgrading of the US credit rating by Fitch as the proximate cause of things, and it may well have been an excuse for some selling, but despite the logic I detailed yesterday, the impact on markets should be di minimis. After all, Treasuries are used for two things largely, either as investments in their own right, or as collateral for other financial transactions. Regarding the first point, nobody is actually concerned that the US will not repay their debt, so if the yield is attractive, investors will still buy them. As to the second point, this could have been an issue but since the S&P downgrade in 2011, collateral agreements have been rewritten to accept not only AAA securities, but also US government securities, with no mention of their rating. So, there is no change in the collateral situation.

If it was not the downgrade, then what has driven the recent upheaval in markets? Arguably, this has been building for quite some time and was looking for a catalyst to get things started. I think there are two ways to consider the situation. For the bears out there, watching equities rally daily despite what appeared to be softening margins along with tightening monetary conditions didn’t make sense. But the rally has been so relentless that the bears have largely capitulated on their views. It seems the key lesson is that the timing of monetary policy transmission is much slower than it had been in the past, or at least that’s what it feels like, and so despite the Fed’s aggressiveness, it hasn’t had nearly the impact anticipated.

To this point, remember, while the Federal government didn’t take advantage of ZIRP to term out its debt, homeowners and corporations did just that. This has resulted in a lot of borrowers with a long runway before needing to refinance their debt and left them somewhat impervious to the Fed’s recent moves. We have all heard that > 50% of mortgages outstanding are at rates < 4.0%. This has resulted in an unwillingness to move and reduced existing home inventories and sales. But all those people have not been impacted by the rate hikes, at least not on their largest single interest payment. And the same has been true for many corporations who termed out their debt in 2020-2021 and even the first half of 2022. While much of that debt will eventually be refinanced, it may be another 5-7 years before we start to see companies feel any stress there. Consider, too, how this has helped lower rated companies, who, if forced to refinance today would see yields in the 8%-12% range but were able to borrow at 5% or less. Of course, that debt was likely 5-year tenor, so that comeuppance is likely to arrive in 2025 or 2026. And maybe that is when we should be looking for the first real problems.

The Fed’s Loan officer survey showed that conditions are continuing to tighten in the bank market, which means that smaller companies are going to be stressed, but the large cap companies that issue debt directly are sitting pretty.

Therefore, if it is not the downgrade, what other reasons could there be? The first thing to remember is that there doesn’t have to be a specific reason for markets to sell off. Markets that are overbought (or oversold) can reverse without any particular driver. Historically, August has been a more volatile and weaker month for equities, often attributed to vacation schedules, with investors and traders both taking their summer trips and leaving skeleton staffs of junior people on the desk. This will result in reduced liquidity and any outside selling impetus can have an overly large impact. Remember, though, a rational look at equity markets indicates that on a historic basis they remain quite richly valued with the Shiller Cyclically adjusted P/E ratio at 31.1, well above its long-term median of 15.93. However, what is typically true is that when an overvalued market starts to correct, it can continue doing so for quite some time until it reaches a more rational valuation. If the bears have all given up, and the bulls are all on vacation, who is left to buy things?

All this is to say that, while the recent equity market weakness may not make sense specifically, there is nothing to say that it cannot continue for a while yet. Turning to bonds, though, that is a different story. Yields around the world are rising and, in many cases, rising sharply. While the BOE just raised rates 25bps this morning, as largely expected, they are simply catching up to the rest of the G10. However, 10-year Treasury yields are +6.7bps as I type (7:20) and now trading at 4.14%, their highest level since last October. My sense is that this move is all about two things, concerns that inflation has seen a local bottom and the dramatic increase in supply just announced by the Treasury. As discussed yesterday, yields above 4% have led to things breaking, so the question is what is set to break now? Perhaps, the stock market selling off will be this breakage, or perhaps there will be some other crisis that flares up. Maybe another large bank going to the wall, or a large corporate bankruptcy in a key sector.

We have discussed rising oil prices and you are all aware of rising gasoline prices every time you go to fill the tank. Headline CPI, when it is released next week, will be well above last month’s 3.0%. Too, yesterday’s ADP Employment number was much stronger than expected for a second consecutive month. If the no landing scenario is correct, then inflation is likely to remain far more stubborn than currently expected and Chairman Powell will not be thinking about thinking about cutting rates any time soon. In fact, at this point, if the Fed starts to think about cutting rates, that likely means that the economy has reversed course and is clearly headed into a recession. Be careful what you wish for.

Summing up, I would be wary of reverting to the buy the dip mentality that has prevailed for more than a decade. The underlying economic and financial situation is changing pretty quickly and that implies previous strategies may not perform that well. Do not forget last year’s market performance.

I would be remiss if I didn’t mention that the BOJ was back in the market again last night, buying an unlimited amount of JGBs as they try to smooth the rise in JGB yields, which are now up to 0.65%. This did help the yen a bit, which has rallied slightly on the day, but overall, the dollar remains much stronger. My take is that we are seeing investors who are uncertain about the medium and long term, buying dollars to buy T-bills, earn a nice piece of interest and reconsider their next move. One thing to note is that the yield curve’s inversion is lessening quite quickly. Last Monday, the inversion was -104bps. This morning it is -75bps. That is a remarkably fast move in a short time. It also implies that the demand for 10-year Treasuries is a little soft right now. As I have written, this inversion could resolve with higher long rates, not lower short rates, and that is not something for which the market is prepared. I believe that would be a clear equity negative.

There is a lot of data this morning starting with Initial (exp 225K) and Continuing (1708K) Claims, Nonfarm Productivity (2.3%), Unit Labor Costs (2.5%), Factory Orders (2.3%) and then ISM Services (53.0) at 10:00. But this is all a lead-up to tomorrow’s NFP data. Fed speakers have been fewer than usual, but we do hear from Richmond’s Thomas Barkin this morning. I see no reason to believe that there will be any new dovishness upcoming.

To my mind, yields are going to continue to rise, equities are going to remain under pressure and the dollar, overall, is going to remain stronger rather than weaker. We will need to see big changes in the data to change that view.

Good luck

Adf

Never-Ending

Posted on August 2, 2023 by fxpoet

A landing that’s soft’s now the bet
By many who poo-poo the debt
But deficit spending
Which seems never-ending
Means prices ain’t coming down yet

So, nominal growth may still rise
Inflation, though, will not downsize
And yields on the bond
Are like to respond
By soaring right up to the skies

Fitch downgraded US government debt one notch to AA+ from its previous AAA. Now, only Moody’s rates the US a AAA credit. As per their announcement, their rationale was threefold: “The rating downgrade of the United States reflects the 1) expected fiscal deterioration over the next three years, 2) a high and growing general government debt burden, and 3) the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.”

Let’s forget the political implications and the commentary from the government as it is completely expected. And I am not here to defend or attack the outcome, but rather hope to try to make sense of what they were thinking and how markets are likely to behave.

Regarding the first issue, expected fiscal deterioration over the next three years, that seems a pretty fair point. After all, fiscal deterioration has been consistently getting worse since the turn of the century, the last time we had a budget surplus. In fact, as per the below Bloomberg chart, absent the Covid drama, the current budget deficit, at -8.5% of GDP, is larger than any time other than the GFC. And this is occurring when, not only is there no recession, but GDP seems to be accelerating. In fact, the Atlanta Fed’s GDPNow forecast has jumped up to 3.86%. It seems fair to ask if part of that ‘growth’ is a direct result of deficit spending.

As to point number two, a high and growing government debt burden, that also seems like a fair point. Since the debt ceiling was removed, government debt has grown by ~$1.2 trillion in exactly 2 months’ time (see Bloomberg chart below). At the same time, the Treasury just announced they would be issuing $1.9 trillion in new debt during the rest of 2023. Those are pretty big numbers and based on the legislation that was passed last year, the IRA and CHIPS act, as well as the fact that recent tax revenues have been declining, it is reasonable to expect the government debt burden to continue to grow.

Finally, this poet is in no position to judge the relative erosion of governance compared to other nations, but on an absolute basis, it is not hard to argue that governance in the US has diminished, at least fiscal governance, given the political split between the House of Representatives and the Senate/White House.

Of course, this all begs the question, does it matter for markets? Well, we have seen this movie before in 2011 when S&P downgraded the US government credit rating after the last standoff in Congress regarding the debt ceiling. While it was a big deal politically, it actually had limited impact on the markets. In fact, it may fairly be said that it marked the bottom in the equity market and ignited a massive multi-year rally. Can we expect the same thing this time? I would contend the situation now is quite different than back then, with a much higher debt/GDP ratio as well as a much higher level of interest rates. The point is that the government’s fiscal stance is more tenuous now as interest payments on existing debt either start to crowd out other spending or drive deficits even higher, as per Fitch’s point.

Back then, 10-year yields were also much lower, ~2.5%, and the debt/GDP ratio was ~90% as compared to today’s ~120%. In other words, there was a little more flexibility for the government. In fact, following the move, bond yields fell another 100bps over the ensuing year, bottoming at 1.39%, the pre-Covid low. An optimistic reading of that outcome is that investors looked around the world and decided that despite the flaws in the US, it was still the safest place to be. Of course, that low interest rate coincided with the Eurozone debt crisis, so perhaps investors were simply fleeing the euro (the dollar did rally) given those problems.

So far, the reaction has been a downtick in equity markets and little movement in the bond market. But it is not clear to me that either of those moves are directly related to this news. Rather, it is entirely possible that we are starting to see the effects of what Fitch is describing, rather than the effects of Fitch’s move.

For instance, there is a growing perception that a soft landing is going to be the result of the Fed’s policy moves. While inflation has obviously fallen from its highs of last year, the two things that have been driving that, lower commodity prices and base effects in the calculation, are reversing going forward. For instance, oil prices are higher by nearly 17% in the past month while the monthly comparison for CPI in July is just 0.0%, so any inflation at all is going to result in a rise in the Y/Y figure.

Instead, I would contend that the massive fiscal stimulus from the IRA and CHIPS Act are going to continue to drive demand, as well as debt issuance, and continue to pressure inflation higher. While nominal growth may remain firm, inflation will too, so real growth will decline. Arguably, the government needs this outcome in order to devalue their massive debt pile. However, whether this will be a positive for risk assets is a much tougher question. Certainly, bond yields are likely to rise in this scenario, and if that is the case, I suspect equity markets may start to revalue as well. Government spending is not organic economic growth. Instead, it is far less efficient and debt driven, thus underpinning the Fitch viewpoint. I fear that this time, the ratings downgrade may result in a different result than last time, with risk assets suffering as we go forward.

And that was certainly the case last night as equity markets throughout Asia were all in the red, as are European equities this morning. Notable declines were seen in Japan (-2.3%), Hong Kong (-2.5%) and Spain (-1.2%), but it is universal. As to US futures, they are all in the red as well this morning.

As to the bond market, 10-year Treasury yields are back above 4.0%, although they are little changed this morning. Remember, the last several times the 10-year yield has gone above 4%, there have been problems somewhere in the market, with the UK bond meltdown and Silicon Valley Bank’s implosion the most widely remembered. The curve is steepening (really getting less inverted) because long rates are rising, not because the Fed is cutting. If the yield curve heads back to normal with 10-year yields at 5.5%, consider how that will impact equities. It won’t be pretty.

Away from oil prices, base metals are under pressure this morning as well, potentially because China has yet to offer real support to its economy, or potentially because yields continue to rise thus hurting the investment case.

Finally, the dollar is broadly stronger this morning, certainly against the EMG bloc with KRW (-1.1%) and PHP (-0.75%) the laggards, but weakness widespread. Both of those currencies are reacting to fading data and concerns over China’s actions going forward. Meanwhile, in the G10, NOK (+0.45%) and JPY (+0.4%) are the outliers on the high side, with the former following oil while the yen’s move looks to be a trading bounce given the lack of news or rate activity. However, the rest of the bloc is under pressure led by NZD (-0.6%) and AUD (-0.5%) with both sliding alongside the metals markets.

On the data front, ADP Employment (exp 190K) is coming shortly *Flash, ADP +324K* with most analysts anxiously awaiting not only the headline print, but any revision to last month’s extraordinary 497K rise. As to Fed speakers, there are none on the calendar today. All in all, the market will be keenly focused on the ADP especially after mildly softer than expected JOLTS Jobs data yesterday as well as a soft ISM Employment print. There are certainly still hints of an impending recession, but the situation remains very uncertain. Remember this, though, prior to the GFC, the consensus view was that a soft landing was going to be achieved. The same was true in 2001 and as far back as 1980. The only time the Fed successfully engineered that soft landing was in 1994 and I am not of the mind that they are going to be successful this time. It’s just not clear what is going to break first.

Good luck

Adf

Walk the Walk

Posted on August 1, 2023 by fxpoet

The Chinese are starting to feel
Recession could really be real
With PMI falling
Most pundits are calling
For policy help with more zeal

But so far, despite lots of talk
The Chinese will not walk the walk
One wonders how long
That they’ll sing this song
And when they’ll stop acting the hawk

Right now, the face of ‘all talk, no action’ is Chinese President Xi Jinping. China’s economy has been slowing, or perhaps a better description is that the post-covid performance has been much less dynamic than had been widely anticipated. Amongst the more concerning lowlights is the incredibly high youth unemployment rate there, with >21% of the population aged 18-24 unable to find work. That is not the sign of economic dynamism. You may recall the enthusiasm that greeted the news that the Covid lockdowns had ended suddenly in January and there was a widespread call for a rally in commodity prices in anticipation of the great reopening. It never really happened. Since then, things have been lackluster at best and the Chinese government has grown increasingly concerned. However, they have not yet grown concerned enough to act in any significant way with fiscal policy support extremely narrow and inconsistent.

Last night simply reinforced these themes as the Caixin PMI Manufacturing data was released at 49.2, a full point below expectations and, of course, below the key 50 level indicating growth. This was the lowest print since December, but a quick look at the numbers since then shows a very limited growth impulse in China. The average reading in 2023 has been 50.1, hardly a sign of a rebound. Now, the Chinese government did come out and say they are going to increase credit to private companies, focusing on small firms and the central government called on cities and provinces to do more to support the property markets. But talk is cheap and until we see real money getting spent, it is hard to get excited about the Chinese economy. Ultimately, while the PBOC is very concerned that the renminbi could fall sharply if they loosened their grip on the currency, I expect that a weaker CNY is going to be a theme for the rest of this year, and probably most of next year, as it offers the one release valve that they have available. 7.50 is still in the cards.

Away from the China story, the market’s focus on central banks intensified as the RBA left rates on hold at 4.10% despite market expectations of a 25bp rate hike. The first casualty of this surprise was the AUD (-1.3%) which is the worst performing currency across the board today. Apparently, their concern is that growth is faltering, and given the lack of growth in their largest export market, China, they believe that inflation pressures are ebbing and they have achieved their objectives. Like all central banks these days, they claim to be data dependent and right now the data are telling them not to worry. I guess that means ~~when~~ if inflation starts to reaccelerate, they will be back at the hiking game. But for now, like central bankers all over the world, they are eager to claim victory over inflation.

We heard this from the ECB last week, and it is quite possible that the BOE hints at that on Thursday as well, although inflation is much stickier in the UK than elsewhere. My point is that the one central bank that is not satisfied is the Fed, where there is still a very wide consensus that the job is not done. As long as US economic activity remains the best around, and that seems highly likely for another few months at least, it is hard to see any other central bank maintaining a more hawkish stance than the Fed. Again, the underlying thesis of dollar strength is the Fed will be the most hawkish of all, and nothing we have seen today would contradict that theory.

How have markets responded to this news? Well, yesterday saw a very late rally to take the US indices higher on the day, but only just, and while the Nikkei (+0.9%) had a good session, continuing its recent run, Chinese stocks, not surprisingly, were weighed down by the baggage of the PMI data. Europe is also feeling the brunt of weak PMI data as the Manufacturing prints there were all in the low 40’s, except for Germany which managed to remain unchanged at 38.8! Virtually all the markets on the continent are down by around 1% this morning in response to the data. In fact, it is data like this that helped inform Madame Lagarde’s belief that the ECB is done, and who can blame her. While inflation may be a problem, and the ECB’s only mandate, given she is a politician first and central banker second, the optics of tightening policy into a rapidly declining economy would be very difficult to explain. Again, this bodes well for the dollar overall. As to the US futures market, they are a bit softer this morning, not dramatically so, but it seems that there is some response to a generally softer tone in the earnings numbers released to date.

Interestingly, despite equity weakness, bond yields are higher in the US and across Europe by a few basis points. For some reason, the bond market does not seem to agree with stocks, nor it seems, with most central bankers. Inflation concerns remain top of the list for bond investors, and other than Down Under, where AGBs fell 8.6bps after the RBA left rates on hold, there seems to be a growing worry that the central banks are ending their fight too soon. As to the US, once again the 10-year yield is approaching 4.0%, clearly a level of great import to the market. I would also note that JGB yields edged ever so slightly lower overnight and remain below 0.60%. However, it is still early days with respect to the policy changes there, so the eventual outcomes are still unclear.

Oil prices are very little changed today, consolidating their recent gains. This must be a concern for the central banks as evidence of slowing economic activity is not leading to slowing demand for oil. That is a key tenet of their policy structure. The belief is weaker growth and recession will reduce demand for energy first, and then other things thus reducing inflationary pressures. But if growth weakens and oil stays firm or rallies, they have a big problem. Now, the metals complex is all softer this morning, behaving as would be expected in a weakening growth scenario, so it is oil that is the current outlier.

As to the dollar, it is king of the hill this morning. While Aussie is the weak link, all the commodity currencies are under pressure, down between -0.6% and -0.9%. But the yen (-0.5%) is also failing to find support on a risk-off day, which comes as a bit of a surprise to all those who continue to believe the BOJ is going to alter policy further. Here, too, I see further weakness vs. the dollar as time progresses. Just wait until the Fed hikes again and sounds hawkish as CPI data rebounds.

In the emerging markets, ZAR (-1.4%) has now edged ahead of the Aussie for title of worst of the day, as a response to the Chinese data, its own weak PMI reading and declining metals prices. But virtually the entire bloc is weaker today with all three geographic areas feeling the pain.

Yesterday’s US data was definitely soft with Chicago PMI at 42.8 and Dallas Fed at -20.0. As well, the Senior Loan Officer Opinion Survey indicated that credit conditions for commercial and industrial loans had tightened further with reduced demand to boot. In fact, the tightening is reaching levels last seen during the covid recession and the GFC. This is not indicative of a soft landing, rather of a much harder one. This morning we see Construction Spending (exp 0.6%), JOLTS Job Openings (9600K) and ISM Manufacturing (46.9) all at 10:00am.

And yet, despite the data and SLOOS, we heard from Goolsbee and Kashkari that they continue to believe a recession will be avoided. This morning, Goolsbee is back on the tape, but we already know his view. However, I do not believe he is in the majority at this point, though he is a voter, so come September, if they hike, perhaps we will have a dissent.

If the data is terrible, perhaps we will see the dollar cede some of this morning’s gains, but absent that outcome, let alone surprising strength, it feels like the dollar has further to rally.

Good luck

Adf

Just Kidding

Posted on July 31, 2023 by fxpoet

Remember Friday
When one percent was declared
The top?  Just kidding

Much has been written about the BOJ’s surprising change in policy at their meeting last Friday, when they ostensibly widened the cap on their Yield Curve Control to 1.00% while explaining that flexibility in operations was the watchword. They did not touch their overnight rate, which remains at -0.10% and there is no apparent belief that they are going to adjust that anytime soon.

Neither market pricing in the OIS market nor any commentary from any BOJ official has hinted at such a move. So, the question is, did they really change their policy?

This matters a great deal for those amongst us who care about USDJPY and its potential future direction. The prevailing narrative has been that once the BOJ altered policy and allowed Japanese interest rates to rise to a more normal setting, investment would flow into JGBs, and the yen would strengthen rapidly. Remember, a big part of this process is that since the yen is the last remaining currency with negative interest rates in the front end of the curve, it remains the financing currency of choice amongst the speculative and hedge fund set. Adding to this discussion was the fact that back in December of last year, when Kuroda-san truly surprised the market by raising the YCC cap from 0.25% to 0.50%, it took less than one day for the 10-year JGB yield to test the new cap. Expectations recently had been that a similar move was likely to be seen this time around as well.

Alas, it is Monday, so some thirty-six market hours into the new policy and already the BOJ has stepped into the market to prevent a further rise in the 10-year yield once it touched 0.60%. Last night they stepped in with a ¥300 billion program of additional QE. One cannot be surprised that USDJPY (+0.9%) is higher on this news as it undermines the entire thesis about imminent JPY strength once they changed policy. And if they didn’t really change policy, as evidenced by the fact that they have already stepped into the market, then THE key pillar of the stronger yen thesis has just been removed. The other problem for the yen bulls is that the US data last week, especially the GDP and IP data, indicate that the Fed will be under no duress if they continue to tighten policy beyond current levels. Despite all the arguments about the Fed making another policy error, and there are sound arguments there, in Jay Powell’s eyes, until NFP starts to fall sharply, or Unemployment starts to rise sharply, or both, there are no impediments to a continuation of the current tightening policy.

It is with this in mind that I foresee continued strength in USDJPY, and while it seems likely that a very rapid move higher will see further intervention by the BOJ/MOF like we saw last autumn, another test of 150 is in the cards. A quick look at the chart below (from tradingeconomics.com) shows that the trend higher in the dollar remains intact with the decline in the first part of July already mostly undone. For those of you who were looking for a reversion to the 120 or 130 level, I fear that is just not in the cards for a long time to come.

Last Thursday the ECB said
That policy, looking ahead
Need not be so tight
And so, they just might
Stop raising rates, pausing instead

Though their only mandate is prices
They’ve come to a bit of a crisis
Seems growth’s really weak
And so, they will seek
A policy, sans sacrifices

The good news in Europe is that Q2 GDP was positive, which followed a negative Q4 and a flat Q1. Hooray! The bad news about the data, which showed a 0.3% rise, is that fully half that number comes from Ireland! Now, Ireland’s weight in the Eurozone economy is tiny, about 4%, so the fact that growth there represented half the entire EZ’s growth is remarkable. However, if you consider that this growth is more illusion than economic activity, it is easier to understand. The growth is a result of the large profitability of US tech companies that generate their profits, from an accounting perspective, in Ireland to take advantage of the extremely low Irish corporate tax rate of 12.5%. So, US tech companies had a good quarter driving Irish GDP higher, and by extension Eurozone GDP higher. But they didn’t really produce that much stuff.

At the same time, Core CPI in the Eurozone printed at 5.5% this morning in July’s preliminary reading, hardly indicative of a collapse and calling into question Lagarde’s seeming dovishness last week. In the end, the dichotomy between the US economy, where the latest data continues to show a robust outcome, and Europe, where the only thing rising is prices with economic activity lackluster at best, remains the key reason why the dollar’s demise is still a theory and not reality.

To summarize the information that we have received from around the world in the past several days, Japan is unwilling to allow interest rates to rise very far, European growth is staggering, US growth is accelerating, the ECB is inclined to stop hiking rates and the Fed continues with ‘higher for longer’. All of this points to the dollar maintaining its value and likely rising further. I have yet to see anything persuasive in the dollar bear case to address all these issues.

Now, those are the big picture views, but let’s take a quick tour of the overnight session. Equities rallied in Asia following the US performance on Friday, but Europe has been a bit more circumspect with a couple of markets showing gains, notably France and Italy, but the rest doing nothing at all. At the same time, US futures are little changed at this hour (7:30).

Arguably, though, it is the bond market where things are really interesting as yields continue to rebound. US Treasuries are higher by 1.5bps and pushing back to that all important 4.00% level this morning. There is a growing belief that if 10-year yields push above 4.10%, that may signal a new framework, a breakout in technical terms, and we could see much higher yields from there. The Fed is likely to welcome such an event as it will help tighten financial conditions, something that they have been unable to achieve thus far. However, I do not believe the equity markets would take kindly to that type of movement, so beware. As to European sovereigns, they are mostly higher by about 1bp-2bps this morning and of course, JGBs saw yields finish higher by 6bps, just below 0.60%.

Oil prices (+1.0%) continue to rise on an organic basis. By this I mean there have been no announcements, no disruptions and no news of any sort that might indicate a change in the current situation. In other words, there is just a lot of buying going on. WTI is well above $81/bbl and we have seen a gain of more than 16% in the past month. Headline inflation will not be sinking on this news. We are also seeing a little strength in the metals space this morning with gold, copper and aluminum all firmer as the week begins. The base metals are responding to continued indications that China is going to support their economy, although direct fiscal payments don’t yet seem likely. Just wait a few months.

Finally, the dollar is net, little changed, although we have a wide array of gainers and losers today. In the G10, AUD (+0.9%) and NZD (+0.75%) are the leaders, rallying alongside the commodity rally, while JPY (-0.8% now), is the laggard based on the discussion above. As to the rest of the bloc, there are more gainers than losers, but the movement has been far less impactful. In the EMG space, MYR (+1.1%) has been the leading gainer on significant (for Malaysia) equity market inflows of ~$40mm -$50mm last night. After that, though, the gainers have mostly been EEMEA currencies, and they have not moved that much. On the downside, ZAR (-0.7%) is the laggard on limited news, implying more of a trading action rather than a fundamental shift. But on this side of the ledger as well, things haven’t moved that far and net, the space is little changed.

It is an important week for data in the US culminating in the payroll report on Friday.

Today	Chicago PMI	43.4
	Dallas Fed Mfg	-22.5
Tuesday	JOLTS Job Openings	9600K
	ISM Manufacturing	46.9
Wednesday	ADP Employment	183K
Thursday	Initial Claims	227K
	Continuing Claims	1723K
	Unit Labor Costs	2.5%
	Nonfarm Productivity	2.2%
	Factory Orders	2.1%
	ISM Services	53.0
Friday	Nonfarm Payrolls	200K
	Private Payrolls	175K
	Manufacturing Payrolls	5K
	Unemployment Rate	3.6%
	Average Hourly Earnings	0.3% (4.2% Y/Y)
	Average Weekly Hours	34.4
	Participation Rate	62.6%

Source: Bloomberg

In addition to this, we get the first post-FOMC Fedspeak with just two speakers, Goolsbee and Barkin, on the calendar this week although the pace picks up next week. As long as the data remains strong, I see no reason for the Fed to change its tune nor any reason for the dollar to back off its recent net strength.

Good luck

Adf

A Suggestion

Posted on July 28, 2023 by fxpoet

Nought point five percent
Is not a rigid limit
It’s a suggestion

At least that is the word we got last night from Kazuo Ueda, BOJ Governor when he announced some surprising policy changes. No longer would 10-yr JGBs be targeted to yield 0.0% +/- 0.50%, which in practice had meant a 0.50% cap. Going forward, the BOJ would buy an unlimited amount of JGBs at 1.0%, if necessary, as its new framework. Perhaps the most humorous part of the concept was the suggestion that they always saw the 0.50% cap “as references, not as rigid limits, in its market operations.” That’s right, after 7 years of a seemingly explicit cap on JGB yields, with the BOJ willing to buy unlimited amounts in order to prevent yields from climbing, now they mention it was merely a suggestion, a guideline rather than a hard limit. It is commentary of this nature that tends to undermine investor trust in central bankers.

Given the surprising nature of the policy changes, although they left their O/N financing rate at -0.10%, it should be no surprise that the market had some large, short-term responses. JGB yields jumped 10bps on the news, trading to a new 9-year high at 0.575% before slipping back a few bps to close the week. The Nikkei, meanwhile, fell nearly 2.5% in the immediate aftermath of the decision, but rallied back all afternoon there to close lower by just -0.4%. It turns out the financial sector benefitted greatly as higher rates really helps them. As to the yen, it saw substantial short-term volatility, as ahead of the meeting it weakened nearly 1.75%, trading above 141.00, but very quickly reversed course and rallied > 2% as the dollar briefly fell to 138.00. In the end, though, the yen is just a hair stronger on the day now, back near 139.50 where things started.

The lesson, I think, is that policy shifts tend to have very immediate consequences, but the longer term impacts, especially in the currency market where we have a lot of moving pieces between the Fed, ECB and BOJ, will take longer to play out.

In Europe, inflation remains
The issue that’s caused the most pains
But growth there is stalling
So, Christine is calling
For slowing the rate hike campaigns

“We have an open mind as to what decisions will be in September and subsequent meetings…We might hike, and we might hold. And what is decided in September is not definitive, it may vary from one meeting to another,” Lagarde said.It was with these words that Madame Lagarde informed us the rate hiking cycle in the Eurozone may have ended. Despite the fact that core CPI remains above 5.0% while their deposit rate is now at 3.75%, seemingly not high enough to effectively combat the inflation situation, it is becoming ever clearer that the European growth story is starting to slide. This is in direct contrast to the US growth story, which based on yesterday’s extremely robust data, shows no signs of fading.

But as I have written numerous times in the past, once the Fed is perceived to have stopped raising interest rates, it was clear the ECB would be right behind them. The entire basis of my stronger dollar thesis has been that other central banks will find it very difficult to tighten policy aggressively to fight inflation if the Fed has stopped doing so.

In the end, no country really wants a strong currency as the mercantilist tendencies of every country, seeking to increase exports at the expense of their domestic inflation situation, remains quite strong. Faster growth with higher inflation is a much preferred economic outcome for essentially every government than slower growth with low inflation. Inflation can always be blamed on someone else (greedy companies, Ukraine War, OPEC+, supply chain disruptions) while faster growth can be ‘owned’ by the government.

So, between the ECB and BOJ, we did see further policy tightening in line with the Fed’s actions on Wednesday. Arguably, the difference is that the US economic data continues to be quite strong, at least on the surface. Yesterday’s first look at Q2 GDP printed at 2.4%, much higher than expected and showing no signs of the ‘most widely anticipated recession in history.’ The strength was seen in Government spending (IRA and CHIPS Act), Private Domestic Investment (which is directly related to that as companies build out new plant infrastructure) and Services, i.e. travel and restaurants. Once again, I will say that as long as the US economy continues to show growth of this nature, and especially as long as the Unemployment Rate doesn’t rise sharply, the Fed will have free rein to continue to raise rates going forward if inflation does not settle back to their 2% target.

One thing to consider regarding the central bank comments and guidance is that virtually every one of them has ended the strict forward guidance we had seen in the past. Rather, data dependence is the new watchword as none of them want to be caught out doing the wrong thing. Alas, the result is that, by definition, if they are looking at trailing data, they will always be doing the wrong thing. I expect that one of the key features of the past 40 years, ever reducing volatility in markets, is going to be a victim of the current framework. It is with this in mind that I suggest hedging financial exposures, whether FX, rates, or commodities, will be far more important to company balance sheets and bottom lines than they have been in the past.

Ok, let’s see how investors are behaving today as we head into the weekend. We’ve already discussed the Japanese market, but Chinese shares, both onshore and in HK, had a very strong day as there was more talk of official policy support for the property market there. Ultimately, it is very clear they are going to need to spend a lot more money to prevent an even larger calamity. European shares, though, are generally little changed this morning with investors preparing to take the month of August off, as usual there. Finally, US futures are higher this morning after what turned out to be a surprising fall in all three major indices yesterday. The overall positive data plus indication that the Fed may be done seemed to be the right conditions for further gains. But markets are perverse, that much we know. We shall see if US markets can hold onto these premarket gains. I would say that a lower close on the day would be quite a negative for the technicians.

In the bond market, yesterday saw US 10-year yields jump 15bps, its largest rise this year, although it is giving back about 4bps of that this morning. European sovereigns, though, are little changed this morning and have not been subject to the same volatility as the Treasury market given the far less exciting economic picture there. If the ECB is truly finished, my take is yields there could slide a little over time.

In the commodity markets, oil (-0.35%) is a touch lower this morning, but the uptrend continues. This certainly seems to be more about reduced supply than increased demand, although with the US data, the demand picture looks better. Interestingly, both gold (+0.6%) and copper (+1.0%) are higher this morning despite the dollar holding its own. Yesterday saw a sharp decline in both and I think there is a realization that was overdone.

Speaking of the dollar, it is modestly softer today after a strong gain yesterday. In the G10, GBP (+0.6%) is the leader followed by NOK (+0.5%) although AUD (-0.6%) and NZD (-0.3%) are taking the opposite tack. The pound seems to be benefitting from anticipation of next weeks’ BOE meeting where 25bps is a given, but the probability of a 50bp hike seems to be creeping up. Meanwhile, NOK is just following oil’s broad trend with WTI just below $80/bbl now. Meanwhile, Aussie seems to be suffering some malaise from the BOJ actions, at least that’s what people are saying although I’m not sure I understand the connection. Perhaps it is the idea that higher JPY yields will result in unwinding the large AUDJPY carry trades that are outstanding.

However, the emerging markets have seen a much wider dispersion of performance with much of the APAC bloc under pressure last night on the back of the strong dollar performance yesterday, while we are seeing strength in LATAM and EEMEA currencies this morning, which really looks an awful lot like simple trading activity with positions getting reduced after yesterday’s dollar performance.

In addition to the GDP data yesterday, we saw a lower-than-expected Initial Claims print at 221K while Durable Goods orders blew out on the high side at 4.7%! Again, lots to like about the US data right now. Today we see Personal Income (exp 0.5%) and Spending (0.4%) along with the Core PCE Deflator (0.2% M/M, 4.2% Y/Y) and finally Michigan Sentiment (72.6). based on yesterday’s results, I would expect the Income and Spending data to be strong along although PCE is probably finding a bottom here.

In the end, even if the Fed has stopped hiking, although with the economy still showing strength that is not a guaranty, I find it hard to believe that the ECB will go any further, and the tendency around the world will be to slow or stop tightening as well. I still like the dollar in the medium term.

Good luck and good weekend

Adf

Resolutely

Posted on July 27, 2023 by fxpoet

Said Jay to the world through the Press
We’ve certainly had some success
But patience is key
As resolutely
We stop any signs of regress

Does this mean that next time we meet
Our actions will be a repeat?
The answer is no
We’re not certain, though
We could if inflation shows heat

And what about Madame Lagarde
Have she and her minions been scarred
By Europe’s recession
Or will their suppression
Of growth lead to outcomes ill-starred

By this time, you are all almost certainly aware that the Fed raised the Fed funds rate by 25bps as widely expected. You may not be aware that the FOMC statement was virtually identical, with only a change in the description of economic growth from ‘modest’ to ‘moderate’, apparently a slight upgrade. This was made clear when Chair Powell, at the press conference, explained the Fed staff was no longer forecasting a recession in the US. Perhaps the following Powell quote best exemplified the outcome of the meeting, “We can afford to be a little patient, as well as resolute, as we let this unfold,” he said. “We think we’re going to need to hold, certainly, policy at restrictive levels for some time, and we’d be prepared to raise further if we think that’s appropriate.”

So, what have we learned? I think we can sum it up by saying nothing has changed the Fed’s mindset right now. They continue to focus on the fact that inflation remains above their target and will continue to implement policies that they believe will address that situation.

The thing that makes this so interesting is everybody seems to have a different interpretation of what that implies. The two broad camps are 1) this was the last hike as inflation continues to fall and they are already hugely restrictive compared to their historical activities; and 2) given the upgrade in economic forecast, and the fact that inflation seems set to remain higher than target for a long time yet, there are more hikes to come.Given the math that goes into the CPI data, it is quite easy to forecast Y/Y CPI if you assume a particular M/M figure for the next period of time. BofA put out a very good chart showing the potential evolution of headline CPI going forward.

The implication here is that unless the M/M data falls to zero or negative, CPI is going to start climbing again. The Fed clearly knows this as does the market. The only disconnect is the question of how the Fed will respond in the various cases. Remember, too, that oil and gasoline prices have risen 13.7% and 11.2% respectively in the past month. The idea that the energy component of CPI will do anything but rise sharply this month seems absurd. As such, I expect that the Fed will continue to lean toward another hike going forward.

The problem they have had is that the pass-through from Fed rate hikes to the economy has been greatly diminished by their previous policy of excessive ZIRP. It is estimated that roughly 80% of US home mortgages have fixed rates below 4%, with half at 3% or less. At the same time, the average duration of corporate debt has lengthened to 6.4 years as the refinancing activity that occurred during the ZIRP period saw extension of tenors widespread. As such, other than the Federal government, who managed to shorten the duration of their outstanding debt during the period of ZIRP, most borrowers are in pretty good shape and not impacted by the Fed’s policies. In fact, they are earning much more on their cash balances. The point is, there is a case to be made that the Fed can maintain ‘higher for longer’ for quite a while without having a significantly deleterious impact on the economy. Perhaps the soft landing is possible after all.

Now, if they continue to hike rates, and there are a number of analysts who believe we are heading to 6% or beyond, things may change. We are already seeing a significant diminution of demand for bank loans, which while that may not bother large corporates, implies that the SME sector is going to break first. Does the Fed care about them? They will only care when the Unemployment Rate rises substantially. This comes back to why I believe that NFP is still the most important data point, regardless of the inflation discussion. Summing it up, the Fed will see two more CPI, PCE and NFP reports before they next meet on September 20^th. It is impossible, at this time, to estimate their actions with this much more data still to be digested. However, if my inflation view is correct, that it will remain stickily higher, I see a very good chance of at least one more Fed funds rate hike.

A quick look across the pond shows that the ECB will be making their latest rate decision this morning with the market expecting a 25bp hike. Unlike in the US, the OIS market is pricing in one further hike after today’s and then that will be the end of the cycle. But…can Madame Lagarde continue to tighten policy if Europe is actually in a recession? We already know that Germany is in a recession, and forecasts for Q2 GDP in Europe, to be released next week, are at 0.3%. The Citi Economic Surprise Index remains mired at -136.7, a level only seen during Covid and the GFC, hardly the comparisons desired. I believe it will be much tougher for an additional rate hike by the ECB unless the data story turns around quickly, and I just don’t see that happening. Overall, it is this dichotomy in economic activity that underlies my bullish thesis on the dollar.

At any rate, the market response to the FOMC has been one of sheer joy. Well, that and the fact that there are still some pretty good earnings results getting released, at least relative to recent expectations, if not on a sequential basis. But it is the former that matters as that is what gets priced into the market. So, equity markets, after yesterday’s breather in the US where they didn’t rise sharply, are mostly higher around the world. Both the Hang Seng and Nikkei rallied nicely, and European bourses are quite robust this morning, with many exchanges higher by > 1%. US futures, too, are in the green, with the NASDAQ showing great signs of strength.

Meanwhile, bond yields have edge a touch lower virtually everywhere with most of Europe seeing declines between 1bp and 2bps, although Treasury yields are less than 1bp lower this morning. There appears to be little concern that Madame Lagarde is going to spoil the party and sound uber hawkish. Even JGB’s are a touch softer, -0.4bps, as the market prepares for tonight’s BOJ announcement. However, there is absolutely nothing expected out of that meeting.

In the commodity space, oil (+1.1%) is higher again this morning as are gold (+0.25%) and the base metals (CU +0.1%, Al +0.6%). The soft(no) landing scenario seems to be gaining some traction here. Either that, or the dollar’s weakness today, which is widespread, is simply being reflected as such.

Speaking of the dollar, it is definitely on its back foot as the market is essentially saying the Fed is done. It is softer vs. the entire G10 bloc, with NOK (+1.05%) leading the way on the back of oil, but SEK (+0.9%) and NZD (+0.7%) also rising nicely alongside the commodity space. Even the euro, which has no commodity benefit whatsoever, is firmer this morning by 0.5% as the market awaits Madame Lagarde.

In the emerging markets, the picture is similar with almost every currency firmer vs. the buck led by HUF (+1.1%) and ZAR (+0.8%). The rand is clearly a commodity beneficiary, while the forint has gained after a story about the ECB being willing to consider Hungarian legislation that will avoid the need to recapitalize the central bank despite its recent losses. Meanwhile, the laggard is KRW (-0.25%) which seems to have responded to the widening interest rate differential between the US and South Korea.

On the data front, we see Q2 GDP (exp 1.8%, down from 2.0% initially reported), Durable Goods (1.3%, 0.1% ex Transport), Initial Claims (235K) and Continuing Claims (1750K) along with several other tertiary figures. There are no Fed speakers on the docket for the next week and I suppose that given the relative calm following yesterday’s meeting, there is not a great deal of near-term concern they need to change any views. I suspect that if tomorrow’s PCE data surprises, we could start to hear more soon.

Today, the mood is risk on and sell dollars. Barring a remarkable surprise from Lagarde, I would not fade the move.

Good luck

Adf

Baked in the Cake

Posted on July 26, 2023 by fxpoet

A quarter is baked in the cake
Ere next time, when Jay takes a break
At least that’s the view
Of so many who
Get paid for, such statements, to make

The question, of course, is why Jay
Would wait, lest inflation’s at bay
The narrative, though,
Is all-in that low
Inflation is now here to stay

Well, it’s Fed Day so all focus will be there until this afternoon at 2:00 when the Statement is released and then, probably more importantly, at 2:30 when Chairman Powell begins his press conference. Under the guise of a picture is worth a thousand words, I believe the next two charts, both unadulterated from Bloomberg are very effective at describing the current market expectations. The first is a tabular and graphic depiction of the Fed funds futures market over the next year, which shows that today’s hike is fully priced in, and then there is a just under 50% probability of a hike either September or November. After that, though, the market is convinced that Fed funds are going to fall, with more than 100 basis points of decline priced in through 2024.

Now, compare that to the second chart, the Dot Plot from the June FOMC meeting:

In truth, the two curves look pretty similar with perhaps the biggest difference the Fed’s current belief that they will absolutely hike twice before the end of 2023 rather than simply a 50% probability of such. So, can we just assume this is the way things are going to be? After all, if markets and the Fed agree on the same outcome, it seems likely to be realized, no?

Alas, this is where the narrative is based on crystal balls, not on data. Whether it is the punditry or the Fed (or the FX Poet), nobody knows how things are actually going to play out. One of the things that seems to be a throwaway line by every Fed speaker but is actually the most important part of the commentary is that their views are based on, ‘if the economy evolves as we expect it to.’ The problem is that the history of Fed prognostications is awful.

Obviously, the most recent glaring error was the ‘inflation is transitory’ narrative that they peddled for a year while inflation was rising sharply for many very clear reasons. Why we should think that their modelling prowess has improved since then is beyond me. I have often opined that the problem for the Fed is that every one of their models is broken since they don’t accurately reflect the economy, not even a little bit. Add to that the underlying premise which is that inflation is naturally at 2% and will head back there on its own, something with exactly zero empirical or theoretical support, and you have a recipe for policy errors.

The latest policy error was the transitory delay, but perhaps the bigger problem for the Fed is the potential for a relatively unprecedented set of economic variables with higher than target inflation combined with slow economic activity yet low unemployment (due to the shrinkage of the labor force.). I don’t think their playbook has a play to address that problem and I fear that the politics of the outcome will have a disproportionate impact on any policies they implement. If there is one thing of which we can be sure, it is that political solutions to economic problems are the worst kind with the longest-term negative impacts.

It is for this reason that Powell’s press conference is so widely anticipated as that is where we will learn any new information. But until then, I expect that markets will remain relatively benign.

A quick tour of the overnight session shows that there was no follow through to Monday night’s Chinese equity performance with the main exchanges in China and Japan all modestly lower. Europe, however, is having a much tougher time this morning with the CAC (-2.0%) leading the way lower as concerns seem to be growing over the ongoing central bank tightening policies continuing into a recession. There was vanishingly little data and no commentary of note, but we have seen some weaker than expected earnings numbers out of the continent, a sign that not all is well. As to US futures, they are essentially unchanged at this hour (8:00) as investors await this afternoon’s Fed meeting. I would be remiss, though, not to point out that there were several worse than expected earnings numbers, notably from Microsoft, which is a chink in the armor of the idea of infinite growth for AI.

Meanwhile, bond markets are under pressure in Europe with yields higher across the board there, on the order of 2.5bps to 3.5bps. This appears to be a move based on expectations of continuing higher interest rates from the ECB. Treasury yields, though, are unchanged on the day, and at 3.88%, currently sit right in the middle of the trading range we have seen for 2023. As to JGB yields, they slipped 2bps last night with limited concern that Ueda-san is going to rock the boat tomorrow night.

Oil prices (-1.0%) are a bit softer, but this looks like a trading correction after a strong run higher rather than a fundamentally based story. Base metals are also softer this morning as the Chinese inspired euphoria seems to have dissipated quickly while gold (+0.4%) is creeping higher despite rising yields and a modestly firmer dollar. It appears to me there is an underlying bid to the yellow metal that will not go away regardless of the macro situation.

Finally, the dollar is slightly firmer this morning as risk aversion seems to be supporting the greenback. JPY (+0.35%) is the G10 outlier on the plus side with the commodity bloc under the most pressure (AUD -0.7%, NOK -0.7%, SEK -0.5%). In the emerging markets, THB (+0.7%) has been the best performer after a surprisingly positive Trade Balance with a large negative one anticipated. However, the rest of the EMG space is mixed with some very weak currencies (HUF -1.0%, ZAR -0.9%) and some other modestly strong ones (BRL +0.4%, MYR +0.3%). The forint story continues to revolve around central bank activity, with concerns they will ease policy with inflation still high, while the rand is simply suffering from its commodity basis. Meanwhile, the real jumped after Fitch upgraded the country’s debt rating BB (stable) from BB-.

Ahead of the FOMC decision, we see New Home Sales (exp 725K) but that will be a nonevent given the afternoon’s agenda. It is a fool’s errand to try to anticipate exactly how Powell will respond to the questions he receives, or even exactly how they will phrase their current views. As such, today is one to watch and wait, then evaluate afterwards.

Good luck

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Finding a Cure

Posted on July 25, 2023 by fxpoet

Apparently President Xi
Is keen to continue to be
The story du jour
While finding a cure
For China and its ‘conomy

But elsewhere, the market’s fixation
Is central bank communication
Tomorrow, Chair Jay
Seems likely to say
They’ve not yet defeated inflation

The story in China continues to be one of weakening economic activity and a government that is increasingly desperate to address the situation while maintaining their iron grip on everything that occurs in the country. Of course, the problem with this thesis is that economic activity works far better without government interference, but that is the bed they have made. At any rate, the word out of the CCP’s Politburo is that more support is coming with expectations now for lower interest rates as well as still looser property investment policies. While it seems they don’t want to make direct cash injections into the economy yet, that appears to be the next step.

However, the announcements last night were sufficient for a bullish slant on everything China along with positive knock-on effects for those nations that are heavily reliant on a strong China for their own economic progress. The result is that we saw dramatic strength in Chinese equity markets with the Hang Seng (+4.1%) and CSI (+2.9%) both having their best days in months. Even with these moves, though, the Hang Seng remains more than 37% below its 2021 highs while the CSI is about 34% off those levels. The point is that while last night’s session was quite positive, belief in the Chinese economic story remains a bit suspect yet.

Elsewhere, however, the PBOC is doing its level best to prevent the renminbi from declining sharply as they set the fix nearly 1% stronger than expected based on analysts’ models, and ultimately, the currency closed 0.6% stronger on the session. Now, it remains well above the 7.00 level, but it seems quite clear that Pan Gongsheng, the freshly appointed PBOC governor, is making a statement that the renminbi should not fall dramatically. I suspect that if the Chinese economy continues to flounder, that attitude may change, but for now, that is the party line. As such, it should be no surprise that the rest of the APAC currency bloc performed well last night, along with AUD (+0.3%) the best G10 performer.

But away from that story, the market’s attention is turning almost entirely to the trio of central bank meetings that are starting with announcements due tomorrow afternoon (Fed), Thursday morning (ECB), and Thursday night late (BOJ). Let us begin with the Fed, where the meeting commences shortly, and they are set to discuss the current situation in the economy as well as how things have changed since their June meeting and what their forecasts for the future look like.

One area that is worth discussing is the Fed’s Reverse Repurchase Program (RRP or reverse repo) which serves as a low-risk investment outlet for excess funds in the system. Prior to the debt ceiling crisis, there was a great deal of concern that when the Treasury started to issue T-bills to refill the Treasury General Account, the government’s checking account, the liquidity to buy those bills might come out of the stock market and undermine the stock market rally. But there was another potential source, the RRP program, which prior to the debt deal had more than $2.3 trillion parked, mostly cash held by Money market funds. However, since the TGA bottomed at the end of May, and the Treasury has been issuing T-bills at a record rate, it turns out that the entire TGA balance has been filled by a reduction in RRP. In other words, there has been no liquidity drain from the markets, writ large, hence the equity markets continued ability to rally. That amount has been approximately $500 Billion. (See chart below with data from Bloomberg and the poet’s calculations)

Of course, there is a cost to this, and that is that the Treasury has been paying a higher yield on T-bills than those money market funds could get in the RRP market, and that, my friends, is adding to the already gargantuan budget deficit. Since the start of this process, 3mo T-bill yields have risen 50bps, right alongside the Fed funds rate. In essence, the Treasury is paying to keep the stock market higher.

There is another short-dated money issue and that is Interest on Reserves, the rate the Fed pays banks for excess reserves that are held at the Fed. That is currently set at 5.15%, between the Fed’s 5.00% to 5.25% band for Fed funds. One subtle tweak the Fed could make is to alter that relative level when they raise rates tomorrow in an attempt to adjust the amount that is held there. After all, other uses for those funds could be satisfying loan demand assuming that existed. Arguably, a lowering of that rate would imply the Fed is seeking fewer excess reserves in the system, somewhat of a tightening exercise.

At this stage, the 25bp rate hike is baked in the cake and is assumed by virtually every analyst with just 5 of the 108 analysts surveyed by Bloomberg calling for no hike. Futures markets are pricing a 97% probability as well, so the reality is that all the action will be in the press conference as well as any new tweaks to the statement. In my view, there has not yet been enough evidence of a considered slowing in inflation for the Fed to change its tune, but by the September meeting, we will have seen a lot more data and depending on how that plays out, things could be different. But not this month.

Heading into this morning’s session, that Chinese stock rally was not really widely followed elsewhere as the Nikkei was unchanged and most of Europe is higher by just basis points. That minimal movement is true in US futures as well.

Bond yields are a touch firmer, about 2bps across Treasuries and virtually the entire European space with only Italy (+4bps) an outlier. The only data of note was the German IFO report, which was on the soft side, but not dramatically so. I suspect that the yield move is in anticipation of the coming central bank activities.

In the commodity space, after another rally yesterday, oil is essentially unchanged and consolidating its recent gains. However, the base metals have rallied sharply on the back of the China news with copper higher by almost 2% and aluminum by 1%. Meanwhile, gold continues to trade in a very narrow range just below $2000/oz.

Finally, the dollar is slightly firmer this morning overall as the China story did not bleed over into any other areas and traders seem to be adjusting positions ahead of the Fed meeting. Surprisingly, NOK (-0.6%) is the worst performer despite oil’s recent gains, but elsewhere, in both the G10 and EMG, it is modest dollar strength around.

This morning we see Case Shiller Home Prices (exp -2.35%) and then the Consumer Confidence reading (112.0) although typically, these do not move markets. With no Fed speakers, the ongoing earnings calendar is likely to be the key driver of markets, although it is not until later this week when we hear from some of the Megacap names that people are getting excited. I suspect there will be little net movement today ahead of tomorrow’s FOMC announcements.

Good luck

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fxpoetry

Explaining the rhyme and rhythm of the FX markets each day

Author Archives: fxpoet

Weakness is Fleeting

Demimonde

Like Goldilocks?

Never-Ending

Walk the Walk

Just Kidding

A Suggestion

Resolutely

Baked in the Cake

Finding a Cure