Category Archives: Uncategorized

Now In Disarray

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The saga of Minister May
Improved not one whit yesterday
When Boris resigned
Pound Sterling declined
And her party’s now in disarray

The news from the UK continues to dominate market headlines as less than twenty-four hours after the resignation of the Brexit Minister David Davis, Boris Johnson, a Brexit hardliner and Foreign Minister also resigned from PM May’s cabinet. While PM May replaced both men quickly, the problem is one of appearances in that she seems to be losing control over her government. The market’s immediate reaction was to sell the pound (it fell 0.7% yesterday after the news and has maintained those losses) as concerns over a leadership challenge and potentially a new election were brought to the fore. However, since then, it seems things have quieted down a bit and there is even talk that this could be a Sterling positive as it may result in a softer Brexit with less economic impact. In the meantime, this morning’s data showed that GDP has been rebounding from Q1’s flat reading, with the monthly May reading rising 0.3% and although IP data was soft (-0.4% in May), Construction was strong (+1.6%) and it appears that Governor Carney will still have enough ammunition to justify a rate increase next month. The risk to that outlook is if a leadership challenge emerges in Parliament and PM May is deposed. In that event, market participants may take a dimmer view of the near future depending on who replaces her.

Away from the British Isles, however, there is less excitement in the G10 economies. The big US news remains political with President Trump naming Brett Kavanaugh to replace retiring Supreme Court Justice Anthony Kennedy. However, on the economic front, there has been precious little news or commentary. In fact, until Thursday’s CPI reading, I expect the US story to be benign unless something surprising happens in the Treasury auctions beginning today, where the US is raising $69 billion via 3yr, 10yr and 30yr auctions.

From Germany we saw the ZEW surveys disappoint with the Sentiment Index falling to -24.7, its lowest print since December 2011 during the European bond crisis. This has encouraged a reversal in the euro, which is down 0.3% this morning after a week of gains. As well, the other, admittedly minor, Eurozone data also pointed to modest Eurozone weakness, thus giving the overall impression that the recent stabilization on the continent may be giving way to another bout of weakness. However, we will need to see more important data weaken to confirm that outcome. Certainly, Signor Draghi is convinced that the worst is behind them, but he has always been an optimist.

In the emerging markets, Turkey has once again stolen the headlines as President Erdogan named his son-in-law as Minister of Finance and Economics, thus following through on his threat promise to take firmer control over monetary policy. In the cabinet reshuffle he also removed the last vestiges of central banking experience so I would look for inflation in Turkey to start to really take off soon, and the currency to fall sharply. And that is despite the fact that it fell 3% yesterday after the announcement. In fact, I would look for more moves of that nature and a print above 5.00 in the not too distant future.

But other than that, while the dollar is stronger this morning, it is not running away. The broad theme today seems to be modest profit taking by traders who had been running short dollar positions, and so a bit of further strength would be no surprise. On the data front, the NFIB Small Business Optimism Index was released earlier at 107.2, stronger than expected and still showing that small businesses remain confident in the economic situation for now. The JOLTs jobs report comes at 10:00 and should simply confirm that the employment situation in the US remains robust. My gut tells me that modest further dollar strength is on tap for today, but really, barring a political bombshell, I expect that things will be very quiet overall. It is the middle of summer after all.

Good luck
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The Winsome Ms. May

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The lady who leads the UK
Last night had a terrible day
Dave Davis resigned
And strongly maligned
The PM, the winsome Ms. May

Arguably the biggest news over the weekend was the sudden resignation last night of the UK Brexit Minister, David Davis, who decided he couldn’t countenance the outcome of Friday’s Cabinet meeting. The crux of that agreement was that the UK would continue to abide by EU food and manufacturing regulations after Brexit becomes final in March. Davis, who had campaigned for Brexit and was always seen as more of a hard-liner, thought this was too much of a concession, and heeded PM May’s general call to leave if he couldn’t get on board. While Dominic Raab, another pro-Brexit voice, quickly replaced him, the resignation has simply highlighted the ongoing uncertainties within the UK on the subject.

Markets, however, have remained surprisingly subdued on the news. It appears that traders are far more focused on how the BOE responds to the Brexit story than on the Brexit story’s daily twists and turns. And as of now, there has been no change in the view that the Old Lady is going to raise rates next month come hell or high water. Futures markets continue to price a more than 80% probability of that occurring. So in the end, despite a key political shakeup, the pound has actually rallied 0.45% and is now more than 2.2% clear of the nadir reached at the end of June. Perhaps the mindset is that PM May now has greater control over the cabinet and so is in a stronger position going forward which means that a soft Brexit will be the outcome. At least, that’s the best I can come up with for now.

Otherwise, the weekend has been extremely quiet. With that in mind I think a recap of Friday’s events is in order. The employment report was probably as good as it gets, at least from the Fed’s perspective. NFP increased a better than expected 213K and last month’s number was revised higher to 244K. The Unemployment Rate actually ticked higher to 4.0%, but that was because the Participation Rate rose as well, up to 62.9%, which while better than last month remains well below the longer-term historical trend. But for now, it demonstrates to the Fed that there is still some slack in the labor market, which means there is less concern that wage increases are going to spur much higher inflation. And the AHE data proved that out, rising 2.7% Y/Y, in line with both expectations and recent history. It seems the Fed is going to continue to focus on the shape of the yield curve rather than rising inflation, at least for now. If, however, we start to see some sharply higher inflation data (CPI is released this Thursday), that may begin to change some thinking there.

The other data Friday showed that the Trade deficit shrank to -$43.1B, it’s smallest gap since October 2016. This is somewhat ironic given that Friday was also the day that the US imposed tariffs on $34 billion of Chinese goods. It is too early to determine exactly how the trade situation will play out, although virtually every economist has forecast it will be a disaster for the US, and if it expands potentially for the world. That said, the equity markets have clearly spoken as Chinese stocks have fallen more than 20% in the past months, while US stocks have edged slightly higher. This story, however, has much further to go with there likely being many new twists and turns going forward.

Here in the middle of the summer, it is a light data week, with Thursday’s CPI clearly the highlight.

Today Consumer Credit $12.7B
Tuesday NFIB Small Biz Optimism 105.6
  JOLT’s Job Openings 6.583M
Wednesday PPI 0.2% (3.2% Y/Y)
  -ex food & energy 0.2% (2.6% Y/Y)
Thursday CPI 0.2% (2.9% Y/Y)
  -ex food & energy 0.2% (2.3% Y/Y)
Friday Michigan Sentiment 98.2

We also hear from four Fed speakers and we are at the point between meetings where there has been enough data for some views to have changed. However, my sense is there will be more discussion of the yield curve than of the economy as that has once again become a hot topic amongst a number of the regional Presidents.

Broadly the dollar has been under pressure overnight, continuing last week’s corrective price action. There has been some indication that data elsewhere in the world, especially in the Eurozone, has started to pick up again. If that trend continues, then I expect that the dollar will remain on its back foot. After all, its recent strength had been predicated on the idea that the US was continuing to show economic strength, diverging from the rest of the world’s near-term prospects. A change in that narrative will clearly change the FX story. However, it is not a foregone conclusion that is the outcome. I remain convinced that the dollar is likely to be the leader for quite a while yet.

Good luck
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Lighthearted

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At this point one must be impressed
Investors have not become stressed
A trade war has started
Yet they are lighthearted
With willingness still to invest

On top of that word from the Fed
Is they will keep pushing ahead
With rate hikes until
Our growth starts to chill
Or when markets start to bleed red

There has certainly been a lot to digest in the past twenty-four hours. Arguably the biggest story is the imposition of tariffs by the US on $34 billion worth of Chinese goods, which began at midnight last night. China is responding in kind and the Trump administration is determining whether they want to up the ante by an additional $200 billion. Now that the trade war is ‘officially’ underway, the key questions are just how far it will go and how long it will last. While there has been nothing in the press indicating that background negotiations are ongoing and that things can be resolved soon, based on the US equity market’s insouciance, it certainly seems that many investors feel that is the case. I hope they are correct, and soon, because otherwise I expect that we will see a more substantial correction in stocks. As to the dollar in this case, I expect that it will continue to benefit from its safe haven status in a time of market turmoil.

A second fear for equity investors has to be the Fed, which explained in yesterday’s release of the June meeting minutes, that while the trade situation could well become a concern in the future, for now they are much more focused on the potential for the US economy to overheat. The upshot is that the Fed is bound and determined to continue normalizing policy by gradually raising rates and by allowing the balance sheet to continue to gradually shrink. Speaking of the balance sheet, starting this month, they are going to allow $40 billion per month to roll off, and then beginning in October, it will be $50 billion per month until they reach whatever size they determine is appropriate. That means that $270 billion of bids for Treasury’s are going missing for the rest of the year. As the Fed continues to drain liquidity from the economy, I expect that the dollar will continue to benefit across the board, and that the US equity market will face additional headwinds. After all, QE was effective in its goal of forcing investors further out the risk curve and driving equity prices around the world higher as central banks everywhere hoovered up government bonds. Well, with yields rising and central banks backing away from the market (all while equity prices remain robustly valued) it seems there is ample opportunity for a substantial correction in stocks.

You may have noticed I said exactly the same thing when discussing the trade war situation. My point is that we are starting to see multiple catalysts align for a potential change in tone. A higher dollar and lower US (and likely global) equity prices seem like an increasingly possible outcome. Be prepared.

This leaves us at our third big story for the day, the payroll report this morning. Yesterday’s ADP Employment number was a mild disappointment, rising 177K rather than the 190K expected, but the reason appeared to be a lack of available workers rather than a lack of demand for hiring. In other words, the labor market in the US remains extremely strong. Or so it seems. Here are this morning’s expectations:

Nonfarm Payrolls 195K
Private Payrolls 190K
Manufacturing Payrolls 18K
Unemployment Rate 3.8%
Average Hourly Earnings 0.3% (2.8% Y/Y)
Average Weekly Hours 34.5
Trade Balance -$43.7B

It strikes me that this is a potential third catalyst that will line up with the trade war and Fed story in that a strong print today will encourage the Fed to continue or even accelerate their activities; it will encourage the administration that they can outlast the Chinese in this war of attrition, and so the dollar is likely to firm up while equity markets suffer. In the event payrolls disappoint, I think we could see the dollar’s modest correction lower continue and I expect that equity markets will be fine, at least in the US.

Remarkably, I don’t have space to more fully discuss what appears to be a euro positive, where Chancellor Merkel has averted disaster in Germany by getting the third coalition partner, the SPD, to agree to her immigration reforms thus keeping her government intact. As long as this internal truce lasts, there should be no further impact on the euro, but if the problem arises again (and I’m pretty sure it will soon) the euro is likely to suffer. At the same time, the pound is on tenterhooks as PM May is meeting with her cabinet today to finalize a negotiating stance regarding Brexit. If she cannot get the cabinet to agree, I expect the pound will feel the heat as concern over the fall of the May government will rise and an election campaign just nine months before the deadline for leaving the EU cannot be seen as a positive, especially with the chance that Jeremy Corbyn, the far-left Labour Party leader could become the next PM. Investors will not appreciate him in that seat, at least not at first.

As to the overnight session, the dollar is slightly softer and equity markets are under modest pressure, including US futures, as the market awaits the labor situation report. Remember, too, that many trading desks remain lightly staffed because of the holiday, and so liquidity is going to be a bit less robust than normal. If pressed my thought is that NFP will print near consensus, around 200K. I just wonder if the Unemployment Rate doesn’t tick even lower. And keep an eye on AHE, where my gut tells me it will be 0.4% enough to get Fed tongues wagging again. Net, I like the dollar to end the week on a strong note.

Good luck and good weekend
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Lack of Dismay

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The deadline for tariffs is nigh
And Friday they’ll start to apply
But so far today
The lack of dismay
Has forced pundits all to ask why

Tomorrow is tariff day, as the US is set to impose 25% tariffs on $34 billion of Chinese goods beginning at midnight tonight. The Chinese are prepared to respond in kind, and it seems that the second battle of the emerging trade war (steel and aluminum were the first) is about to begin. Interestingly, financial markets remain extremely calm at the prospect of escalation with equity prices rebounding from Tuesday’s late losses and the dollar ceding some of its recent gains. I question how long this can continue, especially if we move on to stage three of the battle, where President Trump has promised tariffs on an additional $200 billion of Chinese goods. That poses a bigger problem for China as they only import about $135 billion in goods from the US each year (hence the deficit!)

The question at hand, though, is what type of impact this will have on markets going forward. Economic theory tells us that consumers will seek substitutes for those goods but that prices will rise somewhat to offset the effects of either paying the tariffs or accounting for the higher cost of the substitutes. In other words, inflation, which has been steadily moving higher in the US, is destined to continue that trend, if not accelerate somewhat. From there, it is a short hop to higher US interest rates and a stronger dollar. However, if this process continues long enough, it is likely to undermine the US growth story. If that were to happen, weakening data would likely cause the Fed to grow more cautious in their policy normalization drive. In that event, we are likely to see the dollar’s current strengthening trend stall. As is so often the case, one set of stimuli with a particular response leads to another set of stimuli with the opposite impact. The thing is, it will probably be 2019 before there is any indication that US growth is really slowing due to the trade story, and so I see only a limited chance that the Fed adjusts its policy trajectory this year. In other words, I think despite the tariffs, the Fed will still raise rates twice more in 2018.

Perhaps we will get a better idea of the Fed thinking on the subject when the Minutes of June’s FOMC meeting are released this afternoon. And while we have heard from several FOMC members that they are beginning to become concerned about the impact of the trade war, at this point, the data continues to favor policy continuation.

In the meantime, the dollar is a bit softer this morning as Germany finally printed some good data. For the first time this year, Factory Orders rose (+2.6%). While that is encouraging, it still begs the question as to whether this is the outlier number, or whether the previous five months of data were the aberration. But the euro is higher by 0.35% and pushing back toward 1.1700. That said, it has largely been range bound, between 1.1550 and 1.1750, for the past month. It doesn’t strike me that today’s data point is going to change that.

From the UK, Governor Carney was on the tape explaining that the growth picture there has been good enough to warrant higher rates if it continues. Yesterday saw the Services PMI in the UK rise to 55.1, well above expectations of 54.0, and its highest level in 9 months. The futures market has now increased its probability of an August rate hike to 82%, which barring any disastrous announcement on Brexit, seems sufficient to allow the BOE to act. However, nothing I have read has indicated that the UK is going to come up with a workable solution for the current Brexit issues, and I continue to believe that next March, the UK will be leaving the EU with no deal in hand. If that is the case, whatever the BOE was planning will come under renewed scrutiny, and it seems unlikely that rates there will go any higher. In addition, just like in the wake of the actual vote, I would expect the pound to suffer significantly at that time. All of this tells me that GBP receivables hedgers need to be very proactive in managing those risks, especially when we get a bounce in cable.

In the emerging markets, there has been one major move since I last wrote; MXN is higher by nearly 2.5%. While the move was just beginning Tuesday morning, the market has become enamored of the idea that President Trump and President-elect Obrador are going to be great friends and solve many of the problems that exist between the two nations. I don’t mean to be negative, but I find it hard to believe that will be the case. In fact, I expect that based on campaign rhetoric, the US and Mexico will see increased tension, which I am certain will lead to the peso suffering more than the dollar. In the end, Mexico is far more reliant on the US than the other way around, so stress in that relationship will hurt the peso first.

But otherwise, amid a smattering of data and news, the dollar is mildly softer this morning. After the Minutes are released and digested, all eyes will turn toward tomorrow’s payroll report. And in fact, we get a preview this morning with the ADP employment print (exp 190K) and Initial Claims (225K). We also see ISM Non-Manufacturing (58.3), which is likely to continue to show the current strength of the US economy. In the end, we are range bound, but as of now I still see a better case for dollar strength than weakness going forward.

Good luck
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A New Complication

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Last Friday it seemed immigration
Had ceased as a cause of vexation
In Europe, but then
On Monday again
It suffered a new complication

The euro first rose, then declined
But now there’s a new deal designed
To finally forestall
For once and for all
The chance Merkel might have resigned

Remarkably, the immigration debate in Germany continues to dominate the news. Last night, German Interior Minister Horst Seehofer agreed to a new deal regarding the immigration situation and withdrew his threatened resignation. This led to a major sigh of relief in the markets as the fear of Frau Merkel’s coalition falling apart has once again receded. While Merkel clearly remains in a weakened state, if this deal can be signed by all the parties involved (a big if), the market may be able to move on to its next concerns. It should be no surprise that the euro has rebounded on the news, after all it has tracked the announcements extremely closely, but the rebound this morning, just 0.1%, has been somewhat lackluster after yesterday’s rout. Perhaps that has as much to do with the release of Eurozone Retail Sales data, which disappointed by printing at 0.0% in May, less than expected and yet another indication that growth in the Eurozone is on a slowing trajectory.

As an aside, if I were Mario Draghi, I might be starting to get a little more nervous given that the Eurozone economy is almost certainly trending toward slower growth and the ECB has very little ammunition available to counter that trend. Rates remain negative and QE is set to run its course by the end of the year. It is not clear what else the ECB can do to combat a more severe slowdown in the economy there.

But away from the daily immigration saga in Germany, the dollar has had a mostly softer session. This is primarily due to the fact that it had a particularly strong rally yesterday and we are seeing short-term profit taking.

China remains a key theme of the market as well, with the renminbi having fallen for twelve of the past thirteen sessions with a total decline of nearly 5.0%. While it has rebounded somewhat this morning (+0.35%), that is small beer relative to its recent movement. Last night, PBOC Governor Yi Gang was on the tape explaining that the bank would “keep the yuan exchange rate basically stable at a reasonable and balanced level.” That was sufficient for traders to stop their recent selling spree and begin to take profits. While there are some pundits who believe that the Chinese will allow the renminbi to decline more sharply, I believe there is still too much fear that a sharper decline will lead to more severe capital outflows and potential economic destabilization at home. As such, I expect to see the CNY decline managed in a steady and unthreatening manner going forward. But I remain pretty sure that it will continue to decline.

Other than those two stories, here’s what’s happening today. SEK has been the biggest winner in the G10, rising 1.25% after the Riksbank, although leaving rates on hold at -0.5%, virtually promised they would begin raising them by the end of the year. That is a faster pace than expected and so the currency reaction should be no surprise. However, keep in mind that Sweden is highly dependent on trade, and as trade rhetoric increases, they could well be collateral damage in that conflict. Aussie is the next biggest winner, having risen 0.7% after the RBA also left rates on hold, as expected, but the statement was seen as having a mildly hawkish tinge to it. But remember, AUD had fallen more than 4.5% in the past month, so on a day when the dollar is under pressure, it can be no surprise that the rebound is relatively large.

In the EMG space, MXN is today’s big winner, rallying 1.3% as the new story is that there are now more areas between the US and Mexico where President Trump and President-elect Obrador will be able to find common ground. Certainly both presidents are of the populist stripe, and so perhaps this is true. But my gut tells me that once AMLO and his Congress are sworn in (it doesn’t happen until December 1!) the market will recognize that the investment environment in Mexico is set to deteriorate, and so the currency will follow.

On the data front, yesterday’s ISM data was quite strong at 60.2, well above expectations and a further indication that the economic divergence theme remains alive and well. This morning we await only Factory Orders (exp -0.1%) and Vehicle Sales (17.0M), with the latter likely to be more interesting to market players than the former. Of course, tomorrow is July 4th, and so trading desks are on skeleton staff already. That means that liquidity is probably a bit sparse, and that interest in taking positions is extremely limited. Look for a lackluster session with the dollar probably edging a bit lower, but things to wind up early as everybody makes their escape.

Good luck
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Once More Concerned

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In Europe, on Friday, we learned
That immigrant angst had adjourned
But as it turns out
There’s still much in doubt
Thus traders are, once more, concerned

Frau Merkel continues to fight
To keep her alliance upright
But traders are selling
The euro, propelling
It lower as more comes to light

The only constant in markets these days is change. Friday the euro rallied on the back of the news that the EU had come to a compromise agreement on the immigration issue and so concerns over Chancellor Merkel’s future were allayed. But apparently, that agreement was not all it was cracked up to be. Over the weekend, the CSU, the Bavarian partner of Merkel’s CDU and a key ally in her government, reiterated its hard line immigration stance and Horst Seehofer, the Interior Minister and senior CSU member, indicated he may be close to resigning. If he does, expectations are for the governing coalition to fall, and potentially new elections to be held. Needless to say, with growing concern over the viability in office of Europe’s longest serving and most powerful leader, traders have decided that Friday’s euro rally was a bit premature. And so, the euro has reversed Friday’s gains (-0.4%) and is helping to lead the charge lower for virtually all currencies vs. the dollar.

But it’s not just German politics weighing on the single currency, the data story continues to disappoint as well. PMI data showed that Manufacturing across the Eurozone continues to slowly erode, with the PMI printing at 54.9, its sixth consecutive decline. It is increasingly difficult to believe that the ECB is going to aggressively adjust its policy stance in the wake of what has clearly become slower growth across the continent.

Elsewhere in developed markets, the story is eerily similar. Politics in the UK continue to cause significant uncertainty, as the Brexit debate appears no closer to an internal resolution, let alone an agreement with the EU. There is yet another big Tory leadership meeting this Friday where PM May hopes to reach a cogent negotiating position on the key remaining issues and hence take things up with the EU. However, as there are only nine months left before the UK exits, it is looking increasingly unlikely that an agreement will be reached in time, and I have to believe that the pound will find itself under increasing pressure as the year progresses. In fact, that may well be a good thing for the UK, as they were the only country in Europe to post a better than expected PMI print, 54.4 to be exact, indicating that the weaker pound continues to help the competitiveness of UK manufacturers. In the end, though, the pound is also lower this morning, down -0.5%, and my take is that it is just a matter of time before we test, and break below, 1.30.

Japanese Tankan data (their version of PMI) was also on the soft side, indicating that GDP growth there is not likely to ramp up significantly. It is also indicative of the fact that the BOJ is not about to change its ultra easy monetary policies any time soon. While the yen has edged lower this morning, just -0.1%, my take is the yen is likely to be the most stable currency going forward as fears over a larger market correction will keep its haven status in the forefront and so offset much of the rate differential story that would otherwise weaken the yen.

Pivoting to the emerging markets, two noteworthy currencies are the Mexican peso and Chinese renminbi, both of which have fallen about 0.8% as I type. Interestingly, these stories are completely different. In Mexico, Andres Manuel Lopez Obrador (AMLO) has won the presidential election handily, winning more than 53% of the vote in a three-way election. It also appears that his MORENO party will take control of congress there. The market response is a result of the fact that he is a hard-left populist with previous calls to renationalize the energy industry as well as institute more social welfare programs. Businesses are likely to suffer under his administration, at least that is the current belief, and investors are fleeing what they perceive as a much less receptive environment. It is no surprise the peso is weaker, and quite frankly, it has further to fall. Another 5% or so would be quite realistic, and that assumes that NAFTA doesn’t fall apart. If it does, then we will likely see new record lows for the peso.

China, meanwhile, also finds itself under pressure as the Caixin PMI data last night printed softer than expected at 51.0 and added further pressure to President Xi’s plans for expanded economic growth. Remember, China is still trying to wring excess leverage out of the economy, which means that they will be tightening monetary policy. But tighter money is no way to behave when growth is slowing, and all the evidence of late from China is growth there is slowing. As I have written many times before, the key relief valve for the Chinese economy is going to be the currency, and so last night’s weakness is not an aberration, but rather the continuation of a trend that began back in March and is likely to continue until USDCNY is 7.00 or higher before the end of the year. While 0.8% is clearly a large daily move in the renminbi, and I don’t expect that the PBOC will let any day’s movement get out of hand, this trend is not nearly over.

Which takes us to the holiday shortened week upcoming and its many important data releases.

Today ISM Manufacturing 58.4
  ISM Prices Paid 77.0
  Construction Spending 0.5%
Tuesday Factory Orders 0.1%
Thursday ADP Employment 189K
  Initial Claims 225K
  ISM Non-Manufacturing 58.3
  FOMC Minutes  
Friday Nonfarm Payrolls 195K
  Private Payrolls 189K
  Manufacturing Payrolls 15K
  Unemployment Rate 3.8%
  Average Hourly Earnings 0.3% (2.8% Y/Y)
  Average Weekly Hours 34.5
  Trade Balance -$46.2B

So there is plenty to watch, with this morning’s ISM data likely to continue to show the divergence between the US and the rest of the world in terms of growth. Thursday’s FOMC Minutes will be closely watched regarding any comments on the trade situation as we have heard several Fed speakers highlight their concerns over what is happening there and how it may impact overall growth. And of course, Friday’s payroll report will be closely watched to see if the US growth story remains intact.

Friday, I assume they were dancing in the aisles at the Mariner Eccles Building as Core PCE hit 2.0% for the first time in more than six years! And while I’m assuming that most of you are in my camp when I say that I don’t really like to see the prices of the things I buy constantly go higher, we all know that central banks have convinced themselves that 2.0% inflation is the key to success in an economy. At any rate, we already know that they are willing to allow inflation to rise yet higher for a while, so I expect they will continue to travel behind the curve, raising rates more slowly than inflationary pressures should warrant. But FX is a relative game, and even if the Fed is behind the curve, they are still well ahead of everybody else, and so nothing has changed my view that the dollar will continue to benefit as Q3 progresses.

Good luck
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Perhaps, Has Been Quelled

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In Europe the powers that be
At last got around to agree
On policy specs
That are quite complex
But take pressure off Italy

So immigrants now will be held
Off shore, and some will be expelled
Frau Merkel survived
The euro? It thrived
This problem, perhaps, has been quelled

The dollar is under pressure this morning, largely led by the gains in the euro, which has rebounded 0.75%. The proximate cause of this rise was news from the EU summit that they agreed on a new immigration plan designed to reduce the pressure on Italy, a key staging point for African immigrants to the EU, as well as create a series of camps in North Africa to detain asylum seekers and refugees while they are processed. This has been a huge issue in Europe, with significant divisions amongst the various players, and has been a key driver of the rise of right wing populism on the continent. While it remains to be seen if the agreement actually comes in to force, and if it is effective in its stated goals, at least for now the market is giving it the benefit of the doubt. One critical feature is the belief that German Chancellor Merkel has now removed the threat of her governing coalition partner, the Christian Social Union, leaving the government and thus CDU/CSU/SPD coalition will continue with Merkel at the helm. Given Germany’s preeminent role in Europe, there has been significant concern that if Merkel is pushed out, ensuing EU leadership will be unable to maintain the growth momentum that currently exists. And remember, data continues to show that growth momentum in Europe is slowing anyway.

There was one bright spot on the data front, though, as Eurozone headline CPI printed at 2.0%, exactly as expected, but a positive nonetheless. Of course, the rise was entirely attributed to oil prices, as core CPI actually disappointed, falling to 1.0%, still very far from the target of “just below 2.0%”. It is by no means obvious that a more genuine inflation impulse is brewing on the Continent just yet, and so I continue to believe that the ECB, while it seems likely to end QE in December, will still not be raising interest rates for quite a long time in the future. In fact, my sense now is that Eurozone rates remain at -0.4% until Q1 2020 at the earliest.

Speaking of rates, we did hear from two Fed speakers yesterday, with both commenting on the brewing trade war situation. Bostic and Bullard remain on the dovish side of the spectrum, with each of them explaining that they were quite concerned over the possibility of a yield curve inversion occurring, and both of them remarking that their conversations with businesses in their respective regions highlighted those businesses’ concerns over the trade situation and the impacts it could have going forward. Bullard, in fact, continues to maintain that the Fed needn’t hike rates any further this year, while Bostic seems in the one more time camp.

I think it is time to have a brief discussion on the yield curve inversion situation. To be clear, I am looking at the yield spread between 2-year Treasuries and 10-year Treasuries, which in more normal times, has traded in a range of 75bps-125bps. This means that the 10-year Treasury’s yield was that much higher than the 2-year Treasury’s yield. This morning, however, that spread is just 32bps, and has been trending lower ever since the Fed started tightening policy. When the spread turns negative, it is called an inverted yield curve, and the concern arises from the fact that every time we have seen an inverted yield curve in the past fifty years, a recession has followed within a fairly short period of time.

Now I greatly respect this historical indicator and it makes sense economically that an inverted curve would lead to a slowdown in economic growth, but I think it is critical that we remember one thing that is truly different this time. In the past, the Fed’s balance sheet represented a much smaller proportion of the economy, generally less than 10%, and so any bonds they owned had only a minor impact on market pricing. Therefore it was reasonable to believe that the 10-year yield was an accurate reflection of what the market demanded for that risk. However, that is not today’s situation. Even though the Fed has begun to reduce the size of its balance sheet ever so slowly, it still remains as ~22% of the economy. And if you recall what QE was all about, it was a price insensitive bid for Treasury bonds that was designed to drive long-term rates lower, and it succeeded in doing so.

My concern is that those long-term rates are still a reflection of the Fed’s buying activity during QE, rather than an accurate reflection of investor demands regarding the risk of holding 10-year debt. In other words, they are likely much lower than they otherwise would be, in the absence of QE ever happening, and thus despite the fact that short term rates have been rising and a curve inversion seems possible soon, it may not be giving us the same type of signal. Given the strength of the US economy, and the current US inflation rate, it would not be hard to make the case that 10-year Treasury yields should be 4.5%-5.0%. After all, that would equate to real rates of just 1.7%-2.2% based on the current CPI readings of 2.8%. And real rates of 2% + or – have been the long run historical average. So if the Fed buying has resulted in 10-year Treasury yields being 170bps lower than the historical record for the economy, perhaps the angst over an inverted yield curve is misplaced at current levels. This could well be the first time that the curve inverts and no recession follows. Food for thought.

Anyway, back to the markets. As I mentioned above, the dollar is broadly weaker, which is not only the result of the European situation, but also seems a simple price correction heading into the weekend. Japanese data showed Unemployment falling sharply, as well as the BOJ able to reduce the amount of JGB purchases necessary to maintain stability in rates in that market. Indonesia surprised the punditry by raising overnight rates by 50bps, to 5.25%, which helped support the rupiyah. And in general, the dollar is on its back foot today.

I have been expecting a correction, so this price action is no surprise. Meanwhile, this morning we get the latest Core PCE number, the critical inflation data point that the Fed uses in their sorcery modeling (exp 0.2%, 1.9% Y/Y). We also see Personal Income (0.4%), Personal Spending (0.4%), Chicago PMI (60.0) and Michigan Confidence (99.1) as the month and quarter come to a close. In the end, while the dollar is under pressure today, I continue to look for the Fed to maintain its tightening cycle and the rest of the world to lag, thus the dollar remains more likely to rise going forward.

Good luck and good weekend
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Badly Misled

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There once was a theory that said
QE would prevent further dread
Of financial mayhem
From p.m. to a.m.
Alas we’ve been badly misled

Reality has now showcased
That faith here was somewhat misplaced
Thus markets worldwide
Are starting to slide
While Janet and Ben are disgraced

The human brain is a funny thing. One of its key features is its propensity to search for patterns in potentially random data. But even keeping that in mind, I cannot help but notice a pattern of market jitters across an increasing number of markets.

When the Argentine peso started falling sharply earlier this year (-47% YTD), it was seen as an idiosyncratic response to locally grown problems. After all, the financial situation in that country has been dire for years. When the Turkish lira started falling sharply a few months later (-22% YTD), it was attributed to concerns over the central bank’s diminishing independence in the face of pressure from Turkish President Erdogan. Again, this was seen as country specific and not part of a trend. Traders then noticed that the Brazilian real was seriously underperforming (-18.8% YTD), and it was chalked up to concerns over the upcoming election and ongoing economic malaise. But then the Mexican peso, which had rallied sharply at the beginning of the year, turned tail in April and has fallen more than 11% since then. Of course, this was chalked up to NAFTA and trade issues as well as the seeming certainty that AMLO, a left-wing populist firebrand, will be the next president of the country.

Pivoting to Asia we have started to see sharper declines in the Indian rupee, historically a much less volatile currency than those mentioned above, but now down -6.3% YTD and trading at a new historically low level. Indonesia? The rupiyah is down 8% YTD having fallen 4% in just the past three weeks. Thailand? Similar to Mexico, after a solid Q1 performance, it has fallen 6.2% in Q2 and is now lower by 3% on the year. And of course there is the Chinese yuan, which fell a further 0.3% overnight taking its YTD loss to 1.7%, but its Q2 performance to -6.0%.
This laundry list of currencies that have been under pressure is hardly exhaustive, but merely shown to demonstrate that this is not random data, but an actual pattern. And what is the common denominator for all these countries? Each one of them saw massive investment inflows over the past ten years as the Fed, ECB, BOJ, BOE, BOC and SNB, to name but a few, all massively expanded their balance sheets while driving longer term interest rates lower in an effort to help support their respective economies. In other words, they were all proponents of QE.

QE was always suspect as during the actual asset purchase stages, the central banks explained that the flow of purchases was the key feature of the process that would help improve economic outcomes. However, when they stopped buying assets (although not all of them have) they explained that it was still good because it was the stock of assets they had already purchased that was the important feature helping to improve economic outcomes. And then, when the Fed could no longer countenance the idea that QE was critical, given the US economy’s strong performance, they told us that reducing the balance sheet was merely background noise, “like paint drying” according to then Fed Chair Yellen, and would have no impact at all on markets or the economy. Now I don’t know about you, but this messaging never really made sense. How is it possible that expanding the Fed’s balance sheet >$3 trillion of assets would help the economy, but that contracting the balance sheet would have no impact?

Well, folks, we are witnessing that impact every day now. Whether it’s the Shanghai stock market, down more than 20% since January, or all of the currencies listed above, or rising bond yields across the entire emerging market space, the market somnolence calm that had prevailed for much of the past decade seems well and truly over. And not only that, this process is really just beginning. Market turbulence is going to be the new normal. And I assure you, this is entirely the result of QE, an emergency measure that morphed into central bankers’ favorite and most widely used tool for all occasions.

The point of all this is to remind you that volatility is neither unprecedented nor unusual when it comes to currency markets. In fact, prior to the financial crisis in 2008-9, it was the norm. And so those of you charged with hedging FX exposures need to keep on top of your programs, they are going to be crucial in mitigating earnings volatility going forward.

Please excuse my rant, but every once in a while things just pile up and need to be vented! Turning to the overnight markets, the dollar has actually had a mixed session, e.g. gaining vs. the pound but falling vs. the euro. However, this session follows yesterday’s NY trading which saw the dollar rally across the board. Ultimately, the central banks continue to maintain an outsized impact on the currency markets, and none of them are about to change their current policy trajectories. So a tighter Fed moving much faster than every other central bank means that the dollar will remain supported as we go forward. The question is more how far it will rally rather than if it will rally.

As to today’s data, we see the third reading of Q1 GDP (exp 2.2%) as well as Initial Claims (220K). Two Fed speakers, Bostic and Bullard, add to the mix, but given that the data has remained consistently upbeat in the US, it seems unlikely that they are going to change their tune very much. Instead, the big picture remains the same, broad dollar strength amid more volatile markets, but given recent price action and dollar strength, a mild dollar correction today doesn’t seem a bad bet.

Good luck
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Not So Benign

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The worries in China have spread
From stocks to renminbi instead
Its recent decline
Seems not so benign
And could drive more market bloodshed

Well, if President Xi’s goal is to make China the most talked about nation in financial markets, he is clearly on the right track. Of course, he may not like the tone of the conversation!

Once again, Chinese markets are dominating the global discussion with continued declines overnight in equity markets there (Shanghai -1.1%, Shenzhen -1.3%) alongside the recent weakness in the renminbi. This morning, CNY has fallen a further 0.4%, with the dollar now trading above 6.60 for the first time since last December. It is becoming abundantly clear that the PBOC is quite willing to allow further weakness in what appears to be a reaction to the ongoing trade dispute with the US. In the past two weeks, USDCNY has risen every day with the total movement clocking in at more than 3%, and quite frankly, there doesn’t seem to be any reason for it to stop. Last night the PBOC was seen intervening heavily in the market in an effort to moderate the decline, but it seems highly unlikely that the government there wants to stop it completely. As I mentioned yesterday, their key concern is that a more rapid decline in the yuan will result in significant capital outflows, or at the very least a sharp drop in capital inflows, and that has the potential to destabilize markets in China, and eventually, elsewhere in the world. And for a country that has been trying to burnish its image as a responsible global financial citizen, causing global market destabilization is clearly not the desired outcome. At any rate, given the ongoing standoff regarding the US-China trade situation, it seems highly unlikely that CNY will stop falling soon. Look for a gradual decline with a year-end target of 7.00 still quite viable in my mind.

Away from China, however, FX market activity has been less exciting. While the dollar continues its broad trend higher, the pace remains muted. For example, this morning, amongst the G10 currencies only NZD has moved more than 0.2%, with kiwi falling 0.6% as the market prepares for the RBNZ meeting this afternoon. Expectations are for no change in policy, but the suspicion is that the bank is becoming more dovish due to escalating trade rhetoric between the US and China.

Important economic data from the G10 is more notable by its absence than by what it is telling us about the economy. Last night brought us UK Home Price data, showing the slowest rate of price increases in five years, with prices in London actually falling by 1.9%. Combining this with testimony by Jonathan Haskel, who will take his seat on the MPC come September 1st, which showed him to be somewhat more dovish than Ian McCafferty, the member he is replacing, has clearly weighed on the pound. Otherwise, we saw a bit of mixed confidence data from Italy, soft confidence data from France and weak Irish Retail sales. None of this was very inspiring as evidenced by the euro’s 0.2% decline.

Meanwhile, the emerging market space remains under pressure as concerns over trade weigh heavily on the sector. It is important to remember that virtually every EMG country is dependent on its export sector for economic growth, and as the global free-trade framework that has existed for the past 70 years starts to come undone, these economies are going to suffer. The only potential exception right now is for the oil producers as President Trump’s recent call for a complete boycott of Iranian crude products has helped drive oil prices up by nearly 4% this week. So RUB, MXN and MYR have been able to outperform their EMG peers, although this morning all three are down vs. the dollar. In fact, the dollar has demonstrated strength throughout the market today, just as it has been doing for the past several months.

As to this morning, we see Durable Goods data (exp -1.0%, +0.5% ex transport) and we hear from two Fed speakers, Randy Quarles and Eric Rosengren. However, it seems unlikely that any of this will have a major market impact. Rather, I expect that the broad equity weakness that has been evident of late will continue (currently futures are pointing to a -0.5% opening in the US) and the risk-off tone that has engendered will help the dollar to remain underpinned. And of course, there is the ever present risk of some new commentary from President Trump that has the chance to upset markets. So volatility remains a good bet, as does modest continued dollar strength. This story is not even close to ending.

Good luck
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In re Trade

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Investors are growing afraid
That things will get worse in re trade
In Shanghai they’re shaken
With stocks there forsaken
At home, market bulls are dismayed

For the time being, there is only one story that seems to matter, the brewing trade war. Rhetoric is heating up on both sides of the Pacific and concerns are growing that what initially seemed to be a negotiating position by the US is morphing into a firm stance. It is becoming increasingly clear that President Trump believes that he can ‘win’ a trade war, and that China will suffer much greater harm in a much shorter time period than will the US. And despite yesterday’s equity market decline at home, the story in China remains significantly worse as evidenced by the Shanghai Index, which has now fallen more than 20% since January. At the same time, we continue to see the Chinese yuan suffer on a daily basis, with last night’s decline of a further 0.6% taking the movement over the past week alone to nearly 2.0%.

It can be no surprise that the CNY continues to weaken, as the currency remains the main safety valve for the Chinese economy. China is still mercantilist at heart, and the competitiveness of its exchange rate is a crucial factor in economic growth. As I mentioned yesterday, the PBOC’s key concern is that excessive weakness in the yuan will result in significantly more capital outflow than desired, which will in turn weaken the yuan further and potentially cause a more negative stock market reaction. We saw this occur in August 2015, and then to a somewhat lesser extent in January 2016, and both times the government’s response was to tighten rules restricting capital flows. While those tighter rules remain in effect now, if we see a more accelerated decline in the currency, look for yet another wave of regulation there to prevent further damage. It is, of course, somewhat ironic that as President Xi tries to appear as an internationalist in certain forums, his immediate response to a market hiccup is to close off access to investors, both domestic and foreign.

But CNY is not the only currency impacted by the current narrative. In fact, the entire emerging market space is under pressure with month-to-date declines in KRW (-4.5%), THB (-3.1%), MXN (-2.1%) and CAD (-2.6%). Well, even if Canada is not actually an emerging market, it has clearly been hampered by the trade story and NAFTA. And arguably, that is the driving force across all currencies right now.

Which nations will suffer the most if the global trading framework that has been developed over the past 70 years comes undone? It will be those nations where trade represents the largest share of the economy. A quick look at World Bank data from 2016 on the subject shows that Luxembourg is atop the list, with trade representing >400% of GDP followed closely by Hong Kong (373%) and Singapore (318%). While those are extremely high numbers, heading down the list shows that almost every EU country comes in above 100%, with even mighty Germany at 84%. Meanwhile, the US sits at just 27%. If you wonder why President Trump believes the US can win this ‘war’, it is because of data like this. The US retains the ability to be self-sufficient in almost everything, something that no other nation on the planet can boast. And while it would be inefficient and drive inflation higher, it seems pretty clear that the administration is going to push this envelope as far as it can. So be prepared for the trade story to dominate the headlines for the next several months, especially if US economic data doesn’t falter. And ironically, despite the fact that a weaker dollar would be more beneficial to the US in this case, look for the dollar to continue to outperform.

As to the rest of the FX market, the dollar has stopped its recent corrective decline and has rebounded this morning across the board. There has been vanishingly little data to absorb, and so my sense is that we are merely watching the trade story rhetoric play out. Yesterday’s New Home Sales data was quite strong, but that remains a relatively small sector of the entire housing market, and so is not the best descriptor of the economy. This morning’s data includes Case-Shiller Home Prices (exp 6.8%) and Consumer Confidence (128), neither of which should be too impactful. Rather, market players in every market will continue to watch the tape for the latest trade news and try to determine whether things are still heating up or whether the rhetoric has peaked. If pressed, I would say we are not close to a peak, and that this story has real legs. As such, I think the dollar will continue to be the main beneficiary for the time being.

Good luck
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