When viewing the world as a whole
While most of it’s been on a roll
Five nations stand out
For increasing doubt
Their future’s are under control

It began with Argentina, moved to Turkey and has now spread to Indonesia, India and Brazil. I’m speaking, of course, about the increasing market turmoil in each one of these nations. They all share certain characteristics; each is running a significant current account deficit, each has seen inflation pick up (in some cases quite significantly) and has been forced to raise short term interest rates to counter growing instability in their currency markets, and each has seen outflows of capital by international investors. While the situation has not yet reached the point where contagion is clear, the fact that there are now five countries feeling similar pressures is somewhat disconcerting.

It was roughly twenty years ago when we saw our last EMG crisis (starting in Thailand in 1997, spreading throughout Asia that year and then into LATAM and EEMEA in 1998 and culminating with Russia defaulting on its debt.) It was not a happy time for investors and it certainly was not a happy time for citizens in those countries. This begs the question, are we beginning to see the same type of scenario unfold? On the one hand, EMG countries learned a key lesson then and have all built up much greater FX reserves to help them support their currencies in times of stress. On the other hand, almost every EMG nation, as well as many companies based in those nations, have been funding themselves in the USD market because of the artificially low interest rates available due to Fed monetary policy. In fact, that financing has grown to be over $2.7 trillion. And that offers a different avenue down which contagion can spread.

Now that the Fed is tightening monetary policy by both raising interest rates and reducing the size of their balance sheet, these borrowers are feeling significant stress. And that stress is reflecting itself in weakening currencies. It has become a vicious cycle; higher US rates draws investment back to the US causing capital outflow and a weaker currency, which puts greater stress on those nations’ ability to repay that debt. Of course the weaker currency leads to higher inflation, which drives higher local interest rates which slows the growth cycle in those countries. And that encourages further capital flight and more currency weakness, starting the cycle all over again.

So far we can still count the problem countries on one hand, but with Brazil now added to the mix, we have run out of fingers. This matters to us all, not because we are necessarily invested there, but because of the possible impact it will have on Fed and other G10 central bank thinking. In fact, there has been a pattern recently of the central bank governors of these nations speaking out against the Fed continuing to tighten policy. If the Fed raise rates each quarter this year, my take is that we will need more than two hands to count the countries that are feeling the stress, and that the consequences for global markets will not be positive. So despite last month’s speech by Chairman Powell, where he dismissed the idea that emerging market economies were suffering solely because of Fed policy, it strikes me that the Fed’s reaction function may be forced to change before the year is over. Perhaps rates are not going to go as high as I had previously expected, although inflation still seems like a safe bet to continue rising. However, if this scenario plays out, where the Fed is forced to stop tightening policy because of an EMG crisis, the dollar will still be the beneficiary of a major risk-off event. While I am not forecasting this outcome, I think it is critical that we be aware of the potential for more market volatility because of this situation.

Enough doom and gloom. This morning we are looking at the dollar’s continued correction lower from last month’s strong rally. Despite weak German Factory Order data (-2.5%), the market seems far more focused on the Praet comments from yesterday about the timing of the ECB ending QE. In fact, there were far more articles on the subject today than yesterday. And it has been the driver behind the euro’s 0.4% rise this morning. Meanwhile, the pound has given up its early gains, which were based on higher than expected housing prices, on the news that PM May is trying to quell a battle within her cabinet regarding Brexit. My take from 3000 miles removed is that the problems are intractable and that we are going to see PM May’s government fall and new elections with a new weak PM, Jeremy Corbyn. While my head tells me that this should be a Sterling negative, I have a suspicion that the market will respond to his softer approach to Brexit and actually push the pound higher. But this will likely take a few more weeks, if not months, to play out. In the meantime, I continue to believe that the BOE will be unable to raise interest rates, and the pound has only limited upside for now.

The other story that is getting a lot of press is the G7 meeting that starts tomorrow in Ottawa. The US decision to impose tariffs on imported aluminum and steel from Canada and Europe on national security grounds has resulted in a great deal of pre-meeting commentary by the leaders of all six of the other nations. And rightly so, as they are all clearly US allies and have been for decades. But given that the tariff story has been ongoing for months, it strikes me that there is very little new impact likely from this situation. For FX hedgers, it is just not that important.

Yesterday’s US data showed that oil exports reached a record and the Trade deficit was a smaller than expected -$46.2B. Alas, productivity rose only a scant 0.4% while Unit Labor Costs rose a more than expected 2.9%. Those are not great numbers for the economy, but as we have seen consistently in Q2, risk continues to be added to portfolios with increasing abandon. This morning’s only data point is Initial Claims (exp 225K), and the Fed is in its quiet period ahead of next week’s meeting. All that adds up to the likelihood of a pretty quiet session in the G10 space. Of greater concern will be how the EMG space behaves, especially BRL, which has been depreciating about 2% a day for the past several sessions. If USDBRL should reach 4.00 (currently 3.85), I fear we may see the beginnings of more EMG contagion. However, right now, USD consolidation seems the most likely outcome.

Good luck
Adf

So Peter Praet let us all know
That even though Europe’s growth’s slow
He still thinks it’s right
To make money tight
For doves though, it’s not apropos

“It’s clear that next week the Governing Council will have to make this assessment, the assessment on whether the progress so far has been sufficient to warrant a gradual unwinding of our net asset purchases,” Praet said in a speech in Berlin on Wednesday.

The euro is higher this morning (+0.4%) after a number of comments by ECB officials indicated that despite what has been a clear moderation in the growth trajectory in the Eurozone, they are ready to discuss the timing of the end of QE at next week’s meeting to be held in Riga, Latvia. In addition to Praet’s comment above, we heard from Germany’s Weidmann and Klaas Knot of the Netherlands that ending asset purchases by the end of the year was both “plausible” and “reasonable”. In addition, Ardo Hansson, the Estonian council member, told us to be alert for a faster pace of rate hikes once QE is over. All this is extremely hawkish commentary relative to what we have been hearing, although the speakers are all known hawks.

One needn’t be too cynical to consider that the reason for this sudden show of hawkishness is the concern that if the ECB delays the decision further, the data will start to contradict their efforts. After all, while last month’s inflation reading was surprisingly high, it was clearly due entirely to the recent rise in oil prices, as evidenced by the fact that the core rate remained at 1.1%, which has since moderated significantly. In addition, the initial comments from the new Italian government demonstrate that they are not backing down on their goals of flouting fiscal restraint by both cutting taxes and increasing spending. The concern there is that bond markets are unlikely to take kindly to that type of policy and that Italian BTP’s could sell off quite sharply again. Remember what happened just last week when the market was concerned that a new election would bring even more populists into the governing coalition. The point is that it would seem difficult for the ECB to be tightening policy at the same time the Italian government bond market was falling sharply. So as both these issues present a very real potential future, and as the ECB staff is ready to release their latest economic forecasts, next week may be the only opportunity for the ECB to guide policy before the September deadline. This will certainly be the thrust of the discussion in markets until then.

Beyond the ECB story, the pound has benefitted (+0.3%) from news that the Labour Party has put forward an amendment to the Brexit legislation designed to insure the UK maintains full access to the EU’s single market after the process is complete, a decidedly softer outcome than has been discussed until now. Of course, it is not clear what the benefit of the entire process would be if the UK followed this road, as the key elements they were seeking from leaving the EU, maintaining sovereignty over immigration and legal jurisdiction, would likely be compromised by this stance. And keep in mind this is just a proposed amendment, not a new law, and can still be voted down. In the meantime, though, the pound is higher.

Generally speaking, most currencies are firmer against the dollar this morning, although much of the movement seems to be in sympathy with the euro, rather than because of any specific news. One exception to this idea is INR, where the rupee has rallied 0.35% after the RBI unexpectedly raised rates by 25bps to 6.25%. While they were careful to indicate this was not the beginning of a tightening cycle, given the reality that inflation in India, at 4.8% is well above their midpoint target of 4.0%, it is hard to believe that a single 25bp move will be sufficient. As well, given the rupee has been the worst performing APAC currency this year (-5.0%), and the fact that the Fed continues to tighten policy, it seems that this won’t be the last rate hike we see here.

On the other side of the ledger, BRL had a dismal day yesterday, falling 1.70%, as concerns over yet another populist election outcome grew. The real has been the worst performing currency this year, falling more than 22% so far, and this has forced the central bank into the market to try to stem the decline. Yesterday, they offered an additional $1.5 billion in their weekly swap program, which had only a temporary positive effect. Given the dollar’s underlying weakness this morning, it would not be a surprise to see the BRL perform better today, however, given the driving force seems to be local politics, and that there will be no resolution for another couple of months, I suspect that a test of 4.00 cannot be far away.

Looking forward to today’s session, it brings the bulk of the week’s data from the US with the Trade Balance (exp -$49.0B), Nonfarm Productivity (0.7%) and Unit Labor Costs (2.8%) all released at 8:30. However, we will need to see something extraordinary to drive markets. At this point, the market continues to focus on next week’s central bank meeting bonanza, with the big 3 (Fed, ECB and BOJ) all scheduled. It seems entirely reasonable that given the underlying drivers of today’s movement that the dollar continues to suffer today. However, recent price action across the G10 seems much more like consolidation ahead of next week’s central bank decisions. So hedgers might want to take advantage of the modest recent weakness in the dollar during this period of mild volatility and consolidation.

Good luck
Adf

Momentum in Europe keeps slowing
Though British results show it’s growing
The market’s response
Evoked nonchalance
Resulting in to-ing and fro-ing

This morning is one where there is not very much new to discuss. The big picture stories remain in place and little changed. So Italy is still Italy and its new populist government seems assured of being confirmed by the Italian parliament today, but policy changes remain a future concern, not a present one. The global trade situation remains fraught as the US continues to try to pressure other countries to adjust their trade terms, although so far, there has been precious little movement on this front either. And all the other big background stories (Turkey, Argentina, North Korea) continue to grind on with no new information.

In fact, the biggest market news today has been the better than expected UK Services PMI and Retail Sales data, with the former printing at 54.0 and the latter showing a 4.1% jump according to the British Retail Consortium, it’s largest rise since January 2014. It should be no surprise that the pound rallied on the news, and it is the top performer of the session, currently higher by 0.5%. The futures market also increased the probability of a BOE rate hike in August back toward 40%, from its recent depths of 30%, although I would argue that is not nearly high enough to force the BOE’s hand.

Speaking of the BOE, the key question is, will they really consider raising rates come August? I continue to believe the answer to that is ‘No’, and here is why. On the positive side, today’s data was certainly encouraging, but given the Q1 performance of GDP growing just 0.1%, the data really has to point to significant growth. We will need to see a continuous stream of data that shows UK GDP growth is heading back toward 0.5% or more per quarter in order to exorcise those Q1 demons. That seems a tall order, especially given that the UK’s largest export market, the EU, is having growth issues of its own. But that also points to the other key issue, and the one which I believe will prevent the BOE from moving, Brexit. With a shade over nine months until the UK is scheduled to exit the EU, there has been remarkably little agreement on what the future relationship between the two will look like. The EU has essentially offered the UK the opportunity to remain part of the Customs Union, continue paying into the EU budget, and retain access for UK companies in a manner similar to the situation before Brexit. Of course, that is not very attractive to the Brexiteers. The problem is that the UK has not put forth any concrete proposals as to how to create a workable exit without a complete reversion to WTO rules and no special deals. Every economic analysis shows that a hard Brexit will result in a more significant slowdown in the UK, one where raising rates would be deemed a clear policy error. When adding it all up, it seems far easier for the BOE to remain on the sidelines until there is clarity on Brexit rather than raising rates now and being forced to reverse course in the event things turn out badly. This is especially true given that their sole mandate, inflation, continues to decline and is now only modestly above target. It strikes me that a pound rally based on higher UK rates seems unlikely for now.

The other data of note was the Eurozone PMI data, which showed a continuing slowdown in the economy there. All indications are that the Eurozone saw peak growth in Q4 2017, and that since then, the Continent has been easing back. While recent political turmoil in Italy, and arguably Spain, has probably not helped, this slowdown has been ongoing since well before those situations flared up. Slowing Eurozone growth should continue to undermine any euro rally as it will simply make it that much harder for the ECB to justify tighter monetary policy. In fact, it seems more and more likely at this point that the ECB will not even reduce QE in September, but instead will delay any changes until early 2019. And that will not help the euro.

Apart from these two currencies, the G10 space has been quite dull, with today’s movement hovering in the 0.1%-0.2% range. However, we have seen a sharp move south of the border, with MXN falling 0.75% this morning following a sharp 1.0% decline yesterday. The story here continues to revolve around both NAFTA, which has started to look less likely to get renewed, and the upcoming presidential election, where Andrews Manuel Lopez Obrador (AMLO) is leading the polls by 18% and is now believed to have majority support. This means that the opposition will be unable to prevent some of his worst tendencies, and the nation’s fiscal credibility, to the extent it has any, will be called into further question. My take is that the peso has further to fall as this combination of issues will be too hard for something as mundane as higher interest rates to overcome. Investors will be loath to invest in Mexico if the new regime talks of nationalizing energy assets and other foreign investment. In fact, I would expect the peso could fall far more sharply, especially if the election outcome removes the oppositions voice in policy.

But away from Mexico, even the EMG bloc is relatively quiet this morning, with nothing new in ongoing stories and no new stories to note. As to the US session today, we have ISM Non-Manufacturing released at 10:00 (exp 58.0) and the JOLTS Jobs report (6.543M) at the same time. Certainly, the former will be watched closely, especially given the dearth of news that has been released lately, but my sense is that the market is unlikely to react significantly to the data. Rather, today is setting up to be a pretty dull session. As I wrote yesterday, until the FOMC next week, it is difficult right now to see a good reason for significant movement.

Good luck
Adf

The worries from Europe have faded
As traders have now been persuaded
They needn’t divest
As further unrest
From Italy has been blockaded

So now much attention is turning
To whether the yield curve’s concerning
Its flattening trend,
Has some at wit’s end
With thoughts that recession’s returning

Markets this morning look quite different than they did Friday morning as we have seen two key changes. First, last week’s angst over the Italian government has essentially been forgotten, with yields on Italian government paper falling back further under the premise that the new coalition government is not going to try anything drastic. And second, the very strong jobs report on Friday has led to concerns that the Fed is going to increase its pace of tightening and potentially invert the yield curve.

Looking at Italy first, it seems to me that the idea that all is well is misplaced. After all, the same players are still there, and neither Five Star nor the League has changed their respective electoral platforms. In other words, while there doesn’t appear to be an immediate concern, I expect that we are going to see ongoing pressure from the Italian situation for many months to come. In the end, their proposed fiscal plans are extremely expensive and they just don’t have the money to pay for them. This will require a certain amount of creativity, which I expect will result in the eventual issuance of ‘mini-BOT’s’. These, you might recall, are Italian government issued Treasury notes in small denominations that would be usable for paying taxes and other bills to government institutions. Historically, when paper of this nature is issued, it becomes a medium of exchange for non-government items as well, although they tend to trade at a discount to the main currency. In fact, what will almost certainly happen is that people will hoard their euros and use these notes for everything they can, thus effectively creating a parallel currency in Italy. I’m pretty sure that the ECB will be extremely unhappy about this situation, and that there will be a lot of discussion about the issue. I’m also pretty sure that the euro will come under pretty significant pressure if it occurs.

What I find amazing is that the crisis last week occurred because the new government wanted to appoint Paolo Savona, an avowed euro skeptic, to the post of Finance Minister. If that was such a problem, how can his being appointed European Affairs Minister in the same cabinet be seen as so benign? The only thing of which I’m certain is that this story is not nearly over.

The other big news on Friday was the blowout jobs report, with Nonfarm payrolls jumping 223K and the Unemployment Rate falling to 3.8%. The market response to this data was a sharp equity rally, a sell-off in Treasuries and a dollar rally. Underpinning these moves was the idea that the US growth trajectory continues to outpace that of the rest of the developing world, and so US interest rates would continue to lead the way higher. But that was Friday’s story, not today’s.

This morning the dollar has retraced a decent portion of last week’s gains, with the euro up 0.6%, the pound 0.3% and both Aussie and Kiwi up around 1.0%. We have seen similar moves in emerging market currencies with ZAR +1.2%, TRY +0.5%, and even CNY +0.25%, a large move for the renminbi. This stems, in part, from fears abating and risk-off positions being unwound. However, it also seems to be related to the ongoing trade dialog, where the US has pissed off the entire world regarding the imposition of tariffs. The orthodox economic view of these tariffs is that it will weaken the US economy and drive up prices, both of which ought to undermine the dollar. And I think that is what we are witnessing this morning. Of course, if we have learned anything about the Trump administration, it is that policies can be changed on a whim, and so taking a long-term view on this process would be a mistake in my opinion. There is just too much variability possible.

There is, however, one other thing to watch closely, and that is the shape of the yield curve. The ongoing strong economic data has the market pricing in a more aggressive Fed, thus pushing up short-term yields. However, while Treasury prices have fallen a bit, yields there remain well below the levels seen two weeks ago, and this has led to the 2’s-10’s Treasury spread falling to just 38bps this morning. It is a universal fear that if the yield curve inverts it is a harbinger of a recession, and historically that has clearly been the case.

But I wonder if the signal has the same meaning in this environment. After all, in the past, the Fed’s balance sheet was much smaller relative to the economy, and they affected monetary policy by actually adjusting the quantity of reserves in the system. However, since QE, they no longer do that. Rather, there are still trillions of dollars of excess reserves in the system, and instead they adjust policy by paying interest on those reserves. In the meantime, their balance sheet holds trillions of dollars of Treasury bonds, which has reduced the available supply for investors. Remember, that was the entire purpose of QE, to drive down back end rates. Isn’t it possible, if not likely, that back end rates remain artificially low due to the amount on the Fed’s balance sheet? And if that were the case, wouldn’t the idea that the curve is inverting because back end rates are low result in a suspect signal with regards to a recession? My point is that given how different the monetary situation is in the US now compared to all the previous times the yield curve inverted, isn’t it possible that an inversion now is not a reliable signal? Food for thought.

Ok, a quick look at the very light data calendar this week shows that there is really nothing of note on the docket.

As well, there are no Fed speakers with the FOMC meeting upcoming next week, as they are now in their ‘quiet period’. We do hear from the RBA tonight, but there is no rate move expected. In fact, my sense is that this week is going to be dominated by stories like the ongoing Italian saga and the trade situation. The dollar has had a good run and it makes a lot of sense that it would take a breather and consolidate for a while. My take is that is what we will see until the FOMC meets next week.

Good luck
Adf

The crisis in Rome has abated
As two parties have been mandated
To govern together
Like birds of a feather
The League and Five Star are now mated

So markets have turned their attention
To trade, or perhaps its prevention
New tariffs in place
Have started a race
By nations to show their dissension

Political ructions in Italy have calmed down with the appointment of a new government. President Mattarella has approved the latest cabinet of the coalition government, which is set to win a parliamentary vote and begin governing right away. While its policy mix is unorthodox, and there are still many things that can go wrong, at least the immediacy of a major political problem seems to have been eliminated. Italian bonds rallied although they remain well below prices (yields are higher) than seen this time last week. We have not heard the last of this problem.

Meanwhile, Spanish PM Rajoy just lost a confidence vote and has been replaced by Socialist Party leader Pedro Sanchez, who is heading a coalition including Podemos, a radical leftist party and the Catalan nationalists who want to secede. It seems that this is a marriage of convenience and is unlikely to last for a long time. However, while I expect that things may get messy periodically in Spain, there is no indication that the vibe is anything like in Italy, where the question of EU membership remains a serious topic.

With politics out of the way, we can look at economics. Well, I guess this is politics too. At any rate, as of today, the US has imposed tariffs on steel and aluminum imports from Mexico, Canada and European nations, which has resulted in an immediate response by all three. Each nation has implemented its own tariffs in return taking the world another step away from the idea of free trade. Interestingly the market response to this news was extremely muted. It appears that this may have fallen under the category of old news. Either that or nobody really knows how to respond yet. If pressed, I would suggest that a reduction in global trade will be a dollar negative over time simply because most trade is denominated in dollars. This means there is always a bid for them as countries need to pay their import bills. Reducing those bills will reduce the demand for dollars. Will that be enough to offset the interest rate impacts we have been feeling lately? Probably not yet, but if we see the tariff story increase in scope, then it is a good bet that the structural dollar weakness story will start to dominate the narrative, and we could well see the dollar fall at that point.

One other interesting piece of news overnight was the reduction of JGB purchases by the BOJ in their most recent operation. This continues their process of stealth tapering…or does it? The market response was muted, with the yen actually falling after the news (-0.45%), and my take is that the BOJ already owns so many JGB’s, and there is so little liquidity left in that market, that they just don’t need to purchase so many in order to achieve their rate objective. Remember, their current goal is to keep 10-year JGB yields at 0.0%, and they are comfortable as long as it remains below 0.10%. Well, last night the yield closed at 0.048%, well within its range. This looks like a technical adjustment, not a policy shift, and I would not read anything into the change.

A quick look around the market shows that the dollar, despite its strength against the yen, is having a mixed session. Both the euro and pound are modestly higher (~0.1% each) as PMI data across the Eurozone showed stability, which was better than the declining trend we had been seeing, and the same data from the UK actually ticked higher, albeit to still well below Q4 levels. The rest of the G10 is a mixed bag with AUD and NZD weaker while CAD and CHF are both stronger. The point is that there is no defining dollar story here, each currency seems to be responding to its own catalysts. CAD, for example, continues to benefit from the growing belief that the BOC is going to raise rates in August. EMG currencies have also had a mixed performance with the standout movement coming from TRY again, as the lira has fallen 2% this morning. But we saw strength in INR (+0.4%), IDR (+0.7%), TWD (+0.4%) and KRW (+0.2%) last night. LATAM currencies are little changed this morning and the CE4 have barely edged higher. My point is that there is no rhyme or reason to today’s movement.

Which brings us to the last big data point of the week, this morning’s payroll report. Here are the current expectations:

Yesterday’s Chicago PMI was quite robust at 62.7 and Personal Spending rose a more than expected 0.6%, both data points helping to underpin the idea that the US growth story remains the strongest amongst developed nations. In fact, the Atlanta Fed updated its GDP Now forecast for Q2 to 4.7%, although that seems pretty high. However, considering this news as well as comments from Fed Governor Lael Brainerd yesterday that further gradual rate hikes were appropriate and likely to continue until the Fed Funds rate was above the neutral rate (meaning policy would actually be tightening) has simply reconfirmed the idea that the Fed is going to raise rates at least two more times this year, regardless of the ongoing questions about other currencies. The Fed is on a mission, my friends, and that mission is to normalize policy while they can. There is a clear realization that the economic expansion will not last forever, and they are very keen to have some policy ammunition when the next downturn arrives. While the Fed is far ahead of every other central bank on the planet, they are still inadequately armed. With this in mind, it is easier to understand my strong belief that the dollar is due to continue climbing for the time being. And in fact, unless we see a significant escalation in the brewing trade war, I see no reason for that trend to end.

Good luck
Adf

Inflation in Europe returned
At least for last month, so we learned
Does that mean in June
That Mario’s tune
Will change and QE’s overturned?

Markets continue to relax after Tuesday’s panic over the situation in Italy. Yields on Italian debt have fallen sharply, although not yet nearly to their pre-crisis levels. US Treasury yields are climbing again as investors are no longer desperately seeking safety, although yields here remain below levels seen last week. While the political situation in Italy remains ‘fluid’, it appears, as of now, that the Five-Star / League coalition is going to return to President Matarella with a new government proposal, rather than trying to force a new election. Of course, until Matarella approves the list, the potential for a repeat of Tuesday’s price action remains. However, the market has moved on for now.

Instead, this morning the surprising news has been the inflation data from the Eurozone, where the May data showed a much larger than expected increase to 1.9% with the core level rising to 1.1%. While expectations were for both rates to rise, it appears that rising energy prices had a much bigger impact than forecast. And that is really the crux of the matter as the ECB will be loath to react to inflation that is solely driven by changes in gasoline prices. This begs the question as to what the ECB will do when they meet in two weeks’ time.

If you recall the beginning of the year, the narrative had described a situation where synchronous global growth would push the ECB to announce by the June meeting that they would be ending QE completely in September, and then raising rates sometime in Q2 2019. Of course reality intervened and as it became increasingly clear that global growth remained US led, with the Eurozone starting to lag, that story changed. The latest iteration has been that the ECB will wait until its July meeting to announce its plans, and that a reduction in, though not elimination of, QE was likely to be revealed. Estimates are for QE to decline to either €10 billion or €15 billion per month for the final three months of 2018, with an option to continue if deemed necessary. This altered timeline also pushed the first potential rate hikes back until the second half of 2019. And of course, as this process evolved, the euro declined.

But now the ECB has a different problem, politics is intervening again. Not only is the situation in Italy disruptive, but Spain is also looking at a modest upheaval, where PM Mariano Rajoy, a pro-market, center-right leader is about to face a vote of no confidence from parliament there. The ECB’s problem is that he appears likely to lose the vote, as he leads a minority government with limited support. This opens the way for a more radical left-leaning leadership with designs on increasing government spending and worsening the country’s fiscal outlook. If both Italy and Spain see political shifts to the left, where fiscal rectitude (not that Italy ever had any) is ignored, and market turmoil increases, it will become that much more difficult for the ECB to contemplate tighter monetary policy in the near term. With the July meeting only two months away, Signor Draghi is going to find that he will be unable to please any constituents no matter his actions. The German bloc remains uber hawkish and is very keen to see QE end and higher rates return. The peripheral nations could be devastated if that policy is followed.

It is with this in mind that I continue to look for the ECB to err on the side of easier policy. My contention is that the ECB will not even reduce QE in September, but extend it at €30 billion/month through the end of the year as they await further data to see if inflation is actually beginning to take hold, and to see how things play out in both Italy and Spain. And given that expectation, I continue to look for the euro to decline further as the year progresses. While this morning it has continued its rebound from its Tuesday lows, it is only higher by 0.3%, and trading at 1.1700 as I type. While I don’t doubt we could see a little more upside, I strongly believe it is limited.

In fact, the dollar is softer overall this morning, as the panic attack from Tuesday continues to abate. G10 currencies are all performing well, with a number of others (GBP, CAD, CHF) all rising similar amounts to the euro. Of these, CAD is of interest as it had a much larger move yesterday, jumping 1% in the immediate aftermath of the Bank of Canada announcement yesterday. While they left rates on hold, as universally expected, they removed dovish language from their statement and hinted strongly that they would be raising rates twice more this year, with the next move coming in August. That is a more hawkish stance than the market had expected as there continue to be concerns over the housing market in Canada and the fact that the entire nation seems to be somewhat overleveraged. However, the BOC is looking at the overall growth picture as well as the fact that inflation there is running at 2.3% according to the latest data, and concluding that the economy can withstand modestly higher rates. Consider, that even if they raise rates twice more, their base rate will still only be 1.75%, hardly restrictive. However, given the change in perception, the CAD rally is not surprising.

Turning to the EMG bloc, while APAC currencies all performed well, led by IDR (+0.7%) after the central bank there raised rates for a second time in two weeks, the story in EEMEA is a bit different, with the CE4 all rising, but both TRY and ZAR down a bit. TRY remains extremely volatile as President Erdogan continues to roil markets with his unorthodox economic views, but ZAR appears to be more technical in nature, with profit taking driving the market right now. Finally, both BRL and MXN remain under broad pressure as the issues of elections in both nations and NAFTA for Mexico add to uncertainty in investors’ eyes.

This morning brings a bunch more data as follows: Initial Claims (exp 224K); Personal Income (0.3%); Personal Spending (0.4%); PCE (0.2%, 2.0% Y/Y); Core PCE (0.1%, 1.8% Y/Y) and finally Chicago PMI (58.4). Given the Fed’s utilization of PCE in their models, all eyes will be there at 8:30. But in reality, unless the number is surprisingly different, investors will start to focus on tomorrow’s payroll report. Yesterday’s ADP number was a touch softer than expected, but still a robust 178K. The problem seems to be more about finding workers than job openings available. In the Fed’s eyes, they will be searching for more evidence that wages are rising, as Powell and company will assume that will feed into the general inflation level and encourage continuing policy tightening.

So while the dollar is under pressure today, I expect that this modest correction is coming to an end soon, and that we are far more likely to see it resume its strengthening trend, perhaps as soon as this morning if the data warrants. But the trend remains in place for the dollar to go higher in the medium term.

Good luck
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Apparently all is not lost
No Maginot line has been crossed
But Italy’s still
Devoid of goodwill
And markets will be turned and tossed

The acute fears felt in markets yesterday morning have abated somewhat today. While nothing has really changed in Italy, which has been the epicenter of the current crisis, the tone of the commentary has been softened. As in all politics, the initial disagreement is always loud and abrupt as each side tries to rally its supporters, but in the end, a compromise is usually reached. At least that has been the pattern during the post WWII era. Of course, during the past two years, arguably ever since the Brexit vote, that pattern has been called into question.

My contention is that during the past 75ish years, there has been a tacit bargain between politicians of all stripes and their constituent populations as follows: most people don’t really care that much about politics, nor about who leads their country. They are far more concerned with their personal situation seeking mostly to earn a decent living, take care of their family, go on vacation periodically, and perhaps most importantly, believe that their children’s lives will be as good or better than theirs. While there are certainly single issue voters, who care deeply about a particular subject (think pro or anti-abortion, pro or anti–gun restrictions, etc.), the bulk of the population just doesn’t care that much. This situation is why it is rare, at least in the US, for one political party to win more than two presidential elections in a row; people just get tired of one party trying to do too much and are willing to change things around. And while there have been recessions during this period, they tended to be pretty short-lived and so were not sufficient to alter the big bargain, which could be stated as: we don’t care who wins political office as long as our lives are reasonable. Don’t take too much in taxes and give us a chance to believe things will get better and we are ok.

But then came the financial crisis in 2008-9. The subsequent recovery has been so anemic around the world that after six or seven years, broad sentiment started to change. People looked around and saw that the political classes were not doing simply ok, but were thriving, yet their own circumstances were not improving much at all. At least that was the perception. And it is this change in view that has led to the upheavals in politics that we have witnessed since June 2016, when the UK voted to exit the EU. Antiestablishment candidates and parties have performed extremely well since then, with the Italian elections in March simply the latest manifestation of that situation. The question, at this point, is really about just how far each of these parties is willing or able to push their agenda. And it will differ in each country. So is Italy going to be the straw that breaks the camel’s back? Is this the time when one of the major post WWII institutions, which have been under attack before, finally succumbs to the populist vote?

My view is that the odds are much higher than ever before. Remember, even though the UK left the EU, the EU remains intact and is fighting fiercely to show why it is still relevant. But if Italy were to become Quitaly and leave the Eurozone, it is not clear that the euro would be able to survive the blow. And given that a new election in Italy seems destined by September, and the antiestablishment parties now command ~60% support in the polls, it is entirely possible that bigger things are coming.

Consider the financial repercussions that would occur in this event. Redenomination of Italian euro debt to lire debt would have a devastating impact on the entire Eurozone banking sector, as well as the ECB, which is the largest holder of that debt. All the money that Italy has borrowed from the rest of the Eurozone, its so-called Target2 balances, would be called into question as to its likely repayment. While Italian yields would skyrocket, they would almost certainly repudiate a large chunk of debt (they’ve done it multiple times in their history). The new lire would certainly tumble, but that would have the salutary effect of supporting their export industries. And while inflation would surely rise sharply, it is not hard to believe that the country would be able to recover relatively quickly without the strictures of German fiscal prudence holding them back.

Meanwhile, the euro would likely fall sharply to begin with, but eventually, it should recover. After all, if one of its weakest links were to leave, the remaining countries would represent a stronger bloc. But the one thing that is certain is that markets would be disrupted across the board for at least a few weeks, and possibly longer, as investors tried to figure out what would come next. Yesterday was a little foretaste of what might happen in the event of Quitaly. But it would be a much bigger impact.

However, they are not leaving today, and in fact, the market is far more sanguine that they will not do so at all. Italian bonds have recovered some of yesterday’s losses, while Treasuries and Bunds have both sold off a bit. The dollar has fallen pretty substantially against most currencies, with SEK (+1.35%) actually leading the way in the G10 while the euro has rebounded 0.8%. EMG currencies have also performed well this morning, led by ZAR (+1.1%) and HUF (+1.25%). Given the enormous volatility we have seen in TRY lately, its 1.8% rise seems merely ordinary. Equity markets have rebounded somewhat, with Italy’s MIB leading the way at +2.2%, but the DAX (+0.5%) also showing some spirit. (US futures are little changed at this point.) In other words, yesterday’s risk-off scenario has been unwound to some extent. It seems that the ‘buy the dip’ mentality continues to be a key driver in markets.

While there are many other things that ordinarily would have had an impact on markets (increased discussion of US tariffs, a rate hike in Indonesia, oil’s sharp price decline to name just three), that is not the market’s focus right now. That information will need to be assimilated going forward, but seems unlikely to drive a large price move. Of course, that is until those tariffs are imposed, or OPEC announces a change in policy, or something else happens and Italy drifts into the background. But that, too, is unlikely today.

Rather, looking ahead to this morning we see ADP Employment (exp 187K) and the second estimate for Q1 GDP (exp 2.2%, down from 2.3% initially). Later this afternoon comes the Fed’s Beige Book, which seems likely to continue to show US economic strength. Yesterday saw Case-Shiller Housing prices continuing to advance at a 6.7% clip while Consumer Confidence remains buoyant with a reading of 128.0, up from 125.6 last month. The point is that the data is not driving markets, the story is. If the story continues to evolve where 5-Star and the League in Italy moderate their demands, then we will head back to a data focused market, but that will take a few more days to get market participants to believe it, so my guess is that we remain hostage to Luigi De Maio and Matteo Salvini, the leaders of those two parties for the time being.

Good luck
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Remember “whatever it takes”?
When Draghi addressed old mistakes?
Now all that he’s done
Is under the gun
With Italy’s newfound headaches

But it’s not just Europe’s unrest
That has traders clearly depressed
The EMG bloc
Too’s feeling the shock
And assets there are now distressed

While we enjoyed our Memorial Day holiday in the US, and the UK celebrated (?) its Spring Bank Holiday, the rest of the world decided it was a good time to create some trouble, at least from investors’ perspectives.

Italy is the locus of the primary issue, where the constitution there requires that the winning party in an election propose a cabinet to be approved by the President. Usually this is a mere formality in the process, and any cabinet proposed becomes the new government. But these are not usual times. This time, President Sergio Mattarella has rejected the cabinet, or more specifically, the appointment of 81-year old Paolo Savona as Economics Minister. Savona, a former Bank of Italy official, is a known euroskeptic and given the rhetoric that we have heard from the coalition of the League and 5-Star, both of which have discussed leaving the euro in the past, Mattarella decided that it was too risky to allow someone like Savona into the government. Instead, Mattarella appointed a former IMF official, Carlo Cottarelli, to be PM and form a government. The last phase before a government is seated is that parliament must vote to approve it, and generally this, too, is a mere formality because the winning party, with the majority in parliament is forming the government. But not this time. It is almost certain that Cottarelli will not gather enough support and that will force new elections. The thing is, according to the polls, the antiestablishment coalition is likely to win an even larger share of the vote in the new election, which will ratchet up the pressure further.

It can be no surprise given this unfolding situation that Italian markets are under severe pressure. Italian yields have exploded higher, with 2-year yields rising 169bps, to 2.59% and 10-year yields jumping a further 56bps to 3.31%. Spreads vs. German bunds have blown out and the euro has taken another leg lower, now trading at 1.1550, down 0.6%, to its lowest level since last July. But it is not just Italy that is causing stress in Europe, Spain is also under pressure as PM Mariano Rajoy is due to face a vote of no-confidence, which given he is running a minority government, could well force another election there. Both Portuguese and Greek debt are feeling the pressure as well, with the entire Eurozone periphery seemingly looking to recreate the debt crisis of 2011-2012.

And so, the result this morning is the classic risk-off scenario. Equity markets are getting drubbed, with Italian stocks leading the way lower, -2.7%, but the Spanish close behind at -2.6%, and even Germany down -1.4%. (S&P futures are currently pointing to a 1% decline on the open in the US.) Treasuries, meanwhile, have jumped a full point and the 10-year yield is back down to 2.85% having touched as low as 2.80% earlier in the session. Bunds have also rallied with yields down to 0.27%, as have Gilts. In the FX markets, it can be no surprise that the yen has firmed, rising 0.5% as a haven, but the big winner is the dollar, which has rallied against every other currency. And it is the continued dollar strength that is causing the second set of ructions in the market, specifically in emerging markets.

I have written in the past about the issues with a stronger dollar regarding emerging markets. During the seven-year period when US rates were effectively 0.0%, both emerging market companies and sovereigns availed themselves of the cheap financing. And as long as the dollar remained stable or softened and US rates remained low, everything was grand. But you may have heard that US rates have been rising lately, with the Fed having raised rates six times already and pretty certain to push them another 25bps higher next month, and of course the dollar has been anything but weak. So now, these EMG players are finding that all their plans have been disrupted. The stronger dollar has forced both sets of borrowers to pay up in local currency terms in order to pay interest and repay principal of those loans. And the higher US interest rates have forced them to pay higher rates when it comes time for refinancing. So you can see that this has created a vicious cycle where higher US rates beget a higher US dollar which forces EMG companies to use more local currency to pay their interest, which weakens their currencies causing the dollar to firm up even more.

We have already seen the problems in Argentina and in Turkey and in Malaysia and in Brazil and in Indonesia and in South Africa… The thing is we are likely to see these same problems manifest themselves in a wider array of countries going forward, with a major concern being India, where they are running a significant current account deficit, a harbinger of future problems. And then there is China, which controls things more than most, but which is currently trying to address its own problems regarding over leverage and the shadow banking system. Going forward Chinese room for maneuver is likely to be less robust than it has in the past because of the impressive build-up of leverage there. As I have written in the past, one of the release valves for economic pressure there is the renminbi, and it would not be surprising to see USDCNY head back toward 6.75 if things in the emerging markets continue along this path.

With that as a backdrop, let’s take a quick look at the array of data coming this week:

As you can see, we have a very big data week to add to the mix of market information. Obviously, the payroll data is the big one, but quite frankly, Core PCE cannot be ignored.  And this will all happen with the problems in Europe continuing to unfold and risk likely to be shunned further.

The biggest concern for most central bankers is that it appears a new crisis is unfolding and most of them have very little room for maneuver when it comes to adjusting policy.  If rates are already negative, it’s hard to cut them further.  QE programs are ongoing, and the talk is that they will be winding down.  But ask yourself how can Mario Draghi end QE if Italy is about to collapse in chaos? Meanwhile, the Germans will object strenuously to the continuation of QE if that is the decision.  Ultimately, as I have written in the past, the reality remains that the ECB will find itself in no position to end monetary accommodation for quite a while yet, and the euro will suffer accordingly. In fact, while I was beginning to think that the dollar’s run might be coming to an end, these latest issues have simply reaffirmed that the dollar has further to run.  At this point, regaining all the ground it lost in 2017 seems to be a conservative bet.

For now, markets will react directly to every pronouncement from Italy, so watch the tape for those, but the trend remains your friend, and the trend is for the dollar to continue higher.

Good luck

Adf

The summit betwixt Trump and Kim
Was called off by Trump on a whim
Thus risk was disposed
And when markets closed
The future had looked mighty grim

But last night the news that we heard
Was Kim would still meet, undeterred
Thus buyers returned
And seemed unconcerned
The process was wholly absurd

Yesterday saw risk reduction in the form of softer equity prices and firmer Treasury prices as the ongoing saga of the proposed summit between President Trump and North Korean leader, Kim Jong-Un, was called off by Mr Trump due to the increasingly antagonistic rhetoric by the Koreans. It seems that many investors were basing their decisions on the idea that détente between the two nations would help alleviate one of the thorniest geopolitical issues currently percolating (arguably, Iran is the other right now). So calling off the talks was seen as a distinct negative for markets. But at this point, my take is this is all part of President Trump’s negotiating tactics, based on the fact that the North Koreans responded quite quickly that they were still willing to meet. And perhaps those tactics are working as it makes the Koreans seem more desperate to get a deal done. The upshot is that what had been a mild risk off session before the Korean response, turned around to a mild risk on session. The lesson to be learned here is that basing any financial market decisions on the twists and turns of the current geopolitical process is a hazardous way to act.

As I write this morning, equity markets around the world have edged up from yesterday’s declines, but remain largely within recent trading ranges. The bigger signal is from the Treasury market, where even this morning yields on the 10-year continue to decline, now down to 2.96%, and an indication that bond traders and stock traders see the world differently right now, with the bond boys and girls far more risk averse. Finally, pivoting to the FX universe, after a down and up day yesterday (falling early before rallying into the close), the dollar is extending its late day gains, albeit mildly. The thing is today’s dollar price action seems far less about the dollar per se, and more about the broad swath of negative news we’ve seen from elsewhere.

Data from the Eurozone showed that the German economy has yet to show any signs of a rebound from its much weaker than expected first quarter. The IFO survey printed at 102.2, unchanged, but still continuing its six-month declining trend. The euro edged lower by 0.2% upon the release and has basically remained there since, hovering right around 1.1700. Based on its recent price action, it certainly seems like the euro has further to decline.

The UK gave us the second reading of Q1 GDP, which reconfirmed that growth there was just 0.1%, a mild disappointment to those who have been trying to argue that the first print overstated the problems. The pound also suffered on the release and is down 0.3% on the session, falling to its lowest level in six months. From Japan, Tokyo CPI data, which is seen as a harbinger for the nation as a whole, fell to just 0.4%, weaker than expected and an indication that talk of the BOJ changing its policy anytime soon is foolish. In fact, I think it is more likely that they expand their QQE program than curtail it. The yen, which had benefitted from the recent risk aversion, has backed off slightly today, falling 0.2%.

But that is my point, none of these are dollar stories, rather today is a session of idiosyncratic market reactions. Another great example is SEK, where the Swedish debt office has decided to take a large long krone position, SEK 7 billion ($800M) as part of their management program. This is directly at odds with the Riksbank, who has been working hard to weaken the currency to stoke inflation. The result is that SEK is stronger by 0.3% against the dollar and 0.6% vs. the euro. But again, that is not a dollar situation.

The emerging markets offer the same tale, with Turkey, the current poster child for economic mismanagement, offering to allow banks to repay certain dollar borrowings from the central bank with Turkish lira. That will certainly have a short-term positive impact, but it does nothing to address the underlying fundamentals within the Turkish economy, and is likely to be a temporary benefit at best.

It is difficult to look around the markets today and come away with a consistent theme. Instead, it appears that investors and traders are looking ahead to the long weekend in both the US and the UK and have decided to moderate positions so they can enjoy the beach. Nothing has changed in the background stories, whether it is the Fed’s ongoing policy tightening, or the lack of a compelling case for the ECB to begin to tighten further. Inflation is not evident in Japan, Turkey, Argentina, Indonesia and Brazil are still under significant pressure and the dollar’s recent strength continues to undermine many previous investment memes. Now, none of this has addressed the US fiscal imbalances nor the idea that the dollar is likely to suffer in the long run. But as Lord Keynes reminded us, in the long run we are all dead. It could be a very long time between now and when the market starts to actually take those big structural issues into account. As such, my advice remains to manage your risk based on the current cyclicals and that still points to the dollar advancing for the foreseeable future.

Ahead of the holiday weekend we get one piece of data, Durable Goods (exp 2.6%, 0.0% ex transport) and we get to hear from Chairman Powell at 9:00. I’m confident that the market is far more interested in what he has to say than in the data print. However, it is inconceivable to me that he will change his tune at all. Look for him to continue to dismiss global volatility and to say policy is on the right path for now. In other words, US rates will continue to rise and the dollar along with them.

Good luck and good weekend
A

It’s likely appropriate soon
That rates will be raised, prob’ly June
Or so said the Fed
When Minutes were read
By traders Wednesday afternoon

But also, that self-same report
Explained that the Fed would not thwart
A rise in inflation
Unless the formation
Of bubbles caused them to abort

Yesterday’s price action was a study in contrast. The morning was dominated by the growing fear of contagion as the ongoing rout in the Turkish lira led to a decidedly risk-off tone in markets. Equity markets fell around the world and the dollar, yen and Treasuries all rallied. This was even in the wake of the Turkish central bank finally responding to the lira’s sharp decline and raising a key interest rate 300bps. While that had a temporarily positive impact on TRY, it was not nearly enough to turn broader market sentiment around.

But when the FOMC Minutes were released yesterday afternoon, the market gained a new, happier perspective on the world. While the Minutes made clear that the Fed was going to raise rates in June, it remained circumspect on whether there will be one or two more additional rate hikes coming. But what really turned things around was when traders and investors saw the following words, [a period of inflation] “modestly above 2 percent would be consistent with the committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations.” In other words, the discussion about the symmetry of the 2.0% inflation target was reaffirmed.

The implication is that even as inflation continues to print higher over the coming months, and that seems almost baked into the cake given the arithmetic behind the calculation, the Fed is telling us that they are not going to overreact and raise rates more aggressively than currently forecast. I guess the new debate will be on just what defines ‘modestly.’ Is 2.2% modestly above their target? What about 2.5%? Is there even a number that the FOMC members have in mind? However, the one thing that is clear is that the market has reduced the expected trajectory of Fed rate hikes, and that led to very predictable outcomes. The first was that the US equity markets, which had been under pressure prior to the Minutes, all rebounded and closed higher on the day. The second was the dollar, which has been a huge beneficiary of the evolving theme that the Fed was going to get more aggressive, gave back some recent gains. And finally, Treasury yields fell further as the fear over inflation in the long run was overwhelmed by the idea that the Fed would not be in the business of driving the short end of the yield curve up to inversion.

Which brings us to today’s session. The dollar has continued to cede ground, down broadly, although not universally. For example, the most notable data from the Eurozone was a softer than expected German GfK Consumer Confidence print at 10.7, but the euro is still higher by 0.2%. On the positive side, UK Retail Sales in April were much firmer than expected, rising 1.6% in the month, and helping instill some confidence in the prognosis for the UK economy. It can be no surprise that the pound is the leading gainer today, up 0.4%.

But arguably, the most notable news after the Minutes was the new threat of tariffs of up to 25% on imported automobiles into the US on national security grounds. It should be no surprise that car manufacturers’ stock prices have all suffered, or that the equity markets in both Tokyo and Seoul fell after the news was reported. My sense is that this may also be a tacit way for the administration to signal it wants to see the dollar retreat a bit. Remember, back in February both President Trump and Treasury Secretary Mnuchin discussed how a weaker dollar was beneficial to the US manufacturing sector. While we haven’t heard much on that front lately, I’m confident they are not unhappy that their comments are having this effect. But in the end, barring actual activity by the Treasury on the subject, which I think is an extremely remote probability, the market will continue to focus on the Fed, the ECB, the BOE and their brethren central banks. In other words, FX markets will continue to be driven by central bank activity and expectations thereof.

Putting it all together, the implication is that markets are going to be watching the data even more closely as the central banks are truly becoming data dependent. For the Fed, clearly the PCE data is going to be the primary data point, although CPI will still affect market movement. In the UK and Eurozone, I think the growth story will be the driver, as the ECB has made clear they want to remove QE but need justification to do so, and that justification will come from an end to the recent down trend in economic statistics. Japan is still on the inflation train, so higher prints there will offer the opportunity for the BOJ to back away from some of their QQE. And generally, every G10 central bank will be even more focused than usual on the data results.

The dollar has had an awfully good run for the past six weeks, regaining all of its lost ground from earlier this year and starting to cut into last year’s losses. My take is that the Minutes are going to bring a halt to that run for the time being. I don’t expect the dollar to fall sharply, simply to consolidate its recent gains. However, despite the Fed’s clear willingness to allow inflation to rise above their target, I think that is a limited resource, and one that will be used up before the end of the summer. If pressed, while 2.2% is probably not going to raise any hackles on the FOMC, I think that anything above 2.3% will be seen as courting danger and draw out a completely different tone from the Fed. For now, though, it is a waiting game. Better than expected US data will see the dollar benefit somewhat, and worse than expected data will see it fall. Of course, this all presumes that some emerging market doesn’t go pear-shaped, and cause a broader risk-off meme. In that event, the dollar will benefit just like in the old days!

Today brings the weekly Initial Claims data (exp 220K) and Existing Home Sales (5.60M), neither of which seems likely to drive markets. We continue to hear Fed speakers, as well as other central bank speakers, and until the PCE data gets released next week, I expect that will be the most interesting thing to market participants. Early this morning, BOE Governor Carney and NY Fed President Dudley both spoke at a conference and discussed the replacement of LIBOR, not monetary policy. But we hear from both Bostic and Harker later today, and much more importantly, Chairman Powell tomorrow morning. So there is still plenty that can happen.

Good luck
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