Can anyone be that surprised
That markets, their values revised?
With trade wars prevailing
Investors are wailing
Meanwhile now the buck’s pulverized

Risk, my friends, is on the run. What a difference a week makes! Just last week, we had seen equity markets regain most of their early February losses and inflows into equity funds exploding. The Treasury market was quiescent, trading in a narrow range and the dollar had edged slightly higher amidst dull market activity. Goldilocks had risen Phoenix-like from the ashes of the early February inflation scare. That was so last week. This morning, the world is a completely different place. Clearly, the biggest issue has become global trade after President Trump imposed tariffs on ~$50 billion worth of Chinese imports and the Chinese retaliated, thus far in a measured fashion, with their own tariffs on ~$3 billion of US goods. And remember, this follows in the wake of the US steel and aluminum tariffs that were imposed late last week. (As an aside, the metals tariffs have been reduced to basically China, Russia and Japan with the Canada, Mexico and Europe being left off the list. Japan is a curious inclusion as I thought the Japanese were an ally as well, but that’s the situation.) However, the latest round is completely different, specifically targeting one nation and of much greater scale. It should be no surprise that investors are reducing positions in their riskiest assets and fleeing to the safe havens of the world, at least as currently considered.

First the yen, which is trading back below 105.00 for the first time since Mr Trump’s election in 2016, looks like it has further to run. We continue to see futility in the BOJ’s efforts to create inflation in the economy. Japan continues to run a massive current account surplus, thus drawing more funds into the country, and the expectations that there would be investment outflows given the growing interest rate gap with the US have been short-circuited, not least by the fact that the 10-year yield in the US has fallen nearly 15bps from its recent peak in the rush to safety. Highlighting the problems that Kuroda-san has was last night’s Japanese CPI data, printing at a lower than expected 1.5% with the core, the rate they target, remaining at just 1.0%. Funnily enough, the one thing that will clearly occur if a trade war begins to expand is that inflation will pick up everywhere. Somehow, though, I don’t think Kuroda, or any central banker for that matter, will be pleased with that outcome. In the end, as long as trade is the lead headline, look for the yen to continue to gain, albeit slowly.

Treasuries, as mentioned above, are also still perceived as a haven and yesterday saw a sharp rally with yields there falling to their lowest level since late January. Despite the increased issuance required, and despite the fact that the Fed will be bidding for fewer Treasuries over time, right now investors are responding to the increase in anxiety due to the trade story and its impact on equity prices. One of the things that has been so interesting during the past 18 months has been the positive correlation between bonds and stocks, a direct result of the Goldilocks narrative. Solid growth underpinning higher stock prices but low inflation keeping interest rates in check. Historically, these two asset classes have a negative correlation, and that historic relationship is reasserting itself. The issue here is that countless portfolio strategies were built on the idea that
Goldilocks would go on indefinitely. As it becomes clearer that will not be the case, all of those strategies will find themselves in increasing difficulty and likely see further unwinding. And this points to further equity market adjustments. The real question is the speed with which these occur, and the trade story has simply accelerated the movement.

The other thing that is back in the news is the increase in volatility. Back in February, it was the unwinding of the short volatility ETF’s that drove the equity market correction. But it seems that was merely the first hit to Goldilocks. One of the points I have maintained for a long time is the fact that market volatility, across asset classes, was likely to come back more quickly than generally anticipated. And I have a feeling that is what we are beginning to see now. The VIX index is back near 25, a level seen in February during the rout, and prior to that last seen after the Brexit vote in June 2016. In other words, options are back in vogue. The real question is how long it can retain this elevated level. Volatility is a mean-reverting characteristic, with mildly trending markets typically punctuated by spikes, like we are seeing now. The thing is, given the extraordinary length of time that volatility was depressed by global QE; it is conceivable that it will take a fairly extended period of high volatility to offset the previous condition. As those Goldilocks based strategies are unwound, odds are that market activity will continue to be quite choppy.

So what does this mean for the FX market? Well, I expect that we are going to see some significant divergence in different currencies. For example, the yen and Swiss franc should likely be strong performers during this period. Both remain safe havens, as does gold, which is up more than 1% this morning, and neither is likely to lose that status. As to the euro, my take is it will wind up doing very little at all. While the Eurozone runs a C/A surplus, which is a clear positive for the currency, there is still little indication that the ECB is going to step up the pace of policy tightening. This is going to continue to undermine the euro bullish position of an accelerated pace, and when contrasted to a Fed that has clearly turned more hawkish, will weigh on the euro.

Meanwhile, the pound has been feeling its oats as traders anticipate that the BOE is set on a path of tighter policy with a 25bp hike almost baked in for the May meeting. I continue to question just how much the BOE will be able to do given the overhang of Brexit, but at this point, based on their recent meeting outcome with two voters looking to raise rates immediately, unless we see a serious equity market correction around the world before they meet again, it certainly appears they will raise rates. And arguably, the pound should hold its own accordingly.

The real action will happen elsewhere in the world, with many emerging market currencies likely to see significant pressure. For example, last night KRW fell 1% as South Korea is right in the crosshairs of further trade tensions. We are also seeing stress in other currencies in this bloc as USD funding costs increase due to technical factors in the US. I’m sure you have heard about the widening of the LIBOR-OIS spread, which in the past has been a harbinger of credit stress (it widened sharply during the financial crisis and the European bond crisis) although this time it seems to have a more benign explanation driving it. But in the end, higher LIBOR means higher funding costs for all those emerging market companies and countries that have used the dollar market to manage their finances. The point is that there will be continued stress in this area and that many emerging market currencies are likely to underperform while this market anxiety persists. This is especially true in LATAM and APAC although less so in EEMEA as many of those companies/countries fund in euros. In the end, I have a feeling a broad dollar index will exhibit limited movement, but that we will see some fairly large activity in the crosses.

As to today’s session, there are two data points, Durable Goods (exp 1.7%, 0.6% ex transport) and New Home Sales (620K). We also hear from four Fed speakers, Bostic, Kashkari, Kaplan and Rosengren, however given that we just heard from the Fed on Wednesday, it would be surprising if the message changed at all. And so, with equity markets around the world under continuing pressure and US equity futures pointing lower, my take is we will continue to see risk be removed. Look for further yen strength and emerging market currencies to remain under pressure.

Good luck and good weekend
Adf

It turns out the market misread
How strong are the hawks at the Fed
Though rates they did raise
They saw some delays
Ere rates rise much higher ahead

Meanwhile from the Old World we learned
The path of growth, lower has turned
So Draghi and friends
May need to extend
QE when June’s meeting’s adjourned

The upshot of yesterday’s FOMC meeting and press conference was that the Fed raised rates by 25bps, as expected, but the changes in the dot plot were further out in time than many had forecast, coming in 2019 rather than a fourth hike this year. What this did accomplish was to raise the terminal rate in this cycle to 3.40%, up from the previous rate of 3.10%, although the long-term view remains much lower than historical levels and is still anchored below 3.0%. And so this was declared to be a dovish tightening by pundits everywhere. We also learned that Chairman Powell is not as beholden to his own models, as arguably he hasn’t built any himself, and therefore seems far more willing to listen to others and observe the economy instead of assuming his own model is reality. That is certainly a healthy change! He continues to speak more forthrightly and in another blessing, cut things short at the press conference in less than forty-five minutes as compared to former Chair Yellen’s penchant to ramble on for well more than an hour. So perhaps reality and brevity will come to define Powell’s Fed, and if so, we are all better off.

The market response was less optimistic as equity markets, which had traded higher all day prior to the meeting, fell in its wake and closed lower. The dollar, which had edged lower ahead of the meeting added steam to that movement and fell quite sharply. Meanwhile, Treasury yields, which had been treading water, rose about 3bps. In other words, no market’s expectations were fulfilled. Again, I think that is a positive outcome. I believe the financial markets are far healthier when there are clearly different opinions around instead of the situation we have seen for most of the post financial crisis period, which is everybody has to be in the same trade. A little more daily volatility is likely to result in significantly less drama when there is a major change.

Before I look at today I need to correct something from yesterday’s note, the reasoning behind the strength in MXN and CAD that we saw yesterday. It turns out that the movement was directly related to unconfirmed news that the US was climbing down on a NAFTA demand about US content in automobiles. That had been a major sticking point, especially given the way supply chains for the Big Three had developed over the past twenty years, but now seems to bring the process one step closer to a successful renegotiation. It is not surprise that both currencies rallied on the news.

As to this morning, the noteworthy outcome has been the Eurozone Flash PMI data, which came in softer than expected for the second month running. While the numbers are still strong, the trajectory is less positive than it had been all last year and is starting to call into question just how much faster and for how much longer the Eurozone economy is going to be able to grow above trend. In fact, the euro has traded lower on the news, (-0.2%) although that is only a small portion of yesterday’s gains. Certainly, if the growth trend slows further, Signor Draghi will have a hard time claiming that QE must end abruptly in September and we are likely to see it extended even further. At the same time, the pound has added to yesterday’s gains after UK Retail Sales data showed a surprising improvement, with the headline number rising 0.8% in February compared to expectations of just a 0.4% increase. So for two days running we have seen UK data show resilience despite the ongoing uncertainty over Brexit. One other noteworthy mover in the G10 space has been AUD, which is down 0.35% this morning after Australian labor market data disappointed. The Unemployment Rate rose unexpectedly to 5.6% and the number of employed grew less than expected. This will certainly not encourage the RBA to raise rates sooner, and if it continues, could well see talk of yet another cut eventually. It should be no surprise Aussie is soft this morning.

Meanwhile, in the emerging markets, there has been far less drama and currency movement. Obviously, the big question remains over the tariff announcement the Trump administration is due to make today regarding China. The word is they are seeking to impose tariffs on $50 billion of Chinese imports while the Chinese are readying retaliation. No good can come from this process, but I expect that we will start to go down the road before either side blinks. Interestingly, the renminbi has fallen 0.2% ahead of the news, which for that currency is a pretty good-sized move. But away from that, the EMG bloc is a mixed bag of gainers and losers with nothing showing an outsized reaction to anything.

This morning brings the usual Initial Claims data (exp 225K) and then Leading Indicators at 10:00 (exp 0.3%), although neither seems likely to have a major impact on markets. There are no Fed speakers today, although we hear from three tomorrow morning, so the FX market will be looking for other cues. Equity futures are pointing lower at this point, but the bond market has rallied slightly, generally giving opposite signals to the dollar. My sense is that with the Fed out of the way, the broad based dollar weakening narrative is likely to return, and so further softness is on the cards today. But over the medium term, I continue to look for the dollar to rebound.

Good luck
Adf

The question on lips that we see
Is four hikes more likely than three?
Could well be alluded
If not quite concluded
When next speaks the FOMC

Well, the big day is finally here and at 2:00 this afternoon the FOMC will release its latest monetary policy statement. Shortly thereafter, Chairman Powell will face the cameras in his first press conference as Fed chair. Here’s a recap of the situation as we await the news: at the December policy meeting the Fed raised rates 25bps, their fifth such rate hike since the process began two plus years ago, and penciled in three more rate hikes for 2018. However, in the intervening three months, US fiscal policy has been given a significant boost from both tax cuts and reform and a large increase in deficit spending. We have also seen US data perk up, specifically inflation data on wages, which has been a key lagging indicator for the Fed. Finally, we heard from Chairman Powell in his congressional testimony that in his personal view, things were definitely better in the economy. This series of events has led a large contingent of analysts to now expect the Fed to raise rates four times this year and perhaps again next year. Meanwhile, futures markets are pricing in a 39% probability of a fourth hike in 2018 and not even three hikes in 2019. This is where the rubber meets the road on my views for the dollar going forward. I continue to come down on the side that the Fed will be more hawkish than the market is pricing, and that as the market adjusts US rates higher, the dollar will benefit. But right now, it’s all speculation. We will find out this afternoon, and we can evaluate the situation tomorrow morning.

In the meantime, a look at the FX markets shows that after a very strong performance yesterday by the dollar, it is under pressure this morning. Yesterday’s movement seems to have been the result of positioning, or more accurately the unwinding of some of the massive short dollar positions that are extant. This morning, the most notable story has come from the UK, where the pound has rebounded sharply (+0.5%) after much better than expected UK employment data. The Unemployment rate in the UK fell to a lower than anticipated 4.3%, and the 3-month employment change rose by a much greater than expected 168K. The implication here is that the UK economy is going to weather Brexit far better than might be expected and that Governor Carney and the BOE are right to raise rates soon and begin addressing above target inflation. While I remain skeptical on the issue, if the data continues to show the UK economy improving, then I will have to change my view.

Elsewhere in the G10, the dollar is also lower, but there has been very little in the way of specific data or news to drive the movement. As I said before, this appears to be position adjustments ahead of the FOMC this afternoon.

In the EMG bloc, however, we are seeing some very substantial movement, notably MXN which has rallied more than 1% this morning on the back of the ongoing rebound in oil prices. Oil has reacted to heightening tensions between Saudi Arabia and Iran, collapsing Venezuelan production and increasing demand as evidenced by the surprising inventory drawdown in yesterday’s US data. This movement has helped not only the peso, but also RUB and CAD. The rest of EEMEA is generally firmer this morning as well, as this group continues to mirror the euro’s movements, but APAC currencies had a more mixed session, with both gainers and losers there. It seems that the dollar’s softness really started at the end of the Asian session, so is more developed in Europe. In the end, though, all of these currencies will be beholden to the FOMC’s actions this afternoon, so I wouldn’t get too caught up in the movement thus far.

And that’s really it for the day. At 10:00 we see Existing Home Sales (exp 5.42M) but it is hard to believe that the market will truly respond to that number today. Equity markets are little changed this morning after a bit of a whipsaw earlier this week with sharp declines Monday followed by a modest rebound yesterday. The 10-year yield continues to hover in its 2.85%-2.95% range, showing no signs of wanting to break out in either direction yet. However, one thing of note is the ongoing increase in 3mo LIBOR, which has hit 2.25%, its highest level since 2008. It seems that the increase in borrowing by the Treasury, which has largely been effected through short term Treasury Bills, and the conversion of much corporate cash to even shorter maturities as it is soon to be deployed (remember the repatriation story) has driven this market far more than had been anticipated. The knock-on effects here are that foreign USD borrowers are finding it more expensive to refinance their outstanding debt and thus we are seeing short-term rates rise in other countries around the world, notably those whose currencies are linked to the USD like Saudi Arabia and Hong Kong. Ultimately, this is all of a piece with the rising US rate story and I believe will continue to be supportive of the dollar going forward.

Until the Fed announcement, I find it hard to believe we will see much movement, but afterwards, be prepared for some fireworks. Funnily enough, I think the big risk to the market is that the statement and Powell’s comments are more dovish than expected. The hawkish view has clearly grown in stature lately, so I would guess the pain trade is a more dovish outcome (no indication of four rate hikes this year, no rise in the terminal rate), which would have an immediate negative effect on the dollar. I guess we’ll see in a few hours!

Good luck
Adf

There once was a fellow named Zuck
Whose business had run quite amok
Investors decided
That he should be chided
Thus many tech stocks came unstuck

This was THE story yesterday, the ongoing questions over the data handling by a certain social media company’s business partners. It has raised significant privacy questions and generated a slew of letters from various US Senators and Congressmen regarding just what is happening there, as well as calls for kangaroo courts testimony by company leaders. The impact on markets was broad based as so many tech sector names make their living off the personal data they have accumulated and now parse and sell for profit. The upshot was a sharp sell-off in the tech heavy NASDAQ as well as across all equity markets and a little more uncertainty as to whether the ongoing growth story in the US (and globally) has the legs to continue. And of course, this is critical to the other key issue this week, the FOMC.

With little else making the news
The market continues to muse
‘Bout just what Chair Jay
Is likely to say
Regarding the Fed’s latest views

The question of just what the Fed is going to say tomorrow in their statement that accompanies the universally expected 25bp rate increase remains topic number one in the Fixed Income and FX markets. The debate hinges on whether they will explicitly discuss a fourth rate hike this year, or be more circumspect over the prospects. The futures market continues to move in the direction of clarity with a fourth rate hike now garnering a 36% probability, up 10 points over the past week. In addition, we have the situation where Chair Powell will be giving his first press conference as Fed Chair. The market had become quite used to the soothing and obfuscatory language of Chair Yellen and her immediate predecessors. However, thus far, Powell has seemed to be a bit more forthright in his comments, which means that we could see a bit more volatility once the press conference starts tomorrow. The thing is, I don’t think he cares that much about short-term movements in either equity or bond markets. Rather, barring a collapse that has the potential to drive the economy lower, he and many of his Fed brethren will be comfortable if equity prices see a little compression. Al told, there is no question that tomorrow’s events have the opportunity to move markets. Today, on the other hand, appears less exciting.

The dollar is holding its own this morning, edging higher against most of its counterparts in both the G10 and EMG blocs. We continue to be in a data desert, with today’s major oasis being UK inflation data. Interestingly, despite the ongoing drumbeat that the BOE is going to be raising rates at its May meeting, currently priced at a more than 80% probability, CPI was softer than expected, printing at 0.4% M/M and 2.7% Y/Y. This should be no surprise as the original driver of high inflation in the UK, the sharp decline in the pound, has not only reversed at least half of the movement, but is also now far enough behind us that it is falling out of the data. This, of course, begs the question, of why the BOE feels it is necessary to raise rates into the greatest economic uncertainty the UK has ever known. In the end, while the pound had rallied early in the session on news that the EU was seen as showing a little flexibility in the Brexit talks, the CPI data has removed all that gain and then some, with the pound actually slightly lower on the session as I type. One other modest movement has been in the euro, where the single currency has fallen 0.2% after the release of the German ZEW survey showed expectations falling more sharply than expected. The decline to 5.1 from last month’s 17.8 was clearly a surprise and the euro fell right on the news. Away from those two stories however, it is hard to find anything interesting to discuss in the G10 space. The dollar has generally edged higher against virtually the entire bloc, but movement remains de minimis. My take is we are seeing a small unwinding of short USD positions ahead of the FOMC tomorrow.

The EMG bloc is pretty similar, with most currencies somewhat softer vs. the dollar, but none having moved a great deal. The background questions over South African credit issues and NAFTA for Mexico continue but without any new pieces of information, there has been no market reaction. Arguably, the market is also awaiting the upcoming tariff announcements by the Trump administration regarding China, where the talk is of tariffs on $60 billion of Chinese goods. What I do know is that if they are implemented, we are very likely to see measured inflation start to rise pretty quickly in the US and the pressure on the Fed to normalize policy to increase. As I have been writing for a while, I believe that news will help support the dollar, and given the still prevalent view that the dollar is headed lower, could cause some pain.

As to the upcoming session, there is absolutely no data to be released and the Fed is in the first day of their two-day session, so there will be no Fed commentary. We could hear more about tariffs, which depending on what is said could clearly impact markets. We are likely to continue to hear about the tech sector’s data woes and while equity futures are pointing to little change on the opening, it is hard for me to believe that this is a one-day event. Look for other names to get caught up in this whirlwind and further pressure there. (As an aside, it is issues like data privacy that help you understand the growing interest in blockchain related efforts by so many companies as they try to prevent future occurrences of similar crises.) At this point, there is no evidence that we are moving into a risk-off scenario, but the right confluence of events could well bring us there. However that seems unlikely today. Rather, I like the dollar to continue to drift slightly higher as we await tomorrow’s FOMC.

Good luck
Adf

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

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

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

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

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

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

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

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

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

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

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

Good luck
Adf

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

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

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

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

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

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

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

Good luck and good weekend
Adf

Though Abe rejects
Calls for his resignation
Traders are less sure

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

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

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

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

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

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

Good luck
Adf

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

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

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

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

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

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

Good luck
Adf

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

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

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

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

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

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

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

Good luck
Adf

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

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

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

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

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

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

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

Good luck
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