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

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

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

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

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

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

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

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

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

Good luck
Adf

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

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

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

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

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

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

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

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

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

Good luck
Adf

All government bonds
Are under pressure today…
Except JGB’s

While markets are now anxiously awaiting the payroll report, a key underlying feature of markets this morning has been the virtual global rout in government bond markets. Yields are higher throughout Europe; with German bunds trading at their highest yields in almost three years while UK gilts are back to their highest yield since before the Brexit vote in June 2016. Of course, you are well aware of the ongoing rise in US yields, with the 10-year touching 2.80% yesterday and hovering just below there as I type. Which brings us to Japan, where JGB yields bucked the trend of rising yields. Of course, the reason is because the BOJ was actively intervening in the market overnight, buying JGB’s as part of their yield curve management program. So just when traders were thinking that even the BOJ was going to lean toward tighter monetary policy, the reality shows that there has been no such shift in view from Tokyo. This matters to our view of currencies because the widening yield premium of Treasuries over JGB’s has been enough to underpin USDJPY’s move higher by more than 0.5% this morning. This has been the biggest mover in the G10 space, although the dollar is firmer against all of its counterparts here. Perhaps what is most interesting about this market movement has been the sudden increase in articles describing all the reasons why the bond market rout may continue. By now I’m sure you all know that I believe yields around the world are going to rise, its just that I believe that US yields will be rising faster than others, and more importantly for the dollar, faster than currently priced by the market.

But at this point, all eyes are turning toward the US payroll report. Here are the current forecasts:

This report includes benchmark revisions so can get a bit messy sometimes, but forecasts for revisions to 2017’s data have been quite small, just 95K in the NFP data for the entire year.

So what can we expect? Arguably there are only three potential outcomes here; weak, strong or as expected. In the event the forecasts are on the money, I would look for the recent market trends to continue. That means equities will remain beholden to earnings, bonds will continue to fall, and the dollar will probably give up some of its overnight gains. This would play into the idea that the market pricing for the Fed is on the money and therefore the dollar would have further to decline.

How about a weak report? Well, weakness in NFP, or perhaps more importantly for the Fed in AHE, would cause some serious recalibrating throughout the market. In fact, if the data was weak enough, say 125K for NFP or 2.3% for AHE, it would likely be enough to halt the bond market decline in its tracks. This would be the type of data signal that would get the doves on the Fed crowing (cooing?) again and force the bond bears to rethink how aggressive the Fed will be this year. And the dollar? Ugh, it would not fare well in this case, likely giving up all its overnight gains and then some. In fact, I would expect a weak report to send the euro to new highs for the move, breeching the 1.2550 level and beyond before the end of the day.

Finally, what if the data is strong? NFP above 200K or a decline in the Unemployment rate to 4.0%, or even more interestingly for the Fed, AHE jumping to 2.9%, would play to the bond and stock bears and the dollar bulls. Remember, bond market momentum is already strongly toward a sell-off, and this would exacerbate that trend. At the same time, while US equity markets have spent the past two sessions little changed, equity markets around the world have been under consistent pressure alongside their bond markets. A strong report here and the ensuing bond market sell-off would likely undermine the stock market as well. As to the dollar, this would be nirvana. Positioning in the dollar is extremely short according to futures market indicators and those positions have been broadly profitable to date. However, strength in this report, especially with a new Fed chair coming in, will likely result in a bout of profit-taking at the very least, and I think we could see the dollar close the week far stronger than it started.

And that’s really it for the session. My sense is that strength is in our future and that we are going to see the bond market sell-off continue along with equity market declines and a stronger dollar. Will this be enough to change the trend by itself? Not likely. But it will be one more piece of evidence that the trend is going to change.

Good luck and good weekend
Adf

The FOMC stayed on hold
The outcome most thought would unfold
But ‘further’ than that
What they hinted at
Was on future hikes they were sold

Yesterday played out much as expected with first a strong ADP number (234K) having virtually no impact on the dollar, although it did seem to underpin the equity market in the morning. As I wrote then, given the previous strong print which was followed by a weaker than expected NFP number, pundits put less stock into a beat this month. Then the FOMC released their statement in the afternoon and the universal reading was of a slightly more hawkish stance going forward. The proximate cause of this view was the insertion of the word ‘further’ into the statement at two different points, highlighting a potentially more aggressive stance than previously expected. The key phrase was the following: “The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate.” So it is pretty clear that they are going to be continuing down this path for a while yet, and while they remain somewhat data dependent, they continue to express confidence that the inflation rate will gradually rise toward their target of 2.0%. The FX market response to this was to see the dollar recoup its early session losses and close essentially unchanged on the day. Equity markets, meanwhile, gave back their early gains, also closing essentially unchanged on the day.

But now as we look at markets this morning, we see a mixed session in FX for the first time in more than a week. What had been entirely a dollar story has now evolved into more specific currency discussions. For example, the euro is slightly higher this morning, up 0.25%, after PMI data showed continuing strength in the Eurozone economy. While the reading was unchanged at 59.6, that remains in strong growth territory. The pound has also benefitted this morning from data with Nationwide House prices rising a more than expected 3.2% on a Y/Y basis. While it seems it was more due to a lack of supply rather than an increase in demand, the pound has nonetheless benefitted by roughly 0.15%. However, the yen is finding itself under pressure this morning, down 0.4%, despite a better than expected PMI reading of 54.8. Perhaps it was the significant outflow of foreign equity investment that accompanied the Nikkei’s recent week-long streak of declines. Ironically, the weaker yen supported the Nikkei which itself rallied 1.7% overnight. The one other noteworthy aspect of G10 currencies is the Skandies, where both SEK and NOK have been performing well. Fresh comments from a Riksbank governor describing comfort with the recent rise in Swedish inflation to target levels has the market looking for the first rate hikes in years.

Pivoting to the EMG bloc, it is ZAR which is underperforming today, down 0.5% despite an ongoing wave of positive news. The market seems to be taking profits after a better than expected PMI release of 49.9, much closer to the growth line than expected. However, given the rand has been the best performing currency for the past three months on the back of the politics involving Cyril Ramaphosa’s election to party leader, I guess a little profit-taking cannot be surprising. The dollar has had a solid day against its APAC counterparts after equity markets throughout the region (except in Japan) all continued their recent slide. My sense is that if US equity markets are able to rally today, the fears engendered earlier this week about a correction are likely to fade and we will head back to the narrative of stronger stocks and a weaker dollar.

Data this morning brings Initial Claims (exp 238K); Unit Labor Costs (0.9%); Nonfarm Productivity (0.8%) and ISM Manufacturing (58.8). While the ISM number could be meaningful, with the payroll report on tomorrow’s slate, I would be surprised if traders responded too aggressively to anything but a wild miss, something like 54.0. In fact, I think today’s most likely outcome is one of limited activity as all eyes turn their focus to tomorrow morning. The only caveat is the equity market, which if it fails to hold after some mixed earnings data overnight, could result in the first inklings of a risk-off scenario. After all, Treasury yields continue to rise (currently 2.74%) and that cannot be good for stocks, but should be good for the dollar. At some point, investors will not be able to resist the significantly higher yield on offer from the US compared to its G10 counterparts. However, it’s not clear today will be the day of change. Tomorrow, however, has possibilities.

Good luck
Adf

In Germany workers are pissed
As unions there try to insist
A six percent rise
In wages is wise
If not, strikes they may soon enlist

The market is watching and sees
This outcome, Herr Draghi should please
If it comes to pass
Inflation, at last,
Might rise hinting at no more ease

Meanwhile Janet’s reign is soon done
For stock markets it’s been great fun
Will Powell (called Jay)
Take the punch bowl away?
And if so, will the dollar then run?

The dollar is back under a bit of pressure this morning as equity markets in Europe try to shake off the past two days declines. Asian markets had no such luck, falling for a third consecutive session, but thus far Europe has held up on the strength of yet another disappointing inflation reading for the Eurozone, with CPI in January rising only 1.3%, down from December’s 1.4% reading. At the same time, the unemployment situation in Europe continues to improve, further feeding the conundrum of tightening labor markets and no ensuing inflation. The point is the lack of inflation encourages equity investors to believe that despite the narrative, ECB policy tightening is still a long way off. And this is why there is so much focus on the wage negotiations ongoing in Germany, where the biggest union, IG Metall, is seeking not only a 6% annual wage hike but also additional flexibility for part time workers. Thus far, progress in the negotiations has been slow and starting today there will be one-day strikes across all the regions of Germany by union members, impacting almost every industry. As it is in neither side’s interest for these to be prolonged, I expect a resolution to be agreed soon. And ultimately, it will mean higher wages for German workers. Of course, the key question is will that feed through to the general inflation figures and if so, how long will it take. The obvious connection to the FX market here is that the quicker inflation starts to rise, the quicker the ECB can end QE, which should help further underpin the euro. Certainly, the narrative assumes a direct and rapid response in the inflation data, but we shall see.

However, the euro is not the only currency that has rallied vs. the dollar, it is virtually every other currency that has shown strength this morning. And so, as we have seen for the past week, the driving story remains the dollar itself, not currency specific issues.

Pivoting in that direction shows several key drivers. First, we have seen pretty significant equity market weakness over the past two sessions, with the S&P down more than 2% since Friday. While in the grand scheme of things, that is not very substantial, compared to what we have been witnessing thus far this year (and truthfully all of last year) it is a virtual rout! At the same time Treasury yields have been rising rapidly, reaching their highest levels in nearly four years and showing no signs of stopping. Thus, the question must be asked: Is this the beginning of the end of the rally? It is certainly premature to make that call, but I will say that if we see equities fall further today (futures are currently pointing slightly higher so there is no assurance that will occur), it may be appropriate to label the move the beginning of a trend. How will the dollar behave in this case? My take is that it will initially fall alongside these markets on the belief that investment will flow elsewhere. But if the trend persists and we evolve into a more complete risk-off scenario, I like the dollar to find its footing.

Of course the other story of note today is the FOMC meeting, where the monetary policy statement will be released at 2:00 this afternoon. There is no press conference scheduled and expectations are for no change in policy. In fact, all eyes will be on the wording of the statement for clues as to whether the hawks remain in the ascendancy, or if the doves are regaining ground. If you recall, last meeting there were two dissents to raising rates, Kashkari and Evans, but neither of them is a voting member now as they have rotated away from that role with the changing calendar. This is also Yellen’s last meeting, as her term ends on Sunday and she will be stepping away from the Board completely. As to the wording, while a majority of economists surveyed expect virtually no change to the statement, it is worth watching the description economic activity (currently ‘solid’) and of risks to the economic outlook (currently noted as ‘roughly balanced’ with a chance to be upgraded to ‘balanced’). The inflation wording evokes disappointment but they continue to expect stabilization around 2% over the medium term. Any changes in the inflation outlook will almost certainly impact markets, especially Treasuries, but also stocks and the dollar. In the end, though, there is likely to be little real news from this meeting. March, however, is potentially a different story, with the market pricing in another rate hike and a new Fed chair at the helm.

Finally, we get some more important data today, leading with the ADP Employment report (exp 195K) and then Chicago PMI (64.0). Last month, ADP was quite strong, but the NFP number showed nowhere near the same type of strength. So this month, pundits seem a bit more wary as to its importance. My take is a strong number is likely to be ignored, but a weak one could well push the dollar lower. As to Chicago PMI, it would need to fall a great deal to have any impact. Remember, the market will quickly turn its focus to Friday’s payroll data as well, so this has to be powerful stuff to evoke change.

In the end, the dollar’s recent trend is likely to continue, meaning further modest weakness seems the best bet for now.

Good luck
Adf

This morning the currency war
Has faded as traders look for
The opportune place
More profits to chase
Seems shorting of bonds is in store

For the past five days, the dollar has been the primary topic of conversation among market participants as the reaction to Treasury Secretary Mnuchin’s comments about a weak dollar started a series of verbal fisticuffs over what is and isn’t appropriate for policymakers to discuss. Certainly, given the struggles both the BOJ and ECB have had regarding creating inflation, the last thing they wanted was strength in their currencies. Of course, one could rightfully say that the Fed is not keen on a strong dollar given their own desire to raise inflation. And in the end, despite all the wailing and gnashing of teeth, the dollar has declined by about 1% during this kerfuffle, not nearly enough to change anything in a meaningful manner. And that includes this morning, where the dollar has softened a bit vs. most of its counterparts. For example, after GDP data showed that the Eurozone grew 2.6% Y/Y in Q4, faster than the US Y/Y rate of 2.3%, the euro has rallied about 0.4%. Similarly, strong Japanese employment and spending data, indicating that growth there continues to pick up, helped the yen to a 0.3% rally vs. the dollar. And while both of these currencies are edging back toward recent highs, in truth, neither one has made new ground today.

It appears there are other things on traders’ minds now. In fact, the subject with the most ink spilled today has been the Treasury market, where yesterday’s sharp decline in prices pushed the 10-year yield above 2.70% for the first time since April. This has elevated the question of whether we are entering a bear market in bonds to a new level. You may have seen a number of comments recently from big name bond gurus (Jeffrey Gundlach and Bill Gross to name two) about how the bond market is about to embark on a major sell-off as growth in the US expands and inflation is sure to follow. Adding to their view is the Fed’s process of reducing the balance sheet, which is further removing demand from the Treasury market just as the Treasury will need to borrow more (aka issue more bonds) to fund the increasing budget deficit. So, reduced demand by the key, price-insensitive buyer and increased supply certainly point in that direction. And I strongly agree with this thesis as, if you recall, I forecast 4.0% 10-year yields by year-end. The question here is how will this impact the dollar?

Traditionally, the dollar has benefitted when the spread between US and foreign interest rates widened, and that is clearly what we are seeing. For example, during the past year, the spread between 2-year Treasury notes and 2-year German Bunds has widened by 75bps and is now sitting at 270bps (German 2-year yields remain in negative territory, currently yielding -0.55%). But despite this interest rate move in favor of dollars, the dollar has been under pressure the entire time falling ~14%. And that has been one of the mysteries of the markets in this cycle. Historical patterns do not seem to offer meaningful information on current trading outcomes. Which means there are other drivers.

Clearly, the narrative has been at odds with the current interest rate differential as it continues to focus on expectations for how this spread will narrow over time. The problem I have with that is the narrative timeline that is in focus seems far longer than practical. Are investors really willing to leave 250+bps on the table on the basis of the idea that at some point Eurozone or Japanese interest rates are going to rise faster than US rates? That would be a hard argument to support to an investment committee. But in the short run, it appears to be the situation. There is no question that momentum in the market remains for the dollar to fall further. It also seems highly likely that the interest rate differential is going to continue to widen in the US favor over the rest of this year so this conundrum may not be resolved soon.

One thing that has remained true throughout the various economic cycles in history is that when a country has a combination of tight monetary and loose fiscal policy it’s currency has strengthened while the opposite is also true, loose monetary and tight fiscal policy have tended to undermine that currency. (The data on combinations of tight and tight or loose and loose are less conclusive). Well, I don’t know about you, but it certainly looks to my eye like the US is running relatively tight monetary policy (Fed raising rates and reducing its balance sheet) and loose fiscal policy (huge tax cuts and increased deficit spending) and that continues to point to a rebound in the dollar. And despite the mildly disappointing Core PCE data yesterday (unchanged at 1.5% instead of the tick higher to 1.6% anticipated), I continue to look for the Fed to feel pressure to tighten policy faster than markets are currently pricing which will only exacerbate the current rate dynamics in the dollar’s favor, just not today.

As we look forward to today’s session, the only data of note is the Consumer Confidence Index (exp 123.4) although that generally has little impact on FX markets. Tomorrow is when we start to see more critical things with both ADP employment and the FOMC statement. As such, a quick scan of other markets shows that yesterday’s red numbers across equity markets here have continued overnight with Asia selling off sharply and Europe, despite solid data, also under water. US equity futures are pointing to a lower opening as well. Are we beginning to see a risk-off scenario develop? It will take more than a one-day decline in stocks for that to be the case, but if that story develops some momentum, perhaps the long awaited correction will come. However, until then, despite my long term views on the dollar regaining its footing, it appears that it will remain under pressure for now.

Good luck
Adf

In Europe, according to Knot
QE has done all that it ought
So lets end it soon
While it’s opportune
Ere data is worse than we thought

Klaas Knot is the President of the Dutch Central Bank and a member of the ECB Governing Council. His is a name that doesn’t get much press, but he is certainly well known amongst the finance community. And he is also one of the dyed-in-the-wool monetary hawks on the ECB. On Saturday in a television interview he was quoted as saying about QE “The program has done what could realistically be expected of it. The program is fixed until September, [and] we don’t have to communicate yet that it will be over after September, but I think that’s where we’re headed.” It strikes me that Signor Draghi has a bigger messaging problem in his own house than he does with the comments last week from Treasury Secretary Mnuchin. Arguably, what is more surprising is that the euro, after an early bump up in Asia has actually given back some more ground and is now down 0.25% this morning.

But let’s step back for a moment and try to look at a bigger picture for the dollar. Much has been made over the fact that last year the dollar fell about 11% on a trade-weighted basis and more than 14% vs. the euro. But is the dollar actually ‘weak’? Let’s consider a couple of statistics: the euro initiated trading in 1999 at 1.1715 or so. It has ranged between 0.86 and 1.60 during its life, and clearly those extremes are just that, significant over and undervaluation of the dollar respectively. But 1.24 hardly seems like the end of the world. And while much is made of the fact that the dollar is at its weakest point in the past three years, that conveniently ignores the fact that for the three years prior, it averaged ~1.39. All I’m saying is that 1.24 is hardly the end of the world when it comes to the dollar’s valuation, and the hysteria that has accompanied the recent movement seems a bit overdone.

However, the question we try to address here is how it will behave going forward. There is no question that the current momentum is for the dollar to continue to decline. The narrative continues to focus on the idea that traders have already priced in further Fed tightening while we are just getting started at the ECB and BOJ and that activity from those central banks is going to change the dynamic. In that scenario, the Mnuchin comments certainly added fuel to the fire, but the dollar had been falling long before he opened his mouth. And last week, we heard from both Kuroda and Draghi, with both sticking to their script that they were not going to change anything, and in both cases, the market refusing to believe them. But this is a new week with both a critical data point this morning (Core PCE is released at 8:30 and expected to print at 1.6%) and then the FOMC meeting on Wednesday, and we have payrolls on Friday as well! The narrative also dictates that the Fed will do nothing at this meeting; likely not even change the language of the statement. But I disagree with the narrative, and will feel even more confident if the PCE data continues its recent ascent.

I believe it is a mistake to assume the Fed is going to do nothing here, and I expect to see a more hawkish bias from the statement. I continue to look for measured inflation to rise more rapidly than the mainstream forecast, for the Fed to be more aggressive than currently priced by markets and for the dollar to ultimately gain traction. One noteworthy feature this morning is that 10-year Treasury yields have jumped up to 2.72%, their highest level since the taper tantrum in 2013, and appear set to continue to 3.0% and beyond. That too, will ultimately support the dollar. But it will take time for the narrative to be broken. Given the strength of its signal, we will need to see a lot of contrary evidence to change trader and investor opinions. So for now, though I continue to expect the dollar to strengthen eventually, it will be tough sledding.

And that is really the entire FX story, as it is entirely dominated by the dollar, with every other currency along for the ride. I’m sure that at some point soon we will be looking at individual currency issues again, but for now, it doesn’t seem relevant.

So here is this week’s data rundown:

At this point, I feel this morning’s data could be quite significant. A stronger than expected Core PCE print should be dollar positive, should pressure Treasuries further and may well undermine equities slightly. But the narrative will not be changed easily. We will need to see a series of convincing data over the next several months to get it to move. For now, let’s see what prints this morning but the market will give the benefit of the doubt to data that weakens the outlook, not strengthens it.

Good luck
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Said President Trump ‘bout the buck
Though Stevie said weakness don’t suck
In truth I believe
That what you perceive
Is really I don’t give a f*ck

Who said volatility is dead? Yesterday’s price action in the FX markets was as volatile as we have seen since, arguably, the GBP flash crash in October 2016. The market was still trying to come to grips with an apparent change of policy by the US, where the decades old mantra of ‘a strong dollar is good for the US’ had been unquestioned by both traders and every Administration and has now been called into question by the current Administration. Or at least that seemed to be the case for about twenty-four hours before President Trump, in a CNBC interview, pledged fealty to the strong dollar idea saying,“…the dollar is going to get stronger and stronger, and ultimately I want to see a strong dollar.” It should be no surprise that the dollar rallied after those comments and regained the bulk of the Mnuchin inspired losses.

But that wasn’t the only thing that happened yesterday. If you recall, the ECB met and we heard from Signor Draghi afterwards. To start, the ECB statement was identical with the December statement, so for the euro bulls, that was a bit disappointing. There was no change to the language regarding the end of QE nor when interest rates might start to rise. But during the press conference, aside from Draghi calling out Mnuchin’s comments as impolitic, he did nothing to dissuade the euro bulls from their view that QE is going to end in September and that at the March meeting Draghi will be discussing changes to their strategy. And so despite all the sturm und drang, the euro’s rally continues apace with the single currency rallying 0.55% from yesterday’s closing levels.

Meanwhile, market technicians are becoming extremely excited by the movement as the dollar has fallen below several key technical levels and, according to that group, is set to extend its losses more aggressively. And maybe they’re right, but remember this, none of this activity occurs in a vacuum. The US economy continues to show substantial strength, and we need only see slightly higher than expected inflation readings to force the Fed’s hand into more aggressive tightening than currently forecast. And if there’s one thing about which I am confident, it is that if the Fed starts to get more aggressive, the dollar will find its footing. Interest rate markets continue to price just less than two Fed rate hikes in at this time. The Fed itself expects three and an increase in inflation readings could easily push that to four or five. Remember, it is not a requirement that the Fed only adjusts rates at a meeting with a press conference; they can do so at any time, even with no scheduled meeting if they deem it appropriate. Higher and rising inflation will be the one issue that takes them out of their comfort zone, and I continue to believe that is a very realistic outcome. After all, as I ask frequently, do you feel like your personal inflation rate is 1.5%? I know mine isn’t!

And that was really the story yesterday and overnight. Today brings President Trump’s speech at Davos, scheduled for 8:00 EST and then some important data, notably the first look at Q4 GDP (exp 2.9%) and Durable Goods (exp 0.6%, -ex transport 0.6%). Strength in these data points will only serve to underpin the Fed’s current trajectory. My sense is that Monday’s PCE data will also be very important, given the Fed’s focus on that data as the inflation measure that fits their models. So any uptick relative to expectations there could have much more significant market ramifications.

In the end, my sense is the Goldilocks story for markets is nearing its end. One of its defining characteristics has been the remarkable lack of volatility across all markets, but now we are beginning to see that change. Clearly, yesterday’s FX volatility was driven by exogenous sources, but in many ways, that doesn’t really matter. If volatility turns higher in a more lasting manner, be prepared for it to extend to all markets. And remember this, volatility in equity markets has become a euphemism for falling stock prices, so higher volatility is likely to matter to us all.

Good luck and good weekend
Adf

The dollar continues to reel
As traders collectively feel
That central bank timing
On interest rates climbing
Outside the US has appeal

Once again the dollar is under pressure as yesterday’s comments by Treasury Secretary Mnuchin continue to be main source of market discussion and questions arise as to whether the US is going to start using the dollar’s value as another policy tool. Given the efforts by the Administration to walk back the importance of Mnuchin’s comments and reiterate that they believe in a market-determined value for the dollar, I doubt that is the case. However, traders will be very alert to any further commentary regarding the dollar. Remember, President Trump has been very focused on the US trade imbalance and has mentioned the benefits of a weak dollar in that context. The funny thing is, the dollar has been falling for upwards of a year now without any Administration commentary, and so it seems unlikely that it is a focus for the US government. In fact, the story continues to be that although the Fed has been tightening policy for more than a year and is set to continue to do so, the big change has been the idea that other nations are starting to catch up and are beginning their own journey toward tighter monetary policy. In this reading, the FX market is simply anticipating the eventual higher rates we will be seeing from both Europe and Japan and buying those currencies now.

We have the potential to learn more about how this will play out in a short while as the ECB meeting concludes. While there is no expectation for any policy changes, thus the deposit rate will remain at -0.4% and the Asset Purchase Program will continue at €30 billion per month through September, all eyes will be on the language in the statement released and then even more keenly focused on Signor Draghi at the press conference following the meeting to see if he comes clean about what discussions are actually taking place. Some believe that the statement will remove the possibility that QE will be extended beyond the September date, which would be seen as another bullish euro cue. However, one thing to keep in mind is the old adage; buy the rumor, sell the news. It is entirely possible, if not likely, that the euro’s recent run-up already reflects this expectation and that if the statement is indeed changed, traders will take profits and drive the euro lower. Remember, that prior to the BOJ meeting earlier this week, expectations were growing for a change in the statement there as well, and although there were some subtle ones, clearly they did not satisfy the trading community who have only grown more anxious to see the beginning of the end of QE in Japan. As such, the rumor is still the driver with no news yet released.

I read an interesting take on markets yesterday that I think is worth sharing. This may get a bit arcane so bear with me. The idea is that the 30-year swap spread may be a harbinger of future market and economic activity and the fact that it is rapidly moving back toward positive territory is important. To begin with, the 30-year swap spread is the interest rate differential to exchange the payments between a fixed rate payment in a simple interest rate swap and a Treasury bond with the same maturity. The idea is that since there is no credit risk to hold Treasuries, one would need to receive a higher rate to accept the credit risk associated with a swap counterparty, which is typically a large bank. However, since the financial crisis, these spreads have been negative, meaning that accepting the credit risk of the bank resulted in a lower interest rate than owning Treasury bonds. On the surface, that doesn’t make much sense, but it was a reaction to the changes that occurred due to the crisis. As Kevin Muir, a well regarded trader and pundit explains, “Swap spreads dove because the supply of bank balance sheet was dramatically curtailed. Basically, banks, faced with more regulations and increased capital requirements, withdrew their participation in the swap market. The demand for swaps fell but not as quickly as the supply. The end result was that this mismatch of demand-supply meant that the previously unthinkable occurred, and swap spreads went negative. What would have usually been arbitraged away by proprietary trading desks at banks and other financial institutions was left to persist for years.”

So it is key to understand that this is a historically unusual situation, although it has been with us for the past nine years. It is important because it was an indication of how banks were managing their total balance sheets, meaning that they were husbanding capital and private credit was tight despite the fact that interest rates were low. The lack of private credit creation (aka bank loans) has been one of the features (bugs?) of the recovery from the financial crisis and has also been directly related to the decline in the velocity of money. That combination has arguably been behind the lack of measured inflation despite QE; the slow pace of economic growth; and the previous strength of the dollar. Well the reason I bring it up is because those spreads are racing back toward positive, which implies that private credit creation is making a comeback. Alongside that process we are likely to see inflation move higher as the supply of dollars that the Fed has created start to move around. The other likely outcome is that interest rates are going to go higher. Not only will this activity keep the Fed in active tightening mode, but the growth in demand for credit will push rates higher.

What does this have to do with the dollar? Well, there are two potential dollar drivers here. First, as the velocity of money increases, it will effectively create a significant increase in supply of dollars and therefore likely put further downward pressure on the buck. But at the same time, as interest rates rise, the appeal of the dollar for investors will increase. Currently the market is pricing in less Fed tightening than the Fed itself has penciled in. The narrative continues to be that quiescent inflation will prevent the Fed from having to raise rates aggressively. However, I would argue that inflation will not remain quiescent, that the Fed will find itself behind the curve before very long and they be forced to be more aggressive than they have currently planned, let alone what the market is pricing. Ultimately, if (when) the Fed becomes more aggressive tightening policy this year, look for the dollar to rebound.

As to today, aside from the ECB press conference, we see Initial Claims (exp 240K) and New Home Sales (680K), neither of which is likely to move markets. Meanwhile, the ECB statement was unchanged, so no hints about the future purchase plan that some had hoped for. However, the euro was little changed in the aftermath as all eyes are on Draghi at 8:30. My sense is that for now, the dollar will remain under pressure, with tomorrow’s GDP data, or more likely Monday’s PCE data the next chance for the narrative to come under pressure.

Good luck
Adf

In Davos, Mnuchin explained
A weak dollar wasn’t harebrained
It helps to upgrade
Both exports and trade
Thus for the US much is gained

The dollar is on the outs this morning with one key story the driver. Treasury Secretary Steve Mnuchin has basically moved away from the strong dollar mantra that had been official US policy for at least two decades by telling reporters the following, “Obviously a weaker dollar is good for us as it relates to trade and opportunities, but again, I think longer term the strength of the dollar is a reflection of the strength of the US economy and the fact that it is and will continue to be the primary currency in terms of the reserve currency.” Given the evolution of policies around the world lately, and the fact that President Trump has been consistent in his mercantilist philosophy of trade, the only surprise is the clarity with which he stated his case. After all, almost every major country seems to be seeking to weaken their currency in order to help their own trade situation, and these days as a way to import some inflation. However, comments have usually been about ‘excessive strength’ in a currency needing to be addressed, rather than a specific endorsement for a weaker currency. It appears ‘Beggar Thy Neighbor’ policies are coming back into the light.

This clearly changes a great deal in terms of short and medium term expectations, but do not be surprised if we see an increase in rhetoric about the strength of other currencies by other central banks and governments in the near future. However, for now, the dollar certainly has room to decline further after having made new three-year lows this morning.

In fairness, there was some pretty good data elsewhere as well, which helped underpin other currencies. For example, UK employment data showed a much larger than expected increase in the 3M/3M jobs numbers (exp -12K, actual +102K) and an uptick in average weekly earnings. The upshot is the pound has traded back to 1.4100, its highest point since the day before the Brexit vote in June 2016. While I continue to believe the BOE will be very reluctant to raise rates before the end of the Brexit process when the UK leaves the EU, my view is clearly in the minority with the market pricing in a 77% probability of another 25bp hike before the end of this year.

Turning to the Eurozone, PMI data was released showing modest underperformance in manufacturing but strength in services and in the composite numbers. In fact, we are looking at the strongest composite data here since the immediate aftermath of the financial crisis and ensuing recession, when the global economy was rebounding from a very low base. But for sustained growth, this is the best data for more than a decade. This has merely served to further support for the idea that the ECB is going to be ending QE this year. All eyes are turned to the ECB meeting tomorrow, although it would be quite surprising if Signor Draghi succumbed to the growing pressure to describe changes so soon. All told, however, the euro has rallied to its strongest point in more than three years and the trend remains for further strength.

Meanwhile, USDJPY has traded back below 110 for the first time since September despite Japanese trade data showing a less than expected increase to $3.2B in December. Given the importance of trade to the Japanese economy, currency strength is a much more critical issue, but also given the current US stance on its own trade deficits, I expect the Japanese will be loathe to raise too big a fuss.

The rest of the G10 has also benefitted, as have commodity prices and EMG currencies. In fact, there is nary a currency out there that has weakened vs. the dollar this morning. Ultimately, the question becomes how long can this go on in the face of increasingly tighter US monetary policy. As I have written before, it is clear the FX market believes that other central banks will be more aggressive than current interest rate futures are pricing while the Fed will be less aggressive. Despite the fact that US Treasury yields continue to edge higher, it has not been enough to stop the dollar’s decline. And at this point, it remains to be seen if anything will be able to do that. The next important data points in the US are Q4 GDP on Friday and then the PCE data on Monday, both leading into next Wednesday’s FOMC meeting. Remember, the Fed is entirely focused on Core PCE, which last printed at 1.5% and is forecast to tick up to 1.6%. If that data point is firmer than expected (something which I believe is quite possible) then it may serve to slow the dollar’s decline while pushing US rates higher. However, if it is benign, or softer than expected, look for the pressure on the dollar to continue.

This morning brings only Existing Home Sales data (exp 5.70M), which seems highly unlikely to impact the FX markets. There are no Fed speakers due, but beware of further comments from Davos, where Mnuchin will find himself with more microphones in front of him. Remember, too, President Trump will be speaking there on Friday and there can be no doubt he will discuss trade, and if the currency is mentioned, it will be in a weaker light. So for now, the dollar will remain under pressure with its only hope a Fed that feels forced to respond to faster than expected inflation. But until we see that type of inflation data, the dollar is unlikely to find much support.

Good luck
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