Quite A Thrill

The central bank down in Brazil
Investors there, gave quite a thrill
The currency rallied
While traders all tallied
Their losses from months of ill will

For now, the Brazilian central bank has stopped the bleeding. Friday’s price action was quite impressive, with the real rising more than 5% after the central bank said they would significantly increase the amount of dollars they would add to the market via FX swaps, their preferred method of intervention. Rather than raising interest rates, as we saw in Argentina, Turkey, India and Indonesia, each of which failed to stem their currency’s respective declines, the Brazilians decided to add the USD liquidity by themselves. And it was effective as evidenced by the move in the currency. Alas, for equity investors, it did not solve the problem, with the Bovespa falling another 1.25%, taking it down more than 13% since the beginning of June.

There are now five major emerging market countries that find themselves under significant pressure in the financial markets. All of them run significant current account deficits and all of them have significant amounts of USD debt outstanding that must be repaid or refinanced this year. While the Brazilians managed to stop the problem for now, the future remains quite uncertain, and if I had to guess, I expect that we will see significant further weakness in these currencies as the year progresses.

In Canada there was a breach
As leaders there just could not reach
Consensus on how
That group can endow
The future that most of them preach

Meanwhile, the G7 meeting broke up amid accusations on all sides of bad faith in the discussions, and ultimately no consensus as to what comes next. This is arguably the worst possible outcome, and there is now greater concern that the trade situation is going to become worse. Most analysts and economists had decried the tariffs to date, but had pointed out that the amounts were relatively trivial compared to global commerce. But given the acrimony that has been ongoing since the end of the meeting (at least based on Twitter comments) and the fact that the next set of tariffs are slated to be bigger than the last, it might start to have a more significant impact. If nothing else, it will call into question the underlying positive sentiment that we have seen in most developed markets around the world lately. The market impact, interestingly, has been relatively muted with APAC equity markets generally higher on the session, and EMEA ones all trading in the black as well. In fact, the biggest losers seem to be CAD and MXN, each of which is down more than 0.5% over concerns that the NAFTA negotiations are going to crumble in the wake of the harsh rhetoric following the conference.

But despite all this, the big story this week is really the central banks, with the Fed, ECB and BOJ all meeting between Wednesday and Friday. Current expectations are as follows: the Fed will raise the Fed funds rate 25bps; the ECB will leave policy unchanged, but slightly more than half the analyst community believes they are going to define when and how QE is going to end; while the BOJ is likely to leave policy completely unchanged. As I wrote last week, we have heard from several emerging market central banks about how the Fed’s current trajectory of both interest rate hikes and QT (allowing the balance sheet to gradually shrink) is having a major impact on their own economies. Obviously, we have seen that in the market action over the past several months. So the question is, will Chairman Powell heed these pleas to change the Fed’s current plans and slow things down, or will he continue full speed ahead? My money is on full speed ahead based on two things; first, his speech at the IMF last month demonstrated pretty clearly that he doesn’t buy the story that the Fed’s actions are causing the EMG problems; and second, history shows that every central bank, when it comes to developing crises, is reactive not proactive. The Fed is very keen to get US interest rates back closer to neutral so they have some ammunition when the next downturn comes, in fact I believe this is their primary objective right now. In summary, I see only limited evidence that the Powell Fed is going to change its policy trajectory because of what is happening in a handful of emerging markets. Powell is no Yellen!

And to think, I didn’t even mention the historic summit between President Trump and North Korean leader, Kim Jong-Un, which takes place tomorrow. Of course, the market implications of this summit are much harder to divine. Arguably, a positive outcome should help KRW somewhat, but I just don’t see the clear market impact of any results.

Turning to the overnight markets, we did see some data that had an impact. UK data was quite weak overall with IP -0.8% in April, well below expectations, and the Trade deficit growing to -£5.2B, it’s largest decline since December 2016. While the BOE remains adamant that growth has been better than Q1 data implied, their argument is looking a bit more difficult to maintain this morning. The pound responded by falling 0.4% and the market is now awaiting this week’s employment and inflation data to determine if the BOE will be able to maintain their rhetoric about raising rates. Currently, the market is pricing in about a 60% probability of an August rate hike. We shall see.

The euro, meanwhile, has edged a bit higher, +0.15%, after the new Italian FinMin, Giovanni Tria, committed to the euro and indicated that his focus would be on domestic structural reforms rather than exiting the single currency. Those comments have alleviated the immediate fears and Italia equities have rallied more than 2% in their wake. In addition, Italian government bonds have also rallied, with yields across the curve falling sharply in what looks like a serious short squeeze. Remember though, regardless of these comments, the reality is that the new government looks set to blow up Eurozone fiscal constraints with their tax and spending plans, which means that further problems are sure to arise.

A listing of this week’s data shows that there is much important information due alongside the central bank activities.

Tuesday NFIB Small Biz Sentiment 105.3
  CPI 0.2% (2.8% Y/Y)
  -ex food & energy 0.2% (2.2% Y/Y)
Wednesday PPI 0.3%
  -ex food & energy 0.2%
  FOMC Rate 1.75% – 2.00%
Thursday Initial Claims 224K
  Retail Sales 0.4%
  -ex autos 0.5%
  Business Inventories 0.3%
Friday Empire State Mfg 19.6
  IP 0.1%
  Capacity Utilization 78.0%
  Michigan Confidence 98.7

The Fed will get to see the rest of the world’s view as to what inflation is like tomorrow morning, and despite their utilization of PCE for their models, they cannot be blind to the continued increase in this metric. As well, Retail Sales data on Thursday will be another good indicator of how the economy is performing. Other things happening this week that will matter to markets include the ongoing Brexit story in the UK, where the Brexit bills head back to the lower house of Parliament for voting, and where PM May is hopeful of rebounding from the beating she has been taking from the House of Lords.

All told, there is a great deal on the calendar this week, much of which is likely to have an impact on financial markets. If I had to choose, though, I would contend that the FOMC actions, especially the tone of the statement and the press conference is going to be the single biggest event. Buckle up folks; this is going to be an active week.

Good luck
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All That They’ll Wreak

The G7 gathers this week
With six of them sure to critique
How President Trump
Was too quick to plump
For tariffs, with all that they’ll wreak

As the NY session opens, the dollar has recouped some of its recent losses, although movement overall has been slight. Yesterday saw a mixed session in equities, Treasuries rally sharply late in the afternoon after the Brazilian real fell dramatically along with the Bovespa in Sao Paolo, and the dollar stem its early session losses. In other words, the session devolved into a classic risk-off scenario, arguably led by growing concerns in Brazil. In addition to the ongoing emerging market volatility, market chatter is focused on just how hawkish the Fed will be next week (look for confirmation of a total of 4 rate hikes this year), and what exactly the ECB is going to tell us about the end of QE (less than the market is now looking for). But those meetings are the back half of next week. Before then, we have much else to digest.

First we saw some important data overnight from both China and Japan. Chinese trade data showed a surprising decline in the surplus to $24.9B in May, well below the expected $30B. The big surprise was imports, which rose a stellar 26%! (Maybe there is some method to Trump’s seeming madness). At any rate, the market response has been to see CNY fall about 0.2%, a fair amount in a currency as closely managed as it is. The other noteworthy news overnight was Japanese GDP data, where Q1 was revised lower to -0.6% annualized, a very disappointing outcome, and one which speaks to the idea that the BOJ is nowhere near ready to start exiting QE. In what can be no surprise to veteran yen watchers, the yen rallied in the wake of the report, and is now up 0.3% on the session.

Thus far the rest of the G10 bloc is showing only limited movement, but we are continuing to see pressure increase in the EMG space. As mentioned, BRL fell nearly 2% again yesterday and closed above 3.90 (4.00 is coming soon!) But in addition, MXN is lower by 1.2% this morning, trading above 20.50 as a combination of concerns plague the currency. First off is the increasing likelihood of AMLO becoming the next president of Mexico, bringing along his virtually Marxist views on the economy. Second is the fact that the most recent comments about NAFTA from the White House indicate that progress remains slow and that the president is considering two bilateral deals rather than a reboot of NAFTA. That is seen as a distinct MXN negative as evidenced by today’s movement. And finally, looking at the weakness in BRL, there are still many in the markets who use MXN as a proxy for all LATAM risk given it has the best liquidity if the bloc by far, and who are simply following BRL lower via positions in the peso.

This brings us to the G7 meeting. I find it quite interesting how much credence is suddenly being given to a gathering that has lost its luster, and arguably its raison d’etre, ever since the advent of the G20 in 1999. But there is much being made over comments that French President Macron will not sign a communiqué if the US’ tariffs on steel and aluminum are not lifted. As well, Chancellor Merkel is focused on obtaining exemptions for European companies that do business with Iran, which are now in breach of US rules since the US left the Iranian nuclear agreement. In fact, every member has their own pet peeve, each of which pits their nation against President Trump. I would wager that if you looked at the past 20 G7 communiqués, not one of them had any impact on markets. And I see this as yet another in a long line of useless rhetoric. Each leader is playing to their home crowd on a global stage. And ask yourself this, what would happen if the G7 did not issue a communiqué? I assure you the market impact would be nil.

And that’s pretty much all there is today. US data is completely absent and Fed speakers are muzzled due to the proximity of the meeting. We do see Canadian employment data, however it will need to be extraordinary to change views. Remember, Governor Poloz is laying the groundwork for an August rate hike, and perhaps another in November. I am skeptical we get both, but cannot rule out the first one. However, given oil’s recent sharp price declines, I imagine the CAD is going to have a very hard time rallying on positive news.

With the week drawing to a close, I expect that we will see position squaring, which given the week’s activity, probably means we can see a small amount of further USD strength. But the reality is that next week is what traders are looking toward, with Wednesday and Thursday the keys. Until then, don’t look for much.

Good luck and good weekend
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Increasing Doubt

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

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

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

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

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

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

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

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

Good luck
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Not Apropos

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

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

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

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

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

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

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

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

Good luck
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To-ing and Fro-ing

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

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

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

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

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

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

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

Good luck
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At Wit’s End

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

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

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

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

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

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

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

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

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

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

Today Factory Orders -0.4%
Tuesday ISM Non-Manufacturing 58.0
JOLTS Jobs Report 6.543M
Wednesday Trade Balance -$49.0B
Nonfarm Productivity 0.7%
Unit Labor Costs 2.8%
Thursday Initial Claims 225K

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

Good luck
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Birds of a Feather

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

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

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

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

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

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

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

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

Nonfarm Payrolls 190K
Private Payrolls 184K
Manufacturing Payrolls 18K
Unemployment Rate 3.9%
Participation Rate 62.8%
Average Hourly Earnings (AHE) 0.2% (2.7% Y/Y)
Average Workweek 34.5
ISM Manufacturing 58.5

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

Good luck
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