When Tax Cuts Arrive

The euro has taken a dive
As Italy tries to revive
Its still quite weak growth
By managing both
More spending when tax cuts arrive

It was just earlier this week that pundits were sounding the death knell for the dollar, as they explained the market has already fully priced in Fed rate hikes while other markets, both developed and emerging, were just beginning their turn towards tighter policy. In fact, the convergence trade was becoming all the rage; the idea that as the dollar started to slide, emerging market economies would see reduced pressure on their fundamentals (it would become easier to repay dollar debt) while commodity prices could rebound (most emerging markets are commodity exporters) and so both stock and bond prices in those markets would benefit. At the same time, other developed markets would see a similar, albeit lesser, impact and so market sentiment would get markedly better. Or not.

Yesterday, the market learned that the Italian budget question, something that had been set aside as not really impactful, has become impactful. The announcement by the ruling coalition that they would be targeting a 2.4% budget deficit next year, well above earlier estimates of 1.8% but still below the EU’s 3.0% target, has raised numerous red flags for investors. First, the new budget will do nothing to address Italy’s debt/GDP ratio, which at 131% is second only to Greece within the EU. One of the reasons that the EU wanted that lower target was to help address that situation. The potential consequence of that issue, a larger debt/GDP ratio, is that the ratings agencies may lower their country credit ratings for Italy, which currently stand at Baa2 by Moody’s and BBB by S&P. And given that those ratings are just two notches above junk, it could put the country in a precarious position of having a much more difficult time funding its deficit. It should be no surprise that Italian government bond yields jumped, with 2-year yields spiking 46bps and 10-year yields up 31bps. It should also be no surprise that the Italian stock markets fell sharply, with the FTSE-MIB down 4.1% as I type. And finally, it should be no surprise that the euro is lower, having fallen more than 1.5% since this news first trickled into the market yesterday morning NY time. While this could still play out where the coalition government backs off its demands and markets revert, what is clear is that dismissing Italian budget risk as insignificant is no longer a viable option.

But it’s not just the euro that is under pressure; the dollar is generally stronger against most of its counterparts. For example, the pound is down 0.3% this morning and 1% since yesterday morning after UK data showed weakening confidence and slowing business investment. Both of these seem to be directly related to growing Brexit concerns. And on that subject, there has been no movement with regard to the latest stance by either the UK or the EU. Politicians being what they are, I still feel like they will have something signed when the time comes, but it will be short on specifics and not actually address the issues. But every day that passes increases the odds that the UK just leaves with no deal, and that will be, at least in the short term, a huge pound Sterling negative.

Meanwhile, the yen has fallen to its lowest level vs. the dollar this year, trading through 113.60 before consolidating, after the BOJ once again tweaked its concept of how to manage QE there. Surprisingly (to me at least) the movement away from buying 30-year bonds was seen as a currency negative, despite the fact that it drove yields higher at the back of the curve. If anything, I would have expected that move to encourage Japanese investors to repatriate funds and invest locally, but that is not the market reaction. What I will say is that the yen’s trend is clearly downward and there is every indication that it will continue.

Looking at the data story, yesterday we saw US GDP for Q2 confirmed at 4.2%, while Durable Goods soared at a 4.5% pace in August on the back of strong aircraft orders. For this morning, we are looking for Personal Income (exp 0.4%); Personal Spending (0.3%); PCE (0.2%, 2.3% Y/Y); Core PCE (0.1%, 2.0% Y/Y); and Michigan Sentiment (100.8). All eyes should be on the Core PCE data given it is the number the Fed puts into their models. In addition, we hear from two Fed speakers, Barkin and Williams, although at this stage they are likely to just reiterate Wednesday’s message. Speaking of which, yesterday Chairman Powell spoke and when asked about the flattening yield curve explained that it was something they watched, but it was not seen as a game changer.

In the end, barring much weaker PCE data, there is no reason to believe that the Fed is going to slow down, and if anything, it appears they could fall behind the curve, especially if the tariff situation starts to impact prices more quickly than currently assumed. There is still a tug of war between the structural issues, which undoubtedly remain dollar negative, and the cyclical issues, which are undoubtedly dollar positive, but for now, it appears the cyclicals are winning.

Good luck and good weekend
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I’m Not Thrilled

Said President Trump, “I’m not thrilled”
With how Chairman Powell’s fulfilled
Both job and price mandates
By raising Fed Fund rates
‘Cause soon the Dow Jones could get killed

“I’m not thrilled. I don’t like all of this work that we’re putting into the economy and then I see rates going up. I am not happy about it. But at the same time I’m letting them do what they feel is best.” So said President Trump in an interview on CNBC yesterday afternoon. It should be no surprise that the FX market response was immediate, with the dollar reversing earlier gains.

While this is not the first time that a US president has tried to persuade the Federal Reserve to cut rates (they never want higher rates, I assure you!), it is the first time since George H.W. Bush pushed then Chairman Greenspan to reduce rates more quickly in 1992 (he didn’t). This is a situation fraught with serious consequences as the independence of a nation’s central bank is seen as one of the keys to a developed economy’s success. For instance, recall just several weeks ago when Turkey’s President Erdogan essentially took over making monetary policy there, and how the market has behaved since, with TRY already significantly weaker.

As long as the Fed remains on course to continue raising rates, and despite the Trump comments, Fed Funds futures showed no change in the probability for two more rate hikes this year, I see little reason to change my stance on the dollar’s future strength. However, the bigger problem is if the Fed, independently, decides that slowing the pace of rate hikes is justified by the data, it could still appear to be politically motivated, and so reduce whatever credibility the Fed still maintains. This will remain a background story, at the very least, for a while. So far, there is no indication that Chairman Powell is going to change his stance, which means that policy divergence remains the lay of the land.

In the meantime, the other big FX story comes from China. We discussed yuan weakness yesterday and in the overnight session, the PBOC fixed the onshore currency at its weakest point in more than a year, which in fairness is simply following the dollar’s overall strength, but then when USDCNY made new highs for the year above 6.83, a large Chinese state-owned bank was seen aggressively selling dollars. This tacit intervention helped to steady the market and worked to support the Shanghai Stock Exchange as well, which ultimately rose 2.0% on the day. It is, however, difficult to follow all the twists and turns in the US-China relationship these days, as literally minutes ago, President Trump raised the ante yet again, by saying that he is “ready to go” with regard to imposing tariffs on $500 billion of Chinese goods. That represents all Chinese exports to the US and is considerably larger than ever mentioned before.

Tariffs and protectionism have a very poor history when it comes to enhancing any country’s economic situation, but it is very possible that this continuous ratcheting of pressure may actually be effective at achieving policy changes in this situation as China has plenty of domestically created economic problems already. Recall, President Xi has been on the warpath about excess leverage and the PBOC had been tightening policy in order to squeeze that out of the system. However, growth in China has suffered accordingly, and the recent data indicates that it may be slowing even more. With that in mind, a full-scale trade war with the US would likely be disastrous for China. The last thing they can afford is to see reduced production numbers, as well as loss of access to critical component and technology imports. It is not impossible that Xi blinks first, or that the two presidents recognize that a face-saving deal is in both their interests. It may take a little while, but I have a sense that could well be the outcome. However, until then, look for USDCNY to continue to rally sharply, with a move to 7.00 and beyond very viable. This morning, despite the intervention overnight, it has subsequently weakened 0.4% and shows no signs of stopping.

Finally, one last story has returned from the past to haunt markets, Italy. There appeared to be a push by Five-Star leader, Luigi di Maio, to have the Finmin, Giovanni Tria, removed from office. You may recall that back in May, things got very dicey in Italy before the current government was finally formed as President Mattarella rejected the first proposed cabinet because of the Euroskeptic proposed for the FinMin post. Tria was the compromise selection designed to calm markets down, and it worked. So, if he were forced out, and it has been denied by the Finance Ministry that is the situation, it could lead us right back into a euro area crisis. This is especially true since the populist coalition of the League and Five-Start has gained further strength in the interim. While Italian bond markets suffered on the news, it was not sufficient to impact the euro much. However, we need to keep an eye on this story as it could well resurface in a more malevolent manner.

And that is really today’s situation. Overall the dollar is mildly weaker, but given its performance all week, that has more to do with profit taking on a Friday than other news. Clearly the Trump comments undermined the dollar to some extent, but until policies are seen changing, I think that will only be a temporary situation. With no data due this morning, and no speakers on the agenda, it has all the feelings of a quiet day upcoming. It is, after all, a Friday in July, so the summer doldrums seem appropriate.

Good luck and good weekend
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