Palpably Real

For Jay and his friends at the Fed
Inflation seems just about dead
So all the debate
‘bout rate hikes can wait
With focus on Brexit instead!

Thus turning to England, we learned
The deal, once again, has been spurned
Now fears of no deal
Are palpably real
Though markets seem quite unconcerned

While the headline news is arguably the second defeat of PM May’s Brexit deal in Parliament, I am going to touch on a different theme to start; namely the Fed.

Yesterday’s CPI data printed on the soft side (Headline 1.5%, Core 2.1%) with both coming in 0.1% below expectations. And while the Fed does not target this reading, it is still an important part of the discussion. That discussion continues to turn toward the idea that the Fed has already overtightened policy and that the next move will be a rate cut. Given the overall slowing in US data and highlighting that the Fed has been completely unable to achieve their inflation target of 2.0%, I expect that the next series of Fed comments, once they are past their meeting next week, will focus on greater efforts to achieve their mandate (the self-imposed 2.0% inflation target) and what needs to be done accordingly. I would look for the end of the balance sheet roll-off quite soon, perhaps in April, but in any case, by June, and I would look for futures markets to start pricing in a full rate cut by the middle of next year. I guess the only question is will the equity market continue to rally despite the weakening underlying fundamentals. Certainly, based on the past ten years of experience, the answer is yes. But can markets defy fundamentals forever? I guess we shall see.

PS. If the Fed is starting to turn more actively dovish, rather than its current passive stance, that will immediately undermine the dollar’s value. While for now I continue to see further upside potential for the buck, that is subject to change if the policies underlying that stance change as well.

Now to Brexit. Poor PM May. She really did work hard to try to find a solution as to how to avoid a hard Brexit, but the EU has literally zero interest in seeing the UK leave their bloc and thrive. If that were the case, the temptation for other unhappy countries (Italy anyone?) to also exit would be too great. As such, it was always in the EU’s long-term interest to play hardball like they did. It can also be no surprise that the widely touted adjustment to the codicil to the agreement was an attempt to bamboozle with flowery words, rather than an effort to put something legally binding in place. As such, once Attorney General Cox declared that the new language was no better than the old, which occurred just as I was getting prepared to publish my note yesterday, it was clear that there was no chance of passage. The fact that the vote lost by a smaller amount, only 149 votes vs. 230 votes the first time, is small consolation.

However, now Parliament has taken over and will have to come up with some plans on their own. It is generally much easier to howl from the peanut gallery than to take responsibility so we shall watch this with great interest. It seems that a majority in Parliament want to vote on a bill that will prevent a no-deal Brexit but given there is only one deal on the table and they handily rejected it, that implies they need a postponement from the EU. It is not enough for the UK to say they want to postpone. In fact, the other 27 members of the EU must all vote unanimously to agree. At this point, there has been no clarity on how long a delay they would like, nor what they plan to do with the time. And the EU has made it clear that those are important aspects of agreeing to a delay. For now, the debate in Parliament rages on, and I assume we will learn their answers in the next day or two, and certainly by the end of the week.

Funnily enough, the FX market has weighed the evidence and decided that there will categorically not be a hard Brexit and the odds of no Brexit are increasing. The pound, after yesterday’s wild ride, is back on an upswing and higher by 0.65% as I type. The one thing of which we can be sure is that the pound will continue to react to headline news until a definitive outcome exists. For my money, it appears as though the market is underpricing the probability of a hard Brexit. While I am pretty sure that nobody really wants one, the fact remains that it continues to be a real possibility even if only by legislative accident. One never knows who is looking at the situation there and sees a chance for personal political gain by allowing a hard Brexit. And in the end, given each MP is a politician first and foremost, that cannot be ignored!

Otherwise, the trade talks are ongoing with a positive spin put forth by the US top negotiator, Robert Lighthizer, although no deal is agreed as yet. Overnight data from Down Under showed weakening Consumer Confidence as the housing market there continues to implode, thus it is no surprise to see AUD having fallen by 0.25% and hugging recent lows. And in truth, little else of note is happening in these markets.

This morning we see Durable Goods (exp -0.5%, +0.1% ex Transport) as well as PPI (1.9%, 2.6% core) although nobody really cares about PPI with CPI just having been released. The Fed is now in their quiet period as they meet next week, so we will not get comments there. This leaves the Brexit debate as the primary focus for the FX market today. Based on all that I have read, I actually expect that the debate there will take more than one day, and that we won’t really get much new information today. Hence, I expect limited market activity for now.

Good luck
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Expansion is Done

The planet that’s third from the sun
Is learning expansion is done
At least with respect
To growth that’s subject
To what politicians have done

It ought not be much of a surprise that the dollar is regaining its footing this morning and has been doing so for the past several sessions. This is due to the fact that the economic data continue to point to the US as the last bastion of hope for global growth. Yesterday’s data showed that there is still life in the US economy as both Non-Manufacturing ISM (59.7) and New Home Sales (621K) handily beat expectations. At the same time, the data elsewhere around the world continues to show slowing growth.

For example, Australian GDP growth in Q4 printed at a lower than expected 0.2%, with the annual number falling to 2.3%. While RBA Governor Lowe continues to cling to the idea that falling unemployment (a lagging indicator) is going to save the day, the fact remains that the housing bubble there is deflating and the slowdown in China’s economy is having a direct negative impact on Australian growth. In the wake of the report, analysts throughout Asia adjusted their interest rate forecasts to two rate cuts this year even though the RBA has tried to maintain a neutral policy with an eventual expectation to raise rates. Aussie fell sharply, down 0.75% this morning and >2.5% in the past week. It is once again approaching the 0.70 level which has thus far proven to be formidable support, and below which it has not traded in three years. Look for it to crack this time.

But it is not just problems Down Under. In fact, the much bigger issues are in Europe, where the OECD has just released its latest forecasts for GDP growth with much lower numbers on the table. Germany is forecast to grow just 0.7% this year, the UK just 0.8% and of course, Italy which is currently suffering through a recession, is slated to grow just 0.2% this year! Tomorrow Signor Draghi and his ECB colleagues meet again and there is a growing belief that a decision on rolling over the TLTRO bank financing will be made. I have been pounding the table on this for several months and there has certainly been nothing lately to change my view. At this point, the market is now pricing in the possibility of the first ECB rate hike only in mid 2020 and my view is it will be later than that, if ever. The combination of slowing growth throughout the Eurozone, slowing growth in China and still absent inflation will prevent any rate hikes for a very long time to come. In fact, Europe is beginning to resemble Japan in this vein, where slowing growth and an aging population are the prerequisites for NIRP forever. Plus, the longer growth remains subpar, the more call for fiscal policy ease which will require additional borrowing at the government level. As government debt continues to grow, and it is growing all around the world, the ability of central banks to guide rates higher will be increasingly throttled. When you consider these issues it become very difficult to be bullish on the euro, especially in the long-term. But even in the short run, the euro is likely to feel pressure. While the euro has barely edged lower this morning, that is after a 0.35% decline yesterday which means it is down just over 1.0% in the past week.

In the UK, meanwhile, the Brexit debate continues but hope is fading that the PM will get her bill through Parliament this time. Thus far, the EU has been unwilling to make any concessions on the language of the Irish backstop, and despite a herculean effort by May, it is not clear she can find the votes. The vote is scheduled for next Tuesday, after which, if it fails, Parliament will look to pass some bills preventing a no-deal Brexit and seeking a delay. However, even those don’t look certain to pass. Just this morning, Governor Carney said that a no-deal Brexit would not, in fact, be the catastrophe that had been earlier forecast as many companies have made appropriate plans to handle it. While the underlying thesis in the market continues to be that there will be a deal of some sort, it feels like the probability of a hard Brexit is growing somewhat. Certainly, the pound’s recent performance would indicate that is the case. This morning it is down a further 0.3% which takes the move to -1.75% in the past week.

One last central bank story is that of Canada, where the economy is also slowing much more rapidly than the central bank had believed just a few weeks ago. Last week we learned that inflation is lower than expected, just 1.4%, and that GDP grew only 0.1% in Q4, actually falling -0.1% in December. This is not a data set that inspires optimism for the central bank to continue raising rates. Rather, it should become clear that the BOC will remain on hold, and more importantly likely change its hawkish slant to neutral at least, if not actually dovish. As to the Loonie, it is lower by 0.3% this morning and 2.0% since the GDP release on Friday.

Add it all up and you have a story that explains global growth is slowing down further. It is quite possible that monetary policy has been pushed to its effective limit with any marginal additional ease likely to have a very limited impact on the economy. If this is the case, it portends far more difficulty in markets ahead, with one of the most likely outcomes a significant increase in volatility. If the global economy is now immune to the effects of monetary policy anesthesia, be prepared for a few more fireworks. It remains to be seen if this is the case, but there are certainly some indications things are playing out that way. And if central banks do lose control, I would not want to have a significant equity market position as markets around the world are certain to suffer. Food for thought.

This morning we get one piece of data, Trade Balance (exp -$57.9B) and we hear from two more Fed speakers, Williams and Mester. Then at 2:00 the Fed’s Beige Book is released. It seems unlikely that either speaker will lean hawkish, even Mester who is perhaps the most hawkish on the FOMC. Comments earlier this week from other speakers, Rosengren and Kaplan, highlighted the idea of patience in their policy judgements as well as potential concern over things like the extraordinary expansion of corporate debt in this cycle, and how in the event the economy slows, many more companies are likely to be vulnerable. While fear is not rampant, equity markets have been unable to rally the past several sessions which, perhaps, indicates that fear is beginning to grow. And when fear is in vogue, the dollar (and the yen) are the currencies to hold.

Good luck
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A Little Less Clear

In China, the outcome this year
For growth is a little less clear
The target has changed
To feature a range
That’s lower, but still not austere

The Chinese have reduced their target rate of GDP growth to a range of 6.0%-6.5% from last year’s “about 6.5%” goal. It is, of course, unsurprising that the Chinese met last year’s goal, on paper, as despite significant evidence from individual economic data points, given the lack of independence of the Chinese statistics agency and the political imperative for President Xi to be seen as a great economic leader, 6.6% was determined to be the appropriate representation in 2018. However, given the fact that the growth trajectory in China has been slowing steadily for the past decade, and adding the fact that global growth continues to slow, it seems that even the mighty Chinese bureaucracy can no longer be certain of a particular outcome, hence the range. There is a large group that remains skeptical of the veracity of Chinese data (myself included), and the ongoing gradual reduction in forecasts that we have seen during the past several years simply reinforces the idea that previous data was too rosy.

At the same time, further fiscal stimulus was announced with a cut in VAT and more infrastructure spending, so for now, China remains focused on fiscal support rather than adding more monetary ease and potentially reflating the credit bubble they have spent the last two years trying to deflate. Much of this forecast, naturally, depends on a successful conclusion to the trade talks with the US, and while Sunday night there was a report indicating the deal is almost done, it is not done yet. If, in fact, the mooted deal falls through, look for analyst revisions lower and even government guidance toward the lower end of this range.

As to the renminbi, China has pledged to maintain a stable currency, although they have not indicated exactly what the benchmark for stability will be. This remains a key focus for President Trump and is ostensibly part of the nascent trade agreement. While I believe that economic pressures would naturally tend toward a weaker renminbi over time, as I had forecast at the beginning of the year, the one thing I know is that if the Chinese choose to strengthen the currency in the short run, regardless of the macroeconomic factors that may exist, they will be able to do so. Wall Street analysts are slowly adjusting their forecasts toward a stronger CNY this year, and if a trade agreement is reached, that seems exactly correct. Of course, if the talks founder, all bets are off.

Meanwhile, one week before PM May is set to have another Parliamentary vote on her Brexit deal, she continues to try to get a modification to the terms of the Irish backstop. Uncertainty remains high as to the actual outcome, but it appears to me that either the deal, as written and newly interpreted, will squeak through, resulting in a short delay in order that all sides can pass the appropriate legislation, or the deal will fail and Parliament will vote to ask for a 6-9 month delay with the intent of having a new referendum. While there is still a chance that the UK leaves without a deal at the end of the month, it does seem to be a very small chance. With that in mind, a look at the pound, which has fallen ~1.5% in the past week (-0.15% overnight), and it appears that we are witnessing another ‘buy the rumor, sell the news’ outcome. As hopes grew that there would be no hard Brexit, the pound steadily rallied for a number of weeks. I have maintained that even a positive outcome has only limited further potential upside given the UK economy remains mired in a slowdown and their largest trading partner, the EU, is slowing even more rapidly. Don’t be surprised to see the pound jump initially on a positive vote next week, but it will be short-lived, mark my words.

Pivoting to the euro, this morning’s Services PMI data was mildly better than the flash projections of two weeks ago. The current market interpretation is that the slowdown in the Eurozone has stabilized. And while that may be true for the moment, it is in no way clear the future portends a resumption in growth. Meanwhile, the euro has continued its recent drift lower, with a very modest decline this morning, just 5bps, but approaching a 1% decline in the past week. The ongoing discussion about the ECB is focused on exactly what tools they have available in the event that the slowdown proves more long-lasting than currently hoped expected. I continue to believe that TLTRO’s will be rolled over with an announcement by June, but after that, the cupboard is bare. Pushing rates to an even more negative level will be counterproductive as the negative impact on banks will almost certainly curtail their lending activity. And restarting QE just months after they ended it would be seen as an indication the ECB has no idea what is going on in the Eurozone economy. Therefore, though Signor Draghi will be reluctant to discuss much about this on Thursday at his press conference, pressure on the ECB will increase when they lower their growth and inflation forecasts further. Look for the euro to continue to drift slowly lower and talk of TLTRO’s to increase.

Last night the RBA left rates on hold, which was universally expected, but the market continues to expect an eventual reduction in the overnight interest rate Down Under. The housing market bubble has been rapidly deflating, and while employment has so far held up, remember employment is a lagging indicator. With that in mind, it is not surprising that AUD has fallen -0.25% overnight, and I think the underlying trend will still point lower. This is especially true if the US-China trade talks falter given China’s status as Australia’s largest trading counterparty. Slowing growth in China means slowing growth in Australia, count on it.

As can be seen from these discussions, the dollar is modestly higher overall this morning, although movement in any given currency has been fairly small. While President Trump continues to decry the dollar’s strength, the US remains the only large economy that is not slowing sharply. And as I have written consistently, with the Fed’s clear stance that further tightening is off the table, you can be sure that no other central bank will be looking to tighten policy anytime ahead of the Fed. The president will not get satisfaction on this front anytime soon.

Turning to this morning’s data, we see ISM Non-Manufacturing (exp 57.3) and New Home Sales (600K). We also hear from Fed uber-dove Neel Kashkari, but now that the Fed has turned dovish overall, it is not clear that he can say much that will alter impressions in the market. While throughout February, the dollar was on its back foot, taking a step back shows that it has been range trading since last October. Given the recent data situation, as well as the sentiment shifts we have seen, it does appear that the dollar can grind back toward the top of that trading range (think of the euro at 1.1200), but we are still lacking a catalyst for a substantial change.

Good luck
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Carefully Looking Ahead

The Minutes explained that the Fed
Was carefully looking ahead
But so far it seems
The hawks’ fondest dreams
Of hiking again might be dead

As well, when it comes to the size
Of the Fed’s balance sheet, in their eyes
It’s likely to stay
Quite large like today
Not shrink while they, debt, monetize

Markets are little changed this morning after a lackluster session yesterday when the Fed released their Minutes from the January meeting. Overall, the tone of the Minutes seemed to be slightly less dovish than the tone of the Powell press conference that followed the meeting, as well as much of the commentary we have heard since then. Apparently, Cleveland’s Loretta Mester is not the only one who believes rates will need to be raised further this year, as the Minutes spoke of “several’ members with the same opinion. Of course, that was offset by “several” members who had the opposite view and felt that there was no urgency at all to consider raising rates further this year. Patience continues to be the watchword at the Mariner Eccles building, and I expect that as long as the economic data does not differ dramatically from forecasts, the Fed will be quite happy to leave rates on hold. They specifically mentioned the potential problems that could derail things like slowing global growth, a poor outcome in the US-China trade talks or a disruptive Brexit. But for now, it appears they are comfortable with the rate setting.

The balance sheet story was of even more interest to many market participants as the gradual running off of maturing securities has seemingly started to take a bite out of available liquidity in markets. And in fact, this seems to be where the Fed minutes indicated a more dovish stance in my eyes. While there is still a thought that rates might be raised later this year, it was virtually unanimous that shrinking the balance sheet will end this year, leaving the Fed with a much larger balance sheet (~$3.5-$4.0 trillion) than many had expected. Recall, prior to the financial crisis the Fed’s balance sheet was roughly $900 billion in size. To many, this is effectively a permanent injection of money into the economy and so should support both growth and inflation going forward. However, the risk is that when the next downturn arrives (and make no mistake, it Will arrive), the Fed will have less room to act to support the economy at that time. This is especially true since even with another one or two rate hikes, Fed Funds will have topped out at a much lower level than it has historically, and therefore there will be less rate cutting available as a policy tool.

Adding it up, it seems rate guidance was mildly hawkish and balance sheet guidance was mildly dovish thus leaving things largely as expected. It is no surprise market activity was muted.

This morning, as the market awaits the ECB Minutes, we see the dollar little changed overall, although there have been some individual currency movements. For example, AUD has fallen 0.7% (and dragged NZD down -0.5%) after a well-respected local economist changed his rate view to two RBA rate cuts later this year due to the rapidly weakening housing market. Prior to this, the market had anticipated no rate movement for at least another 18 months, so this served as quite a change. And all this came despite strong Australian employment data with the Unemployment rate remaining at 5.0% and job growth jumping by 39K.

Meanwhile, mixed data from Europe has leaned slightly bullish as surprisingly strong French Composite PMI data (49.9 vs 49.0 expected) offset surprisingly weak German Manufacturing PMI data (47.6 vs 49.7 expected). I guess the market already knows that Germany is slowing more rapidly than other nations in the Eurozone (except for Italy) due to the ongoing trade friction between the US and China. But despite the ongoing Gilets Jaune protests, the French economy managed to find some strength. At any rate, the euro has edged higher by 0.15% after the reports. At the same time, the pound has also rallied 0.15% after releasing the largest budget surplus on record (since 1993), and perhaps more importantly, on some apparent movement by the EU on Brexit. PM May is hinting that she may be able to get a legally binding way to end the backstop in a codicil to the Brexit negotiations, which if she can, may allow cover for the more euro skeptical members of her party to support the deal. There is no question the pound remains completely beholden to the Brexit story and will continue to do so for at least another month.

Pivoting to the trade talks, there are several stories this morning about how negotiators are preparing a number of memos on separate issues with the idea they will be brought together at the Trump-Xi meeting to be held in the next several weeks. There is no question that the market continues to view the probability of a deal as to be quite high, but I keep looking at the key issues at stake, specifically with regards to IP and the coercion alleged by US companies, and I remain skeptical that China will back away from that tactic. The Chinese do not view the world through the same eyes as the US, or the Western World at large. As per an article in the WSJ this morning, “We must never follow the Western path of constitutionalism, separation of powers and judicial independence,” Mr. Xi said in an August speech. That comment does not strike me as a basis for compromise nor enforcement of any deal that relies on those issues. But for now, the market continues to believe.

And that’s pretty much the stuff that matters today. We do get most of our data for the week this morning with Initial Claims (exp 229K), Durable Goods (1.5%, 0.3% ex transport), Philly Fed (14.0) and Existing Home Sales (5.00M). While individually, none of them have a huge impact, the suite of information if consistently strong or weak, could well lead to some movement given the broad sweep of the economy covered. There are no Fed speakers on the docket today, and so it doesn’t appear that there is much reason to expect real movement today. Equity markets around the world have seen limited movement and US futures are flat to slightly lower. Treasury yields are slightly firmer but remain at the bottom end of their recent trading range. Overall, it seems like a dull day ahead.

Good luck
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