Uncomfortably High

Said Carney, exhaling a sigh
The odds are “uncomfortably high”
More pain will we feel
If there is no deal
When England waves Europe bye-bye

Yesterday the BOE, in a unanimous decision, raised its base rate by 25bps. This outcome was widely expected by the markets and resulted in a very short-term boost for the pound. However, after the meeting, Governor Carney described the odds of the UK leaving the EU next March with no transition deal in hand as “uncomfortably high.” That was enough to spook markets and the pound sold off pretty aggressively afterwards, closing the day lower by 0.9%. And this morning, it has continued that trend, falling a further 0.2% and is now trading back below 1.30 again.

By this time, you are all well aware that I believe there will be no deal, and that the market response, as that becomes increasingly clear, will be to drive the pound still lower. In the months after the Brexit vote, January 2017 to be precise, the pound touched a low of 1.1986, but had risen fairly steadily since then until it peaked well above 1.40 in April of this year. However, we have been falling back since that time, as the prospects for a deal seem to have receded. The thing is, there is no evidence that points to any willingness to compromise among the Tory faithful and so it appears increasingly likely that no deal will be agreed by next March. Carney put the odds at 20%, personally I see them as at least 50% and probably higher than that. In the meantime, the combination of ongoing tightening by the Fed and Brexit uncertainty impacting the UK economy points to the pound falling further. Do not be surprised if we test those lows below 1.20 seen eighteen months ago.

This morning also brought news about the continuing slowdown in Eurozone growth as PMI data was released slightly softer than expected. French, German and therefore, not surprisingly, Eurozone Services data was all softer than expected, and in each case has continued the trend in evidence all year long. It is very clear that Eurozone growth peaked in Q4 2017 and despite Signor Draghi’s confidence that steady growth will lead inflation to rise to the ECB target of just below 2.0%, the evidence is pointing in the opposite direction. While the ECB may well stop QE by the end of the year, it appears that there will be no ability to raise rates at all in 2019, and if the current growth trajectory continues, perhaps in 2020 as well. Yesterday saw the euro decline 0.7%, amid a broad-based dollar rally. So far this morning, after an early extension of that move, it has rebounded slightly and now sits +0.1% on the day. But in the end, the euro, too, will remain under pressure from the combination of tighter Fed policy and a decreasing probability of the ECB ever matching that activity. We remain in the 1.1500-1.1800 trading range, which has existed since April, but as we push toward the lower end of that range, be prepared for a breakout.

Finally, the other mover of note overnight was CNY, with the renminbi falling to new lows for the move and testing 6.90. The currency has declined more than 8% since the middle of June as it has become increasingly clear that the PBOC is willing to allow it to adjust along with most other emerging market currencies. While the movement has been steady, it has not been disorderly, and as yet, there is no evidence that capital outflows are ramping up quickly, so it is hard to make the case the PBOC will step in anytime soon. And that is really the key; increases in capital outflows will be the issue that triggers any intervention. But while many pundits point to 7.00 as the level where that is expected to occur, given the still restrictive capital controls that exist there, it may take a much bigger decline to drive the process. With the Chinese economy slowing as well (last night’s Caixin Services PMI fell to 52.8, below expectations and continuing the declining trend this year) a weaker yuan remains one of China’s most important and effective policy tools. There is no reason for this trend to end soon and accordingly, I believe 7.50 is reasonable as a target in the medium term.

Turning to this morning’s payroll report, here are the current expectations:

Nonfarm Payrolls 190K
Private Payrolls 189K
Manufacturing Payrolls 22K
Unemployment Rate 3.9%
Average Hourly Earnings (AHE) 0.3% (2.7% Y/Y)
Average Weekly Hours 34.5
Trade Balance -$46.5B
ISM Non-Manufacturing 58.6

Wednesday’s ADP number was much stronger than expected at 213K, and the whisper number is now 205K for this morning. As long as this data set continues to show a strong labor market, and there is every indication it will do so, the only question regarding the Fed is how quickly they will be raising rates. All of this points to continued dollar strength going forward as the divergence between the US economy and the rest of the world continues. While increasing angst over trade may have a modest impact, we will need to see an actual increase in tariffs, like the mooted 25% on $200 billion in Chinese imports, to really affect the economy and perhaps change the Fed’s thinking. Until then, it is still a green light for dollar buyers.

Good luck and good weekend

For How Long?

The US economy’s strong
Denial of this would be wrong
It’s not too surprising
That rates will be rising
The question is just, for how long?

Despite the Trump administration’s recent discussion of imposing 25% tariffs on $200 billion of Chinese imports, rather than the 10% initially mooted, the Fed looked at the economic landscape and concluded that things continue apace. While they didn’t adjust rates yesterday, as was universally expected, the policy statement was quite positive, highlighting the strength in both economic growth and the labor market, while pointing out that inflation is at their objective of 2.0%. Market expectations for a September rate hike increased slightly, with futures traders now pricing in a nearly 90% probability. More interestingly, despite the increased trade rhetoric, those same traders have increased their expectations for a December hike as well, with that number now hovering near 70%. At this point, despite President Trump’s swipe at higher rates last week, it appears that the Fed is continuing to blaze its rate-hiking path undeterred.

The consequences of the Fed’s stance are starting to play out more clearly now, with the dollar once again benefitting from expectations of higher short term rates, and equity markets around the world, but especially in APAC, feeling the heat. The chain of events continues in the following manner. Higher US rates have led to a stronger US dollar, especially vs. many emerging market currencies. The companies in those countries impacted are those that borrowed heavily in USD over the past ten years when US rates were near zero. They now find themselves struggling to repay and refinance that debt. Repayment is impacted because their local revenues buy fewer dollars while refinancing is impacted by the fact that US rates are that much higher. With this cycle in mind, it should not be surprising that equity markets elsewhere in the world are struggling. And those struggles don’t even include the potential knock-on effects of further US tariff increases. Quite frankly, it appears that this trend has further to run.

Meanwhile, the week’s central bank meetings are coming to a close with this morning’s BOE decision, where they are widely touted to raise the Base rate by 25bps, up to 0.75%. It is actually quite amusing to read some of the UK headlines talking about the BOE raising rates to the ‘highest in a decade’, which while strictly true, seems to imply so much more than the reality of still exceptionally low interest rates. However, given the ongoing uncertainty due to the Brexit situation, I continue to believe that Governor Carney is extremely unlikely to raise rates again this year, and if we are headed to a ‘no-deal’ Brexit, which I believe is increasingly likely, UK rates will head back lower again. Early this morning the UK Construction PMI data printed at a better than expected 55.8, its highest since late 2016, but despite the strong data and rate expectations, the pound has fallen 0.35% on the day.

Other currency movement has been similar, with the euro down 0.35%, Aussie and Kiwi both falling more than 0.5% and every other G10 currency, save the yen declining. The yen has rallied slightly, 0.2%, as interest rates in Japan continue to respond to Tuesday’s BOJ policy tweaks. JGB’s seem to have quickly found a new home above the old 0.10% ceiling, and there is now a growing expectation that as the 10-year yield there approaches the new 0.2% cap, the longer end of the JGB curve will rise with it taking the 30-year JGB to 1.00%. While that may not seem like much to the naked eye, when considering the nature of international flows, it is potentially quite important. The reason stems from the fact that Japanese institutional investors tend to hedge the FX exposure that comes from foreign fixed income purchases thus reducing their net yield from the higher rates received overseas to something on the order of 1.0%. And if the Japanese 30-year reaches that 1.0% threshold (it is currently yielding 0.83%), there is a growing expectation that those same investors will sell Treasuries and other bonds and bring the money home. That will have two impacts. First, I would be far less concerned over an inverting yield curve in the US as yields across the back end of the US curve would rise on those sales, and second, the dollar would likely rally overall on higher rates, but decline further against the yen. These are the type of background flows that impact the FX market, but may not be obvious to most hedgers.

Turning to the emerging markets, the dollar is firmer against virtually all of these currencies as well. One of the biggest movers has been CNY, falling 0.5% and now trading at its weakest level since May 2017. The renminbi’s decline has been impressive since mid-April, clocking in at nearly 9%, and clearly offsetting some of the impact of the recent tariffs. But remember, the renminbi’s decline began well before any tariffs were in place, and has as much to do with a slowing Chinese economy forcing monetary policy ease in China as with the recent trade spat. At this point, capital outflows have not yet become a problem there, but if history is any guide, as we get closer to 7.00, we are likely to see more pressure on the system as both individuals and companies seek to get their money out of China and into a stronger currency. I expect that there are more fireworks in store here.

Aside from China, the usual suspects continue to fall, with TRY having blasted through 5.00 overnight and now down 1.5% on the day. But we have also seen significant weakness in ZAR (-1.75%), KRW (-1.15%), and MXN (-0.75%). Even INR is down 0.5% despite the RBI having raised rates 0.25% overnight to try to rein in rising inflation pressures there. So today’ story is clear, the dollar remains in the ascendancy on the back of optimism in the US vs. increasing pessimism elsewhere in the world.

A quick peek at today’s data shows that aside from the weekly Initial Claims (exp 220K) we see only Factory Orders (0.7%). Yesterday’s ADP Employment data was quite strong, rising 219K, while the ISM Manufacturing report fell to a still robust 58.1, albeit a larger fall than expected. However, given the Fed’s upbeat outlook, the market was able to shake off the news. At this point, however, I expect that eyes are turning toward tomorrow’s NFP report, which will be seen as taking a much more accurate reading on the economy. All in all, I see no reason for the dollar to give back its recent gains, and in fact, expect that modest further strength is in the cards.

Good luck


Still At Its Peak

Three central bank meetings this week
Seem unlikely, havoc to wreak
When they all adjourn
Attention will turn
To joblessness, still at its peak

In the current central bank calendric cycle, the ECB meeting was the first to be completed, and last Thursday we learned virtually nothing new about Mario Draghi’s plans. The ECB is going to reduce QE further starting in October and is due to end it completely by year end. As to interest rates, ‘through summer’ remains the watchword, with markets forecasting a 10bp rate rise in either September or October of next year.

This week brings us the other three big central bank meetings, starting with the BOJ’s announcement tomorrow evening, then the FOMC on Wednesday and finally the BOE on Thursday. Going in reverse order, the market remains convinced that Governor Carney will raise rates 25bps, with a more than 80% probability priced in by futures traders. While I think it is a mistake, it does seem increasingly likely it will be the outcome. As to the Fed, there are no expectations of any policy adjustments at this meeting, and as there is no press conference following, I expect that the statement, when released Wednesday afternoon, will have little market impact.

This takes us to tomorrow evening’s BOJ meeting, which is the only one where there seems to be any real uncertainty. Last week I discussed the questions at hand which boil down to whether or not Kuroda and company have come to believe that QQE is not only ineffective, but actually beginning to have a detrimental impact on the Japanese economy. After all, they have been at it for the better part of five years and have still had zero success in achieving their 2.0% inflation goal. The three biggest problems are that Japanese banks have seen their business models decimated by increasingly narrow lending spreads; the ETF purchase program has had an increasingly large distortive impact on the Japanese stock markets as the BOJ now owns roughly 4% of all Japanese equities; and finally, the yield curve control plan has essentially broken the JGB market as evidenced by the fact that they continue to see sessions where there are actually no trades in the 10-year JGB. (Consider what would happen if there were no trades in 10-year Treasuries one day!)

With all of this as baggage, there has been increasing discussion that the BOJ may seek to tweak the program to try to make it more effective. However, they have painted themselves into a corner because if they reduce their activity in the JGB market, the market is likely to see it as a reduced commitment to QE and it is likely to result in higher yields there, which can easily lead to two separate but related outcomes. First, USDJPY is likely to fall further, as higher JGB yields lead to more interest for Japanese investors to bring their funds home. Given the disinflationary impact of a stronger currency, this would be a disaster. And second, if there is less support for JGB’s, given the fungibility of money and the open capital markets that exist, we are likely to see yields rise in US, UK, European and other developed markets. While Chairman Powell may welcome this as it will reduce concern over the Fed inverting the yield curve, the rest of the world, which retains far easier monetary policy, is likely to be somewhat less welcoming of that outcome. And this is all based on anonymous reports that the BOJ is going to make some technical adjustments to their program, not change the nature of what they are doing. So if you are looking for some fireworks this week, the BOJ is your best bet.

However, beyond the central banks, the market will turn its attention to Friday’s employment report here in the US. Last Friday saw a robust GDP report, as widely expected, and further proof of the divergence between the US and the rest of the global economy. This Friday could simply add to that impression. Here is the full listing of this week’s data, which is quite robust:

Tuesday BOJ Rate Decision -0.10% (unchanged)
  Personal Income 0.4%
  Personal Spending 0.4%
  PCE 0.1% (2.3% Y/Y)
  Core PCE 0.1% (2.0% Y/Y)
  Case-Shiller Home Prices 6.4%
  Chicago PMI 62.0
Wednesday ADP Employment 185K
  ISM Manufacturing 59.5
  ISM Prices Paid 75.8
  FOMC Rate Decision 2.00% (unchanged)
Thursday BOE Rate Decision 0.75% (+0.25%)
  Initial Claims 221K
  Factory Orders 0.7%
Friday Nonfarm Payrolls 190K
  Private Payrolls 185K
  Manufacturing Payrolls 22K
  Unemployment Rate 3.9%
  Average Hourly Earnings 0.3% (2.7% Y/Y)
  Average Weekly Hours 34.5
  Trade Balance -$46.2B
  ISM Non-Manufacturing 58.7

So, as you can see there is much to be learned this week. With the focus on the central banks and Friday’s payroll data, don’t lose sight of tomorrow’s PCE report, because remember, that is the Fed’s go-to number on inflation. Overall, looking at forecasts, things remain remarkably strong in the US economy this long into an expansion, which is something that has many folks concerned. We also continue to see important corporate earnings releases this week for Q2, which given the high profile misses we had last week, could well impact markets beyond individual equity names.

As to the dollar through all this, it is a touch softer this morning, but remains on the strong side of its recent trading range. While I still like it higher, there is so much potential new information coming this week, it is probably wisest to remain as neutral as possible for now. For hedgers, that means the 50% rule is in effect.

Good luck