A Half Point’s Preferred

Said Williams, the Fed must be swift
When acting if growth is adrift
The market inferred
A half point’s preferred
Which gave all stock markets a lift

If there was any doubt that markets are still entirely beholden to the Fed, they should have been removed after yesterday’s price action. First, recall that a number of emerging market central banks cut interest rates, some in a complete market surprise (South Korea), while others were anticipated (Indonesia, South Africa, Ukraine) and yet all of those currencies strengthened on the day. It is always curious to me when a situation like that occurs, as it forces a deeper investigation as to the market drivers. But this investigation was pretty short as all the evidence pointed in one direction; the Fed. Yesterday afternoon, NY Fed President John Williams gave an, ostensibly, academic speech about how central banks should respond to economic weakness and highlighted that they should act quickly and aggressively in such cases. Notably, he said, “take swift action when faced with adverse economic conditions” and “keep interest rates lower for longer.” The market interpretation of those comments was an increased expectation for a 50bp rate cut by the Fed at the end of the month. Stocks reversed early losses, bonds rallied, with yields falling 4bps and the dollar fell as much as 0.5%. While a spokesperson for the NY Fed made a statement later trying to explain that Williams’ speech was not about policy, just academic research, the market remained convinced that 50bps is coming to a screen near you on July 31! We shall see.

The problem with the 50bp theme is that the economic data of late has actually been generally, although not universally, better than expected. Consider that last week, both core CPI (2.1%) and PPI (2.3%) printed a tick higher than expectations; Retail Sales were substantially stronger at 0.4% vs. the 0.1% expected; and both the Empire State and Philly Fed indices printed stronger than expected at 4.3 and 21.8 respectively. Also, the jobs report at the beginning of the month was much stronger than expected. Of course, there have been negatives as well, with IP (0.0%), Housing Starts (-0.9%) and Building Permits (-6.1%) all underperforming. In addition, we cannot forget the situation elsewhere in the world, where China printed Q2 GDP at 6.2%, its lowest print in the 27 years they have been releasing quarterly data, while Eurozone data continues to suffer as well. The implication is that if you assume there is a case for a rate cut at all, the case for a 50bp rate cut relies on much thinner gruel.

At this point, even if we continue to see stronger than expected US data, I believe that Powell and company are locked into a rate cut. Given that futures markets have fully priced that in, as well as the fact that the equity markets are unquestionably counting on that cut, disappointment would serve to truly disrupt markets, potentially impinging on financial conditions and certainly draw the ire of the White House. None of these consequences seem worthwhile for the potential benefit of leaving 25bps of dry powder in the magazine. Add to this the fact that we have heard from several Fed members; Bostic, Kaplan and George, none of whom are enthused about a rate cut at all. Now, of those three, only Esther George is a current voter, but one dissenting vote will not be enough to sway a clearly dovish FOMC. Add it all up and I think we see 25bps when the dust settles. Of course, if that’s the case, it is entirely realistic to see equity prices ‘sell the news’ unless Powell is hyper dovish in the press conference.

And in truth, that is the entire story today. Virtually every story in the financial press focuses on rate cuts, whether the question about the Fed, or the discussion of all the other central banks that have already acted. There is an ongoing argument about whether the ECB actually cuts rates next week, or if they simply prepare the market for a cut in September and the reinstitution of QE in January. Most analysts are opting for the latter, believing that Signor Draghi will wait and see, but if they know they are going to cut, why wait? I think there is a much better chance of immediate action than is being priced into the market.

On the Brexit front, the voting by Tory members continues, and by all accounts, Boris is still in the lead and due to be the next PM. That will continue to pressure the pound, as unless there is further movement by the EU, the chances of a no-deal Brexit will continue to rise. In fact, next week will be quite momentous as we hear from the ECB and get the UK voting results on Thursday.

Away from these stories, most things fall into the background. For example, China Minsheng Group, a major Chinese conglomerate, is defaulting on a $500 million bond repayment due in August. Clearly, this is not a positive event, but more importantly speaks to two specific issues, the lack of US dollar liquidity available in emerging markets as well as the true nature of the slowdown in the Chinese economy. This will be used as further ammunition for the camp that believes the Chinese significantly overstate their economic data.

Turning to this morning’s activity, the only data point is the Michigan Sentiment data (exp 98.5) and we get one more Fed speech, from uber-dove James Bullard. The dollar is stronger today, after yesterday’s afternoon selloff, having risen 0.35% vs. the euro and with gains also against the yen (0.3%), Aussie (0.25%) and most emerging market currencies (MXN 0.3%, ZAR 0.6%, CNY 0.1%). My sense is that yesterday afternoon’s price action was a bit overdone on the dollar, and so we will see more of that unwound ahead of the weekend. Look for modest further USD strength.

Good luck and good weekend
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Could Not Be Severer

For two years the EU played rough
On Brexit and called every bluff
They forced the UK
To see it their way
And every pushback they’d rebuff

But now that the date’s drawing nearer
And Johnson can’t be any clearer
He’ll walk with no deal
It’s now become real
That Brexit could not be severer

So Barnier finally blinked
Agreeing the Irish were linked
And in a surprise
He talked compromise
Though as yet, no new deal’s been inked

The pound is higher this morning as news that the EU is willing to discuss a compromise for the Irish border has clearly changed the discussion. If you recall, the EU has been adamant that the only deal available is the one that erstwhile PM May negotiated, which includes a section on the Irish border that could easily keep the UK beholden to the EU in perpetuity. Naturally, the Brexiteers were not happy with that outcome and it eventually led to May’s resignation.

The problem for the EU is that Boris Johnson, who is the most likely candidate to become the new PM when results are announced next week, has been abundantly clear that if the EU doesn’t fix the parts of the deal that are controversial, he will take the UK out on October 31 without a deal. And there is no indication he is bluffing. So suddenly the EU has figured out that a no-deal Brexit is a real possibility and that they may no longer have the upper hand. Consider that the UK has already suffered economically during the run-up to the actual exit, while the EU’s suffering has been self-inflicted and not related to Brexit at all. Given the EU’s economy is broadly slowing already, the last thing they need is something like Brexit, which would likely tip the EU into recession if there is no deal. And voila, the EU has finally figured out that they have much to lose in this negotiation.

It should be no surprise that the pound has rallied on the news, although the 0.5% rally is not that impressive. But it’s a start, and if the two sides can come to an agreement on the Irish situation, then there is a real opportunity for the pound to rebound sharply. After all, a smooth Brexit has always been likely to drive the pound back toward 1.40. While it is still way too early to assume that outcome, at least it is back on the table.

The other theme of the overnight session has been central bank rate cuts, with South Korea surprising analysts with a 25bp cut to 1.50% while they lowered forecasts for both growth and inflation for 2019 and 2020. The ongoing trade situation between the US and China is a major headache for the Koreans, and don’t forget they have their own direct trade issue with Japan regarding the Japanese export of key materials for Korean manufacturing. We also saw Indonesia cut rates 25bps, beginning the reversal of the 175bps of rate hikes they implemented in 2018. While growth there remains solid, with inflation falling and forecasts for slowing growth in its key export markets, this was not a great surprise. Analysts are looking for two more cuts this year as well. Interestingly, neither the won nor rupiah weakened on the news, with both currencies firmer by 0.15% when the market closed in Asia time.

And perhaps that is the theme for today, mild dollar weakness despite other nation’s activities. But the operative word is mild. In fact, the pound’s rally, which was also helped by surprisingly robust Retail Sales data, is by far the largest move of the session. Otherwise, in both G10 and EMG spaces, we are seeing some back and forth on the order of 0.10%-0.20%, hardly enough to get excited about.

Clearly, there is much more market discussion on the earnings season as it unfolds in the US. Yesterday’s big news was Netflix, which missed estimates on subscriber growth in Q2 and has seen its stock fall sharply in the aftermarket. But Eurozone equities are under pressure as well after weak results from SAP and Nordea Bank presage further struggles on the continent.

Now here’s something to consider. Right now, the market is fully priced for a Fed cut at the end of the month, and there is a strong expectation that the ECB meeting next week is going to outline its future policy ease. Those have been key drivers in the broad equity market rally we have seen since June, and if either Powell or Draghi disappoints, equity markets are certainly going to suffer. But what if earnings data comes in broadly worse than expected, a la Netflix last night, and equity prices fall regardless of the rate story. After all, by almost every measure, valuations in the US equity space are quite high so a decline may well be due on its own, rate cuts or not. The question is how those same central banks will respond. Will they ease more aggressively to prevent a further decline, or will they ignore the outcome? In the past, this wasn’t really a consideration as central banks were focused only on inflation and employment or growth. But these days I’m not so sure that is the case. Just beware if earnings data start to stumble.

Turning to this morning’s session, there are only two US data points, Initial Claims (exp 216K) and Leading Indicators (0.1%). We also hear from two Fed speakers, Bostic and Williams, although both have already explained their views earlier this week. On that subject, we heard from FOMC voter Esther George yesterday and she has been the first Fed speaker to be clear that there is no reason for a rate cut anytime soon. Now she has always been one of the more hawkish Fed members and it would not shock me if she dissented at the next vote assuming a rate cut is the outcome. Wouldn’t it be interesting if the first dissent under Powell’s tenure was looking for a cut and the second, in the following meeting, was looking to stay on hold? It certainly indicates there is a diversity of opinion at the Fed, at least with regard to the proper policy implementation if not with regard to Keynesianism.

And that’s all there is for today. Earnings data are likely to be the main drivers as neither data point is seen as a market mover. With the dollar on its back foot this morning, I see no reason for it to turn around at this time. Look for a further slow decline.

Good luck
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Be Prepare for Mayhem

Next week when the former PM
Steps down be prepared for mayhem
Both Johnson and Hunt
Are willing to punt
May’s deal, which they’re quick to condemn

Remember, back in the day, when I suggested that the probability of a hard Brexit was much higher than the market was assuming? In fact, I have been highlighting this fact pretty consistently since, at least, January heading up to the original deadline. Well, now, it appears that the market is figuring out that the probability of a hard Brexit is higher than they previously assumed. Last night, in a debate between the two candidates for PM, front-runner Boris Johnson and Jeremy Hunt, both were clear that the Irish backstop was dead in the water, and both were clear that they would be willing to walk away with no deal. Ongoing negotiations have become more difficult as the UK is making more demands and the EU is now complaining that the UK is trying to “bully” them! This is the funniest statement that I have ever seen. For two years, the EU essentially bullied PM May into agreeing to things that were unpalatable, including the Irish backstop. Now all of a sudden, the EU’s tender feelings have been hurt by the UK pushing back!

Since the original vote, pundits around the world have assumed that the UK would bear the brunt of the fallout from Brexit. After all, the rest of the EU is the UK’s largest trading partner, and the UK only represents something like 10% of EU exports. But as the EU dips back into recession with monetary policy already stretched, it is becoming clearer that the EU will suffer greatly in a no-deal Brexit. Just ask Germany how its auto manufacturers will be impacted when suddenly there are tariffs on BMW’s in the UK. The point is that both sides are likely to feel pain, although it seems the UK has already absorbed part of it, while the rest of the EU has been laboring under the assumption that the UK would cave in eventually. My view is there is no chance of a deal at this point and there are only two possible outcomes; no-deal Brexit or no Brexit. However, there seems to be limited willingness to hold a second referendum to try to overturn the first one, with major splits within both main parties there. And that leads to a no-deal Brexit. Be prepared.

It should be no surprise that this has had a pretty big impact on the pound this morning, which has fallen by 0.75% to its lowest level since January 2017. And this is despite better than expected employment data where wages grew a stronger than expected 3.6% in May, while the Unemployment rate remained at 45-year lows of 3.8%. While the UK economy seems to be holding up reasonably well, I continue to look for the BOE to cut rates in November after the hard Brexit occurs, if only as a precaution for a quick slowdown. Meanwhile, the pound is likely to continue to decline between now and then, testing 1.20 before long. However, vs. the euro, where the pound has also been sliding, I expect that trend to stabilize and even reverse. This is due to the fact that the Eurozone is going to suffer far more than currently anticipated from a hard Brexit. Right now, the cross is trading at 0.9030. I would look for a move in the euro to 1.05-1.06 and the cross to head down to 0.88.

Away from the Brexit story, things are a bit less exciting on the currency front. Broadly the dollar is strong today, as weaker Eurozone data (German ZEW Sentiment fell more than expected to -24.5) has pundits discussing a recession in Germany and confirming a more aggressive policy ease from the ECB. As such, the euro is lower by 0.3% this morning, as all the dovishness from the Fed is being offset by all the dovishness from ECB members.

Down Under, the RBA Minutes continue to highlight the need to keep policy accommodative as they, too, recognize that their old models need tweaking and that lower rates will not lead directly to further inflation. Aussie, which has actually performed pretty well overall since Powell’s first testimony last week, is lower by 0.2%. While the RBA is likely to remain on hold for now, look for more cuts as soon as the Fed starts to cut.

And those have really been the key drivers in the market today. Looking at the CE4, all of them have fallen roughly the same 0.3% as the euro meaning there is no new information to be gleaned. LATAM currencies are barely budged and APAC has also seen very limited movement overnight. The same can be said of global equity markets, which have seen very limited movement, on the order of 0.2% as investors await the next big story. Arguably, that story will start to be told next week by the ECB, with the punchline added by the FOMC at the end of the month. In the meantime, earnings season is beginning, so individual equity prices are likely to see movement, but it is hard to get excited about a macro move in the near term. And bonds? Well, they have stopped falling as the overly aggressive long positions seem to have been unwound. I expect they will start to rally again, albeit at a slower pace than we saw at the beginning of the month.

This morning brings the most interesting data of the week, Retail Sales (exp 0.1%, 0.1% ex autos), as well as a spate of Fed speakers including Chairman Powell at 1:00 this afternoon. If Retail Sales disappoint already low expectations, look for bonds to rally along with stocks as the dollar falls. If they are quite strong, I think the market is far less prone to react as the July rate cut is still a done deal. It just will have a much smaller probability of being a 50bp cut.

Good luck
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Still Writing Obits

The Germans, the Chinese and Brits
Have seen manufacturing hits
But in the US
There’s been more success
Though bears are still writing obits

It is fair to say that the global economic growth rate continues to slow. We have seen weaker data as the norm, whether in manufacturing, housing or agriculture; we have seen a never-ending stream of central bankers expressing concern over this slowing growth and promising to respond appropriately; and we continue to see equity markets trade to new highs. Something seems amiss.

Yesterday was a perfect example of this phenomenon with an ISM print of 51.7, its fourth consecutive decline and the weakest reading since October 2016. In fairness, it was better than consensus estimates of 51.0, and the US was the only major economy to show continued expansion in the sector, but the trend is foreboding. The new orders component was exceptionally weak, and highlights those concerns going forward. And yet, equity prices traded to new highs yesterday afternoon, before ceding some ground into the close.

There has been a pretty complete disconnect between the fundamentals of stock valuation (at least the theories we learned in finance class about discounted future cash flows) and the actual price of stocks. And this is a global phenomenon, not merely a US outlier.

Of course, the missing link in this puzzle is central bank activities. Markets have become entirely dependent on central bank largesse to justify their valuations. Central bankers, after a decade of ZIRP and NIRP led to a huge increase in the financialization of the global economy, are now beholden to markets when they make decisions. This was made plain in January, when the Fed pivoted after equity markets plummeted following their last rate increase. They literally could not stand the pressure for even two weeks before reversing course.

So, the question becomes, will equity markets now dictate every central bank action going forward? While rhetorical, it is not hard to believe that the answer is yes. Despite all the current conversation regarding an uncomfortably low inflation rate as the driver for policy ease, it is abundantly clear that the only data point on which every central bank focuses, is their domestic stock market. I fear this is a situation that will result in extremely negative outcomes at some point in the future. However, there is no way to determine, ex ante, when those negative outcomes will manifest themselves. That is why bulls are happy, they buy every dip and have been rewarded, and why bears are miserable, because despite their certainty they are correct, thus far the central banks have been able to delay the pain.

In the end, though, the story on global growth remains one of a slowdown throughout the world. For all their largesse to date, central banks have not yet been able to reverse that trend.

With that out of the way, let’s see what those central bank activities have wrought in the FX markets. The first thing to note was that the dollar actually had an impressive day yesterday, rallying 0.7% vs. the euro and 0.5% vs. the pound after the ISM data. Given the better than expected print, market participants decided that the Fed may not be as aggressive cutting rates after all, and so the key recent driver of dollar weakness was reevaluated. Of course, one day’s reaction does not a trend make, and this morning, the dollar is backing off yesterday’s rally slightly.

Last night the RBA cut rates another 25bps, to a record low of 1.00%, and left the door open for further rate cuts in the future. Aussie, however, is higher by 0.4% this morning on a classic, sell the rumor, buy the news reaction. In the end, Australia remains entirely dependent on growth in China and as that economy slows, which is clearly happening, it will weigh on the Australian economy. While Australia managed to avoid ZIRP in the wake of the financial crisis, this time around I think it is inevitable, and we will see AUD resume its multiyear weakening trend.

Weighing on the pound further this morning were two data points, the Construction PMI at 43.1, its weakest in more than ten years, as well as the ongoing malaise in housing prices in the UK. Brexit continues to garner headlines locally, although it has not been front page news elsewhere in the world because of all the other concerns like trade, OPEC, North Korea, and in the US, the beginnings of the presidential campaigns.

But there is a very interesting change ongoing in the Brexit discussion. Throughout the process, the EU has appeared to have the upper hand in the negotiations, forcing their views on outgoing PM May. But with all signs pointing to a new PM, Boris Johnson, who has made clear he will leave with or without a deal, suddenly Ireland is finding itself under extreme pressure. A recent report by the central bank there indicated that a hard Brexit could result in a 4.0% decline in Irish GDP! That is HUGE. At the same time, the EU will require Ireland to uphold the border controls that are involved in the new separate relationship. This means they will need to perform any inspections necessary as well as arrange to collect tariffs to be charged. And the UK has made it clear that they will not contribute a penny to that process. Suddenly, Ireland is in a bad situation. In fact, it is entirely realistic that the EU needs to step in to delay the impact and cave to an interim deal that has nothing to do with PM May’s deal. At least that is the case if they want to maintain the integrity of their borders, something which has been given short shrift until now. My point is that there is still plenty of Brexit mischief ahead, and the pound is going to continue to react to all of it. In the end, I continue to believe that a hard Brexit will result in a weaker pound, but I am not so sure it will be as weak as I had previously believed. Maybe 1.20-1.25 is the right price.

In the US today there is no data to be released although we do hear from NY Fed president Williams and Cleveland Fed President Mester this morning. If the Fed is serious about staying on hold at the end of this month, rather than cutting the 25bps that the market has already priced, they better start to speak more aggressively about that fact. Otherwise, they are going to find themselves in a situation where a disappointed equity market sells off sharply, and the pressure ratchets even higher on them to respond. Food for thought as we hear from different Fed speakers during the month.

Good luck
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The Doves Are Ascendant

A recap of central bank actions
Shows sameness across all the factions
The doves are ascendant
And markets dependent
On easing for all their transactions

Yesterday’s markets behaved as one would expect given the week’s central bank activities, where policy ease is the name of the game. Stock markets rose sharply around the world, bond yields fell with the dollar following yields lower. Commodity prices also had a good day, although gold’s rally, as a haven asset, is more disconcerting than copper’s rally on the idea that easier policy will help avert a recession. And while, yes, Norway did raise rates 25bps…to 1.25%, they are simply the exception that proves the rule. Elsewhere, to recap, the three major central banks all met, and each explained that further policy ease, despite current historically easy policy, is not merely possible but likely going forward.

If there were questions as to why this is the case, recent data releases serve as an excellent answer. Starting in the US yesterday, Philly Fed, the second big manufacturing survey, missed sharply on the downside, printing at 0.3, down from last month’s 16.6 reading and well below expectations of 11.0. Combined with Monday’s Empire Manufacturing index, this is certainly a negative harbinger of economic activity in the US.

Japan’s inflation
Continues to edge lower
Is that really bad?

Then, last night we saw Japanese CPI data print at 0.7%, falling 0.2% from the previous month and a strong indication that the BOJ remains far behind in their efforts to change the deflationary mindset in Japan. It is also a strong indication that the BOJ is going to add to its current aggressive policy ease, with talk of both a rate cut and an increase in QE. The one thing that is clear is that verbal guidance by Kuroda-san has had effectively zero impact on the nation’s views of inflation. While the yen has softened by 0.2% this morning compared to yesterday’s close, it remains in a clear uptrend which began in April, or if you step back, a longer-term uptrend which began four years ago. Despite the fact that markets are anticipating further policy ease from Tokyo, the yen’s strength is predicated on two factors; first the fact that the US has significantly more room to ease policy than Japan and so the dollar is likely to have a weak period; and second, the fact that overall evaluations of market risk (just not the equity markets) shows a great deal of concern amongst investors and the yen’s haven status remains attractive.

Closing out our analysis of economic malaise, this morning’s Flash PMI data from Europe showed that while things seem marginally better than last month, they are still rotten. Once again, Germany’s Manufacturing PMI printed well below 50 at 45.4 with the Eurozone version printing at 47.8. These are not data points that inspire confidence in central bankers and are amongst the key reasons that we continue to hear from virtually every ECB speaker that there is plenty of room for the ECB to ease policy further. And while that is a suspect sentiment, there is no doubt that they will try. But once again, the issue is that given the current status of policy, the Fed has the most room to ease policy and that relative position is what will maintain pressure on the buck.

Away from the central bank story, there is no doubt that market participants have ascribed a high degree of probability to the Trump-Xi meeting being a success at defusing the ongoing trade tensions. Certainly, it seems likely that it will help restart the talks, a very good thing, but that is not the same thing as making concessions or coming to agreement. It remains a telling factor that the Chinese are unwilling to codify the agreement in their legal system, but rather want to rely on administrative rules and guidance. That strikes as a very different expectation, compared to the rest of the developed world, regarding what international negotiations are designed to achieve. When combined with the fact that the Chinese claim there is no IP theft or forced technology transfer, which are two of the key issues on the table for the US, I still have a hard time seeing a successful outcome. But I am no trade expert, so my views are just my own.

And finally, Brexit has not really been in the news that much lately, at least not on this side of the pond, but the Tory leadership contest is down to the final two candidates, Boris Johnson and Jeremy Hunt, the Foreign Secretary. The process now heads to the roughly 160,000 active members of the Conservative Party, with Johnson favored to prevail. His stance on Brexit is he would prefer a deal, but he will not allow a delay past the current October 31, 2019 deadline, deal or no deal. It is this dynamic which has undermined the pound lately and driven its lagging performance for the past several months. However, this will take more time to play out and so I expect that the pound will remain in limbo for a while yet.

On the data front, we see only Existing Home Sales (exp 5.25M) this morning, but with the FOMC meeting now past and the quiet period over, we hear from two Fed speakers, Governor Brainerd (a dove) and Cleveland Fed President Mester (a hawk). At this point, all indications are that the Fed is leaning far more dovish than before, so it will be telling to hear Ms Mester. If she comes across as dovish, I would expect that we will see both stocks and bonds rally further with the dollar sinking again. Thus, a tumultuous week is ending with the opportunity for a bit more action. The dollar remains under pressure and I expect that to be the case for the foreseeable future.

Good luck
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Called Into Question

A key market gauge of recession,
The yield curve, has called into question
Growth’s pace up ahead
And whether the Fed
Will restart financial repression

While markets this morning have stopped falling, there is no question that investors are on heightened alert. Yesterday saw further declines in the major stock indices and a continuation of the dollar’s rally alongside demand for Treasuries and Bunds. Today’s pause is hardly enough to change the predominant current view which can best be summed up as, AAAAGGGHHHH!

In the Treasury market, 10-year yields reached their steepest inversion vs. 3-month yields, 14bps, since 2007. While many pundits and analysts focus on the 2-year vs. 10-year spread, which remains slightly positive, the Fed itself has published research showing the 3-month vs. 10-year spread is a better indicator of future recessions. So the combination of fears over a drawn out trade war between the US and China and ongoing uncertainty in Europe given the Brexit drama and the uptick in tensions between Italy and the European Commission regarding Italy’s mooted budget, have been enough to send many investors hunting for the safest assets they can find. In this classic risk-off scenario, the fact that the dollar and the yen remain the currencies of choice is no surprise.

But let’s unpack the stories to see if the fear is warranted. On the trade front, every indication of late is that both sides are preparing for a much longer conflict. Just this morning China halted all imports of US soybeans. The other chatter of note is the idea that the Chinese may soon halt shipments of rare-earth metals to US industry, an act that would have significant negative consequences for the US manufacturing capability in the technology and aerospace industries. Of course, the US ban on Huawei and its increased pressure to prevent any allies from buying their equipment strikes at the heart of China’s attempts to move up the value chain in manufacturing. All told, until the G20 meeting in about a month’s time, I cannot foresee any thaw in this battle, and so expect continued negative consequences for the market.

As to Brexit, given the timing is that there won’t be a new Prime Minister until September, it seems that very little will happen in this arena. After all, Boris Johnson is already the favorite and is on record as saying a hard Brexit suits him just fine. While my personal view is that the probability of that outcome is more than 30%, I am in the minority. In fact, I would argue the analyst community, although not yet the market, is coalescing around the idea that no Brexit at all has become the most likely outcome. We have heard more and more MP’s talk about a willingness to hold a second referendum and current polls show Remain well ahead in that event. Of course, the FX market has not embraced that view as evidenced by the fact the pound remains within spitting distance of its lowest levels in more than two years.

Finally, the resurrection of the Italy story is the newest addition to the market’s menu of pain, and this one seems like it has more legs. Remarkably, the European Commission, headed by Jean-Claude Juncker, is demanding that Italy reduce its fiscal spending by 1.5% of GDP despite the fact that it is just emerging from a recession and growth this year is forecast to be only 0.3%. This is remarkable given the Keynesian bent of almost all global policymakers. Meanwhile, Matteo Salvini, the leader of the League whose power is growing after his party had a very strong showing in last week’s EU elections, has categorically rejected that policy prescription.

But of more interest is the fact that the Italian Treasury is back to discussing the issuance of ‘minibots’ which are essentially short-term Italian notes used by the government to pay contractors, and which will be able to trade in the market as a parallel currency to the euro. While they will be completely domestic, they represent a grave threat to the sanctity of the single currency and will not be lightly tolerated by the ECB or any other Eurozone government. And yet, it is not clear what the rest of Europe can do to stop things. The threat of a fine is ludicrous, especially given that Italy’s budget deficit is forecast to be smaller than France’s, where no threats have been made. The thing is, introduction of a parallel currency is a step into the unknown, and one that, in the short-term, is likely to weigh on the euro significantly. However, longer term, if Italy, which is generally perceived as one of the weaker links in the Eurozone, were to leave, perhaps that would strengthen the remaining bloc on a macroeconomic basis and the euro with it.

With that as background, it is no surprise that investors have been shunning risk. While this morning markets are rebounding slightly, with equity indices higher by a few tenths of a percent and Treasury yields higher by 3bps, the trend remains firmly in the direction of less risk not more.

The final question to be asked is, how will the Fed respond to this widening array of economic issues? Arguably, they will continue to focus on the US story, which while slowing, remains the least problematic of the major economies. At least that has been the case thus far. But today we have the opportunity to change things. Data this morning includes the first revision of Q1 GDP (exp 3.1%) as well as Initial Claims (215K) and the Goods Trade Balance (-$72.0B) at 8:30. There are concerns that the Q1 data falls below 3.0% which would not only be politically inconvenient, but perhaps a harbinger of a faster slowdown in Q2. Then, throughout the next week we get a significant run of data culminating in the payroll report next Friday. So, for now, the Fed is going to be watching closely, as will all market participants.

The predominant view remains that growth around the world is slowing and that the next easing cycle is imminent (fed funds futures are pricing in 3 rate cuts by the end of 2020!) However, Fed commentary has not backed up that view as yet. We will need to see the data to have a better idea, but for now, with risk still being shunned, the dollar should remain bid overall.

Good luck
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Will Powell React?

The Treasury curve is implying
That growth as we knew it is dying
Will Powell react?
Or just be attacked
For stasis while claiming he’s trying?

Scanning markets this morning shows everything is a mess. Scanning headlines this morning shows that fear clearly outpolls greed as the driving force behind trading activity. The question at hand is, ‘Have things gone too far or is this just the beginning?’

Treasury and Bund yields are the best place to start when discussing the relative merits of fear and greed, and this morning, fear is in command. Yields on 10-year Treasuries have fallen to 2.23% and 10-year Bunds are down to -0.17%, both probing levels not seen in nearly two years. The proximate causes are numerous. First there is the continued concern over the trade war between the US and China with no sign that talks are ongoing and the market now focusing on a mooted meeting between President’s Trump and Xi at the G20 in June. While there is no chance the two of them will agree a deal, as we saw in December, it is entirely possible they can get the talks restarted, something that would help mitigate the current market stress.

However, this is not only about trade. Economic data around the world continues to drift broadly lower with the latest surprise being this morning’s German Unemployment rate rising to 5.0% as 60,000 more Germans than expected found themselves out of work. We have also been ‘treated’ to the news that layoffs by US companies (Ford and GE among others) are starting to increase. The auto sector looks like it is getting hit particularly hard as inventories build on dealer lots despite what appears to be robust consumer confidence. This dichotomy is also evident in the US housing market where despite strong employment, rising wages and declining mortgage rates, home prices are stagnant to falling, depending on the sector, and home sales have been declining for the past fourteen months in a row.

The point is that the economic fundamentals are no longer the reliable support for markets they had been in the recent past. Remember, the US is looking at its longest economic expansion in history, but its vigor is clearly waning.

Then there are the political ructions ongoing. Brexit is a well-worn story, yet one that has no end in sight. The pound remains under pressure (-0.1%, -3.0% in May) and UK stocks are falling sharply (-1.3%, -3.3% in May). As the Tory leadership contest takes shape, Boris Johnson remains the frontrunner, but Parliament will not easily cede any power to allow a no-deal Brexit if that is what Johnson wants. And to add to the mess, Scotland is aiming to hold a second independence referendum as they are very keen to remain within the EU. (Just think, the opportunity for another border issue could be coming our way soon!)

Then there is the aftermath of the EU elections where all the parties that currently are in power in EU nations did poorly, yet the current national leadership is tasked with finding new EU-wide leaders, including an ECB President as well as European Commission and European Council presidents. So, there is a great deal of horse-trading ongoing, with competence for the role seen as a distant fifth requirement compared to nationality, regional location (north vs. south), home country size (large vs. small) and gender. Meanwhile, Italy has been put on notice that its current financial plans for fiscal stimulus are outside the Eurozone stability framework but are not taking the news sitting down. It actually makes no sense that an economy crawling out of recession like Italy should be asked to tighten fiscal policy by raising taxes and cutting spending, rather than encouraged to reinvigorate growth. But hey, the Teutonic view of the world is austerity is always and everywhere the best policy! One cannot be surprised that Italian stocks are falling (-1.3%, -8.0% this month).

At any rate, the euro also remains under pressure, falling yesterday by 0.3%, a further 0.1% this morning and a little more than 1% this month. One point made by many is that whoever follows Signor Draghi in the ECB President’s chair is likely to be more hawkish, by default, than Draghi himself. With that in mind, later this year, when a new ECB leader is named, if not yet installed, the euro has the chance to rally. This is especially so if the Fed has begun to cut rates by then, something the futures market already has in its price.

Other mayhem can be seen in South Africa, where the rand has broken below its six-month trading range, having fallen nearly 3% this week as President Ramaphosa has yet to name a new cabinet, sowing concern in the market as to whether he will be able to pull the country out of its deep economic malaise (GDP -2.0% in Q1). And a last piece of news comes from Venezuela, where the central bank surprised one and all by publishing economic statistics showing that GDP shrank 19.2% in the first nine months of 2018 while inflation ran at 130,060% last year. That is not a misprint, that is the very definition of hyperinflation.

Turning to today’s session, there is no US data of note nor are any Fed members scheduled to speak. Given the overnight price action, with risk clearly being cast aside, it certainly appears that markets will open that way. Equity futures are pointing to losses of 0.6% in the US, and right now it appears things are going to remain in risk-off mode. Barring a surprise positive story (or Presidential tweet), it feels like investors are going to continue to pare back risk positions for now. As such, the dollar is likely to maintain its current bid, although I don’t see much cause for it to extend its gains at this time.

Finally, to answer the question I posed at the beginning, there is room for equity markets to continue to fall while haven bonds rally so things have not yet gone too far.

Good luck
Adf