Tag Archives: #Brexit

Brexit Doomsday

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In London, Prime Minister May
Has started revealing, some say
Details of the deal
Which optimists feel
Could postpone the Brexit doomsday

With the elections now past, market participants are looking for the next potential catalysts for movement and Brexit regularly leads the list. According to the British government, the deal is 95% complete, although the Irish border issue remains unsolved. The essence of this issue is as follows: ever since the Good Friday Agreement in 1998, Northern Ireland has been part of the UK, but has had no hard border between itself and the Republic of Ireland. As both Ireland and the UK were members of the EU, there were no issues regarding tariffs or trade, and so the process worked effectively. However, now that the UK is leaving the EU, as well as the customs union, suddenly there are likely to be tariffs on goods that cross that border. The problem stems from the fact that neither side wants a ‘hard’ border between the two nations, meaning no customs checking there. Therein lies the problem. How can Northern Ireland remain in the customs union but not England, Wales and Scotland? It would mean a border of some type between Northern Ireland and the rest of the UK. Of course, that doesn’t go over very well either. Hence the stalemate. The EU is willing to allow Northern Ireland to maintain its current stance with Ireland, but not the rest of the UK. The UK doesn’t want Northern Ireland to have a different status than itself with the EU. Those are exactly opposite positions and there is no obvious middle ground.

The risk becomes that PM May negotiates a deal, which will by definition be imperfect, and that said deal gets defeated in a Parliamentary vote, thus leaving nothing completed. Given the shrinking timeline available to come up with a deal, less than five months at this point, it seems pretty clear that this is the last opportunity to get something done. The market, at least based on the recent performance of the pound, has become increasingly optimistic that a solution will be found. While the pound has edged slightly lower overnight, it is up by more than 3% since Halloween with the entire movement based on the idea that a deal will be done. In addition, this morning there have been several comments by investors that a Brexit deal will result in a powerful rally in the pound, up to 1.50 or beyond. While I disagree with that assessment, it is important that everyone understands the different viewpoints in the market. The idea is that a Brexit deal will end uncertainty, spur investment and allow the BOE to become more aggressive raising interest rates. And while some of that is certainly true, for the pound to reach 1.50, the dollar will need to be much lower against all its counterparties, and I just don’t see that outcome.

The other key story today is the FOMC meeting, where no change in policy is anticipated, although there are some analysts looking for a tweak to the policy statement. At this point, it seems abundantly clear that the Fed is unconcerned with the level of the stock market, and that last month’s decline will have no bearing on their policy decision. There is talk of a tweak to IOER, where the Fed may reduce that rate relative to the current Fed Funds corridor of 2.00% – 2.25%, but I agree with the analysts who say that it makes limited sense for the Fed to do something this month, and they will be better off waiting until December when they raise rates again.

Beyond that, the data overnight showed a modest slowdown in Chinese exports with a reduction in their trade surplus, both globally and with the US. We also saw that German exports decline 0.8%, a surprisingly weak outcome attributed to ongoing issues with the German diesel auto sales. While yesterday morning saw the dollar under significant pressure across the board, the reality is that it reversed many of those losses during the session. This morning the dollar is marginally higher across the board, but the movements have not been significant. For example, the euro is lower by 0.15% and the pound by 0.3%. We have seen similar magnitude moves by the commodity bloc, and the yen has softened by 0.2%. As you can see, it has been a dull market.

In the EMG space, the dollar is generally, though not universally, stronger but here, too, the magnitude of movement has been modest, on the order of 0.2%-0.4% overall.

The only piece of data aside from the FOMC meeting is Initial Claims (exp 214K) this morning, and aside from the fact that this data continues to show a robust labor market, it has not been a market catalyst for a long time. After a big equity rally yesterday, futures are pointing slightly softer to open, and Treasury yields, after rallying sharply at the beginning of the month, remain near their multiyear highs with this morning’s level at 3.23%.

In sum, it is hard to get excited about large upcoming movement in the market today, and so a modest further dollar rally seems about right. Removing some more of the recent excesses would make sense in the context of the still uncertain outcomes from key issues like Brexit and the Italian budget quesoins.

Good luck
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Hardliners Abhorred

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According to sources, it seems
That Minister May and her teams
Have neared the accord
Hardliners abhorred
As they’ll need to give up their dreams

While there is much in store for markets this week from the US, between the midterm elections tomorrow and the FOMC meeting on Thursday, today’s biggest headline is really about the UK and Brexit. Allegedly, albeit with no corroboration from either side, the entire UK will remain in the customs union, not just Northern Ireland, in the immediate aftermath of Brexit as the two sides continue to work out the eventual solution. May’s idea is that she will present this to her cabinet with an ultimatum to approve it and send it to Parliament in order to get the process completed before the end of the year. And while the other 27 members of the EU must also ratify the deal, the current belief is that there will be limited problems doing that. However, this all remains speculation at this point, except for the fact that May and her cabinet have a meeting scheduled for tomorrow where more details should become available.

It cannot be surprising that the pound has rallied on the news, jumping 60 pips on the open although since giving back about half that original gain. The broad consensus in the market is that any deal will result in the pound trading sharply higher, although I am skeptical that it can stay much above 1.35 for any meaningful amount of time. Even if the Brexit monkey climbs off the pound’s back, the market will still have to account for the fact that UK growth is slowing more sharply than its peers and that the pressure for the BOE to raise rates will likely ebb accordingly. But for now it remains speculation as to whether a deal is imminent or not. And as long as that uncertainty remains, the pound will be beholden to the latest story or headline on the subject.

Away from the pound though, the dollar is starting to show some life at this stage of the morning. Friday’s employment report, with NFP printing at 250K and AHE at 3.1%, confirmed that growth in the US continues to outperform virtually every other region in the world, and will have done nothing to dissuade the Fed from continuing its rate hiking strategy. While there is no expectation of any activity by the Fed on Thursday, the market probability for a rate hike in December remains above 80%. As long as US data continues to outpace that of the rest of the world, it seems unlikely that the Fed is going to stop.

Regarding the US midterm elections, clearly there is the potential for a market reaction depending on the results and whether the Republican party maintains its hold on the House of Representatives. If not, a split government (it is assumed that they will retain the Senate) will clearly impede the president’s plans for further economic stimulus programs and reintroduce brinksmanship to things like budget discussions. Net, given the current economic situation, I expect that after a kneejerk response, it is unlikely to have a significant impact for a while. However, it does open the possibility of more inflammatory rhetoric, including the threat of impeachment hearings, which may well detract from the dollar’s performance going forward. As we learned following President Trump’s election, markets pay close attention to significant electoral changes. With this in mind, it is important to remember that many pundits have been forecasting the Democrats will retake the House, so if the Republicans hold on, even with a much smaller majority, that may be an outcome not currently priced into the market. My point is that there is still great uncertainty to the outcome, and it is not entirely clear the FX impact that will result.

Away from those stories, the biggest news we saw was the weaker than expected Caixin PMI data from China. The Services print was 50.8 with the Composite number at just 50.5. The latter was at its weakest in more than two years and is an indication that the trade conflict with the US is continuing to take a toll on the Chinese economy. In addition, there were several articles in the press this weekend explaining that despite President Trump’s tweets last week, the meeting between Xi and Trump is really just going to get the trade negotiations restarted. There is no deal imminent. It should be no surprise that the renminbi has weakened during the session, especially after last week’s remarkable rally. So the 0.3% decline this morning needs to be kept in context, and simply represents a move back toward its previous trend.

Broadly speaking, the dollar is performing well against the EMG bloc today with MXN (-0.4%), INR (-0.9%) and KRW (-0.5%) indicative of the type of market activity ongoing.

Looking ahead to the upcoming data, we see that beyond the Fed and election, there is precious little that we will learn.

Today ISM Non-Manufacturing 59.3
Tuesday JOLT’s Jobs Report 7.1M
Thursday Initial Claims 214K
  FOMC Rate Decision 2.25%
Friday PPI 0.3% (2.5% Y/Y)
  -ex food & energy 0.2% (2.3% Y/Y)
  Michigan Sentiment 98.0
  Wholesale Inventories 0.3%

So between the US elections and PM May’s cabinet meeting with its chance to make real Brexit headway, there is much to look for this week. But the data will not be the story. As to today’s session, APAC equity markets have reversed some of last week’s gains after it became clear that trade situation wasn’t going to improve in the very short term. US equity futures are pointing lower, although Europe is modestly higher. It all strikes me as though traders are biding their time awaiting the big news, which makes sense. Look for a dull session today, but with the chance for some fireworks tomorrow, at least in the pound if something happens in the cabinet meeting.

Good luck
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Real Strides

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In Twenty-sixteen when we learned
That Britain, the EU, had spurned
The pound took a fall
While casting a pall
On how future growth might be earned

For nearly two years chaos reigned
While Brexiteers strongly maintained
A deal will be made
With no one betrayed
And there is still much to be gained

Well last night it seems that both sides
Have finally made some real strides
It’s no real surprise
To see the pound rise
As delegates closed the divides

The big story this morning is that there seemed to be real movement in the Brexit negotiations with an agreement “95% complete” according to the UK government. The key was an agreement regarding financial services, obviously an enormous issue for the UK, whereby UK financial firms would still be given access to the EU based on the “equivalence” of regulations. While this is not quite as robust as the current situation, being within the bloc, it is seen as sufficient to allow continued cross border access in both directions. Of course, the Irish border situation remains outstanding, but there is talk that progress has been made there and that the benefit of a finance deal will be sufficient to offset hard-line concerns over Ireland.

The market response was immediate with the pound jumping more than 1.0% when the headlines hit. If a Brexit deal is reached, the pound likely has further to rise as there is no question it has suffered based on the increasing likelihood of a no-deal situation. That said, a full-throated rally seems unlikely. There are still many other issues that are going to weigh on the pound, notably the dollar’s underlying strength as well as UK economic malaise. In fact, data early this morning showed that the UK manufacturing PMI fell much more than expected to a reading of just 51.1, its lowest reading since the month after the Brexit vote. Obviously, this data did not include the positive news from today, but it is indicative of how the UK economy continues to slow along with the rest of the world. If a deal is signed, I expect the pound could rally another few percent, but anything more than 1.35 would seem to be a stretch based on the economic fundamentals.

But the Brexit story set the tone for the FX market as the dollar is softer across the board, in many other cases having fallen by more than 1% as well. For example, the euro has rallied by 0.6% amid general enthusiasm generated by yesterday’s global stock rebound. We have also seen both Aussie (+1.1%) and Kiwi (+1.4%) jump sharply, as commodity prices stabilize and risk appetite improves.

This theme was also made evident by movements in government bonds around the world, where, for example, Treasury yields are 10bps higher over the last two sessions. In addition, EMG currencies, which had a terrible month in October, have shown some life this morning. Today we see the Mexican peso has rallied 0.8%, while South Africa’s rand is up 1.5%. Even the Chinese yuan, which has been closely scrutinized due to its approaching the critical 7.00 level, has rallied today by 0.4%, its largest gain in more than three weeks. In fact, most EMG currencies are higher, with many gaining more than 0.5%. In other words, it has been a broad-based USD decline. After a strong multi-week run in the dollar, it can be no surprise that a correction has occurred.

Turning to the data situation, yesterday’s ADP number was quite strong, 227K, and the Employment Cost Index (ECI) showed that wages are rising at a 3.1% clip Y/Y, the fastest in several years. While yesterday’s Chicago PMI disappointed slightly at 58.4, that remains a very firm reading historically. Looking forward to today’s session, we hear from the BOE, where policy is forecast to be unchanged, and we will get updated economic forecasts. If a Brexit deal is signed, look for the UK to raise rates several more times next year as there should be a positive growth impact. Then from the US we see Initial Claims (exp 213K), Nonfarm Productivity (2.2%), Unit Labor Costs (1.0%) and ISM Manufacturing (59.0). While these will be seen as important, tomorrow’s payroll data is still going to be the focus, especially the Average Hourly Earnings (AHE) number. With the ECI pointing higher, if AHE shows the same thing, watch for more talk of the Fed becoming even more aggressive.

Ultimately, the US data picture continues to point to strength in the US economy, especially relative to what we are seeing throughout the rest of the world. The EU is slowing, the UK is slowing, China is slowing and so are most other places. As long as this remains the situation, it is hard to expect the dollar to retreat in any meaningful way. While no market moves in a straight line, the dollar’s trend remains higher.

Good luck
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Just Let It Go

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Said Brussels to Italy, No
Your budget is not apropos
Go fix it and then
Come back here again
Said Italy, just let it go

In England, meanwhile, PM May
Is finding she can’t get her way
A challenge is forming
With more Tories warming
Up to the thought she shouldn’t stay

The world seems to be getting messier by the day. Despite the ongoing vitriol in the US election process, the dollar continues to benefit from the fact that problems elsewhere seem to be worse. For example, the euro is under pressure this morning with two key stories driving the market. First, in an unprecedented move, the EU rejected Italy’s draft budget by claiming that it’s deficit targets were not in line with EU directives of reducing debt. Not surprisingly, the populist government in Italy simply said that fiscal stimulus was required to get the economy growing again, and they were going to enact it anyway. There are two issues here impacting the euro, the first being that markets are likely to drive Italian interest rates higher and add significant pressure to the Italian economy, notably the banking sector, which is tightly tied to those rates. The second is that if a major country is willing to ignore EU guidance on an important issue like this, what does that say about the credibility of the entire EU construct and the euro by default.

The other key issue was the release of much weaker than expected Flash PMI data for Germany, France and the entire Eurozone. Remember yesterday the Bundesbank indicated that GDP growth in Q3 would be flat in Germany, undermining markets there. Well, today, we learned that growth in Q4 isn’t exactly shining either, with the Manufacturing PMI printing at 52.3, its lowest level since early 2016. This data added to the pressure on the euro, which has fallen 0.6% on the day and is now touching 1.1400 for the first time since mid-August. It appears that regardless of the ongoing structural concerns in the US, the cyclical growth and interest rate story remains the market’s driver for now.

Turning to the UK, yesterday saw a rally in the pound after a story circulated that the EU was going to offer a compromise on how to treat the UK after Brexit, allowing them to stay within the customs union. However, this morning, there appears to be a growing insurgency within the Tory party and a challenge to PM May appears to be coming. If she were ousted, that would become quite problematic with regards to the ongoing negotiations as Cabinet members would change, and policy direction would likely as well. Given the late date, just five months left before the split is finalized, it would speak to a much higher probability of a hard Brexit with no deal, and a much lower pound. With this in mind, it is not surprising that the pound has ceded yesterday’s gains and is down 0.6% as well this morning.

Away from those two stories, the dollar is generally, but not universally, stronger. It is noteworthy that USDCNY is higher by 0.2%, pushing back to the top of its recent range just above 6.95, and starting to move into the area where many are counting on the PBOC to intervene. There are a number of analysts who continue to believe that a move above 7.00 will lead to a significant increase in capital outflows from China, and a much bigger risk-off movement. This is something about which the Chinese are extremely concerned. However, looking around APAC currencies overnight, both INR (+0.5%) and KRW (+0.25%), arguably the next most important ones, showed strength vs. the dollar as yesterday’s sharp decline in oil prices was seen as a positive for both of these large oil importers.

On the rate front, the Riksbank in Stockholm left interest rates on hold, as expected, but basically promised to raise them in either December or February. SEK is modestly weaker vs. the dollar, but almost unchanged vs. the euro, perhaps a better measure of the impact. This morning, the Bank of Canada will also announce its rate decision with expectations nearly universal that they will raise rates by 25bps to 1.75%. Ahead of the announcement, the Loonie is flat.

And those are really the FX stories of the day. Equity markets around the world seem to be rebounding from yesterday’s US led sell-off, although US equity futures are still pointing lower as I type. Treasury yields have fallen from yesterday’s closing levels, but remain in the vicinity of 3.15%. As mentioned, oil prices tumbled yesterday by more than 4% after Saudi Arabia indicated they would make up for any reduction in Iranian crude exports due to the US sanctions that are to begin in earnest next week. And gold, the traditional safe haven, is basically flat on the day, although about 1% lower than the peak of $1240/oz it reached during the nadir of yesterday’s equity market movement.

This morning we see our first real data of the week, with New Home Sales expected to print at 625K. We also get the Fed’s Beige Book at 2:00pm. Speaking of the Fed, yesterday Atlanta Fed President Bostic reiterated that the Fed was on the right path and that gradual rate increases were appropriate. Today we hear from Bullard, Mester and Bostic again. While the housing data has softened lately, and even some of the earnings data has been a bit softer than expected, there is no strong rationale for any of these regional presidents to change their views. In fact the one thing I would mention about earnings is how many companies are raising prices to cover increased materials costs or tariff impacts. If anything, that sounds pretty inflationary to me, and I would guess to the Fed as well.

If US equity markets follow through on the opening and continue to decline, the dollar should remain well bid overall. But my sense is that we are going to see some bargain hunters coming in here, help the stock markets bounce and see the dollar decline by the time NY goes home.

Good luck
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Some Whiplash

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It seems that the pumping of cash
By China was good for a flash
Of higher stock prices
But there’s still a crisis
So traders there felt some whiplash

In Europe, the same might be said
As traders, Italian debt fled
The EU today
Rome’s budget will weigh
With portents of more strife ahead

Remember how the officially induced rally in the Chinese equity market was going to stabilize markets? Yeah, me neither. It seems that, last night, despite lots more talk and promises of more funding, investors in those equity markets were decidedly unimpressed with the prospects and have resumed their active share selling. Overnight saw the Shanghai composite decline 2.25% and drag the rest of Asian markets lower alongside (Nikkei -2.7%, Hang Seng -2.9%). The impact on the CNY was very much as would be expected, a modest decline of 0.25% as traders test the PBOC resolve of preventing a move to 7.00.

This has also impacted European markets, which are lower across the board, none more so than Germany’s DAX which has fallen 2.0%. Given the ongoing angst over the Italian budget situation, one might have expected the Italian markets to be the worst performers, but Germany revealed its own little secret this morning, Q3 GDP growth there is expected to be 0.0%! That’s right, Europe’s strongest economy is going to suffer a stagnant quarter, and so equity markets have responded accordingly. This is not to imply that all is rosy in Rome, just that the Germans had a bigger surprise today.

Before moving on to the Italian story, let me note that the situation in China needs to be watched carefully going forward for another reason. For the past ten years, central banks around the world have controlled the price action in markets. Whether it was the first QE implementation by Benny the Beard, or Signor Draghi’s “whatever it takes” comments, when central bankers spoke, markets responded as the bankers desired. But lately, those same central banks seem to have lost a little bit of their mojo, as comments they make in an effort to sway markets have a shorter and shorter half-life. The fact that despite a concerted effort by every senior financial official in China, including President Xi, to talk up equity markets, and by reference the health of the Chinese economy, has had such a short lived impact, may well imply that the meme of central banks controlling markets is coming to an end.

And to my mind, that would be a good thing. Ten years of unprecedented monetary policy actions have dramatically distorted price signals in virtually every market. Whether it is the abnormally low spread between high-yield debt and government bonds, or the idea that P/E ratios of 100 are the signs of a good investment, markets no longer offer price discovery. Or perhaps they no longer offer the opportunity to discern value in a price. Keep in mind that there are still more than €5 trillion of debt outstanding that have negative interest rates. But while I may see this as a positive step toward markets regaining their functionality, the central banks are likely to feel very differently. If their words are no longer effective tools to manage markets, they will be forced to enact actual policies, some of which may be contrary to fiscal considerations. ‘Forward guidance’ is much easier to implement (and comes with much less political fallout) than actual policy changes. Just remember, if this thesis is correct, market volatility in every market is going to increase going forward.

Now back to our regularly scheduled programming. The Italian budget continues to be topic number one in terms of current risks to market stability. Thus far the Italian government has been unwilling to change its plans and the EU is studying them closely to determine if the budget breaks the rules. The problem for the EU is that if they crack down hard, reject the budget and tell Rome what to do, it is likely to further inflame the anti-establishment forces in Italy, and potentially have a bigger detrimental impact on the European Parliament elections to be held early next year. However, if they do nothing, the risk is that Italy finds itself in a situation where it has increased difficulty in refinancing its debt, and that could stress the entire Eurozone project. It was much easier for the EU to act tough with Greece, whose economy was so tiny. Italy has the third largest economy in the Eurozone , and if they have financing troubles it could quickly lead to problems throughout the continent, and directly impact the euro. In other words, there is no good answer.

The market impact of this ongoing situation has been a gradual erosion in the euro’s value, which fell about 0.7% yesterday, although it has stabilized this morning. While the German GDP story is obviously a negative for the currency, the reality is that the euro, for now, is beholden to the Italian budget story. If Italy remains recalcitrant, look for further weakness. Meanwhile, the pound, too, suffered yesterday, falling a penny alongside the euro, as the ongoing Brexit story continues to weigh on the currency. Consider that there are essentially five months left to find a compromise and that the problem has not gotten any easier. Despite the lack of progress, I still expect some sort of face-saving deal at the end of the process, but the risk situation is highly skewed. If there is no deal, look for the pound to fall very sharply, maybe another 5% right away, whereas any deal will likely only see a relief rally of 2% or so. Hedgers beware.

And those are really the only stories that matter today. There is a great deal of discussion regarding the US midterm elections, and how any given result may impact markets, but that is well beyond the purview of this note. Generally, risk was tossed overboard yesterday as 10-year Treasury yields fell 5bps, gold rallied and so did the dollar, the yen and the Swiss franc. This morning, there has been less movement in that group of havens, although risk assets remain under pressure. My sense is that given the absence of any US data, the broad risk profile will drive the dollar. To me, all signs point to further equity weakness and therefore more haven buying. I like the dollar in that scenario.

Good luck
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Unwavering

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Said Xi, our support is “unwavering”
For stocks, which of late have been quavering
A rally ensued
The result, which imbued
A feeling the bulls have been savoring

Make no mistake about it, while President Xi Jinping is ‘president-for-life’ in China, and the most powerful leader since Deng Xiaoping, it turns out that the stock market is more powerful still. Despite last night’s 4% rally by the Shanghai Index, the market remains 25% lower than the highs seen in January. On Friday, we heard from a number of Chinese financial officials, each of them explaining how the government would support the market, and saw quasi-official purchases by Chinese brokerage firms. Over the weekend, President Xi, in a speech, promised a cut in personal income taxes as well as “unwavering” support for state owned enterprises. In other words, the combination of the trade spat with the US and the government’s previous efforts to deflate the real estate bubble by tightening liquidity and cracking down on non-bank financing seems to have been too much for Xi to bear. The equity market there has become too important to Chinese consumer sentiment to be ignored by the government, and a nearly 30% decline during the past nine months has really increased the pressure on Xi and his comrades. Since a key underpinning of Xi’s power is continued strong economic growth, the market signals had become too great to ignore. Hence the weekend actions, which also included promises of further tax cuts in the VAT rate, and the all-out effort to not merely halt the equity market decline, but reverse it.

For the moment, it has worked, with global equity markets responding favorably to the Chinese lead and risk being more warmly embraced by traders, if not long-term investors. European equity markets are higher, Treasury prices are falling, except in Italy (a truly high risk asset these days) where yields on the 10-year BTP have fallen 17bps today. Meanwhile, the dollar is little changed, having been slightly softer earlier in the session but now showing signs of life. The renminbi is also little changed this morning, continuing to hover near 6.94, while the PBOC looks on nervously. It has become increasingly apparent that regardless of the trade situation, there is very limited appetite to allow USDCNY to trade to 7.00 or beyond right now, as the fear of an uptick in capital outflows remains palpable. Although, eventually, I think that is exactly what will happen, it appears that the PBOC is going to allow only a very slow movement in that direction.

Away from China, the other ‘good’ news of the day was from Italy, where Moody’s cut the sovereign debt rating one notch to Baa3, its lowest investment grade, and adjusted the outlook to stable. This downgrade had been widely expected, but fears had been growing that it could actually be a two notch downgrade, into junk status, which would have resulted in forced selling of Italian debt by funds with mandates to only invest in investment grade bonds. The confirmation of a stable outlook has resulted in widespread relief by the market, although Standard & Poors will release their newest report next week, also slated to be a downgrade, but also expected (hoped?) to be a single notch and to remain in investment grade territory. For now, the result has been a huge rally in Italian bonds, with yields falling 14bps to 3.44% and the spread over German bunds declining to 298bps, its first time below 300 in two weeks. The thing is, there has been no indication that the Italians are going to alter their budget to meet EU requirements, and that is what started this latest round of problems.

Elsewhere in Europe Brexit remains the biggest unknown, with a deal still far from concluded. The key issue is still the Ireland situation and the competing demands for no hard Irish/Northern Irish border vs. the willingness to allow Northern Ireland to have a completely different set of trading rules than the rest of the UK. Over the weekend, PM May seemed to signal some willingness to move toward an EU suggested solution, but that is likely to imperil her tenure as PM given the strong resistance by hard-line Brexiteers. The pound is the worst performing G10 currency this morning, down 0.3%, but my sense is that for a substantive move to occur we will need to get a clear signal one way or the other, and that does not look imminent.

Another issue, which is in the background right now, but will start to become more interesting as we head into 2019, is the funding status of Eurozone banks that took advantage of the TLTRO financing during the Eurozone bond crisis. That cheap funding is set to mature beginning next year, and given the ECB’s stated goals of ending QE and eventually returning interest rates back to a more normal level, it means that bank funding costs throughout Europe are set to rise, and rise sharply. This will impact regulatory issues enacted in the wake of the financial crisis, as once those loans have less than 1-year remaining in them, they no longer count as long term capital. The point is that while the Eurozone economy has been recovering, a sharp rise in bank financing costs could easily undermine recent strength and force the ECB to reconsider the trajectory of tighter policy. Easier than expected ECB monetary policy would definitely weaken the single currency. This is not an issue for today, but we need to keep an eye out for potential concerns going forward.

Turning to the data story, this week doesn’t have much, but it does include the first look of Q3 GDP growth in the US, which could be critical for both markets and the upcoming elections. We also see New Home Sales, the last of the housing data, which thus far, has been quite weak.

Wednesday New Home Sales 625K
  Fed’s Beige Book  
Thursday Initial Claims 214K
  Durable Goods -1.0%
  -ex Transport +0.5%
  Goods Trade Balance -$74.9B
Friday Q3 GDP 3.3%
  Michigan Sentiment 99

On top of the GDP we have six Fed speakers, but there seems to be a pretty uniform set of expectations that they are on the right path with gradual rate increases the correct policy for now. In other words, don’t look for any new information there.

That sets us up for a week dependent on any changes in several ongoing stories, notably the Brexit negotiations, the Italian budget situation and Chinese market intervention. For now the signs are that the Chinese will continue to support things while Brexit will go nowhere. In the end, Italy has the best chance to rock the boat further, although I doubt that will occur this week. So look for a fairly quiet FX market, with the dollar remaining in its trading range waiting the next catalyst of note.

Good luck
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From Brussels

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From Brussels, the word is stop spending
Your budget, you must start amending
But Rome has replied
Get off our backside
And stop being so condescending

The fight between Rome and Brussels is intensifying as the EU has prepared to formally reject Italy’s 2019 budget. Explaining that the forecast budget deficit was too large and potentially destabilizing, EU FinMin’s are trying to apply pressure to prevent any further flouting of their rules. The problem is that the EU has only limited power, other than persuasion, to force change. There is a rule that allows them to impose a penalty of 0.2% of GDP on the offending nation if the situation gets out of control, but it has never been enacted in the entire history of the EU. And just getting to that point would require numerous meetings, lawsuits and hysterics, all of which will take a great deal of time. As well, the precedent is that when both France and Germany ran above target budget deficits for nearly a decade each in the 1980’s and 1990’s, a fine was never imposed. One other thing is that technically, Italy is within the rules, which call for a budget deficit of no more than 3.0%. Meanwhile, Italy is forecasting a 2.4% deficit. In the end, however, the market is growing increasingly concerned that this situation will get worse, not better, as can be seen from the sharp price decline in Italian government debt. In the past two days, the 10-year yield there has risen nearly 30bps and is now 328bps higher than German Bunds, the widest spread since 2013, just before the Greek crisis began.

With this in mind, it should be no surprise that the euro has come under renewed pressure. Yesterday it declined 0.45% and it is now pushing back toward the lows for the year seen in mid August. Recently I highlighted that the structural issues in the US seemed to be starting to exert more influence in the FX markets, which would help weaken the greenback. However, I didn’t really discuss the structural (existential?) issues in the euro, which also have the potential to cause significant damage to the currency. The difference is that the European issues are headline news every day, (the ongoing Italian budget fight and the ongoing Brexit negotiations), neither of which are likely to add value to the single currency. Whereas, the US structural issues, the twin deficits, don’t get nearly as much airtime, and tend to be at the back of traders’ minds. Even the trade issue, which is obvious and acute, does not lead in the US press, as the focus has turned to the mid-term elections here. In the end, it is quite reasonable that we may see yet another leg lower in the euro, testing, and breaking, the August lows. This is self-inflicted by Europe, not a product of Fed policy.

This morning, however, the dollar is actually underperforming slightly. Despite the ongoing Brexit question, the pound has rebounded slightly from yesterday’s decline on the strength of better than expected public finance data that showed the government borrowed less than expected. Meanwhile, the commodity bloc is rebounding on the strength of better performance in both base metal and agricultural markets. And finally, the yen is slightly softer as equity markets seem to have halted their slide, for now, and inflation data continues to disappoint encouraging traders to believe that the BOJ will not be ending their ultra easy monetary policy anytime soon.

Turning to China, we see that the renminbi is little changed this morning, hovering near the 6.94 level despite weaker than expected economic data last night. In fact, GDP in Q2 rose only 6.5%, below the expected 6.6% level, and indicating that the Chinese economy is clearly feeling the strains of the trade conflict with the US. This was made manifest in two ways; first components of the data like Fixed Asset Investment and Retail Sales were both softer than expected (although surprisingly the trade figures remain solid), but second, and more importantly, there was a concerted effort by Chinese financial mandarins to talk up the economy. Statements from PBOC Governor Yi Gang, CSRC head Liu Shiyu and vice premier Liu He were all released within minutes of the opening of the Shanghai stock market and focused on explaining how good things were and that there were no reasons to worry. At this point I must note that the Shanghai index opened lower by more than 1%, following yesterdays 2.9% decline, so the timing was not coincidental. In the end, the Chinese stock markets rallied in the afternoon, closing up by 2.6%, although the move appeared to be completely driven by official buying, rather than ordinary investors.

Stepping back, the overriding theme of late has been increased uncertainty over the economy due to political machinations. Whether it is Brexit, the Italian budget, the US mid-term elections or weakening Chinese growth, key market drivers are nonmarket events. For equities, earnings results have had less impact. In currencies, rate moves don’t seem to be the driver either. When markets reach a point where movement is driven entirely by outside actors, it becomes extremely difficult to manage risk effectively as nobody knows where the next tape bomb is coming from. It was much easier when all eyes were on the Fed and the ECB, as at least there was some consistency. In other words, look for more volatility across markets going forward.

As to the data story today, the only release is Existing Home Sales (exp 5.30M), where it wouldn’t be a great surprise to see a weak number given the weakness we saw in Wednesday’s Housing Starts data. We also hear from Atlanta Fed President Bostic. Yesterday’s two Fed speakers did exactly what was expected, with vice chairman Quarles saying the Fed was on the right course, and uberdove Bullard explaining that there was no reason to raise rates further. Neither one seemed to have a market impact.

I think the weight of evidence is that the dollar is likely to continue to creep higher today as the US rate picture continues to support it, the Italian budget story continues to undermine the euro, and the unlikelihood of positive news from a host of other nations seems set to keep investors focused on higher US yields. Unless the Italians capitulate, which I think is highly unlikely, I think the dollar edges up more before the weekend comes.

Good luck and good weekend
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A Source of Great Strains

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Inflation in England is easing
Which most people there find quite pleasing
But Brexit remains
A source of great strains
As Europe continues its squeezing

Yesterday’s broad equity market rally brought relief to most investors as it allayed concerns that the end was nigh. While many continue to be bullish, there is no doubt that there is rising concern about the idea that the good times will eventually end. In the wake of yesterday’s rally, however, fears have abated somewhat and market chatter is now focused on more mundane things like data and the FOMC Minutes.

With that in mind, the most noteworthy data overnight was the UK Inflation report that showed that CPI rose only 2.4%, well below expectations of a 2.6% rise, and seemingly indicating that earlier fears of stagflation in the UK economy were widely overblown. In fact, both sides of that equation, GDP growth and inflation are moving in the preferred direction, with GDP outperforming while CPI is underperforming. This situation will reduce pressure on the Old Lady with regards to policy moves as the necessity of hiking rates in an environment where price rises are moderating is quite limited. Thus it should be no surprise that the pound is under modest pressure today, falling 0.3% in the wake of the data release. However, in the broad scheme of things, the pound remains little changed from its level back in June and July.

Ultimately, while the monthly data releases are important, all eyes remain on the Brexit situation and estimates of how and when things there will be settled. The latest news is that the currently mooted plan, essentially splitting Northern Ireland from the rest of the UK, at least from a commerce perspective, does not have support in Parliament. At the same time, the Europeans believe they retain the upper hand in the negotiation as EU President Donald Tusk has called for PM May to come forward with some new creative solutions, implying it is her problem, not theirs. It is almost as though the EU doesn’t want to work at solving the problem at all. There is a big EU meeting today and tomorrow but right now, there doesn’t appear to be anything new to discuss, and while negotiations are ongoing, the issue is likely insoluble. After all, the competing demands are to prevent any visible customs border between Ireland and Northern Ireland while insuring that customs and duties are charged for all products that cross that border. As I have written many times, I expect there will be a fudge solution that doesn’t solve the problem but more likely kicks the can down the road for a few years. However, each day that passes increases the probability that there is no solution and the result is short-term chaos in markets and a much weaker pound. The risk/reward in the pound argues to maintain a net short position, as any potential gains are likely to be small relative to any potential losses depending on the actual outcome.

Away from the Brexit story, however, there is precious little else happening in the G10 bloc. Eurozone CPI was released right on the money, with the headline confirmed at 2.1%, but core remains a full percentage point below that. There is no indication that the ECB is going to change their policy stance at this point, and so look for QE to end in December while interest rates remain unchanged for at least another nine months following that. The euro has edged lower in recent trading, but the 0.2% decline is hardly enough to change any opinions, and as I mentioned yesterday, the bigger picture shows that it has barely budged over the course of the past five months. As to other currencies in the bloc, the RBA Minutes highlighted that low interest rates were likely to be maintained for another few years as the Unemployment Rate drifts lower, but there is, as yet, no evidence of rising wage pressures. Aussie seems likely to remain under broad pressure, especially as the US continues to tighten policy.

Turning to the EMG bloc, Chinese data last night showed that the money supply was continuing its steady 8.3% growth and that far from austerity, new loans continue to be made at a solid clip. It is quite clear that the PBOC is easing policy while trying to use regulatory tools to prevent additional liquidity moving into real estate where they continue to try to deflate a bubble. So far, it has been working for them. In the meantime, the renminbi continues to trade around 6.92, making no move toward the feared 7.00 level, but also not showing signs of strength. It is becoming quite clear, however, that outbound capital flows are starting to increase as for the third month running, China’s holdings of US Treasuries have fallen, this time by about $6 billion. Ignore all that you hear about China using Treasuries as a weapon; they have no alternative place to park their cash. Rather, the most likely explanation for a reduction in holdings is that they have been selling dollars in the FX market and need to sell Treasuries to get those dollars to deliver.

And those are really the big stories of the day. Yesterday’s US data was solid with IP growing 0.3% and Capacity Utilization running at 78.1%, largely as expected. This morning brings Housing Starts (exp 1.22M) and Building Permits (1.278M), and then this afternoon at 2:00 we see the FOMC Minutes. Given how much we have already heard from Fed speakers since the meeting, it strikes me that there is very little new information likely to appear. However, there are those who are looking for more clarity on the ongoing discussion about the neutral rate and where it is, as well as how important a policy tool it can be.

Equity futures have turned lower as I type, now down 0.2% while Treasury yields seem to have found a new home in the 3.15%-3.20% range. Arguably, today’s big risk is that the equity market resumes last week’s sharp declines and risk is jettisoned. However, that doesn’t appear that likely to me, rather a modest decline and limited impact on the FX market seems more viable for today.

Good luck
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Ready To Burn

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The chances last week of a deal
On Brexit quite clearly seemed real
But Saturday showed
T’is still a long road
Ere both sides, their bad feelings, heal

Meanwhile there’s another concern
In Europe, while Italians spurn
Demands to be sparing
And start in repairing
A fiscal house ready to burn

Thus far today, the evidence is mixed as to whether the equity market rout cum risk-off scenario is truly over, or simply took a breather on Friday. The rebound in stock markets around the world on Friday was met with a collective sigh of relief, but the overnight session saw APAC markets give up almost all of that ground with most closing down between 1.5%-2.0%. Europe opened lower as well although has since traded back to flat as traders everywhere wait for the US session to begin. Currently, futures are pointing lower by 0.4%, but there is a long time between now and the open, so sentiment may shift yet again before then. The key question is will investors, who have not seen a substantial correction in US equity markets in more than nine years, see this as the beginning of the end? Or as a chance to buy the dip? At this point, we can only wait and watch.

In the meantime, there are several stories that are important, but whose market impact has been diluted by the broad risk theme that has exerted itself in the past week. The first is about Brexit, where last week it seemed that a deal would be announced at the EU Summit to be held this Wednesday in Brussels. Alas, over the weekend, intense negotiations broke down and no further ones are slated ahead of that meeting. It seems that the Irish border issue remains intractable for now, as Ireland’s demand of no hard customs border with Northern Ireland cannot fit within the EU framework unless Northern Ireland is essentially separated from England. And neither side has been willing to cave on the issue, which, after all, is entirely about national sovereignty where fudging is far more difficult. Surprisingly, despite this setback, the pound is actually slightly higher on the day, having rallied 0.15%, although the euro has rallied double that. So EURGBP is stronger as the market continues to believe that the UK will be impacted more negatively than the EU in the event of a no-deal outcome.

Keep in mind, though, that both the Germans and Dutch have lately figured out that the UK is one of their top export markets for autos, chemicals and agriculture, and that the direct impact to those two nations is likely to be significantly greater than to most of the rest of the bloc. The point is that if there is no deal, the euro, which has gained some 12% vs. the pound since the initial Brexit vote in 2016, may find itself under more pressure than currently anticipated. In any event, it is hard to get excited about either currency in the short term.

Adding to the euro’s woes is the Italian budget situation, where the government in Rome will submit its budget proposals today. There has been no change to their recent estimates of a 2.4% deficit for next year, and that is based on what are seen as overly optimistic GDP growth forecasts, which means the actual number is likely to be much higher. There is also no indication that either 5-Star or the League are about to sacrifice their hard earned political capital and cave in to the EU’s demands.

You may recall that in Greece, when this situation played out, newly elected PM Alexis Tsipris sounded full of fury when telling his people they would never give in. You may also recall that he caved within a week of the first meeting. The difference this time is that, as the third largest economy in the EU, Italy actually matters to the entire structure there. With that in mind, my forecast is for some mollifying words on both sides but for the Italians to get their way, or at least most of it. While this may be a short-term euro positive, I think it actually undermines the long-term prospects for the currency.

Beyond these two headline stories we continue to hear about the US-China trade situation, which has not improved one iota since last week. Much concern was expressed at the IMF meetings over the weekend, but this is entirely being controlled by President Trump, and will almost certainly continue until at least the mid-term elections are past. At that point, it would not be surprising to see a softening of rhetoric and a deal finally agreed. But while that may make sense, it is by no means certain. In the meantime, the renminbi continues to trade toward the lower end of its recent range although there has been no indication that the PBOC is going to let it slide much further.

And those are the main stories for the session, which quite frankly remains far more focused on the equity markets than the dollar. Data this week brings the latest reading of Retail Sales and a few other things as well:

Today Empire Manufacturing 19
  Retail Sales 0.6%
  -ex autos 0.4%
  Monthly Budget $71.0B
Tuesday IP 0.2%
  Capacity Utilization 78.2%
  JOLT’s Job Openings 6.945M
  TIC Flows $47.7B
Wednesday Housing Starts 1.22M
  Building Permits 1.276M
  FOMC Minutes  
Thursday Initial Claims 212K
  Philly Fed 20
  Leading Indicators 0.5%
Friday Existing Home Sales 5.30M

Interestingly, I don’t think the Minutes will matter that much as we have heard extensively from so many Fed members explaining their views. Rather, today’s Retail Sales is likely to be the most important number of the week, as it could be the first sign the tariffs are having an impact.

In the end, all eyes remain focused on the equity and bond markets (which have been little changed overnight with 10-year yields up just 1bp to 3.15%), and I think the dollar remains secondary for now. But right now it seems risk-off is a dollar negative, so if equities fall, don’t be surprised to see the dollar fall too.

Good luck
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Change Can Come Fast

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There once was a market that soared
With tech stocks quite widely adored
The Fed, for eight years
Suppressed any fears
And made sure that rates were kept floored

But nothing, forever, can last
Now ZIRP and QE’s time has passed
Investors are frightened
‘Cause Powell has tightened
Beware because change can come fast!

Many of you will have noticed that equity markets sold off sharply in the past twenty-four hours, and that as of now, it appears there is more room to run in this correction. The question in situations like these is always, what was the catalyst? And while sometimes it is very clear (think Brexit or the Lehman bankruptcy) at other times movements of this nature are simply natural manifestations of a very complex system. In other words, sometimes, and this appears to be one of them, markets simply move because a confluence of seemingly minor events all occur at the same time. Trying to ascribe the movement to yesterday’s PPI reading, or comments from the IMF meetings, or any other specific piece of information is unlikely to be satisfying and so all I will say is that sometimes, markets move further than you expect.

Consider, though, that by many measures equity prices, especially in the US, are extremely richly valued. Things like the Shiller CAPE, or the Buffet idea of total market cap/GDP both show recent equity market levels at or near historic highs. And while the tax cuts passed into law for 2018 have clearly helped profitability this year, 2019 comparisons will simply be that much tougher to meet. There are other situations regarding the market that are also likely having an impact, like the increase in algorithmic trading, the dramatic increase in passive indexing and the advent of risk parity strategies. All of these tended to lead to buying interest in the same group of equities, notably the tech sector, which has been the leading driver of the stock market’s performance. If these strategies are forced to sell due to investor withdrawals, they will do so with abandon (after all, they tend to be managed by computer programs not people, and there is no emotion involved at all) and we could see a substantial further decline. Something to keep in mind.

But how, you may ask, is this impacting the FX markets? Interestingly, the dollar is not showing any of its risk-off tendencies through this move. In fact, it has fallen against almost all counterpart currencies. And while in some cases, there is a valid story that has nothing to do with the dollar per se, in many cases, it appears that this is simply dollar weakness. For example, the euro has rallied 0.5% this morning, after a 0.25% gain yesterday. Part of this has been driven by modestly higher than expected inflation data from several Eurozone countries (Spain and Ireland) while there is likely also a benefit from the story that the Brexit negotiations seem to be moving to a conclusion. However, despite the positive Brexit vibe, the pound has only managed a 0.15% rise this morning. The big winner in the G10 space has been Sweden, where the krone has rallied 1.5% after it also released higher than expected CPI data (2.5%) and the market has priced in further tightening by the Riksbank.

Looking at the EMG space, the dollar has fallen very consistently here, albeit not universally. We haven’t paid much attention to TRY lately, but it has rallied 1.4% today, and 5.5% in the past month. While yesterday they did claim to create some measures to help address the rising inflation there, they appear fairly toothless and I suspect the lira’s recent strength has more to do with the market correcting a massive decline than investor appetite for the currency. But all of the CE4 are rallying today, albeit in line with the euro’s 0.5% move, and there have been no stories of note from the region.

Looking to APAC, the movement has actually been far less pronounced with THB the best performer, rising 0.7% but the rest of the space largely trading within 0.2% of yesterday’s close. In other words, there is no evidence that, despite a significant decline in equity markets throughout the region, that risk-off sentiment has reached dramatic proportions. Now, if equity markets continue their sharp decline today, my best guess is that we will see a bit more activity in the currency markets, likely with the dollar the beneficiary.

Finally, LATAM currencies have had a mixed performance, with MXN rising 0.5% this morning, but BRL having fallen more than 1% on news that the mooted finance minister for Jair Bolsonaro (assuming he wins the second round election) is being investigated for corruption.

Turning to this morning’s session, the key data point of the week is released, with CPI expected to have declined to 2.4% in September (from 2.7%) and the core rate to have risen to 2.3%, up from August’s reading of 2.2%. With every comment from a Fed speaker focused on the idea of continuing to increase Fed Funds until they reach neutral, this data has the opportunity to have a real impact. If the release is firmer than expected, look for bonds to suffer, equities to suffer more and the dollar to find support. However, if this data is weak, then I would expect that the dollar could fall further, maybe back toward the bottom of its recent range, while the equity market finds some support as fears of an overly tight Fed dissipate.

So there is every opportunity for some more market fireworks today. As I believe that inflation remains likely to continue rising, especially based on the anecdotal evidence of rises in wages, I continue to see the dollar finding support. Of course, that doesn’t speak well of how the equity market is likely to perform if I am correct.

Good luck
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