Dashing Hopes

Said Trump when he landed in London
Your Brexit deal needs to be undone
Because as it stands
We’ll never shake hands
On trade, dashing hopes ere they’ve begun

On Thursday, PM Theresa May has had yet another trying day. President Trump came to town and wasted no time skewering her recently outlined Brexit framework indicating that if the UK heads down her preferred road (you remember, trade in goods to remain within the EU umbrella, but services to be wide open) that the US would not be able to sign a free trade deal. Trump’s point, albeit indelicately made, is that a comprehensive trade deal with the UK will be impossible because the EU will be involved. And, as you may remember, Trump has several issues with the way the EU approaches trade. This was a terrible blow to May because she has clearly been counting on a deal with the US to help offset the changed status with the EU.

It should be no surprise that the pound did not take the news well and as I type, it is lower by 0.6% today and 1.7% this week. And this is despite the fact that Governor Carney virtually promised to raise rates at next month’s BOE meeting. We are still a long way from any resolution on the Brexit situation, and I continue to believe that uncertainty over the outcome will weigh on Pound Sterling. The pound remains some 12.5% below its levels prior to the Brexit vote two years ago. While it is still well clear of the lows seen at the beginning of last year (1.2000 or so) given my belief that there will be no Brexit deal signed, I expect that the market will return to those lows over time. Higher rates or not, confidence in the UK right now is somewhat lacking.

The other big news overnight was the Chinese data releases that showed that the trade surplus rose sharply to $41.6 billion with the US portion rising to a record $29 billion. This may be a timing issue with many companies anxiously shipping product ahead of the imposition of tariffs. But it also could simply reflect that the Chinese economy is slowing down, thus import growth is ebbing, while the US economy continues to power ahead and lead the global economy. In the end, I am certain that the Trump administration will look at these numbers and feel further justification in their stance on trade.

But on top of the trade data, Chinese Money Supply growth continues to ebb, a sign that economic activity on the mainland is slowing. Other indications of a Chinese slowdown are that the government’s campaign to reduce excess leverage seems to have gone into reverse. There have been several stories about how Beijing is now looking for local governments to insure they spend allocated money rather than worry about cutting back on new allocations. It seems that there is a growing fear that real GDP growth (not necessarily what is reported) is slipping more quickly than President Xi is prepared to accept. With this in mind, it is no surprise that the renminbi is under further pressure this morning, down 0.45%, and is now trading back at levels not seen since last August. And it has further to fall. I expect that we will be testing 7.00 before the year is over.

One last noteworthy item was yesterday’s CPI release, where headline CPI printed at 2.9%, its highest since 2012, and the ex food & energy number printed at 2.3%. What this tells us is that wage gains are barely keeping up with inflation, and so consumers are not really benefitting from the recent modest uptick we have seen there. We heard from both Chairman Powell and Philly President Harker yesterday and both indicated they were comfortable with the Fed’s current trajectory. Both also indicated that while the trade situation has not yet impacted the economy in any meaningful way, they could foresee how that might come about and cause the Fed to rethink their strategy. As of now, I remain in the four hikes this year camp, and will need to see a substantial change to the economic data to change that view.

Turning to the overnight FX performance, the dollar has continued its recent uptrend, rising against almost all its counterparts in both the G10 and the EMG. In fact, the dollar has risen every day this week, completely unwinding last week’s decline. There was a modest amount of data from the Eurozone, all pointing to the ongoing lack of inflation in the region, which continues to undermine the ECB’s case to normalize policy quickly. We also continue to see issues throughout emerging markets with TRY, for example, plummeting 6% this week as the market responds to President Erdogan’s cabinet moves. Remember, he installed his son-in-law as FinMin and ousted all the market friendly ministers in the cabinet. As I have written before, this currency has much further to fall.

Meanwhile, US equity markets continue to power ahead, well at least the big tech names continue to do so and that has been sufficient to drive the averages higher overall. However, market breadth continues to narrow which is always an ominous trend. Treasury yields have been stable in the 10-year space, but the 2-year continues to march higher and that spread is down to 26bps, edging ever closer to inversion. While I believe that the signaling effect this time is not quite the same due to the massive distortions in bond markets brought about by QE, I am in a minority view there.

In the end, the big trends remain intact, which means to me that the dollar is going to continue its march higher. Hedgers keep that in mind as you start to think about your 2019 hedging needs.

Today’s only data is Michigan Sentiment (exp 98.2) and then we hear from Atlanta Fed President Rafael Bostic. But given what we just heard from Harker and Powell (and Brainerd and Williams earlier in the week), there is no indication that the Fed is going to change its tune in the near future. The trend is your friend, and right now that trend is for the dollar to continue to rally.

Good luck and good weekend


The Fed’s Fallen Short

This morning’s inflation report
Ought show that the Fed’s fallen short
In holding down prices
And so my advice is
It’s time, those short dollars, abort

Yesterday’s session was dominated by two key themes; the suddenly increased trade tensions after the announcement of a new list of $200 billion of Chinese tariff targets, and the sharp decline in oil prices (WTI – 5.0%) after Libya declared the end of force majeure with respect to shipments from its eastern port. The oil price decline, which occurred despite a surprisingly large drawdown of US inventories, was in sync with other commodity prices, notably copper which fell 2.5% and is now down more than 16% in the past month. Copper is generally seen as an important harbinger of future economic growth given its widespread use throughout different industries, and so falling demand for copper often leads to slower economic growth. And yet, despite the declining commodity price environment, yesterday’s PPI data (3.4% Y/Y) was the strongest in more than six years while expectations for today’s CPI are similarly elevated with consensus views looking for 0.2% monthly increases in both headline and core data which translates into 2.8% headline and 2.3% core on a Y/Y basis.

If those expectations are met, the Fed will certainly continue its hiking cycle, which ought to continue to support the dollar going forward. The other key dollar support has been risk aversion, which is where the trade story comes into play. As long as trade tensions remain front-page news, investors are likely to remain skittish which means they will be reducing risk and looking for safe places to invest. US Treasuries remain the global safe haven of choice, and so both Treasuries and the dollar should continue to benefit from this situation.

Yesterday I mentioned that there had been no indication that there were background talks ongoing between the US and China regarding trade, something I found surprising given the situation. However, this morning there is a story that such talks are, in fact, proceeding which implies to me that there will be some type of solution that arrives before the next round of tariffs are in place. Look for concessions on both sides as well as comments highlighting the strength of the Sino-US relationship, especially with regard to North Korea. At least that’s my view. But it will be several months before anything comes to fruition, and so we are likely to be subject to further volatility on the subject.

One of the impacts of the China trade story was yesterday’s very sharp decline in the renminbi (-1.1%), which resulted in the currency falling to its weakest level since last August. Some pundits see this as an attempt to adjust for the recent tariff impositions by the US, but a case can be made that since the dollar was so strong overall yesterday, (USDX +0.65%), the CNY move was not really out of character. And this morning, the renminbi has already retraced half of that movement, so I am inclined to give the Chinese the benefit of the doubt here and accept the broad dollar strength thesis. In fact, one of the things that continues to haunt the PBOC is their mini devaluation in 2015, which triggered significant capital outflows and forced the imposition of very strict capital controls in China. Regardless of the trade situation, I assure you the Chinese will do all they can to prevent a repeat of that outcome. However, steady depreciation of the renminbi going forward remains my base case.

Otherwise, in G10 space the Bank of Canada raised rates by 25bps, as expected, which helped the Loonie temporarily, but in the end, it seems that weaker oil prices overwhelmed the rate hike and CAD fell 0.75% on the day. However, the BOC continues to sound upbeat on the economy for now and is positioned to continue to track the Fed’s policy for the next year or two.

From the UK, this morning, we received PM May’s latest Brexit position paper which is seeking to have the UK track EU goods regulations, but simultaneously looking for the UK to go completely its own way regarding services and seek trade agreements around the world on that basis. While it is an interesting idea, and one with merit given that services represent ~80% of the UK economy, with less than nine months before the Brexit date, it feels like they may not be able to complete much of the process in time. However, the BOE appears completely ready to raise rates next month with the market pricing an 80% probability of the event and Governor Carney commenting that growth in the UK continues to perform as the BOE expected in its rebound from Q1. The pound, however, has added a small 0.1% decline this morning to yesterday’s 0.5% slide.

Beyond these stories, nothing of note to the FX markets has really been evident. Given the strength of yesterday’s dollar move, it would be no real surprise if there was a small retracement, but in fact, I have a feeling that we are going to see high side surprises in the CPI data which will only serve to increase Fed expectations and support the dollar. So my money is on the dollar continuing its strengthening trend of the week and closing yet higher today.

Good luck

Lack of Dismay

The deadline for tariffs is nigh
And Friday they’ll start to apply
But so far today
The lack of dismay
Has forced pundits all to ask why

Tomorrow is tariff day, as the US is set to impose 25% tariffs on $34 billion of Chinese goods beginning at midnight tonight. The Chinese are prepared to respond in kind, and it seems that the second battle of the emerging trade war (steel and aluminum were the first) is about to begin. Interestingly, financial markets remain extremely calm at the prospect of escalation with equity prices rebounding from Tuesday’s late losses and the dollar ceding some of its recent gains. I question how long this can continue, especially if we move on to stage three of the battle, where President Trump has promised tariffs on an additional $200 billion of Chinese goods. That poses a bigger problem for China as they only import about $135 billion in goods from the US each year (hence the deficit!)

The question at hand, though, is what type of impact this will have on markets going forward. Economic theory tells us that consumers will seek substitutes for those goods but that prices will rise somewhat to offset the effects of either paying the tariffs or accounting for the higher cost of the substitutes. In other words, inflation, which has been steadily moving higher in the US, is destined to continue that trend, if not accelerate somewhat. From there, it is a short hop to higher US interest rates and a stronger dollar. However, if this process continues long enough, it is likely to undermine the US growth story. If that were to happen, weakening data would likely cause the Fed to grow more cautious in their policy normalization drive. In that event, we are likely to see the dollar’s current strengthening trend stall. As is so often the case, one set of stimuli with a particular response leads to another set of stimuli with the opposite impact. The thing is, it will probably be 2019 before there is any indication that US growth is really slowing due to the trade story, and so I see only a limited chance that the Fed adjusts its policy trajectory this year. In other words, I think despite the tariffs, the Fed will still raise rates twice more in 2018.

Perhaps we will get a better idea of the Fed thinking on the subject when the Minutes of June’s FOMC meeting are released this afternoon. And while we have heard from several FOMC members that they are beginning to become concerned about the impact of the trade war, at this point, the data continues to favor policy continuation.

In the meantime, the dollar is a bit softer this morning as Germany finally printed some good data. For the first time this year, Factory Orders rose (+2.6%). While that is encouraging, it still begs the question as to whether this is the outlier number, or whether the previous five months of data were the aberration. But the euro is higher by 0.35% and pushing back toward 1.1700. That said, it has largely been range bound, between 1.1550 and 1.1750, for the past month. It doesn’t strike me that today’s data point is going to change that.

From the UK, Governor Carney was on the tape explaining that the growth picture there has been good enough to warrant higher rates if it continues. Yesterday saw the Services PMI in the UK rise to 55.1, well above expectations of 54.0, and its highest level in 9 months. The futures market has now increased its probability of an August rate hike to 82%, which barring any disastrous announcement on Brexit, seems sufficient to allow the BOE to act. However, nothing I have read has indicated that the UK is going to come up with a workable solution for the current Brexit issues, and I continue to believe that next March, the UK will be leaving the EU with no deal in hand. If that is the case, whatever the BOE was planning will come under renewed scrutiny, and it seems unlikely that rates there will go any higher. In addition, just like in the wake of the actual vote, I would expect the pound to suffer significantly at that time. All of this tells me that GBP receivables hedgers need to be very proactive in managing those risks, especially when we get a bounce in cable.

In the emerging markets, there has been one major move since I last wrote; MXN is higher by nearly 2.5%. While the move was just beginning Tuesday morning, the market has become enamored of the idea that President Trump and President-elect Obrador are going to be great friends and solve many of the problems that exist between the two nations. I don’t mean to be negative, but I find it hard to believe that will be the case. In fact, I expect that based on campaign rhetoric, the US and Mexico will see increased tension, which I am certain will lead to the peso suffering more than the dollar. In the end, Mexico is far more reliant on the US than the other way around, so stress in that relationship will hurt the peso first.

But otherwise, amid a smattering of data and news, the dollar is mildly softer this morning. After the Minutes are released and digested, all eyes will turn toward tomorrow’s payroll report. And in fact, we get a preview this morning with the ADP employment print (exp 190K) and Initial Claims (225K). We also see ISM Non-Manufacturing (58.3), which is likely to continue to show the current strength of the US economy. In the end, we are range bound, but as of now I still see a better case for dollar strength than weakness going forward.

Good luck