Tag Archives: #china

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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Propense to Inveigh

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The Minutes released yesterday
Had not very much new to say
Rates will keep on rising
And assets downsizing
Despite Trump’s propense to inveigh

The market reaction was swift
With 10-years receiving short shrift
The stock market fell
(Was this its death knell?)
While dollars received quite a lift!

And here I thought the FOMC Minutes would be dull and boring with limited market impact. I couldn’t have been more wrong. While the text itself was as dry as usual, it seems the market read between the lines and gleaned the following: interest rates are going to go higher for a while yet, a longer time than previously considered.

Arguably the biggest change in the September FOMC statement was the removal of the sentence regarding policy being accommodative. Chairman Powell focused on this at the ensuing press conference, and has commented on it since then as well. The gist of his message has been that since the dividing line between accommodative and not accommodative is so uncertain (r* is immeasurable) and that it is not likely to be stationary either, there is no way the Fed can be certain they have reached that target. Given that premise, describing their policy as accommodative seemed to express too much precision in something that is extremely uncertain.

However, the compilation of views from the Minutes seemingly showed a larger group of members sounding hawkish. In the end, the market read this to mean that the Fed was going to be raising rates at least another 100bps before they stop. Consider that if they act every quarter through the end of 2019, raising rates 25bps each time, Fed Funds is going to be in a range of 3.25%-3.50% at the end of next year. And while that is still low on a historic basis, it is much higher than markets have seen in more than a decade. Based on what we have heard from the ECB and BOJ, it is also much higher than their cash rates are going to be at that time. In fact, it is quite possible that in both those cases, cash rates will still be 0.00% or negative at the end of next year.

If you play out that scenario, it cannot be very surprising that the dollar was a beneficiary of the release of the Minutes. So yesterday’s 0.6% decline in the euro makes a great deal of sense. In fact, the dollar index performed in exactly the same manner, rising 0.6% on the day. And one thing to keep in mind is that Fed funds futures markets are still pricing in only a 25% probability that rates will be that high at the end of next year. If the Fed stays the course, and there is no reason yet to believe they won’t, that market will need to adjust, and other markets will adjust accordingly.

So a quick recap of the G10 currencies showed that the dollar performed will against all of them yesterday, but has since ceded some of that ground in what appears to be a short-term trading effect. So this morning’s 0.15% rise in the euro, or 0.1% rise in the pound hardly seems compelling.

But there was another story of note yesterday as well, the US Treasury issued its semiannual report on currencies and, once again, did not find China a currency manipulator by its legal definition. This cannot be a real surprise because despite the President’s constant complaints, according to the law, a country can only be designated a manipulator if three conditions are met; consistent currency intervention, running a large trade surplus with the US and running a large current account surplus overall. In fact, China has not been actively intervening on a net basis in the FX markets, and its overall current account surplus has actually fallen to near flat, although obviously it continues to run a large surplus with the US.

Recent price action in USDCNY had been extremely stable, with the PBOC seeking to maintain very modest volatility and expressly saying that they would not be using the exchange rate as a ‘weapon’ in trade. But interestingly, last night, after the release of the Treasury report, the PBOC fixed CNY at its weakest level in nearly two years and the renminbi fell 0.25%. As well, Chinese stock markets continued their recent declines, with Shanghai falling another 2.9% and now trading at its lowest point since December 2014. Concerns are growing that the Chinese economy may be slowing faster than anticipated and this is also being reflected in commodity prices, where base metals have been falling along with oil. (Oil also suffered because of the ongoing inventory build in the US, which when combined with fears over slowing global growth have been sufficient to add a little caution to all those claims that $100 oil was returning soon.)

And those were the big stories yesterday. The US data was surprisingly weak, with both Housing Starts and Building Permits falling and coming in well short of expectations. But this market is far more focused on the Fed and its perceived intentions than on a piece of data. That tells me that this morning’s Initial Claims (exp 212K) and Philly Fed (20.0) are unlikely to move markets. Of more interest may be speeches by two Fed speakers, Bullard and Quarles, especially if they delve into more detail of their policy expectations.

Equity futures are pointing lower, and Treasury yields have maintained yesterday’s gains and are back at 3.20%. My sense is that risk is being reduced across the board here, thus driving both stocks and bonds lower at the same time. If that is true, then look for further commodity price weakness and the dollar to retain its recent gains.

Good luck
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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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Not Quite Yet Elated

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The sell-off in stocks has abated
Though bulls are not quite yet elated
Most bonds, which had jumped
This morning were dumped
While dollar bears still are frustrated

Two days of substantial equity weakness has halted this morning, with Asian markets rebounding nicely and Europe also on the rise. As usual, it is not clear exactly what caused this reaction, but there are several reasonable candidates. The first was a softer than expected US inflation print yesterday morning. If, in fact, inflation in the US continues to remain just north of 2.0%, then the Fed may feel much less urgency to raise rates aggressively, and markets around the world will appreciate that change of stance. Remember, one of the reasons that we have seen such disruption elsewhere in the world, most notably throughout emerging market economies and markets, is that during the eight year long period of US ZIRP, companies and governments around the world gorged themselves on cheap USD debt. Eight rate hikes later, that debt is no longer so cheap, especially when it comes time for those borrowers to refinance. So any hint that the Fed will have a lower terminal rate is going to be perceived as a market positive.

The other news was a surprise increase in the Chinese trade surplus, which rose to $31.7B, far above the expected $19.4B. Exports, to everyone’s surprise, rose 14.5% despite the tariff situation. While some of this may be due to timing issues of when these shipments were recognized, the news was positive nonetheless. I expect that as we go forward, Chinese export data is likely to suffer, but for now, the news is better than expected. Beyond those two stories, it is difficult to make a case for any real change anywhere.

One of the interesting things about the past two sessions is that while risk was clearly being jettisoned, the dollar was not a beneficiary like it had been in the past during these events. Traditionally, dollar strength accompanies weak equity and commodity markets, but not this time. Of course, one of the big issues in the market right now is the structural deficit in the US. Expansionary fiscal policy here has resulted in the highest non-wartime budget deficits on record, now approaching $1 trillion for this year and certain to be more than that next year, which means that the Treasury is going to need to issue a lot more debt to pay for things. At the same time, the Fed continues to reduce its bid for Treasury bonds as it shrinks its balance sheet steadily. This combination of events is almost certainly going to lead to higher US interest rates out the curve, as more price sensitive investors become the marginal buyer.

For the past six months, higher US rates have been an unalloyed USD positive, driving the dollar back to its levels of late last year and scotching all the talk of a significant dollar decline. But if you recall, I wrote about the opposing structural and cyclical issues facing the dollar several months ago, where the cyclical highlighted the faster growth in the US economy and higher interest rates as a dollar support, while the structural issues of growing twin deficits (budget and current account) pointed to a weaker currency going forward. It is entirely possible that the market’s recent behavior, where despite a risk-off situation the dollar is falling, is an indication that the structural issues are starting to lead the conversation. If that is the case, the dollar is likely to have seen its peak. While it is too early to know for sure, this is something that we will monitor closely going forward.

With regard to specifics in today’s session, most currencies have halted their rally but not really declined much. Other than the Chinese trade data, there has not been much of interest released today, and in the US all we get is Michigan Sentiment (exp 100.4). What we do know is that it is a Friday at the end of a stressful week for markets, which typically results in less active markets. Equity futures in the US are pointing higher, and as long as the US markets follow suit with Asia and Europe and rebound, I expect the dollar will do very little on the day. However, if we see this early strength turn around and US equity markets wind up closing lower on the day, look for much more global anxiety over the weekend and the risk-off sentiment to resume in earnest next week. That includes, at this time, further dollar weakness. So unusually, a modest equity market rally should result in modest USD strength, while a sell-off will likely see the dollar suffer as well.

Good luck and good weekend
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The Next Year Or So

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Said Williams, “the next year or so”
Should see rates reach neutral, you know
At that point we’ll see
If our GDP
Is humming or soon set to slow

The dollar is under very modest pressure this morning, although in reality it is simply continuing to consolidate its recent gains. While there have been individual currency stories, the big picture continues apace.

As I write, the IMF is holding its annual meeting in Indonesia and so we are hearing much commentary from key financial officials around the world. Yesterday, IMF Managing Director Lagarde told us that the ongoing trade tensions were set to slow global growth. Overnight, we heard from NY Fed President John Williams, who said that the US economy continued to be strong and that while there is no preset course, it seemed likely that the Fed would continue to adjust policy until rates reached ‘neutral’. Of course, as nobody knows exactly where neutral is, there was no way to determine just how high rates might go. However, there was no indication that the Fed was going to pause anytime soon. Dallas Fed President Robert Kaplan, who said that he foresaw three more rate hikes before any pause, corroborated this idea. According to the dot plot, 3.00% seems to be the current thinking of where the neutral rate lies as long as inflation doesn’t push significantly higher than currently expected. All this points to the idea that the Fed remains on course to continued policy tightening, with the risks seemingly that if inflation rises more than expected, they will respond accordingly.

The other truly noteworthy news was from the UK, where it appears that a compromise is in sight for the Brexit negotiations. As expected, there is some fudge involved, with semantic definitions of the difference between customs and regulatory checks, but in the end, this cannot be a great surprise. The impetus for change came from Germany, who has lately become more concerned that a no-deal Brexit would severely impact their export industries, and by extension their economy. The currency impact was just as would be expected with the pound jumping one penny on the report and having continued to drift higher from there. This seems an appropriate response as no deal is yet signed, but at least it appears things are moving in the right direction. In the meantime, UK data showed that Q3 GDP growth is on track for a slightly better than expected outcome of 0.7% for the quarter (not an annualized figure).

As to the other ongoing story, there has been no change in the tone of rhetoric from the Italian government regarding its budget, but there are still five days before they have to actually submit it to their EU masters. It remains to be seen how this plays out. As I type, the euro has edged up 0.15% from yesterday’s close, but taking a step back, it is essentially unchanged for the past week. If you recall, back in August there was a great deal of discussion about how the dollar had peaked and that its decline at that time portended a more significant fall going forward. At this point, after the dollar recouped all those losses, that line of discussion has been moved to the back pages.

Turning to the emerging markets, Brazil remains a hot topic with investors piling into the real in expectations (hopes?) of a Bolsonaro win in the runoff election. That reflected itself in yet another 1.5% rise in the currency, which is now higher by more than 10% over the past month. The China story remains one where the renminbi seems to be on the cusp of a dangerous level, but has not yet fallen below. Equity markets there took a breather from recent sharp declines, ending the session essentially flat, but there is still great concern that further weakness in the CNY could lead to a sharp rise in capital outflows, or correspondingly, more draconian measures by the PBOC to prevent capital movement.

But after those two stories, it is harder to find something that has had a significant impact on markets. While Pakistan just reached out to the IMF for a $12 billion loan, the Pakistani rupee is not a relevant currency unless you live there. However, this issue is emblematic of the problems faced by many emerging economies as the Fed continues to tighten policy. Excessive dollar borrowing when rates were low has come back to haunt many of these countries, and there is no reason to think this process will end soon. Continue to look for the dollar to strengthen vs. the EMG bloc as a whole.

This morning brings our first real data of the week, PPI (exp 2.8%, 2.5% ex food & energy). However, PPI is typically not a market mover. Tomorrow’s CPI data, on the other hand, will be closely watched for signs that inflation is starting to test the Fed’s patience. But for now, other than the Brexit news, which is the first truly positive non-dollar news we have seen in a while, my money is on a quiet session with limited FX movement. The only caveat is if we see significant equity market movement, whereby a dollar reaction would be normal. This is especially so if equities fall and so risk mitigation leads to further dollar buying.

Good luck
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Growth Would Be Marred

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The IMF’s Christine Lagarde
Explained global growth would be marred
By tariffs imposed
Which keep borders closed
To products that ought not be barred

The dollar has continued its recent ascent this morning, edging higher still against most of its counterparts as US interest rates continue to climb. In fact, as I type, the 10-year Treasury has breached 3.25% for the first time in more than seven years, and quite frankly, there is no reason to think this trend is going to stop. Rather, given the significant amount of new issuance that will be required by the Treasury Department, and the fact that the Fed is reducing the amount of bonds that it purchases as it shrinks its balance sheet, we should expect to see yields continue higher. Back in January I forecast that the 10-year yield would reach 4.00% by the end of the year. For the longest time that seemed impossible, but while still a difficult conclusion, given the speed with which yields have risen recently, it doesn’t seem quite as far-fetched as it used to.

At any rate, the market stories today are largely the same as those from yesterday. Perhaps the key headline was the IMF announcement that they had reduced their estimates for global growth for 2018 and 2019 by 0.2% to 3.7% for both years. The key change since their last estimate was the increased trade tensions between the US and China and the estimated impact those will have on nations around the globe. However, they did not adjust their estimate of US growth, which is likely to encourage the Trump Administration to continue down the path of further tariffs in their negotiation strategy.

Beyond that story, we are still in the grips of the Italian budget situation, where there has been no indication that the coalition government is going to adjust policy to reduce the projected deficit. Given that every one of these situations in Europe turns into a game of chicken, it is probably too early to assume no solution will be found. However, it is important to remember that DiMaio and Salvini, the heads of the 5-Star and League parties respectively, and the real power in the government, are both anti-establishment, and there appears to be a very real chance that they ignore the European Commission and the EU rules. Certainly the Italian stock and bond markets are concerned over that outcome, as 10-year yields there have risen another 10bps while the FTSE MIB has fallen a further 0.5%. This process will continue to weigh on the euro for now so it should be no surprise that the single currency has fallen by 0.5% this morning. But arguably it is not only the Italian situation impacting the euro, we also saw German trade data, which reported a significant decline in imports, -2.7%. While this did result in an increased trade surplus, sharply falling imports is not a sign of economic strength, and so this was likely not seen as a positive. Net, the combination of ongoing tighter US monetary policy and stalling growth in Europe should help underpin the dollar going forward.

Looking at the rest of the G10 space, the dollar is firmer virtually across the board, with the only exception the Japanese yen, which is flat on the day. Though some may argue that slightly better than expected Economy Wathers Survey data helped, this appears to me to be a consequence of a broader risk-off sentiment that is sweeping the markets. A stronger dollar and a stronger yen are natural consequences of this mentality. What is interesting, however, is that two other natural haven assets, gold and Treasuries, are not performing in the same way. I think the explanation for both is the same: higher US short term rates, now above 2.0% across products, is of sufficient attraction to draw frightened investors into Treasury bills rather than taking the risk of a 10-year note. As well, now that cash earns a return, the opportunity cost of holding gold has increased substantially. Given this situation, it appears there is much further to go for the dollar, as fear will drive investors to short term dollar holdings. With this in mind, I suspect we will hear much less about an inverting yield curve for a time. After all, given the sharp rise in 10-year yields and the increased demand for short term assets, it will be very hard for that to occur.

Flipping to emerging markets, the dollar is broadly stronger here as well, across all three regions. In fact, the only noteworthy exception is BRL, which rallied 1.5% yesterday in the wake of the results of Sunday’s presidential election. It is clear that the market remains highly in favor of a President Bolsonaro there, and I expect that as we approach the run-off vote in three weeks’ time the real will continue to perform well. However, this movement has all the earmarks of a ‘buy the rumor, sell the news’ scenario, which means that a sharp dollar rally could well result in the wake of the run-off vote no matter who wins. Granted, if Fernando Haddad, the left wing candidate wins, I would expect the real’s decline to be much sharper.

Away from that, USDCNY is trading above 6.93 today as the Chinese continue to try to ease policy domestically without causing too much market turmoil. While the Trump Administration is apparently looking at naming China a currency manipulator in the latest report due shortly, given the dollar’s overall strength, it appears to me that the movement is entirely within the confines of the overall market. Quite frankly, it still seems as though the Chinese are quite concerned about a ‘too-weak’ renminbi as a trigger to an increase in capital outflows, and so will prevent excessive weakness for now. That said, I expect CNY will continue to weaken going forward.

And that’s really it for today. The NFIB Small Business Optimism Report was released at 107.9, softer than expected but still tied for the second highest reading of all time. Confidence in the economy remains strong. All we have for the rest of the day are speeches by Chicago Fed President Evans and NY’s John Williams. However, given what we have heard lately and the dearth of new news likely to change opinions, it beggars belief to think that anything new will come from these comments. In other words, there is nothing standing in the way of the dollar continuing to rise on the back of ever tighter US monetary policy.

Good luck
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Both Flexed Their Muscles

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In China more policy ease
Did nothing to help to appease
The stock market bears
Who unloaded shares
Along with their spare RMB’s

Then tempers between Rome and Brussels
Got hotter as both flexed their muscles
The latter declared
The budget Rome shared
Was certain to cause further tussles

This morning the dollar has resumed its uptrend. The broad theme remains that tighter US monetary policy continues to diverge from policies elsewhere around the world, and with that divergence, dollar demand has increased further.

China’s weekend action is the latest manifestation of this trend as Sunday they announced a one-percentage point cut in the Required Reserve Ratio (RRR) for all banks. This should release up to RMB 1.2 trillion (~$175billion) of liquidity into the market, helping to foster further economic activity, support the equity markets and keep a lid on interest rates. At least that’s the theory. Alas for the Chinese, whose markets were closed all of last week for national holidays, the Shanghai Composite fell 3.7% on the day, as they caught up with last week’s global equity market decline. It is not clear if the loss would have been greater without the RRR cut, but one other noteworthy feature of the session was the absence of any official attempts to support the market, something we have seen consistently in the past. It ought not be surprising that the renminbi also suffered overnight, as it fell nearly 0.5% and is now trading through the 6.90 level. If you recall, this had been assumed to be the ‘line in the sand’ that the PBOC would defend in an effort to prevent an uptick in capital outflows. As it is just one day, it is probably too early to make a judgment, but this bears close watching. Any acceleration higher in USDCNY will have political repercussions as well as market ones.

Speaking of political repercussions, the other noteworthy story is the ongoing budget saga in Italy. There has been no backing down by the populist government in Rome, with Matteo Salvini going so far as to call Brussels (the EU) the enemy of Italy in its attempts to impose further austerity. The Italians are required to present their budget to the EU by next Monday, and thus far, the two sides are far apart on what is acceptable for both the country and EU rules. At this point, markets are clearly getting somewhat nervous as evidenced by the ongoing decline in Italian stock and bond markets, where 10-year yields have jumped another 15bps (and the spread to German bunds is now >300bps) while the FTSE-MIB Index is down another 2.5% this morning. Given that this is all happening in Europe, it is still a decent bet that they will fudge an outcome to prevent disaster, but that is by no means a certainty. Remember, the Italian government is as antiestablishment as any around, and they likely relish the fight as a way to beef up their domestic support. In addition to the Italian saga, German data was disappointing (IP fell -0.3% vs. expectations of a 0.4% gain), and the combination has been sufficient to weigh on the euro, which is down by 0.4% as I type.

Beyond these stories, the other big news was the Brazilian election yesterday, where Jair Bolsonaro, the right wing candidate, came first with 46% of the vote, and now leads the polls as the nation prepares for a second round vote in three weeks’ time. The Brazilian real has been the exception to EMG currency weakness over the past month, having rallied nearly 9% during the last month. It will be interesting to see if it continues that trend when markets open there this morning, but there is no question that the markets believe a Bolsonaro administration will be better for the economy going forward.

Otherwise, the stories remain largely the same. Ongoing US economic strength leading to tighter Fed policy is putting further pressure on virtually all EMG currencies throughout the world. And it is hard to see this story changing until we see the US economy show signs of definitive slowing.

Turning to the upcoming week, data is sparse with CPI being the key release on Thursday.

Tuesday NFIB Business Optimism 108.9
Wednesday PPI 0.2% (2.8% Y/Y)
  -ex food & energy 0.2% (2.5% Y/Y)
Thursday Initial Claims 206K
  CPI 02% (2.4% (Y/Y)
  -ex food & energy 0.2% (2.3% Y/Y)
Friday Michigan Sentiment 100.5

As to Fed speakers, we have three regional Fed Presidents (Evans, Williams and Bostic) speaking a total of seven times this week. However, it is pretty clear from comments lasts week that there is no indication the Fed is going to relax their view that gradually tighter policy is appropriate for now. The one thing that can derail this move would be much softer than expected CPI data on Thursday, but that just doesn’t seem that likely now. Look for the dollar to continue to trend higher all week.

Good luck
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