Pending A-pocalypse

Inflation’s on everyone’s lips
As traders now need come to grips
With data still soft
But forecasts that oft
Point to pending a-pocalypse

Is inflation really coming soon?  Or perhaps the question should be, is measured inflation really coming soon?  I’m confident most of us have seen the rise in prices for things that we purchase on a regular basis, be it food, clothing, cable subscriptions or hard goods.  And of course, asset price inflation has been rampant for years, but apparently that doesn’t count at all.  However, the focus on this statistic has increased dramatically during the past several months which is a huge change from, not only the immediate post-pandemic economy, but in reality, the past thirty years of economic activity.  In fact, ever since Paul Volcker, as Fed Chair, slew the inflationary dragon that lived in the 1970’s, we have seen a secular move lower in measured consumer prices alongside a secular move lower in nominal interest rates.

But the pandemic has forced a lot of very smart people (present company excluded) to reconsider this trend, with many concluding that higher prices, even the measured kind, are in our future.  And this is not a discussion of a short-term blip higher due to pent up demand, but rather the long-term trend higher that will need to be addressed aggressively by the Fed lest it gets out of hand.

The argument for inflation centers on the difference between the post GFC financial response and the post Covid shock financial response.  Back in 2009, the Fed cut rates to zero and inaugurated their first balance sheet expansion of note with QE1.  Several more bouts of QE along with years of near zero rates had virtually no impact on CPI or PCE as the transmission mechanism, commercial banks, were not playing their part as expected.  Remember, QE simply replaces Treasuries with bank reserves on a commercial bank balance sheet.  It is up to the commercial bank to lend out that money in order for QE to support the economy.  But commercial banks were not finding the risk adjusted returns they needed, especially compared to the riskless returns they were receiving from the Fed from its IOER program.  So, the banking sector sold the Fed their bonds and held reserves where they got paid interest, while enabling them to have a riskless asset on their books.  In other words, only a limited amount of QE wound up in the public’s pocket.  The upshot was that spending power did not increase (remember, wages stagnated) and so pricing pressures did not materialize, hence no measured inflation.

But this time around, fiscal policy has been massive, with the CARES act of nearly $2 trillion including direct payments to the public as well as forgivable small business loans via the PPP program.  So, banks didn’t need to lend the money to get things moving, the government solved that part of the equation. Much of that money wound up directly in the economy (although certainly some found its way into RobinHood accounts and Bitcoin), thus amping up demand.  At the same time, the lockdowns around the world resulted in broken supply chains, meaning many goods were in short supply.  This resulted in the classic, more money chasing fewer goods situation, which leads to higher prices.  This helps explain the trajectory of inflation since the initial Covid impact, where prices collapsed at first, but have now been rising back sharply.  While they have not yet reached pre-Covid levels, it certainly appears that will be the case soon.

Which leads us back to the question of, what will prevail?  Will the rebound continue, or will the long-term trend reassert itself?  This matters for two reasons.  First, we will all be impacted by rising inflation in some manner if it really takes off.  But from a markets perspective, if US inflation is rising rapidly, it will put the Fed in a bind with respect to their promise to keep rates at zero until the end of 2023.  If the market starts to believe the Fed is going to raise rates sooner to fight inflation, that will likely have a very deleterious effect on equity and bond prices, but a very positive effect on the dollar.  The combination of risk-off and higher returns will make the dollar quite attractive to many, certainly enough to reverse the recent downtrend.

Lately, we are seeing the beginnings of this discussion, which is why the yield curve has steepened, why stock markets have stalled and why the dollar has stopped sliding.  Fedspeak this week has been cacophonous, but more importantly has shown there is a pretty large group of FOMC members who see the need for tapering policy, starting with reducing QE, but eventually moving toward higher rates.  Yesterday, uber-dove Governor Lael Brainerd pushed back on that story, but really, all eyes will be on Chairman Powell this afternoon when he speaks.  To date, he has not indicated a concern with inflation nor any idea he would like to taper purchases, so any change in that stance is likely to lead to a significant market response.  Pay attention at 12:30!

With that as backdrop, a quick tour of the markets shows that risk appetite is moderately positive this morning.  While the Nikkei (+0.85%) and Hang Seng (+0.9%) both did well, Shanghai suffered (-0.9%) despite data showing record export performance by China last year.  Europe is far less exciting with small gains (DAX +0.2%, CAC +0.1% and FTSE 100 +0.7%) following Germany’s release of 2020 GDP data showing a full-year decline of “just” -5.0%, slightly less bad than expected.  US futures are mixed at this hour, but the moves are all small and offer no real news.

Bond markets show Treasury yields higher by 2bps, while European bonds have all seen yields slip between 1.0 and 1.7bps, at least the havens there.  Italian BTP’s are selling off hard, with yields rising 5.7bps, and the rest of the PIGS have also been under pressure.  Oil prices are little changed this morning, still holding onto their gains since November.  Gold prices are slightly softer and appear to be biding their time until the next big piece of news hits.

Finally, the dollar is somewhat mixed this morning, with the G10 basically split between gainers and losers, although the gains have been a bit larger (AUD +0.4%, SEK +0.3%) than the losses (CHF -0.2%, JPY -0.1%).  But this looks like position adjustments and potential order flow rather than a narrative driven move.  EMG currencies are also split, but there are clearly more gainers than losers here, with the commodity bloc doing best (ZAR +0.85%, RUB +0.65%, BRL +0.6%) and losses more random led by KRW (-0.25%) and CZK (-0.2%).  If pressed, one needs look past oil and gold to see agricultural commodities and base metals still performing well and supporting those currencies.  KRW, on the other hand is a bit more confusing given the growth in China, it’s main exporting destination.  Again, position adjustments are quite viable given the won’s more than 11% gain since May.

This morning’s data slate includes only Initial Claims (exp 789K) and Continuing Claims (5.0M), which if far from expectations could wiggle markets, but seem unlikely to do so as everyone awaits Powell’s speech.  Until then, I expect that the dollar will continue to remain supported, but if Powell reiterates a very dovish stance, we could easily see the dollar head much lower.  Of course, if he gives credence to the taper view, look for some real market fireworks, with both bonds and stocks selling off and the dollar jumping sharply.

Good luck and stay safe
Adf

The UK’s Current Plight

In England, the doves are in flight
Explaining that NIRP is alright
But hawks keep maintaining
That zero’s restraining
Despite the UK’s current plight

What we’ve learned thus far in 2021 is that Monday is risk-off day, at least, so far.  Yesterday, for the second consecutive week, risk was under pressure as equity markets everywhere fell, while the dollar rallied sharply.  But just like last week, where risk was avidly sought once Monday passed, this morning has seen a rebound in many equity markets, as well as renewed pressure on the dollar.

But aside from a very early assessment of a potential pattern forming, this morning brings a dearth of market-moving news.  Perhaps the most interesting is the battle playing out inside the BOE, where Silvana Tenreyo, one of the more dovish MPC members, has been making the case that in the current situation, the UK should cut the base rate into negative territory.  Her analysis, as well as that of other central banks like the ECB, SNB and Danish central bank, have shown that there are many benefits to the policy and that it has been quite effective.  Of course, those are three of four central banks (the BOJ is the other) that currently maintain negative rates, so it would be pretty remarkable if those studies said NIRP was a failure.  The claim is that NIRP increases the amount of lending that banks extend, thus encouraging spending and investment as well as weakening the currency to help the export industries in the various countries.  And the studies go on to explain that all these factors help drive inflation higher, a key goal of each of those central banks.

Now, there is no question that those are the theoretical underpinnings of NIRP, alas, it is hard to find the data to support this.  Rather, these studies tend to give counterfactual analyses, that indicate if the central banks had not gone negative, things would have been worse.  For instance, let’s look at CPI in the Eurozone (-0.3%), Switzerland (-0.8%) and Denmark (+0.5%).  Not for nothing, but those hardly seem like data that indicate inflation has been supported.  In fact, in each of these countries, inflation was going nowhere fast before the pandemic, although I will grant that Covid has depressed the numbers further to date.  And how about the currency?  Well, one of the biggest stories of the past six months has been how the dollar has declined nearly 10% against these currencies.  Once again, the concept of a weaker currency seems misplaced.

The point here is that the discussion is heating up in the UK, with the independent MPC members pushing for a move below zero, while the BOE insiders are far more reluctant, explaining that the banking system would see serious harm.  (I think if one looks at the banking system in Europe, it is a fair statement that the banks there are not performing all that well, despite (because of?) 6 years of NIRP.  The BOE counterpoint was made this morning by Governor Bailey who explained there were still many issues to be addressed and implied NIRP was not likely to be implemented in the near future.  With all this as background, it should be no surprise that the pound has been the best performer in the G10 today, rising 0.6%, after Bailey’s comments squashed ideas NIRP was on its way soon.

But the dollar, overall, is softer today, not nearly reversing yesterday’s gains (except vs. the pound), but generally under pressure.  However, there is precious little that seems to be driving markets this morning, other than longer term stories regarding fiscal stimulus and Covid-19.

So, a quick tour of markets shows that Asian equity markets shook off the weakness in the US yesterday and rallied nicely.  The Nikkei (+0.1%) was the laggard, as the Hang Seng (+1.3%) and Shanghai (+2.1%) showed real strength.  Europe, on the other hand, is showing a much more mixed picture, wit the DAX (+0.1%) actually the best performer of the big 3, while the CAC (0.0%) and FTSE 100 (-0.6%) are searching for buying interests.  The FTSE is likely being negatively impacted by the pound’s strength, as there is a narrative that the large exporters in the index are helped by a weak pound and so there is a negative correlation between the pound and the FTSE.  The problem with that is when running the correlation analysis, over the past two years, the correlation is just 0.08% and the sign is positive, meaning they move together, not oppositely.  But it is a nice story!  And one more thing, US futures are green, up about 0.25% or so.

Bond markets are selling off this morning as yields continue to rise on expectations that the future is bright.  10-year Treasury yields are up to 1.16%, which is a new high for the move, having rallied a further 1.2bps this morning.  But we are seeing the same type of price action throughout Europe, with yields higher by between 1.7 bps (Bunds) and 4.0bps (Italian BTP’s), with Gilts (+2.3bps) and OATs (+2.0bps) firmly in between.  What I find interesting about this movement is the constant refrain that H1 2021 is going to be much worse than expected, with the Eurozone heading into a double dip recession and the US seeing much slower than previously expected growth as many analysts have downgraded their estimates to 1.0% from 4.0% before.  At the same time, the message from the Fed continues to be that tighter policy is outcome based, and there is no indication they are anywhere near thinking about raising rates.  With that as background, the best explanation I can give for higher yields is concerns over inflation.  Remember, CPI is released tomorrow morning, and since the summer, almost every release was higher than forecast.  As I have written before, the Fed is going to be tested as to their tolerance for above target inflation far sooner than they believe.

The inflation story is supported, as well, but this morning’s commodity price moves, with oil higher by 1.3% and gold higher by 0.8%.  In fact, I believe that inflation is going to become an increasingly bigger story as the year progresses, perhaps reaching front page news before the end of 2021.

Finally, as mentioned above, the dollar is under broad-based, but generally modest pressure this morning.  After the pound, AUD (+0.35%) and CAD (+0.25%) are the leading gainers, responding to the firmer commodity prices, although NOK (0.0%) is not seeing any benefit from oil’s rise.  In the EMG space, it is also the commodity linked currencies that are leading the way, with ZAR (+0.9%), RUB (+0.8%) and MXN (+0.5%) topping the list.  Also, of note is the CNY (+0.3%) which is back to levels last seen in June 2018, as the strengthening trend their continues.

On the data front, the NFIB Small Business Optimism index showed less optimism, falling to 95.9, well below expectations, again pointing to a slowing growth story in H1.  The only other data point from the US is JOLT’s Job Openings (exp 6.4M), which rarely has any impact.  I would like to highlight, in the inflation theme, that Brazilian inflation was released this morning at a higher than expected 4.52% in December, which is taking it back above target and to levels last seen in early 2019.  If this continues, BRL may become a high yielder again.

Finally, we hear from 6 different Fed speakers today, but again, unless they all start to indicate tighter policy, not just better economic outcomes, in H2, while the dollar may benefit slightly, it will not turn the current trend.  And that’s really the story, the medium-term trend in the dollar remains lower, but for now, absent a catalyst for the next leg (something like discussion of YCC or increased QE), I expect a bit of choppiness.

Good luck and stay safe
Adf

Blue Wave at Last

Psephologists have now decided
The run-off election provided
A blue wave at last
So laws can be passed
Republicans view as misguided

The market responded by sellin’
The 10-year, with traders foretellin’
Inflation to come
As Powell stays mum
While financing Treasury’s Yellen

While the election results from Georgia are not yet final, the indications at this time are that the Democratic party won one of the seats with the second one still too close to call.  However, the market has already made its decision, that both seats flipped to the Democrats and that the Senate will now be split 50:50, which means that the Vice President will be able to cast the deciding vote.  The clear implication is that, while hardly a mandate, the Democrats will control both the executive and legislative branches and be able to implement a great deal of their agenda.  In other words, the blue wave high tide has finally crested.

The initial reaction to this news has been seen in the sell-off of the 10-year Treasury, where the yield has risen to 1.02% as I type, its first foray above 1.00% since March 19th, during the first days of the Covid-19 market panic.  The reflation trade is back in vogue, with expectations now that the new administration will be aggressively adding fiscal stimulus, thus increasing Treasury issuance significantly and ultimately steepening the yield curve as demand for long-dated Treasuries will not be able to keep pace with the new supply.  However, given the already record levels of debt outstanding, the government simply cannot afford for interest rates to rise too far, as if they do, interest payments will soak up an ever-increasing proportion of available revenues.  It is for this reason that I continue to believe the Fed will increase their current activity, and whether tacitly, by expanding QE and extending the maturity of purchases, or explicitly, by setting a yield target, implement Yield Curve Control (YCC).

At the same time, the Fed has made it abundantly clear that higher inflation is of no concern to the committee.  The latest proof comes from Chicago Fed President Charles Evans, who explained to us yesterday, “Frankly, if we got 3% inflation, that would not be so bad.  It is very difficult to imagine out of control inflation, even with the large debt that fiscal authorities have been running up.”   Perhaps, as a Regional Fed President, he simply lacks imagination.  After all, just yesterday, almost at the same time he was recounting his views, the ISM Prices Paid index printed at 77.6, well above expectations and at a level seen only twice, briefly, in the past decade.  There is a strong correlation between this index and PPI, so the idea that inflation pressures are building is hardly unimaginable.

Which brings us back to the prospects for the dollar, as well as other markets.  While yields have climbed today, the prospect of inflation rising more rapidly and real rates falling further into negative territory still informs my view that the dollar has further to decline.  This will become more obvious when the Fed steps in to prevent the rise in nominal yields, which I am confident will occur sooner rather than later.  Again, while I don’t anticipate a dollar collapse, as other central banks will fight to prevent such an outcome, further dollar weakness is in the cards.

Speaking of other central banks fighting the dollar’s weakness, last night the PBOC started to do just that by establishing the CNY fix at a weaker renminbi rate than anticipated.  Since August 1st, CNY has appreciated by nearly 8% vs. the dollar, which for an economy that remains heavily reliant on exporting for GDP growth, is a growing problem.  As the PBOC makes no bones about directing the value of the currency, you can expect that they will be actively managing the renminbi’s value going forward in an effort to prevent too much further strength.  But, as long as both nominal and real yields remain positive in China, that will attract significant capital flows and continue to pressure the renminbi higher.

So, what has all this news done to other markets?  Well, most of Europe is ecstatic at the election outcome, at least that seems to be the case based on the rallies seen in equity markets there.  The FTSE 100 (+2.3%) is leading the way, but we are seeing strong gains in the DAX (+0.9%) and CAC (+0.8%) as well, despite the fact that the PMI Services data disappointed across the board.  The story in Asia was more mixed with the Nikkei (-0.4%) and Australia (-1.1%) underwhelmed by the outcome, although the Hang Seng (+0.2%) and Shanghai (+0.6%) both wound up in the green.  As to US futures, as I type, they are a mixed bag, with DOW futures higher by 0.2%, SPU’s lower by 0.4% while NASDAQ futures are down 2.0%.  The latter’s decline are a response to the election results as concerns grow that Big Tech will now be in the crosshairs of Congress for more regulation if not outright dismemberment.

While we have already discussed the Treasury market, European government bonds are mostly softer today as well, with yields rising as much as 4bps in the UK, although German bunds are unchanged on the session.

Another inflationary impulse comes from oil, where yesterday the Saudis surprised the market by unilaterally cutting production by 1 million barrels/day helping to take WTI above $50/bbl for the first time since late February.  If this rally continues, look for gasoline prices to creep higher, one of the key sentiment indicators regarding the perception of inflation.

And finally, the dollar remains broadly under pressure this morning, with NOK (+0.75%) the leading gainer in the G10 on the back of the oil rally, although both AUD (+0.6%) and NZD (+0.65%) are also having a good day as both commodity prices gain and they serve as a proxy for Asian growth.  Meanwhile, the euro (+0.35%) is trading at new highs for the move and back to levels not seen since April 2018.

Emerging market currencies are universally higher this morning, led by PLN (+0.85%), MXN (+0.8%) and HUF (+0.8%).  Those stories are easy to see, with oil helping the peso, while the CE4 currencies are tracking the euro’s strength.  Asian currencies, while all firmer, did not show nearly the enthusiasm, with gains between 0.1% and 0.2%, but of course, the election results were not fully known during their session.

On the data front, this morning brings ADP Employment (exp 75K) as well as Factory Orders (0.7%) and the PMI Services index (55.2).  Then, this afternoon, we see the FOMC Minutes of the December meeting, one where they disappointed many folks by not easing further. The first thing to note is that after yesterday’s ISM data, the ADP forecast increased from 50K.  Clearly, the manufacturing sector remains in better shape than expected.  At the same time, the Minutes ought to be interesting as perhaps we will learn more about attitudes regarding any prospects for what could change policy.  Of course, given the world was a different place then, and as Evans explained, inflation is of no concern, the real question from the Minutes will be what will the Fed do next to ease further.

As to the dollar, it is hard to see a short-term path in any direction other than lower, but I continue to expect the decline to be slow and orderly.

Good luck and stay safe
Adf

No Antidote

In Georgia, today’s runoff vote
For Senate is no antidote
To nationwide fears
The quartet of years
To come, more unease, will promote

Investors expressed their dismay
By selling stocks all yesterday
As well, though, they sold
The buck and bought gold
Uncertainty’s with us to stay

Markets certainly got off to an inauspicious start yesterday as a number of concerns regarding upcoming events, as well as the possibility that some markets are overextended, combined to induce a bit of risk reduction.  Clearly, the top story is today’s runoff election in Georgia, where both US Senate seats are up for grabs.  The Republicans currently hold a 50-48 majority, but if both seats are won by the Democratic candidates, the resulting 50-50 tie will effectively give the Democrats control of the Senate as any tie votes will be broken by the Vice-President.  In that event, the Democrats should be able to institute their platform which, ostensibly, includes infrastructure spending, the Green New Deal, or parts thereof, and more substantial stimulus to address the impact of the coronavirus.

This blue wave redux has been a key topic in markets of late.  You may recall that heading into the election in November, when the polls were calling for the original blue wave, the market anticipated a huge amount of fiscal stimulus driving significantly larger Federal budget deficits.  The ensuing Treasury bond issuance required to fund all this spending was expected to result in a much steeper yield curve, a continuing rally in the stock market as the economy recovered (and this was before the vaccine) and a declining dollar.  As the runoff election approached, markets started to replay that scenario which has, until yesterday, led to successive new all-time high closes in equity indices as well as a steeper Treasury yield curve.  As well, the dollar has remained under pressure, as that remains one of the strongest conviction trades of 2021.

But yesterday, and so far this morning, we are seeing a potential change of heart, or perhaps just a note of caution.  Because if the Republicans retain one of the two seats, that will put paid to the entire blue wave hypothesis.

Of course, there is another possibility that is driving investor caution, and that is the idea that markets, especially equity markets, remain extremely frothy at current levels.  Certainly, on a historical basis, valuation indicators like P/E or Shiller’s CAPE, or Price/Book or even Total Market Cap/GDP are at historically high extremes.  Is it possible that the market has already priced in every conceivable positive event to come?  There are those who would make that argument, and if they are correct, then the required catalyst for a correction of some sorts is likely not that large.  For instance, if the Republicans win even one seat, the entire stimulus bandwagon may never get going, let alone any of the more widescale projects.  And that could well be enough to force a rethinking of the endless stimulus theory with a resultant revaluation of investment risks.

One of the things that always bothered me about the blue wave hypothesis was the idea that the Treasury yield curve would steepen, and the dollar would decline.  Historically, a steeper yield curve has indicated a strengthening US economy which has drawn investment and strengthened the dollar.  I don’t believe that relationship will change, however, a weaker dollar does make sense if you consider how the Fed is likely to respond to rising Treasury yields; namely with Yield Curve Control (YCC).  The US government cannot afford for interest rates to rise substantially, especially as the amount of debt issued continues to grow rapidly.  In fact, the only way it can continue to pay interest on the growing pile of debt is to make sure that interest rates remain at historically low levels.  The implication is that if the Treasury continues to flood the market with issuance, the Fed will be required to buy all of it, and then some, in order to prevent yields from rising.  And whether it is explicit, or implicit, that YCC is going to result in increasingly negative real yields in the US (as inflation is almost certainly going higher).  Now, if you wanted a catalyst to drive the dollar lower, increasing negative real yields is a perfect solution.  While that may not be such a benefit for investors and savers, it will help the Fed retain the upper hand in the global policy ease race, and with it, help undermine the value of the dollar.  It is, in fact, the basis for my views this year.  All that from the Georgia run-off elections!  Who would have thunk?

As to markets this morning, yesterday’s weakness remains fairly widespread in the equity space, as all European bourses are lower (DAX -0.4%, CAC -0.5%, FTSE 100 -0.1%) after a mixed Asian session (Nikkei -0.4%, Hang Seng +0.6%, Shanghai +0.7%).  In fact, Shanghai reached its highest level since August 2015, the previous bubble we saw there.  US futures, meanwhile, are little changed at this hour as traders await the first indications from the Georgia elections.

Bond markets are broadly lower this morning, with Treasury yields higher by 1.3bps and most European bonds showing similar rises in their yields.  On the one hand this is unusual, as bonds generally benefit from a risk off mood.  On the other hand, if I am correct about the move toward negative real yields, bonds will not be a favored investment either and could well underperform going forward, at least until the central banks increase their purchases.

Another beneficiary of negative real yields in the US is gold, which rallied sharply yesterday, more than 2%, and is up a further 0.3% this morning, back at $1950/oz.  Oil, meanwhile, is starting to move higher as well, up 1.8%, as some optimism over the outcome of the OPEC+ meeting is adding to the broad commodity rally.

And finally, the dollar is generally weaker this morning, down against all its G10 counterparts and many of its EMG counterparts as well.  In the G10, SEK (+0.6%) is the leader, which appears to simply be an example of its higher beta relative to the euro or pound vs. the dollar. But we are also seeing the commodity bloc perform well (AUD +0.5%, CAD +0.3%, NOK +0.3%) alongside their main exports.  However, this is clearly a dollar weakness story as the yen (+0.25%) is rallying alongside the rest of the bloc.

Interestingly, in the EMG group, ZAR (-1.35%) is the worst performer, followed by RUB (-0.6%), neither of which makes sense based on the G10 performance as well as that of commodities.  However, it is important to remember that short dollar is one of the most overindulged positions in markets, and the carry trade has been a favorite with both these currencies benefitting from that view.  This looks like a bit of position unwinding more than anything else.  On the positive side in this bloc, the CE4 remain solid and are leading the way, while LATAM currencies are little changed on the open.

On the data front, this week brings a lot of new information culminating in the payroll report on Friday.

Today ISM Manufacturing 56.7
ISM Prices Paid 65.0
Wednesday ADP Employment 50K
Factory Orders 0.7%
FOMC Minutes
Thursday Initial Claims 803K
Continuing Claims 5.1M
Trade Balance -$67.3B
ISM Services 54.5
Friday Nonfarm Payrolls 50K
Private Payrolls 50K
Manufacturing Payrolls 16K
Unemployment Rate 6.8%
Average Hourly Earnings 0.2% (4.5% Y/Y)
Average Weekly Hours 34.8
Participation Rate 61.5%
Consumer Credit $9.0B

Source: Bloomberg

Last Thursday saw a stronger than expected Chicago PMI and yesterday’s PMI data was strong as well, so the economy remains a bit enigmatic, with manufacturing still robust, but services in the dumps.  The payroll expectations are hardly inspiring, and with lockdowns growing in the States, as well as worldwide, it doesn’t bode well for Q1 at least, in terms of GDP growth.  We also hear from seven Fed speakers this week, which could well be interesting if anyone is set to change their tune regarding how long easy money will remain the norm.  However, I doubt that will happen.

The dollar remains on its back foot here, and I see no reason for it to rebound in the short run absent a change in the underlying framework.  By that I mean, something that will imply real yields in the US are set to rise.  Alas, I don’t see that happening in the near future.

Good luck and stay safe
Adf

The Dollar’s Fate (In the Coming Year)

With apologies to Henry Wadsworth Longfellow

Listen, my children, and you shall hear
Of the dollar’s fate in the coming year
In the wake of a time that’s ne’er been seen
Since the Spanish Flu of Nineteen Eighteen
Perhaps Twenty-One will bring joy, not fear

Recapping Twenty shows that despite
A plague of biblical magnitude
The printing press revealed its might
As governments everywhere, debt, accrued
And flooded the markets with cash untold
(The better their citizens be controlled)
But all of that money was used, not for,
Increased production of goods onshore
Instead, for the purchase of stocks galore

Thus, equity markets at home rose higher
With Asia, too, on proverbial fire
Though Europe lagged, as the ECB
Was late to the party with more QE
Risk was embraced with a multiplier
Government bonds, though falling of late
Had seen yields tumble, year-to date
And lastly, the dollar, is now descending
As traders await this trend extending

Looking ahead, what can we expect?
Has Covid passed? Will ‘normal’ return?
Or are there surprises we’ve yet to learn?
Will stocks continue their flights of fancy?
Will bonds, inflation, at last detect?
Will dollars, everyone, start to spurn?
Will gold and bitcoin still seem chancy?

Regarding the virus, it’s not dead yet
Though hope springs eternal, and at last
The vaccines imply the worst has passed
But life, as we knew it, has been reset
Working from home (or living at work)
Is mainstream now, and not just a quirk
Office demand will certainly slide
And travel for business will lessen worldwide
Normal has changed, for boss and for clerk

Let us now speak of growth and inflation
Will growth improve on last year’s “success”?
Or will it instead fall flat and regress
Lockdown renewals bode ill for salvation
Policymakers constantly flail
As policy efforts constantly fail
Stimulus, fiscal, continues to flow
Interest rates are now forevermore low
Central banks tell us that this combination
Is perfect to counter a fearful stagnation
But in their efforts, good times to hail
The rising of prices will bypass their gaze
Leading to many more difficult days
GDP this year will struggle to One
Inflation, however, at Four, will not stun

How, then, will markets respond to this fate?
Equity prices at first will inflate
By spring, though, ‘twill be clear something’s amiss
Traders, their holdings, will start to truncate
While we shall not tumble into the abyss
Do not be shocked if the market does fall
Some twenty percent, at the least, is my call
What about bonds? How will they react?
Powell will ne’er let their prices contract
Yield Curve Control is the future we’ll see
Alongside the horror of pure MMT
Hence, ten-year bonds when December arrives
Will keep up their value, a cat with nine lives
One percent will be the height they attain
Implying the real yield most certainly dives
And so, the dollar will suffer great pain

Starting in Europe where Madame Lagarde
Is trying to keep up with Fed Chairman Jay
Sadly, what’s clear, at the end of the day
The ECB’s structure will make it too hard
While Fed and the Treasury work hand in hand
Pushing more money throughout all the land
Treaties in Europe have outcomes, unplanned
PEPP’s not enough for a rebound unscarred

Even though growth throughout Europe will sag
Even though prices will still be a drag
Nothing Lagarde can create will impact
The outcome, a euro that’s sure to move higher
Thus, if it’s something you need to acquire
At year-end, One-Thirty, you’ll need, that’s a fact

Tumultuous best describes last year’s UK
Twixt Covid and Brexit, the nation felt pain
Unhappily, this year, to Johnson’s dismay
Could worsen for every old bloke on the street
With growth in the toilet while prices show heat
It doesn’t seem much like Pound Sterling could gain

But real rates keep diving throughout the US
Offsetting those troubles, so if you need quid
Come Christmas, One-Fifty, if I had to guess
Is what they will cost as the dollar’s declined
Looking elsewhere, perhaps north of the border
Canada still seems a bit out of order
Oil’s rebounded but still seems confined
Meanwhile, housing there is quite well bid

However, again, it is Fed Chairman Jay
Who’s promised support for considerable time
Thus, when we get to our next Boxing Day
One-Fifteen for Loonies you’ll see on your screen
Eastward now, let’s turn our gaze as we glean
Whether the yen can continue its climb
Long-term, the dollar, its trend has been clear
Even before the debasement of late
Several percent, like a clock every year
Why would this year, something new, demonstrate?

Frankly, it won’t, as the Fed’s in control
Rather, the yen, will continue to roll
So, Winter Solstice this year will reveal
Dollar-Yen, Ninety-Six, where you can deal
Let us turn now to both future and past
Bitcoin and gold, which have both been amassed
Can both their prices continue to rise?
Certainly, as they’ve restricted supplies

For centuries, gold has defined what’s secure
Its glitter unblemished while paper’s debased
So, don’t be surprised if the relic’s embraced
As buyers pay Three Grand their wealth to insure
But youth has ideas which to many seem odd
And bitcoin is one such that’s been called a fraud
So, is it? Or is Bitcoin digital gold?
An updated version important to hold
As fiat debasement continues apace
This digital token gains further allure
And this year it seems Bitcoin’s making its case
As something that everyone needs to procure

It’s starting this year right around thirty grand
And hodlers believe that ‘tween here and the sky
Unless countries call for Bitcoin to be banned
A doubling or tripling’s the gain they’ll apply
One last thing I’ll highlight in digital space

The DCEP is now leading the race
This digital yuan, the first CBDC
Is coming soon courtesy of Mr Xi
It’s impact initially is quite unclear
But I guarantee that inside of a year
Nations worldwide will each roll out their own
And each will define a DC trading zone

While last year was filled with surprises galore
This year we’re likely to see many more
And finally, thank you, my readers and friends
For listening to all the twists and the bends
Now looking ahead to Twenty Twenty-One
Let’s all keep perspective and try to have fun.

Good luck, stay safe and have a wonderful new year
Adf

DCEP = Digital Currency / Electronic Payment
CBDC = Central Bank Digital Coin

Much Bluer Skies

Ahead of the Fed, PMI’s
From Europe were quite a surprise
It seems that despite
The lockdowns in sight
The future has much bluer skies

Preliminary PMI data from around the world this morning is the market’s key focus, at least until 2:00 this afternoon when we hear from the Fed.  But, in the meantime, the much better than expected readings surprised the market and are driving yet another increase in risk appetite.  (One wonders if that appetite will ever be sated!)

Starting in Asia, Australian data was considerably stronger than last month, with the Composite figure printing at 57.0, its second highest print in the (short) history of the series.  On the other hand, Japanese data was the sole disappointment, with the Composite slipping 0.1 to 48.0, still pointing to a contracting economy.  The European numbers, however, were all much better than expected with Germany printing 2 points higher than expected at 52.5 on the Composite while France (49.6 Composite) actually beat expectations by 6.6 points.  As such, the Eurozone Composite PMI printed at 49.8, significantly better than expectations of a 45.7 print.  The point here is that while the Eurozone economy is hardly booming (other than German manufacturing), there is a clear sense that the worst may be behind it.

Of course, what makes this so surprising is that the German government has shuttered non-essential businesses until January 10th, with hints that could be extended, after the largest single day fatality count was recorded yesterday.  We are also hearing from other European countries, (France and Italy), that further lockdowns and restrictions on gatherings are being considered as the second (third?) wave of Covid-19 sweeps across the continent.  Yet, not only markets, but businesses have clearly grabbed hold of the idea that the vaccine is going to lead to a swift end to the government intervention in virtually every economy and allow economic activity to resume as it was before.

The spanner in the works, as it were, is that governments are loathe to cede power and control once it is obtained.  If this holds true again, then businesses need to be prepared to have far more rules and restrictions imposed on their operations, something which is typically not associated with an economic boom.  However, for now, it appears that the prospect of the tightest restrictions being lifted outweighs the potential longer-term negative impacts of intrusive government.  So, as Timbuk 3 explained back in 1986, “The Future’s So Bright (I Gotta Wear Shades).

With that in mind, a quick turn to the FOMC meeting today shows us that the market consensus is for no policy changes in scope or size, but rather, more clarity on what is required for the Fed to consider tighter policy in the future.  Expectations continue to center on achieving a specific Unemployment Rate or Inflation Rate or, probably, both in combination.  Perhaps Chairman Powell will resurrect the Misery Index (not the current show on TBS, but the original one defined by Ronald Reagan, when he was running for president in 1980, as the sum of inflation and unemployment.)  For instance, a target of 3.5% Unemployment and 2.0% Inflation would seem to be right where policymakers would be thrilled.  Alas, today we are looking at a reading of 7.9%, with a poor mixture to boot (Unemployment 6.7%, CPI 1.2%).  However, as long as Congress fails to pass a new fiscal stimulus bill, do not be too surprised if the Fed does change the program, with my bet being on Operation Twist redux, where they extend the maturities of their current purchases.  We will find out at 2.

Turning to the markets, all that hunger for risk has shown up in all markets today, with equities and commodities broadly firmer while bonds and the dollar are broadly weaker.  Last night, following the strong equity performance in the US yesterday, we saw less impressive, but still positive price action in Asia with the Nikkei (+0.3%) and Hang Seng (+1.0%) both rallying although Shanghai was flat on the day.  Europe, however, has embraced the PMI data, as well as word that a Brexit deal is approaching (told ya so!) and markets there are all much firmer; DAX (+1.6%), CAC (+0.7%), FTSE 100 (+1.0%).  Finally, US futures are actually the laggards this morning, with all three in the green but the magnitude of those gains more muted than one might have expected, in the 0.2%-0.3% range.

Bond markets have come under pressure as there is certainly no case to own a low yielding haven asset when one can be gorging on risk, but the price declines are far larger in Europe (Bunds and OATs +3.7bps, Gilts +2.7bps) than in the US (Treasuries +1.0bp).  Interestingly, even the PIGS bonds are selling off as it appears Portugal is not quite so interesting a place to hold your cash when the yield there is -0.04% on 10-year paper!

Commodities are firmer, with gold having a second strong performance in a row, up 0.4% this morning, and oil prices are also drifting higher, albeit barely so at this hour.  And finally, the dollar is under significant pressure this morning after breaking through several key technical levels, with only CAD (-0.4%) underperforming in the G10.  And in truth, I cannot find a good reason for the decline as there don’t appear to be either technical or fundamental reasons evident.  On the other side, though, NOK (+0.45%) and GBP (+0.4%) are the leading gainers, although the rest of the space is higher by about 0.3%.  Aside from the Brexit hopes, this is all really about the dollar and the ever-growing conviction that it has much further to fall as 2021 approaches and unfolds.

As to the emerging markets, the CE4, taking their cues from the euro, are leading the way with CZK (+0.75%) and PLN (+0.6%) at the head of the pack.  Beyond those, the gains are less impressive, on the order of 0.2%-0.3%, with APAC currencies little changed overnight and LATAM currencies opening with less oomph than we are seeing in Europe.

On the data front, ahead of the FOMC this afternoon, we see Retail Sales (exp -0.3%, +0.1% ex autos) and then the preliminary PMI data as well (55.8 Manufacturing, 55.9 Services).  My sense is stronger than expected data would have only a limited impact on the dollar, but if the data is weak, another wave lower seems quite possible.

And that is really what we have today.  For now, the dollar is under pressure and likely to remain so.  At 2:00, there is potential for an additional leg lower, if the Fed opts to increase QE or extend maturities, but I cannot make a case for the dollar to benefit from their announcement.  In fact, for now, the only thing that can help the dollar is the fact that it has already moved a long way, and it could be due for a simple trading correction.

Good luck and stay safe
Adf

Unrequited

It cannot be very surprising
That Boris and friends keep devising
More reasons to talk
Yet both sides still balk
At genuinely compromising

For now, though, the market’s delighted
With risk appetite reignited
Pound Sterling has soared
With stocks ‘cross the board
Though bond love has been unrequited

Aahh, sweet temptation.  I’m sure most of us know, firsthand, how difficult it can be to impose self-control when it comes to something we really want, but know we shouldn’t have, like that extra cookie after dinner.  Or perhaps, it is the situation of something we really don’t want, but know we need, like that trip to the dentist.  In either case, getting ourselves to do the right thing can be an extraordinary struggle.  That is the best analogy I can find for the countless Brexit trade talk deadlines that have been made and passed since the actual Brexit agreement was signed on January 31, 2020.

You may recall last Thursday’s dinner date between Boris and Ursula, where the outcome was a declaration that if a deal could not be reached by the weekend’s close (yesterday), none would ever come.  The thing about Brexit deadlines, however, is that they only exist in the mind of the individual setting them.  It appears to be a tool designed to impose self-control on the speaker.  However, like so many of us, when we claim we will eat only one cookie, we find the temptation to eat another too great to ignore.  This appears to be the same situation when it comes to establishing Brexit talk deadlines, both sides really want a deal, and hope that a deadline will be the ticket to finding one that can be agreed.  But in the end, the only true deadline is the one inscribed in the Brexit agreement, which is December 31, 2020.  And with that as prelude, it is quite clear that the latest deadline has been ignored, and both sides have explained that a deal is within reach and they will continue talking, right up until New Year’s Eve if necessary.

This past Friday, there were rumors rampant that the whole situation would fall apart, and that risk would be jettisoned as soon as markets opened in Asia last night.  Expectations were for a huge Treasury rally, with sharp declines in stock markets.  But for now, that situation remains on hold, and the good news has inspired further risk acquisition, with most equity markets solidly higher along with oil while bonds are selling off along with the dollar.

As I have maintained for the past several months, despite all the rhetoric on both sides, the most likely outcome remains a successful conclusion to the talks.  It is unambiguously in both sides’ interest to agree a deal, and everything that we have seen has been for each sides’ domestic constituents as proof they fought to the last possible second and got the best deal possible.  In fact, part of me believes a deal has already been agreed, it just hasn’t yet been revealed as the timing is not propitious for both sides.  Whatever the situation, though, for now, the market has been satisfied that there is nothing imminent that is going to stop the risk rally.

And that pretty much sums up the session, there is nothing imminent that is going to stop the risk rally.  Looking ahead for the week, Retail Sales on Wednesday morning is arguably the most important data point, but of more importance is the FOMC meeting that same day, with the afternoon statement and press conference.  We will focus on that tomorrow and Wednesday, but as of now, there is no change expected in either the interest rate structure or quantity of QE, but there is some discussion of a change in tenor of QE purchases.

With all that in mind, then, let us look at markets overnight.  As discussed, risk appetite is growing as a combination of the positive Brexit story and the first rollouts of the Covid vaccine encourage the outlook that the timeline for reigniting economic growth is nearing.  Adding to this story is the news that a US fiscal stimulus bill may be close to being agreed, and, naturally, we know that every central bank will continue to add liquidity to the markets for as long as they deem fit, which currently seems to be indefinitely.  Interestingly, this is all occurring despite Germany imposing renewed harsh lockdowns through January, and word that we are going to see the same in Italy, Spain and the UK.

But here’s what we have seen.  Asian equity markets were generally positive (Nikkei +0.3%, Shanghai +0.7%) although the Hang Seng (-0.4%) lagged.  European markets are all higher, with some pretty good gains (DAX +1.25%, CAC +1.1%) although the FTSE 100 (+0.4%) is lagging on the strength of the pound, which negatively impacts so many companies in the index.  And finally, US futures are all green with gains between 0.6% and 0.9%.

Bond markets are selling off, which should be no surprise, with Treasury yields higher by 2.5 bps, although most of Europe has seen more moderate price declines, with yields higher by less than 2 basis points across the board.  With one exception, UK gilts have seen yields rise 6.7 basis points, as hopes for a Brexit deal have led to a lot of unwinding of Friday’s rally.

Meanwhile, oil prices are firmer (WTI +1.1%) but gold is actually softer (-0.7%) despite the dollar’s broad weakness.  In the G10 space, GBP (+1.5%) is the leader by far, as renewed hope has forced some short covering.  But the entire bloc is firmer with NOK (+1.1%) benefitting from oil’s rise, while the rest of the group has gained on a more general risk appetite with gains between 0.2% (CAD) and 0.6% (SEK).  The surprise here is JPY (+0.3%) which given the risk attitude, would have been expected to decline as well.

EMG currencies are mostly firmer, but the move seems to have ignored peripheral APAC currencies, where a group have seen very modest declines of 0.1% or so.  On the plus side, however, ZAR (+1.0%) leads the way, despite weaker gold prices, as Consumer Confidence data was released at a strong gain compared to Q3.  Elsewhere, BRL (+0.7%) and PLN (+0.7%) are the next best performers, with broad dollar sentiment the clear driver.  In fact, the entire CE4 is strong, as they demonstrate their ongoing high beta performance compared to the euro (+0.35%).

Data this week is really concentrated on Wednesday, but is as follows:

Tuesday Empire Manufacturing 6.9
IP 0.3%
Capacity Utilization 70.3%
Wednesday Retail Sales -0.3%
-ex autos 0.1%
FOMC Rate Decision 0.00% – 0.25%
Thursday Initial Claims 823K
Continuing Claims 5.7M
Philly Fed 20.0
Housing Starts 1533K
Building Permits 1558K
Friday Leading Indicators 0.4%

Source: Bloomberg

So, really, all eyes will be turned toward Washington and Chairman Powell as we await any indication that the Fed is going to change policy further.  Expectations are growing around new forward guidance, for explicit economic targets to be achieved before adjusting rates, but in any case, there is no expectation for rates to rise before the end of 2023.  Perhaps new forecasts and the new dot plot will add some new information, but I doubt it.

For now, risk remains in vogue, and as long as that remains the case, the dollar will remain under pressure.  But don’t expect a collapse, instead a modest decline, at least vs. the G10.  Certainly, there are some emerging currencies, notably BRL, which I think have room to run a bit more.

Good luck and stay safe
Adf

Death Knell

Though dinner was not quite a bust
And everything key was discussed
No deal was secured
And now we’re assured
Past Sunday all hope will combust

The pound, not surprisingly, fell
As traders have heard its death knell
Now eyes have all turned
To Frankfurt, concerned
Christine, Europe’s problems, won’t quell

One need only look at the pound’s performance this morning (GBP -0.8%) to understand that last night’s much touted dinner meeting between Boris and Ursula did not come to any conclusions.  While there appeared to be great comradery all around, and both parties were quick to say they understand how the other side feels, neither was willing to give ground.  The upshot is that the newest deadline appears to be this Sunday coming, when if a deal is not reached, there is a consensus that no deal will be reached in time.  While I continue to believe that this remains political theater, even if Sunday is simply another false deadline, the real deadline is now exactly 3 weeks away, so something needs to happen soon if a no-deal Brexit is to be prevented.  History has shown that deals of this nature, especially in Europe, always come down to the last possible moment.  We shall see if Sunday is that moment.  As to the potential impact on the pound, no-deal could easily take us to 1.25, while a successful conclusion is probably good for 1.40.

On to the day’s other major event, the ECB meeting, where Madame Lagarde is presiding over her fractious team once again as they seek to explain to us exactly what recalibration means.  You may recall that at the October meeting, Lagarde promised that the ECB would “recalibrate” its tools by this meeting.  This has come to be code for increased monetary policy easing of the following nature: €500 billion of additional PEPP purchases and a minimum 6-month extension of both the emergency pandemic program as well as the original QE, the APP (Asset Purchase Program) to run through the end of 2021.  In addition, the TLTRO III program is expected to be extended and expanded.  Expectations are growing that there may be two more tranches of these loans, that the loan tenors may be extended beyond 3 years, and that the interest rate, currently -1.0%, could be cut further.  One of the problems with the TLTRO, though, is that the two biggest users, Italy and Spain, have almost run out of capacity to use more of these loans, so any benefit on this front, even with expansion, is likely limited.

And truthfully, those are really the two key stories of the session so far.  Interestingly, yesterday’s news about an agreement regarding the EU’s pandemic budget seems to have had virtually no impact on the markets as yet.  You may recall that when this was first mooted, back in the summer, and the idea that the EU would issue joint bonds was agreed, many thought this was Europe’s Hamiltonian moment, finally bringing Europe’s fiscal house under one roof, and preparing for great things going forward.  So far, this has not been the case.  But the lack of market response to key steps forward must be a little disheartening for those involved.  Of course, it remains to be seen if this budget is truly the beginning of something new, or simply a response to the Covid pandemic, where Germany and its frugal neighbors felt they had no choice but to accept the outcome.  Certainly, if this is the true way forward, it removes one of the biggest structural impediments to the single currency and opens the way for a secular appreciation.  We shall see.

As to markets today, yesterday’s late day sell-off in the US was followed with modest Asian weakness (Nikkei -0.2%, Hang Seng -0.35%, Shanghai 0.0%) although European bourses have held onto modest gains.  Right now, the FTSE 100 (+0.7%) is leading the way (remember, a weaker pound typically helps the FTSE), with the CAC (+0.3%) and DAX (+0.1%) showing much less promise.  As to US futures, they are very little changed at this hour with no real information from their movement of a few points in either direction.

Bond markets, however, are a little more consistent, generally rallying slightly with yields edging lower.  The biggest mover are UK Gilts, with 10-year yields lower by 5.7 basis points as investors and traders are betting on a weaker UK economy with a no-deal outcome.  After that, the PIGS are doing well, with yields lower between 2-4 bps, as visions of further ECB purchases dance in investors’ heads.  Treasuries are moving in the same direction, but the 1 basis point decline in yield is hardly game-changing.

Commodity markets continue their confusing ways, this time with oil rallying slightly, (WTI
+1.5%) while gold is declining, -0.3%.  And finally, the dollar is having, what can only be described, as a mixed session.  In the G10, the pound has actually extended its early losses and is now down -1.0%.  As well, JPY (-0.3%) is also weaker despite (because of?) what seemed to be pretty reasonable manufacturing data overnight.  The rest of the bloc, however, is firmer vs. the dollar led by AUD (+0.6%) on the back of rising iron ore prices, although the gains fall away to much more modest outcomes beyond that.  CAD (+0.3%) seems to be benefitting from the rise in oil prices but nothing else is even noteworthy.

Emerging market currencies are also mixed, with the gainers led by BRL (+0.8% on the open) after the central bank left rates on hold last night, as universally expected, but also explained that the pledge to keep rates at that level may be coming to an end as inflation starts to rise in the country.  This was taken as quite hawkish, so I would look for further BRL appreciation going forward.  Elsewhere on the plus side is RUB (+0.45%) clearly benefitting from oil’s rise, and HUF (+0.35%) which continues to benefit from the EU budget deal.  On the downside, ignoring TRY, ZAR (-0.4%) is the worst performer, seeming to suffer from a surge in Covid cases, with KRW (-0.3%) seeming to feel the pressure of yesterday’s tech stock sell-off in the US.

We finally get some data of note this morning led by the weekly Initial Claims (exp 725K) and Continuing Claims (5.21M) data.  But we also see the latest reading on headline CPI (0.1%, 1.1% Y/Y) and core (0.1%, 1.5% Y/Y).  The great inflation/deflation debate continues amongst the economic community with the deflationists continuing to point to the data as their trump card, but the inflationists continuing to point to real life.  My money is on inflation, probably as soon as next year, that is far higher than the Fed currently anticipates.

And that’s really it for the day.  All eyes will be on the tape at 7:45 when the ECB releases their statement, and then Madame Lagarde will be on camera starting at 8:30am.  Barring a breakthrough on Brexit today (which seems highly unlikely) the pound seems to have room to fall further.  As to the euro, that is in Lagarde’s hands.  And the dollar in general?  The recent slow trend lower remains intact, and I wouldn’t start that fight quite yet.

Good luck and stay safe
Adf

The Table is Set

In Brussels, the table is set
As Boris and Ursula bet
That dinner together
Will be the bellwether
To ending the hard Brexit threat

So, appetite for risk is whet
With central banks sure to abet
More equity buying
As they keep on trying
To buy every last piece of debt

There hasn’t been this much interest in a meal in Europe since the one painted by DaVinci some 530 years ago.  Clearly, the big story is this evening’s dinner date between UK PM Boris Johnson and European Commission President Ursula von der Leyen, where they will make what appears to be the final attempt to get some political agreement on the last issues outstanding in order to complete the Brexit trade deal.  With just over three weeks before the UK exits the EU, time is clearly of the essence at this stage.  I remain confident that an agreement will be reached as it is in both sides’ collective interest to do so.  Rather, the current political theater is seen as necessary, again for both sides, in order to demonstrate they did everything they could to achieve the best possible outcome.  After all, Boris is going to have to cede some portion of UK sovereignty, and the EU is going to have to cede some adherence to their extraordinarily large canon of laws.

The FX market seems to share my opinion as the pound has rallied more than 1% since I wrote yesterday and is currently firmer by 0.7% since yesterday’s close.  As I wrote last week, I remain convinced that the market has not actually priced in a successful completion of a deal, rather that the pound’s performance over the past several months, a nearly 10% rise since July 1st, has simply been reflective of the broad dollar decline and not a bet on a positive Brexit outcome.  As such, I believe there is a good amount of upside potential for the pound in the event of a positive result, perhaps as much as 3% right away, and 5%-6% over time.  Similarly, if a deal is not reached, a 5% decline is in the cards.  But, for now, all we can do is wait to hear the outcome.  Dinner is at 8pm in Brussels, so likely there will be little news before 4pm this afternoon.

Away from the Brexit story, however, the market discussion continues to revolve around prospects for a quick implementation of the Covid-19 vaccine and the resumption of pre-pandemic economic activity.  One of the conundrums in this regard is that despite what appears to be a growing belief that the vaccine will solve the covid crisis, thus enabling a return to economic growth, the central banking community will continue to inject unfathomable sums of liquidity into banks, (and by extension markets and maybe even the economy), to support economic growth.  It seems a bit duplicative to me, but then I’m just an FX salesman sans PhD.  After all, if the vaccine will allow people to revert to their former selves, what need is there for central banks to keep buying bonds?  (And in some cases, equities.  As an aside, yesterday the BOJ reached a milestone as the largest equity holder in Japan, outstripping the government pension fund, GPIF, and now in possession of nearly 8% of the entire market there.)

The thing is, there is no prospect that this behavior is going to change.  For instance, tomorrow the ECB’s final meeting of the year will conclude, and they are expected to expand the PEPP by at least €500 billion and extend the tenor of the program between six months and a year.  In addition, they are expected to expand the TLTRO III program (targeted long-term refinancing operations) by another year, and there were even some hints at a rate cut there.  The latter would be extraordinary as the current rate is -1.0%.  This means that European banks that borrow funds in this program pay -1.0% (receive 1.0% pa) as long as they lend these funds on to corporate and business clients, with no restrictions on what they can charge.  Balances in this program have fallen from €1.3 trillion to just €180 billion since the summer, so it is believable that the rate will change.  The ECB particularly likes this program as they believe it really encourages business loans.

Something else to watch in tomorrow’s meeting is whether either the statement, or Madame Lagarde in her press conference opening, discusses the exchange rate.  Since the euro first traded above 1.20 back in September, which brought an immediate response from the ECB via some jawboning, the single currency had really done very little, until November, when the latest move higher began.  Now, after a 4% rally, it would not be surprising for the ECB to once again mention the importance of a “competitive” (read: weak) euro.  With inflation in the Eurozone remaining negative, Lagarde and company simply cannot afford for the euro to rise much further.  And none of this discussion includes what may well come from the FOMC next week!

But on to today’s activity.  Risk appetite continues to be strong where equity markets in Asia (Nikkei +1.3%, Hang Seng +0.75%) and Europe (DAX +0.8%, CAC +0.2%, FTSE 100 +0.4%) are all continuing yesterday’s modest gains.  The one exception here is Shanghai (-1.3%) which seemed to respond to inflation data overnight (CPI -0.5%).  The cause here seems to be declining pork prices (remember last year the Asian Swine Flu resulted in the culling of Chinese herds and dramatic price rises) but also the expectation that the PBOC is not going to change course with respect to forcing the deleveraging of the real estate sector and concomitant bubble there.

Bond markets are behaving as one would expect in a risk-on scenario, with Treasury yields reversing yesterday’s 2bp decline, while Bunds and OATs have both seen yields edge higher by 1 basis point.  Oil prices have rallied 1.5%, partly on risk attitude and partly on the story of an attack on Iraqi oil assets disrupting supply.  Finally, gold, which has really been rebounding since the end of last month, has given up 0.65% this morning.

Lastly, the dollar is generally softer today, against most G10 and EMG currencies.  AUD (+0.9%) is the leader this morning after the Westpac Consumer Confidence Survey printed at a much higher than expected 112.0.  For reference, that was the highest print since October 2010!  But as mentioned, the pound is firmer, as is virtually the entire bloc, albeit with less impressive moves.

In emerging markets, HUF (+0.8%) is the leading gainer, followed by PLN (+0.7%) and CZK (+.4%), all of which are far outperforming the euro (+0.1%).  It seems that the EU Stimulus deal, which was being held up by Hungary and Poland over language regarding the rule of law, has finally been agreed by all parties, with those three nations set to receive a significant boost when it is finally implemented next year.  On the flip side, TWD (-0.4%) was the worst performer as a late session sell-off wiped out early gains.  At this point, there is no obvious catalyst for the move, which looks very much like a large order going through an illiquid market onshore.

There is no data of note this morning and no speakers either.  Risk appetite remains the driver, with not only vaccine euphoria, but also hopes for a US stimulus bill rising as well.  In other words, everything is fantastic!  What could possibly go wrong?

As long as equities continue to rally, the dollar is likely to remain under pressure, but with the ECB on tap for tomorrow, I don’t expect a breakout, unless something really positive (or negative) comes out of dinner in Brussels.

Good luck and stay safe
Adf

Still a Threat

For Boris, and all Brexiteers
They can’t wait for this, Eve, New Year’s
Alas, as of yet
There is still a threat
That no deal might bring both sides tears

Investors, however, seem sure
The UK, a deal, will secure
That’s why Britain’s pound
Is robustly sound
Let’s hope that view’s not premature

EU official sees UK trade deal “imminent” barring last-minute glitch

This Reuters News headline from this morning, aside from being inane, is a perfect example of the market narrative in action.  The broad view is that a deal will be reached, despite the fact that deadline after deadline has been missed during these negotiations.  The pound has rallied nearly 10% since the only deadline of consequence on June 30.  That was the date on which both sides would have been able to extend the current negotiations.  However, no extension was sought by the UK and none granted, so we are heading into the last four weeks of the year with nothing concrete completed.  And yet, markets on the whole continue to trade under the assumption a deal will be reached and there will be no meaningful disruption to either the UK or EU economy on January 1st.

And that is the point of the headline.  It is essentially telling us a deal is a given, and both sides are now just playing to their domestic constituencies to show how hard they are working to achieve a ‘good’ deal.  In fact, once again today, the French held out the possibility that they would veto a deal as French European Affairs Minister, Clement Beaune, told us, “If there is a deal which is not good, then we would oppose it.  We always said so.”  This comment appears to be just another part of the ongoing theater.  A senior UK official, meanwhile, claimed talks had regressed because of a change in the EU’s position regarding the fishing issue.

But let’s go back to the pound.  A 10% rally in five months is a pretty impressive outcome.  Can this movement be entirely attributed to Brexit beliefs?  At this stage, I think not.  Consider, that during that same period, both SEK and NOK have rallied nearly 11%.  And even the laggard of the G10, JPY, has rallied 3.5% in the second half of the year.  The point is that perhaps the market has not priced in as high a probability of a successful outcome as many, including me, had thought likely.  After all, if the other nine G10 currencies have rallied an average of 8.0% in a given time frame, at the margin, the additional 1.6% that cable has rallied does not seem that impressive after all.

What are the potential ramifications of this line of thinking?  Well, assuming that a deal is actually reached on time, and I believe that is the most likely outcome, it seems possible that the pound has considerably more upside than the rest of the G10.  Looking back to the original referendum in the summer of 2016, the pound touched 1.50 the night of the vote, before it became clear that Brexit was going to be the outcome.  Since then, in Q1 2018, the pound traded above 1.40, but that too, was simply a reflection of the times as the euro was trading above 1.25.  In other words, the Brexit impact on the pound, other than in the immediate aftermath of the vote, seems to have been remarkably modest.  Certainly, month-to-month movement has been in lockstep with all the other G10 currencies, and it is only the level of the pound, which adjusted back in June 2016, which is different.  The implication is that the announcement of a successful deal is likely to see the pound outperform higher.  This is opposite my previous views but appears to account for the historical price action more effectively.  Remember, within two days of the Brexit vote, the pound fell 11%.  While a deal seems unlikely to recoup that entire amount, perhaps half of that is available, which from current levels means that a move above 1.40 is viable without a corresponding rise in the euro.  At that point, the pound will revert to being just another G10 currency, with price movement locked into the dollar narrative, not the Brexit narrative.  Food for thought.

As to today’s session, it is payrolls day with the following expectations according to Bloomberg:

Nonfarm Payrolls 470K
Private Payrolls 540K
Manufacturing Payrolls 45K
Unemployment Rate 6.7%
Average Hourly Earnings 0.1% (4.2% Y/Y)
Average Weekly Hours 34.8
Participation Rate 61.7%
Trade Balance -$64.8B
Factory Orders 0.8%

The question, of course, is has this data yet returned to its prior place of importance in investors’ minds.  And arguably, the answer is no.  There continues to be a strong market narrative that the current data is unimportant because everyone knows that the ongoing lockdowns are going to make things look worse.  This is true all over the world (except, perhaps, China).  But given the near universal central bank promises of low rates forever for the foreseeable future, investors continue to add risk to their portfolios with abandon.  In order to change that mindset, I believe we would need to see a number so shocking, something like -1000K, that it could indicate the impact of Covid might not be temporary.  But barring that, my sense is the payroll number has lost its luster.

It will be interesting to see if that luster returns in the post-Covid environment, or perhaps some other statistic will embody the zeitgeist in the future.  Remember, NFP has not always been that important.  When Paul Volcker was Fed Chair, M2 money supply was the only number that mattered.  Once Alan Greenspan took over, it was the trade data that drove markets.  Perhaps inflation will be deemed “THE” number going forward, especially in the event that MMT becomes the norm.

Ahead of the data, a tour of markets shows that risk appetite is positive, if modest.  European equity markets are generally firmer (CAC +0.3%, FTSE 100 +0.8%) although the DAX just gave up its earlier gains and is now lower by 0.2%.  Overnight, things were also fairly dull as the Nikkei (-0.2%) slipped modestly while both the Hang Seng (+0.4%) and Shanghai (+0.1%) edged higher.  In fact, the best performer overnight was South Korea with the KOSPI (+1.3%) rallying on continued strong data and KRW (+1.35%) rallying on the back of inflows to the KOSPI as well as market technicals.  Meanwhile, US futures are higher by roughly 0.3% at this hour.

The bond market has slipped a bit with yields rising by 2bps in Treasuries, but European govvies, which had been softer (higher yields) earlier in the session, have found support with yields now edging lower by about 0.5bps.  It seems a Bloomberg story released a short time ago indicated that the ECB is likely to extend their PEPP by a full year, not the 6 months mooted by most analysts.

As to the dollar, it is actually mixed in the G10, but movement has been modest in both directions.  So, CHF (+0.25%) and GBP (+0.2%) are leading the way, but realistically don’t tell us much given how insignificant the moves have been.  On the downside, NZD (-0.4%) and AUD (-0.2%) are lagging, but neither has released data of note.  Essentially, this all seems like position adjustments.

Emerging markets, however, have seen a bit more demand with the commodity bloc supported after OPEC+ reached a compromise and helped oil prices back above $46/bbl.  This is the highest they have been since before the Covid panic, so it is quite important from a market technical perspective.  In the meantime, RUB (+0.55%) and MXN (+0.5%) are leading the way (after KRW of course) with most others in this space higher by much lesser amounts.

And that’s where we stand heading into payrolls and then the weekend.  Nothing has changed the dollar weakening narrative, and the pound remains the true wildcard.  Despite my change of heart regarding the pound’s upside, that does not change my view that if the negotiations fall apart and no Brexit deal is reached, the pound can decline 5%-7%.  Arguably, we are looking at some symmetry there.  In any event, a case for a larger move in the pound is very viable, one way or the other.

Good luck, good weekend and stay safe
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