Uncomfortably High

Said Carney, exhaling a sigh
The odds are “uncomfortably high”
More pain will we feel
If there is no deal
When England waves Europe bye-bye

Yesterday the BOE, in a unanimous decision, raised its base rate by 25bps. This outcome was widely expected by the markets and resulted in a very short-term boost for the pound. However, after the meeting, Governor Carney described the odds of the UK leaving the EU next March with no transition deal in hand as “uncomfortably high.” That was enough to spook markets and the pound sold off pretty aggressively afterwards, closing the day lower by 0.9%. And this morning, it has continued that trend, falling a further 0.2% and is now trading back below 1.30 again.

By this time, you are all well aware that I believe there will be no deal, and that the market response, as that becomes increasingly clear, will be to drive the pound still lower. In the months after the Brexit vote, January 2017 to be precise, the pound touched a low of 1.1986, but had risen fairly steadily since then until it peaked well above 1.40 in April of this year. However, we have been falling back since that time, as the prospects for a deal seem to have receded. The thing is, there is no evidence that points to any willingness to compromise among the Tory faithful and so it appears increasingly likely that no deal will be agreed by next March. Carney put the odds at 20%, personally I see them as at least 50% and probably higher than that. In the meantime, the combination of ongoing tightening by the Fed and Brexit uncertainty impacting the UK economy points to the pound falling further. Do not be surprised if we test those lows below 1.20 seen eighteen months ago.

This morning also brought news about the continuing slowdown in Eurozone growth as PMI data was released slightly softer than expected. French, German and therefore, not surprisingly, Eurozone Services data was all softer than expected, and in each case has continued the trend in evidence all year long. It is very clear that Eurozone growth peaked in Q4 2017 and despite Signor Draghi’s confidence that steady growth will lead inflation to rise to the ECB target of just below 2.0%, the evidence is pointing in the opposite direction. While the ECB may well stop QE by the end of the year, it appears that there will be no ability to raise rates at all in 2019, and if the current growth trajectory continues, perhaps in 2020 as well. Yesterday saw the euro decline 0.7%, amid a broad-based dollar rally. So far this morning, after an early extension of that move, it has rebounded slightly and now sits +0.1% on the day. But in the end, the euro, too, will remain under pressure from the combination of tighter Fed policy and a decreasing probability of the ECB ever matching that activity. We remain in the 1.1500-1.1800 trading range, which has existed since April, but as we push toward the lower end of that range, be prepared for a breakout.

Finally, the other mover of note overnight was CNY, with the renminbi falling to new lows for the move and testing 6.90. The currency has declined more than 8% since the middle of June as it has become increasingly clear that the PBOC is willing to allow it to adjust along with most other emerging market currencies. While the movement has been steady, it has not been disorderly, and as yet, there is no evidence that capital outflows are ramping up quickly, so it is hard to make the case the PBOC will step in anytime soon. And that is really the key; increases in capital outflows will be the issue that triggers any intervention. But while many pundits point to 7.00 as the level where that is expected to occur, given the still restrictive capital controls that exist there, it may take a much bigger decline to drive the process. With the Chinese economy slowing as well (last night’s Caixin Services PMI fell to 52.8, below expectations and continuing the declining trend this year) a weaker yuan remains one of China’s most important and effective policy tools. There is no reason for this trend to end soon and accordingly, I believe 7.50 is reasonable as a target in the medium term.

Turning to this morning’s payroll report, here are the current expectations:

Nonfarm Payrolls 190K
Private Payrolls 189K
Manufacturing Payrolls 22K
Unemployment Rate 3.9%
Average Hourly Earnings (AHE) 0.3% (2.7% Y/Y)
Average Weekly Hours 34.5
Trade Balance -$46.5B
ISM Non-Manufacturing 58.6

Wednesday’s ADP number was much stronger than expected at 213K, and the whisper number is now 205K for this morning. As long as this data set continues to show a strong labor market, and there is every indication it will do so, the only question regarding the Fed is how quickly they will be raising rates. All of this points to continued dollar strength going forward as the divergence between the US economy and the rest of the world continues. While increasing angst over trade may have a modest impact, we will need to see an actual increase in tariffs, like the mooted 25% on $200 billion in Chinese imports, to really affect the economy and perhaps change the Fed’s thinking. Until then, it is still a green light for dollar buyers.

Good luck and good weekend
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Is That Despair?

Forward guidance is
Kuroda-san’s newest hope
Or is that despair?

The BOJ has committed to keep the current extremely low levels for short- and long-term interest rates for an “extended period of time.” Many of you will recognize this phrase as Ben Bernanke’s iteration of forward guidance. This is the effort by central banks to explain to the market that even though rates cannot seemingly go any lower, they promise to prevent them from going higher for the foreseeable future. Alas, forward guidance is akin to Hotel California, from which, as The Eagles famously sang back in 1976, “you can check out but you can never leave.” As the Fed found out, and the ECB will learn once they finally end QE (assuming they actually do so), changing tack once you have promised zero rates forever can have market ramifications. The first indication that forward guidance might be a problem came with the ‘taper tantrum’ in 2013, but I’m confident it won’t be the last.

However, for the BOJ, now trumps the future, and they needed to do something now. But forward guidance was not the only thing they added last night. It was the cover for their attempts to adjust policy without actually tightening. So, yield curve control now has a +/- 20bp range around 0.0% for the 10-year JGB, double the previous level, and thus somewhat more flexible. And they reduced the amount of reserves subject to the -0.10% deposit rate in order to alleviate some of the local banks’ profit issues. In the end, their commitment to maintaining zero interest rates for that extended period of time was sufficient for FX traders to sell the yen (it fell -0.40%), and JGB yields actually fell a few bps, closing at 0.065%, which is down from 0.11% ahead of the meeting. All in all, I guess the BOJ did a good job last night.

There is, however, one other thing to mention, and that is they reduced their own inflation forecasts (to 1.1% in 2019, 1.5% in 2020 and 1.6% in 2021) for the next three years, indicating that even they don’t expect to achieve that elusive 2.0% target before 2022 at the earliest. In the end, the BOJ will continue to buy JGB’s and equity ETF’s and unless there is a substantial acceleration in global growth, (something which seems increasingly unlikely) they will continue to miss their inflation target for a very long time. As to the yen, I expect that while it fell a bit last night, it is still likely to drift higher over time.

In Europe the story is still
That growth there is starting to chill
The data last night
Did naught to delight
Poor Mario, testing his will

Beyond the BOJ, and ahead of the FOMC announcement tomorrow, the major news was from the Eurozone where GDP and Inflation data was released. What we learned was that, on the whole, growth continued to slow while inflation edged higher than expected. Eurozone GDP rose 0.3% in Q2, its slowest pace in a year, while headline inflation rose 2.1%, its fastest rate since early 2013. Of course the latter was predicated on higher energy prices with core CPI rising only 1.1%, still a long way from the ECB’s target. The point is that given the slowing growth trajectory in the Eurozone, it seems that Draghi’s confidence in faster growth causing inflation to pick up on the continent may be unwarranted. But that remains the official line, and it appears that the FX market has accepted it as gospel as the euro has traded higher for a third consecutive day (+0.3%) and is now back in the top half of its trading range. If Q3 growth continues the trajectory that Q2 has extended, it will call into question whether the ECB can stop buying bonds, or at the very least, just how long rates will remain at -0.4%, with those looking for a September 2019 rate hike sure to be disappointed.

There is one country in Europe, however, that is performing well, Sweden. GDP growth there surprised the market yesterday, rising 1.0% in Q2 and 3.3% Y/Y. This has encouraged speculation that the Riksbank will be raising rates fairly soon and supported the krone, which has rallied 1.0% since the announcement.

The final piece of news to discuss from last night was from China, where the PMI readings all fell below expectations. The official Manufacturing data was released at 51.2, down from last month’s 51.5 and the third consecutive monthly decline. The non-manufacturing number fell to 54.0, its weakest print since October 2016. These are the first data from China that include the impact of the US tariffs, and so are an indication that the Chinese economy is feeling some effects. I expect that the government there will add more stimulus to offset any more severe impact, but that will simply further complicate their efforts at reducing excess leverage in the economy. Meanwhile, the renminbi slid 0.25% overnight.

This morning’s data releases bring us Personal Income (exp 0.4%), Personal Spending (0.4%) and PCE (2.3% headline, 2.0% core), as well as the Case-Shiller Home price index (6.4%), Chicago PMI (62.0) and Consumer Confidence (126.0). In other words, there is much for us to learn about the economy. While I believe the PCE data could be market moving, especially if it is stronger than expected, I continue to believe that traders and investors remain far more focused on Friday’s payroll report than this data. Recent weakness in equity markets has some folks on edge, although futures this morning look benign. But if we do see that weakness continue, the chances of a full-blown risk off scenario materializing will grow substantially. And that means, the dollar has the potential to rally quite sharply. Keep that in mind as a tail risk, one where the tail grows fatter each day that equity markets disappoint.

Good luck
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A Rate Hike’s in Store

Said Mario Draghi once more
‘Through summer’ a rate hike’s in store
When pressed on the timing
That they’d end pump priming
He gave no more scoop than before

As we await this morning’s Q2 US GDP data (exp 4.1%), it’s a good time to review yesterday’s activity and why the euro has given up the ground it gained during the past week. The ECB left policy on hold, which was universally expected. However, many pundits were looking for a more insightful press conference regarding the timeline that the ECB has in mind regarding the eventual raising of interest rates. Alas, they were all disappointed. Draghi continues to use the term ‘through summer’ without defining exactly what that means. It appears that the uncertainty is whether it means a September 2019 hike or an October 2019 hike. To this I have to say, “are they nuts?” The idea that the ECB has such a precise decision process is laughable. The time in question is more than twelve months away, and there is so much that can happen between now and then it cannot be listed.

Consider that just six months ago, Eurozone growth was widely expected to continue the pace it had demonstrated in 2017, which was why the dollar was weak and falling. But instead, despite a large majority of forecasts pointing to great things in Europe, growth there weakened sharply while growth in the US leapt forward. So here we are now, six months later, with the dollar significantly stronger and a new narrative asking why Eurozone growth has disappointed while US growth is exploding higher. Of course the US story is blamed based on the tax changes and increased fiscal stimulus from the budget bill. But in Europe, we have heard about bad weather, a flu epidemic and, more recently, rising oil prices, but certainly nothing that explains the underlying disappointment. And that was only a six-month window! Why would anyone expect the ECB, who are notoriously bad forecasters, to have any idea what will happen, with precision, in fourteen months’ time?

However, that seems to have been the driving force yesterday, lack of confirmation on the timing of the ECB’s initial rate hike next year. And based on the French GDP data this morning (0.2%, below expectations of 0.3% and far below last year’s 0.7% quarterly average), it seems that growth expectations for the Eurozone may well be missed again. Personally, I am not convinced that the ECB will raise rates at all in 2019. Given the recent trajectory of growth in the Eurozone, it appears we have already seen the top, and that before we get ‘through summer’ next year, the discussion may turn to how the ECB are going to help support the economy with further QE. Given this reality, it should be no surprise that the euro suffered yesterday, and in the wake of the weak French data, that it is still lower this morning, albeit only by an additional 0.15%.

Elsewhere the pound fell yesterday after the EU rejected, out of hand, PM May’s solution for the UK to collect tariffs on behalf of the EU. That basically destroyed her attempt to find a middle ground between the Brexiteers and the Bremainers, and now calls into question her ability to remain in office. In fact, she is running out of time to come up with a deal that has a chance of getting implemented. The current belief is that if they do not agree on something by the October EU meeting, there will not be sufficient time for all 29 members to approve any deal. It is with this in mind that I continue to question the BOE’s concerns over slowing inflation. My gut tells me that if they do raise rates next week, it will need to be reversed by the November meeting after the Brexit situation spirals out of control. The pound fell 0.65% yesterday and is down a further 0.1% this morning. That remains the trend.

Another noteworthy event from Tokyo occurred last night as the BOJ was forced to intervene in the JGB market for the second time this week, bidding for an unlimited amount of bonds at 0.10% in the 5-10 year sector. And this time, they bought ~$74 billion worth. Speculation remain rife that they are going to adjust their QQE program next week, but given the fact that it has been singularly unsuccessful in achieving its aim of raising inflation to 2.0% (currently CPI there is running at 0.2%), this appears to be a serious capitulation. If they change policy without any success behind them, the market is likely to aggressively buy the yen. USDJPY is down 1.7% in the past six sessions, and while it rallied slightly yesterday, it seems to me that USDJPY lower is the most likely future outcome.

Yesterday morning’s overall dollar malaise reversed during the US session and has carried over to this morning’s trade. And while most movement so far this morning is modest, averaging in the 0.1%-0.2% range, it is nearly universally in favor of the buck.

This morning brings the aforementioned GDP data as well as Michigan Sentiment (exp 97.1, down a full point from last month), although the former will be the key number to watch. Yesterday’s equity market session was broadly able to shake off the poor earnings forecast of a major tech firm, and this morning has a different FANG member knocking it out of the park. My point is that risk aversion is not high, so this dollar strength remains fundamental. At this point, I look for the dollar to continue to benefit from the current broad narrative of diverging monetary policy, and expect that we will need to see some particularly weak US data to change that story.

Good luck and good weekend
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