Quite Foreboding

In this, the eighth month of the year
The market’s succumbing to fear
With Turkey imploding
It feels quite foreboding
And folks, it can get more severe!

On Friday I discussed the Turkey situation as one beginning to spiral out of control. Well, this morning it has lived up to that billing with the lira falling an additional 7.5% as I type, although that includes a substantial recovery from its worst levels today. Now, the central bank there has finally reacted by loosening reserve requirements and offering foreign currency loans to local banks in unlimited size, but those moves have had only a limited positive impact on the currency. And since President Erdogan refuses to countenance higher interest rates, it seems that the next move is going to be capital controls, and it is likely to come pretty soon. In fact, if the recent pace of the lira’s decline continues unchecked, and I see no reason for it to stop yet, I expect that we will see capital controls before the week is out, and maybe as soon as tomorrow.

Here’s the thing. Turkey’s growth over the past decade has largely been debt driven (after all, who’s hasn’t?) but the Turks have been one of the most aggressive in using USD funding such that dollar debt represents >50% of the total debt in the economy. When the Fed turned from ultra easy monetary policy to begin tightening, it really began to hurt them. And as Chairman Powell has not only continued the process begun under Yellen, but increased the pace, the pain has become unbearable for Turkey’s economy. So it is fair to say that Turkey’s problems are self-inflicted (had they taken a more local and gradual path toward growth they arguably wouldn’t be in this bind), but those problems are not unique within the emerging markets, and at a certain point to investors, it doesn’t matter.

As I mentioned Friday, herd behavior amongst investors is the rule, not the exception. And as liquidity in Turkish asset markets dries up, and it has, investment managers will be looking to sell other risky assets in order to manage their overall portfolios. That is a key reason why ZAR has fallen by 2.5% this morning. Too, the Mexican peso has fallen 2% and even the Korean won, which is nobody’s idea of an emerging market (per capita GDP ranks ahead of Spain, Italy and New Zealand according to the CIA) has fallen 1.0%. The point is, if an asset manager cannot sell what he wants to sell to reduce risk, then he will sell what he can sell in order to limit portfolio damage. And this is how contagion starts!

So does Turkey really matter? In the FX markets, prior to the recent situation, the Turkish lira was a favored carry trade component, with investors seeking to earn what had been very high yields with a relatively stable currency. But that trade is over, and by all appearances, Turkey is going to be facing a recession pretty soon, which means that real trade flows are likely to diminish as well. In that sense, Turkey doesn’t matter too much.

But when you put this situation in the context of what else is happening in the world, this could well be the proverbial last straw. We have already been dealing with escalating trade tensions that show no sign of ebbing; a seeming stalemate in the Brexit talks opening the door to the UK crashing out of the EU with no deal; a populist government in Italy threatening to challenge Eurozone fiscal rules; and not least, a Federal Reserve that, despite everything else going on, is hell-bent and determined to continue raising interest rates. It should be no surprise that a number of equity markets around the world have struggled so far this year, but there is still a lot more green than red on screens. However, market sentiment can only take so much stress before investors decide that the risk is no longer worth the reward. I fear that we may be approaching that point. Market sentiment can be fleeting, and right now, we seem to be watching it flee!

With that in mind, a look at the G10 currency space confirms everything we have seen for the past several sessions. The dollar is broadly higher, with the euro -0.3% and the pound -0.2% although the yen, as is its wont in a crisis, has rallied 0.5%. Equity markets around the world are bathed in red, with the Nikkei falling 2% overnight and European shares, on average, down about 0.5%. US equity futures are pointing to a -0.3% opening in New York as well. Treasuries and Bunds have continued their modest rally, with yields falling another 1-2bps, and commodity prices are under pressure again. In other words, this is a classic risk off performance.

What can stop this? Historically, it has been the IMF that would step in and help support a country and its currency when stressed in this manner (remember Argentina a few months ago getting a $50 billion line of credit), but I am skeptical of that happening this time around. There are two things likely to prevent the IMF from getting involved: first, President Erdogan has been extremely vocal in his disdain for orthodox economic policies like raising interest rates in to help combat rising inflation, but the IMF will demand tighter monetary and tighter fiscal policy, neither of which Erdogan is likely to embrace; and second, for the IMF to act, the US has to be on sides, and the current situation has been partly aggravated by the diplomatic row between the US and Turkey. It seems hard to believe that President Trump will give the IMF the leeway to extend help. Unfortunately, I fear that there is more turmoil in our future.

Turning to the data review this week, there is a modest uptick in the volume of data, but it is not clear any of it will be critical to the Fed’s view of the world.

Tuesday NFIB Small Business 106.9
Wednesday Nonfarm Productivity 2.3%
  Unit Labor Costs 0.3%
  Empire State Mfg 20
  Retail Sales 0.1%
  -ex Autos 0.3%
  IP 0.3%
  Capacity Utilization 78.2%
Thursday Housing Starts 1.26M
  Building Permits 1.31M
  Initial Claims 215K
  Philly Fed 22
Friday Michigan Sentiment 98

Arguably, Retail Sales will be the most watched number, but everything we have heard from Fed speakers of late has been full speed ahead, so we will need to see much weaker data to change that perspective. Either that or a total collapse in the emerging market space, with the latter situation seemingly far more likely than the former. In the end, I see no reason to change my views on the dollar’s broad trajectory, which remains higher for the foreseeable future.

Good luck
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Dashing Hopes

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

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

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

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

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

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

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

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

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

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

Good luck and good weekend
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Now In Disarray

The saga of Minister May
Improved not one whit yesterday
When Boris resigned
Pound Sterling declined
And her party’s now in disarray

The news from the UK continues to dominate market headlines as less than twenty-four hours after the resignation of the Brexit Minister David Davis, Boris Johnson, a Brexit hardliner and Foreign Minister also resigned from PM May’s cabinet. While PM May replaced both men quickly, the problem is one of appearances in that she seems to be losing control over her government. The market’s immediate reaction was to sell the pound (it fell 0.7% yesterday after the news and has maintained those losses) as concerns over a leadership challenge and potentially a new election were brought to the fore. However, since then, it seems things have quieted down a bit and there is even talk that this could be a Sterling positive as it may result in a softer Brexit with less economic impact. In the meantime, this morning’s data showed that GDP has been rebounding from Q1’s flat reading, with the monthly May reading rising 0.3% and although IP data was soft (-0.4% in May), Construction was strong (+1.6%) and it appears that Governor Carney will still have enough ammunition to justify a rate increase next month. The risk to that outlook is if a leadership challenge emerges in Parliament and PM May is deposed. In that event, market participants may take a dimmer view of the near future depending on who replaces her.

Away from the British Isles, however, there is less excitement in the G10 economies. The big US news remains political with President Trump naming Brett Kavanaugh to replace retiring Supreme Court Justice Anthony Kennedy. However, on the economic front, there has been precious little news or commentary. In fact, until Thursday’s CPI reading, I expect the US story to be benign unless something surprising happens in the Treasury auctions beginning today, where the US is raising $69 billion via 3yr, 10yr and 30yr auctions.

From Germany we saw the ZEW surveys disappoint with the Sentiment Index falling to -24.7, its lowest print since December 2011 during the European bond crisis. This has encouraged a reversal in the euro, which is down 0.3% this morning after a week of gains. As well, the other, admittedly minor, Eurozone data also pointed to modest Eurozone weakness, thus giving the overall impression that the recent stabilization on the continent may be giving way to another bout of weakness. However, we will need to see more important data weaken to confirm that outcome. Certainly, Signor Draghi is convinced that the worst is behind them, but he has always been an optimist.

In the emerging markets, Turkey has once again stolen the headlines as President Erdogan named his son-in-law as Minister of Finance and Economics, thus following through on his threat promise to take firmer control over monetary policy. In the cabinet reshuffle he also removed the last vestiges of central banking experience so I would look for inflation in Turkey to start to really take off soon, and the currency to fall sharply. And that is despite the fact that it fell 3% yesterday after the announcement. In fact, I would look for more moves of that nature and a print above 5.00 in the not too distant future.

But other than that, while the dollar is stronger this morning, it is not running away. The broad theme today seems to be modest profit taking by traders who had been running short dollar positions, and so a bit of further strength would be no surprise. On the data front, the NFIB Small Business Optimism Index was released earlier at 107.2, stronger than expected and still showing that small businesses remain confident in the economic situation for now. The JOLTs jobs report comes at 10:00 and should simply confirm that the employment situation in the US remains robust. My gut tells me that modest further dollar strength is on tap for today, but really, barring a political bombshell, I expect that things will be very quiet overall. It is the middle of summer after all.

Good luck
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