A Too Bitter Pill

Three stories today are of note
First, Italy’s rocking the boat
Next Brexit is still
A too bitter pill
While OPEC, a cut soon may vote

The outcome in all of these cases
Has been that the market embraces
The dollar once more
(It’s starting to soar)
And quite clearly off to the races

On this Veteran’s Day holiday in the US, where bond markets will be closed although equity markets will not, the dollar has shown consistent strength across the board. Interestingly, there have been several noteworthy stories this morning, but each one of them has served to reinforce the idea that the dollar’s oft-forecast demise remains somewhere well into the future.

Starting with Italy, the current government has shown every indication that they are not going to change their budget structure or forecasts despite the EU’s rejection of these assumptions when the budget was first submitted several weeks ago. This sets up the following situation: the EU can hold firm to its fiscal discipline strategy and begin the procedure to sanction Italy and impose a fine for breaking the rules, or the EU can soften its stance and find some compromise that tries to allow both sides to save face, or at least the EU to do so.

The problem with the first strategy is the EU Commission’s fear that it will increase the attraction of antiestablishment parties in the Parliamentary elections due in May. After all, the Italian coalition was elected by blaming all of Italy’s woes on the EU and its policies. The last thing the Commission wants is a more unruly Parliament, especially as the current leadership may find themselves on the sidelines. The problem with the second strategy is that if they don’t uphold their fiscal probity it will be clear, once and for all, that EU fiscal rules are there in name only and have no teeth. This means that going forward, while certain countries will follow them because they think it is proper to do so, many will decide they represent conditions too difficult with which to adhere. Over time, the second option would almost certainly result in the eventual dissolution of the euro, as the problems from having such dramatically different fiscal policies would eventually become too difficult for the ECB to manage.

With this in mind, it is no surprise that the euro is softer again today, down 0.6% and now trading at its lowest level since June 2017. In less than a week it has fallen by more than 2.0% and it looks as though this trend will continue for a while yet. We need to see the Fed soften its stance or something else to change in order to stop this move.

Turning to the UK, the clock to make a deal seems to be ticking ever faster and there is no indication that PM May is going to get one. Over the weekend, there was no progress made regarding the Irish border issue, but we did hear from several important constituents that the PM’s current deal will fail in Parliament. If Labour won’t support it and the DUP won’t support it and the hard-line Brexiteers won’t support it, there is no deal to be had. With this in mind it is no surprise that the pound has suffered greatly this morning, down 1.4% and back well below 1.30. You may recall that around Halloween, the market started to anticipate a Brexit deal and the pound rallied 3.7% in the course of a week. Well, it has since ceded 2.7% of that gain and based on the distinct lack of progress on the talks, it certainly appears that the pound has further to fall. Do not be surprised if the pound trades below its recent lows of 1.2700 and goes on to test the post-Brexit vote lows of 1.1900.

The third story of note is regarding OPEC and oil prices, which have fallen nearly 20% during the past six weeks as US production and inventories continue to climb while the price impact of sanctions on Iran turned out to be much less then expected. This has encouraged speculation that OPEC may cut its production quotas, although the news from various members is mixed. Adding to oil’s woes (and in truth all commodity prices) has been the fact that global growth has been slowing as well, thus reducing underlying demand. In fact, the biggest concern for the market has been the slow down in China, which continues apace and where stories of further policy ease by the PBOC, including interest rate cuts, are starting to be heard. Two things to note are first, the typical inverse correlation between the dollar and commodity prices such that when the dollar rises, commodity prices tend to fall, and second, in line with the dollar’s broad strength, the Chinese yuan has fallen further today, down 0.3%, and pushing back to the levels that inspired calls for a move beyond 7.00 despite concerns over increased capital outflows.

And frankly, those are the stories of note. The dollar is higher vs. pretty much every other currency today, G10 and EMG alike, with no distinction and few other stories that are newsworthy. Looking at the data this week, there are two key releases, CPI and Retail Sales along with a bit of other stuff.

Tuesday NFIB Biz Confidence 108.0
  Monthly Budget -$98.0B
Wednesday CPI 0.3% (2.5% Y/Y)
  -ex food & energy 0.2% (2.2% Y/Y)
Thursday Initial Claims 215K
  Philly Fed 20.2
  Empire State 20.0
  Retail Sales 0.5%
  -ex Autos 0.5%
Friday IP 0.2%
  Capacity Utilization 78.2%

Overall, the data continues to support the Fed’s thesis that tighter monetary policy remains the proper course of action. In addition to the data we will hear from three Fed speakers including Chairman Powell on Wednesday. It seems hard to believe that he will have cause to change his tune, so I expect that as long as the rest of the world exhibits more short-term problems like we are seeing today, the dollar will remain quite strong.

Good luck
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Powell’s Fixation

Though spending by business has slowed
(And debt from the government growed)
There’s no indication
That Powell’s fixation
On raising rates soon will erode

The Fed left rates on hold yesterday, as universally expected. The policy statement was largely unchanged although it did tweak the wording regarding business investment, which previously had been quite strong but is now slowing somewhat. That said, there is absolutely no indication that the Fed is going to slow its trajectory of rate increases anytime soon. With the meeting now out of the way, I expect that the Fedspeak we hear going forward will reinforce that view, with only Kashkari and Bullard seeking to slow the pace, and neither of them is yet a voting member. The market response was actually mildly surprising in that equities sold off somewhat after the news (and have fallen sharply in Asia and Europe) despite the fact that this was the expected outcome. Meanwhile the dollar has continued to rebound from its recent lows touched on Wednesday, with the euro having declined 0.2% further this morning and 1.4% from its peak.

As an aside, I am constantly amazed at the idea that the Fed, especially as overseen by Jay Powell, is more than mildly interested in the happenings in the stock market. The Fed mandate is clear, maximum employment and stable prices, notably lacking any discussion of rising equity markets. Alas, ever since the Maestro himself, Alan Greenspan, was Fed Chair, it seems that the default reaction has been to instantly add liquidity to the market if there was any stock market decline. The result is we have seen three massive bubbles blown in markets, two of which have burst (tech stocks and real estate) with the third ongoing as we speak. If you understand nothing else about the current Fed chairman, it is abundantly clear that he is unconcerned with the day-to-day wobbles in financial markets. I am confident that if there is a significant change in the economic situation, and markets respond by declining sharply, the current Fed will address the economic situation, not the markets, and that, in my view, is the way policy should be handled.

But back to today’s discussion. I fully admit that I did not understand the market response to the election results, specifically why the dollar would have declined on the news. After all, a split Congress is not going to suddenly change policies that are already in place, especially since the Republican majority in the Senate expanded. And as the Fed made clear yesterday, they don’t care about the politics and are going to continue to raise rates for quite a while yet. Certainly, we haven’t seen data elsewhere in the world which is indicative of a significant uptick in growth that would draw investment away from the US, and so the dollar story will continue to be the tension between the short-term cyclical factors (faster US growth and tighter monetary policy) vs. the long-term structural factors (rising budget deficits and questionable fiscal sustainability). Cyclical data points to a stronger dollar; structural data to a weaker one, and for now, the cyclical story is still the market driver. I think it is worth keeping that in mind as one observes the market.

Regarding other FX related stories, the Brexit situation is coming to a head in the UK as PM May is trying to get her cabinet to sign off on what appears to be quite a bad deal, where the Irish border situation results in the UK being forced to abide by EU rules without being part of the EU and thus having no input to their formation. This is exactly what the Brexiteers wanted to avoid, and would seemingly be the type of thing that could result in a leadership challenge to May, and perhaps even new elections, scant months before Brexit. While I have assumed a fudge deal would be agreed, I am losing confidence in that outcome, and see an increasing chance that the pound falls sharply. Its recent rally has been based entirely on the idea that a deal would get done. For the pound, it is still a binary outcome.

The Italian budget story continues to play out with not only Brussels upset but actually the backers of the League as well. While I am no expert on Italian politics, it looks increasingly likely that there could be yet another election soon, with the League coming out on top, five star relegated to the backbenches, and more turmoil within the Eurozone. However, in that event, I think it highly improbable that the League is interested in leaving the euro, so it might well end up being a euro positive net.

So the week is ending on a positive note for the dollar, and I expect to see that continue throughout the session. This morning’s PPI data was much firmer than expected with the headline print at 2.9% and the core at 2.6%, indicating that there is no real moderation in the US inflation story. This data is likely tariff related, but that is no comfort given that there is no indication that the tariff situation is going to change soon. And if it does, it will only get worse. So look for the dollar to continue its rebound as the weekend approaches.

Good luck and good weekend
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Good Times Will Endure

Elections are out of the way
The outcome caused little dismay
Investors seem sure
Good times will endure
With stocks set to rally today

The dollar, however, is weak
Some pundits claim we’ve seen the peak
Still folks at the Fed
See rate hikes ahead
Which could, on those views, havoc wreak

The midterm elections are now past, with expectations largely fulfilled. The Democrats will run the House, while the Senate’s Republican majority has actually grown by four seats to a 53-47 count. At least that’s what appears to be the case at this time, although there are some runoff elections that need yet to be completed in the next weeks. The traditional view of a political split is that gridlock will ensue and very little in the way of new policy will come out of the next Congress. However, in this case, things may not actually work out that way. Consider the fact that President Trump’s populist leanings may well dovetail with Democratic priorities, especially on spending. It wouldn’t be that surprising if the next budget is even more stimulative than the last, especially as by next summer it is highly likely that the US growth impulse will be slowing down somewhat as the effects of the last stimulus fade away. And through it all, there is no indication that the Fed is going to stop raising interest rates, so I might argue that things haven’t changed all that much.

The risks to this view are if the new Democratic majority in the House chooses to use their power to rehash the battles from 2016 or, more disconcertingly for markets, decide that they want to proceed with an Impeachment process against the President. Two things about this issue are that, first, with the Republicans in control of the Senate, there is essentially zero probability that the President would be removed from office, so it would all be for show. But second, as I mentioned yesterday, the last time we saw this movie, in the autumn of 1998, the dollar fell sharply during the proceedings. This is just something to keep in mind as headlines start to flow going forward.

Enough about the elections. The market response overnight showed equity markets feeling a little better, with Europe higher and US futures pointing in the same direction, although APAC markets were largely flat. Meanwhile, the dollar has come under pressure across the board. The latter seems a little counterintuitive, although I guess it is simply a result of the embrasure of risk by investors. There is no need to flock to dollars, or yen for that matter, if expectations turn positive. And that’s what we seem to have seen.

Focusing on the FX market, the dollar is down pretty sharply across the board. Both the euro and the pound are higher by more than 0.5% despite what I would argue was some mildly negative news. In the Eurozone, while German IP was a touch firmer than expected at +0.2%, Retail Sales data throughout the Eurozone was actually quite weak, with both Italian and Austrian data showing contraction while the French managed to just hold on to an unchanged result, and all three coming well short of expectations.

Meanwhile, the pound continues to trade on hopes that a Brexit breakthrough is coming, despite the fact that yesterday’s widely publicized cabinet meeting produced exactly nothing. PM May has two potential problems here; first is the question of actually coming up with a deal that her cabinet can agree to support that also has EU support, a task that has thus far been out of reach. Second, remember that May has a coalition partner, not a majority in Parliament, and the Labor Party is now coming on record that they will vote against any deal. If that is the case, it is entirely possible that it all falls apart and the UK leaves the EU with no deal in place. While the pound has rallied nicely over the past week, up more than 3.5%, I continue to see the downside risks being significantly greater than the upside. Certainly the rally on a deal announcement would be much smaller in magnitude than the decline in the event of a hard Brexit. Hedgers must keep this in mind as they manage their risks.

As to the rest of the G10, the dollar has fallen even further than the euro and pound, with 0.7% pretty common across virtually the entire bloc. The only two exceptions are JPY, with a more modest 0.3% rally and CAD with a similar gain. My sense is the former is all about risk reduction mitigating some of the dollar weakness, while the latter is related to the fact that oil prices continue to fall, having come down nearly 20% from their highs reached in early October.

In the EMG bloc, there is broad dollar weakness as well with IDR leading the way (+1.5%) and ZAR jumping a solid 1.25%. We discussed the IDR story yesterday as investment flows continue to find their way back to the country given its continued strong growth and low inflation. ZAR, on the other hand, has benefitted from the combination of broad dollar weakness and gold’s recent strength, with the “barbarous relic” having rallied more than 4% in the past month. But it is not just those two currencies showing strength this morning; it is a universal dollar down day, with most freely traded currencies rising more than 0.5%.

And that’s really the day overall. There is no US data to be released today, and the Fed is just starting its two-day meeting, although there is no expectation that there will be any policy change regardless of the fact that it has been pushed back a day in deference to Election day yesterday. There is certainly no reason to believe that the dollar will reverse course in the near term, unless we see a significant uptick in US data that might cause the Fed to step up their pace of activity. However, that is not going to happen today, no matter what, and so I would look for the dollar to continue the overnight move and sell off modestly from this morning’s levels. Although I do not believe that the big picture has changed, any dollar strength is likely to be fleeting in the near future.

Good luck
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Trembling With Fear

The one thing increasingly clear
Is markets are trembling with fear
As stock markets tumble
Most central banks fumble
Their message, then get a Bronx cheer

Being a central banker has become much more difficult recently, especially in the wake of yesterday’s global equity market rout. It seems that policies that they have collectively promulgated, QE and ZIRP/NIRP are now quite long in the tooth, and no longer having the positive impact desired. Let’s recap quickly.

The Great recession in 2008 called for an extraordinary monetary response by central banks around the world, and rightly so. The deepest recession since the Great Depression saw liquidity across many markets completely dry up. Even FX, arguably the most liquid market of them all, had structural problems. So the combination of QE and USD swap lines offered by the Fed to the rest of the world’s central banks was an appropriate response to help untangle the mess. Alas, fiscal policy never chipped in to the recovery and central banks took it upon themselves to do all the lifting, thus relieving governments of the need to make hard decisions. In hindsight, this was a key mistake!

Fast forward ten years to today and the situation, remarkably, is that most of that extraordinary monetary stimulus is still sloshing around the world as other than the Fed and the Bank of Canada (who raised rates yesterday and indicated they would be quickening the pace of doing so in the future), no other major central bank has done anything of note. The ECB, the BOJ and the PBOC are all still adding liquidity to their systems, while the BOE has raised rates just 25bps, net, from the lows established after the crisis. And the same is true of peripheral nations like Switzerland, Sweden and Australia, where interest rates remain at their post crisis nadirs (-0.75%, -0.50% and 1.50% respectively).

The problem for these central banks is that growth is starting to slow on a global basis. Whether it is the increased trade friction between the US and China, concerns over Brexit or simply that the US recovery (which still arguably drives most of the global economy) is now the longest on record and due to end, the situation is increasingly fraught. And that’s the rub. If interest rates are already negative, what can central banks do to stimulate the economy in the event of a recession? The answer, of course, is not much. More QE and even deeper negative interest rates are unlikely to have the same positive impact the first efforts had, in fact they could have the opposite effect by generating greater concern amongst investors and causing a more severe sell-off in markets. But politically, no central bank will be able to sit by and do nothing if a recession does appear. As I said, central banking has become much more difficult lately.

That is all a preamble to discuss what is going on in markets right now. FX is a backburner issue with equities front and center around the world. While European markets have stabilized at this time, one session of stability is not sufficient to declare an end to the rout. In the end, markets remain beholden to broad sentiment, the narrative if you will, and for the past ten years that narrative was that continued low inflation combined with steady growth would allow the central banks to maintain ultra easy monetary policy with no negative side effects. But in the past year, the cracks in that narrative have grown to the point where it is no longer seen as viable. First, inflation has begun to creep higher in certain areas around the world, notably the US and China. At the same time, growth data appears to have peaked last quarter. Tomorrow we will see the first estimate of Q3 GDP growth in the US (exp 3.3%), which is already considerably lower than Q2. In addition, we have seen Chinese growth slow more than expected and German growth fall to 0.0% in Q3. The combination of rising inflation and slower growth has put central banks in a bind forcing them to choose which issue to address first. The problem is by addressing one they are likely to exacerbate the other. So as the Fed fights threats of higher inflation, it impedes growth. Meanwhile, China has opted to support growth, thus feeding faster inflation. In the end, as the next recession looms closer, central banks will find themselves with fewer policy arrows in their quiver.

But this is an FX note, so let’s take a quick look at the market this morning. The dollar is a touch softer, with both the euro and the pound higher by 0.15% while we are seeing similar moves in most emerging market currencies. Activity in the market seems muted relative to the excitement in equities, but my sense is this will not last. Rather, if the equity sell-off continues, the dollar should find itself in a much stronger position. As to the stories that have been driving things in FX, the Italian budget, Brexit, central bank policies, there have been no real changes in the past twenty-four hours. The possible exception is that the interest rate futures market in the US has removed one price hike from the Fed’s expected path as concern grows that a continues slide in the stock market will lead to weaker growth and less need to keep driving rates higher. It seems that the Fed realizes that it began its tightening process far too late (thank you Chair Yellen!) and is now desperately trying to catch up so they can respond to the next downturn. But hey, the ECB is MUCH further behind.

Looking forward to today’s session, we start with the ECB meeting, where they announced no change in policy rates, but we still await Signor Draghi’s press conference at 8:30. It will be interesting if he continues to characterize the Eurozone economy risks as balanced, or if the downside risks are now elevated. If the latter, look for the euro to decline sharply! We also get US data including Durable Goods (exp -1.0%, ex transport +0.5%) and the Goods Trade Balance (-$74.9B). Yesterday’s New Home Sales data was awful, just 553K, well below expectations, and another sign that parts of the economy here are rolling over. I still don’t believe that the data turn has been enough to change the Fed’s mind about a December rate hike, but if numbers start to fall, watch out. Tomorrow’s GDP print will be quite important to the market. But today, I think the ECB dominates the story.

Good luck
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Not Quite Yet Elated

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

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

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

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

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

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

Good luck and good weekend
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Southeast of France

The nation that’s southeast of France
Seems willing to leap at the chance
Of increasing spending
While also descending
Into a black hole of finance

Today’s markets have been dominated by a renewed fear that Italy may become Quitaly, quitting the euro in an effort to regain control of their finances. This view came about when Claudio Borghi, the chairman of the lower house budget committee (analogous to the House finance committee in the US), said that the euro was “not sufficient” to solve Italy’s fiscal issues. That was seen as an allusion to the idea that if Italy ditched the euro and returned to the lire, they would have more flexibility to implement the fiscal policies they wanted. In this case, flexibility can be understood to mean that Italy would be able to print and spend more money domestically, while allowing the lire to depreciate. The problem with the euro, as Italy sees it, is since they don’t control its creation, they cannot devalue it by themselves. There can be no surprise that the euro declined, falling 0.6% after a 0.3% decline yesterday. Of course, Italian stock and bond markets have also suffered, and there has been a more general feeling of risk aversion across all markets.

In the meantime, the latest Brexit news covers a new plan to allegedly solve the Irish border issue. It seems that PM May is going to offer up the idea that the UK remains in the customs union while allowing new checks on goods moving between Northern Ireland and the UK mainland. The problem with this idea, at least on the surface, is that it will require the EU to compromise, and that is not something that we have seen much willingness to embrace on their part. Remember, French President Macron has explicitly said that he wants the UK to suffer greatly in order to serve as a warning to any other members from leaving the bloc. (Funnily enough, I don’t think that either Matteo Renzi or Luigi Di Maio, the leaders of the League and Five-Star Movement respectively in Italy, really care about that.)

For now, the market will continue to whipsaw around these events as hopes ebb and flow for a successful Brexit resolution. While it certainly doesn’t seem like anything is going to be agreed at this stage, my suspicion remains that some fudge will be found. The one caveat here is if PM May is ousted at the Conservative Party conference that begins later this week. PM Boris Johnson, for instance, will tell the Europeans to ‘bugger off’ and then no deal will be found. In that case, the pound will fall much further, but that seems a low probability event for right now. With all of that in mind, the pound has fallen 0.6% this morning and is back below 1.30 for the first time in three weeks.

In fact, the dollar is higher virtually across the board this morning, with AUD also lower by 0.6% after the RBA left rates unchanged at 1.50% while describing potential weakening scenarios, including a slowdown in China. Even CAD is lower, albeit only by 0.15%, despite the resolution of the NAFTA replacement talks yesterday.

Emerging markets have fared no better with, for example, IDR having fallen nearly 1.0% through 15,000 for the first time in twenty years, despite the central bank’s efforts to protect the rupiyah through rate hikes and intervention. We have also seen weakness in INR (-0.6%), ZAR (-1.3%), MXN (-0.6%), TRY (-1.9%) and RUB (-0.7%). Stock markets throughout the emerging markets have also been under pressure and government bond yields there are rising. In other words, this is a classic risk-off day.

Yesterday’s ISM data was mildly disappointing (59.8 vs. 60.1 expected) but continues to point to strong US economic growth. Since there are no hard data points released today (although we do see auto sales data) my sense is the market will turn its focus on Chairman Powell at 12:45, when he speaks at the National Association of Business Economics Meeting in Boston. His speech is titled, The Outlook for Employment and Inflation, obviously the exact issues the market cares about. However, keeping in mind the fact that Powell has been consistently bullish on the economy, it seems highly unlikely that he will say anything that could derail the current trend of tighter US monetary policy. Combining this with the renewed concerns over Europe and the UK, and it seems the dollar’s rally may be about to reignite.

Good luck
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A Terrible Day

The UK’s Prime Minister May
Last night had a terrible day
Her plans for a deal
Were seen as unreal
As hawks in the EU held sway

But elsewhere the market’s embraced
The concept that fear was misplaced
Instead, stocks they’re buying
And so, fortifying
The idea, for risk, they have taste

Arguably, the key headline this morning was the extremely poor reception British PM May received from her 27 dinner companions at the EU dinner last night. She continues to proffer the so-called Chequers deal (named for the PM’s summer residence where the deal was agreed amongst Tory members several weeks ago), which essentially says the UK will toe the EU line when it comes to manufactured and agricultural goods, but wants a free hand in services and immigration. French President Macron was quick to dismiss the notion as he remains adamant that leaving the EU should be seen as a disaster, lest any other nations (Italy are you watching?) consider the idea. At any rate, while the pound had been rallying for the past week, reaching its highest level since early July, that all came a cropper last night. The growing hope that a Brexit deal would be found has been shattered, at least for now, and it should be no surprise that the pound has suffered for it. This morning, it is leading the way lower, having fallen 0.6% from yesterday’s closing levels.

However, while the dollar is modestly firmer this morning across the board, my strong dollar thesis is being severely tested of late. We have seen the dollar fall broadly all week despite the resumption of the march higher in US yields. Or is it because of that movement that the dollar is falling? Let’s consider the alternatives.

Several months ago I wrote about the conflicting cyclical and structural aspects of the market that were impacting the dollar’s value. The cyclical factors were US growth outpacing the rest of the world and the Fed tightening monetary policy faster than any other central bank. This combination led to higher US rates and a better investment environment in the US than elsewhere, and consequently, an increase in dollar buying for global investors to take advantage of the opportunities. Thus higher short-term interest rates led to a higher US dollar, along with a flatter yield curve.

On the other hand, the structural questions that hang over the US economy consist of the impact of late cycle fiscal stimulus in the form of both tax cuts and increased spending. The fact that this was occurring at the same time the Fed was reducing the size of its balance sheet meant that at some point, it seemed likely that increased Treasury supply would find decreased demand. The growing budget and current account deficits would in turn pressure the dollar lower while the excess Treasury supply would push long-term yields higher ending up with a weaker dollar and a steeper yield curve.

Starting in April, it became clear that the cyclical story was the primary market driver, with strong US growth pushing up short-term rates as well as US corporate earnings. Investors flocked to the US to take advantage with the dollar rallying sharply while US equity markets significantly outperformed their foreign counterparts. This was especially notable in the EMG space, where a decade of QE had forced funds to the highest yielding assets they could find, which happened to be those EMG markets. But now that there was an alternative, those funds were quick to return to the US, driving EMG equity markets lower and hammering those currencies as well. There was also a great deal of concern that if the divergence in markets continued, it could result in much more significant losses elsewhere that would eventually come back to haunt US markets.

But a funny thing happened last week, US CPI printed lower than expected. Now you might not think that a 0.1% miss on a number would be that important, but essentially what that signaled to markets was that the Fed would be more likely to ease back on the pace of tightening, thereby slowing the rise in the short-term interest rate structure. It also indicated that US growth may not be as robust as had been previously thought, and therefore, opportunities here, while still excellent, needed to be weighed against what was going on elsewhere in the world. At the same time, elsewhere in the world we have seen continued central bank rhetoric about removing policy accommodation, with ECB President Draghi’s press conference seen as mildly hawkish, while the BOJ seems to be in stealth taper mode. We have also seen the trade situation get pushed to the back of the collective market’s mind as the US imposed a lower tariff rate than expected on Chinese goods, and has not yet moved forward on any other tariffs.

But wait, there’s more!, after four months of selling off, EMG assets have suddenly started to look like they represent a ‘value’ play, with the first buyers tentatively dipping their toes back into those markets. And finally, remember that the speculative long dollar position has been building for months and reaching near record levels. Adding it all up leads to the following conclusion: there is room for the dollar to continue this decline in the medium term. Continued fund movement into EMG markets combined with the reduction of the long dollar positions will be more than sufficient to continue to drive the dollar lower.

That combination is what has taken place this week, and despite the break today, it seems quite viable that we will continue to see this pattern for a bit longer. In the end, I don’t think that the market will completely ignore the cyclical dollar prospects, but for now, the broad structural story is holding sway. Add to this the idea that market technicians are going to get excited about selling dollars because it has reached levels below the 50-day and 100-day moving averages, and thus is ‘breaking out lower’, and we could be in for a couple of months of dollar weakness. If this is true, while individual currencies could still underperform, like the pound if the Brexit situation collapses, it is entirely possible that Chairman Powell could find himself in the best position he could imagine, continuing to remove policy ease while the dollar falls, thus ameliorating the President’s concerns. But it’s not clear to me that is such a good thing overall. We shall see.

Good luck and good weekend
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