Brexit Doomsday

In London, Prime Minister May
Has started revealing, some say
Details of the deal
Which optimists feel
Could postpone the Brexit doomsday

With the elections now past, market participants are looking for the next potential catalysts for movement and Brexit regularly leads the list. According to the British government, the deal is 95% complete, although the Irish border issue remains unsolved. The essence of this issue is as follows: ever since the Good Friday Agreement in 1998, Northern Ireland has been part of the UK, but has had no hard border between itself and the Republic of Ireland. As both Ireland and the UK were members of the EU, there were no issues regarding tariffs or trade, and so the process worked effectively. However, now that the UK is leaving the EU, as well as the customs union, suddenly there are likely to be tariffs on goods that cross that border. The problem stems from the fact that neither side wants a ‘hard’ border between the two nations, meaning no customs checking there. Therein lies the problem. How can Northern Ireland remain in the customs union but not England, Wales and Scotland? It would mean a border of some type between Northern Ireland and the rest of the UK. Of course, that doesn’t go over very well either. Hence the stalemate. The EU is willing to allow Northern Ireland to maintain its current stance with Ireland, but not the rest of the UK. The UK doesn’t want Northern Ireland to have a different status than itself with the EU. Those are exactly opposite positions and there is no obvious middle ground.

The risk becomes that PM May negotiates a deal, which will by definition be imperfect, and that said deal gets defeated in a Parliamentary vote, thus leaving nothing completed. Given the shrinking timeline available to come up with a deal, less than five months at this point, it seems pretty clear that this is the last opportunity to get something done. The market, at least based on the recent performance of the pound, has become increasingly optimistic that a solution will be found. While the pound has edged slightly lower overnight, it is up by more than 3% since Halloween with the entire movement based on the idea that a deal will be done. In addition, this morning there have been several comments by investors that a Brexit deal will result in a powerful rally in the pound, up to 1.50 or beyond. While I disagree with that assessment, it is important that everyone understands the different viewpoints in the market. The idea is that a Brexit deal will end uncertainty, spur investment and allow the BOE to become more aggressive raising interest rates. And while some of that is certainly true, for the pound to reach 1.50, the dollar will need to be much lower against all its counterparties, and I just don’t see that outcome.

The other key story today is the FOMC meeting, where no change in policy is anticipated, although there are some analysts looking for a tweak to the policy statement. At this point, it seems abundantly clear that the Fed is unconcerned with the level of the stock market, and that last month’s decline will have no bearing on their policy decision. There is talk of a tweak to IOER, where the Fed may reduce that rate relative to the current Fed Funds corridor of 2.00% – 2.25%, but I agree with the analysts who say that it makes limited sense for the Fed to do something this month, and they will be better off waiting until December when they raise rates again.

Beyond that, the data overnight showed a modest slowdown in Chinese exports with a reduction in their trade surplus, both globally and with the US. We also saw that German exports decline 0.8%, a surprisingly weak outcome attributed to ongoing issues with the German diesel auto sales. While yesterday morning saw the dollar under significant pressure across the board, the reality is that it reversed many of those losses during the session. This morning the dollar is marginally higher across the board, but the movements have not been significant. For example, the euro is lower by 0.15% and the pound by 0.3%. We have seen similar magnitude moves by the commodity bloc, and the yen has softened by 0.2%. As you can see, it has been a dull market.

In the EMG space, the dollar is generally, though not universally, stronger but here, too, the magnitude of movement has been modest, on the order of 0.2%-0.4% overall.

The only piece of data aside from the FOMC meeting is Initial Claims (exp 214K) this morning, and aside from the fact that this data continues to show a robust labor market, it has not been a market catalyst for a long time. After a big equity rally yesterday, futures are pointing slightly softer to open, and Treasury yields, after rallying sharply at the beginning of the month, remain near their multiyear highs with this morning’s level at 3.23%.

In sum, it is hard to get excited about large upcoming movement in the market today, and so a modest further dollar rally seems about right. Removing some more of the recent excesses would make sense in the context of the still uncertain outcomes from key issues like Brexit and the Italian budget quesoins.

Good luck
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Propense to Inveigh

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

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

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

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

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

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

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

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

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

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

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

Good luck
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Doves Will Despise

Come two o’clock later today
The Fed will attempt to convey
How high rates may rise
Though doves will despise
The idea that more’s on the way

Ahead of the conclusion of the FOMC meeting today, very little has happened in the FX markets, and in fact, in most markets. At this point, given the fact that the Fed remains one of the key drivers to global monetary policy, and the still significant concern that the ongoing divergence in Fed policy with that of the rest of the world can have negative consequences, pretty much every investor is awaiting the Fed statement and Chairman Powell’s press conference. It is a foregone conclusion that they will raise the Fed Funds rate by 25bps to 2.00% – 2.25%.

So the big question is just what the dot plot will look like, especially since today is the first time we will see their 2021 forecasts. Economists and analysts have slowly accepted that the Chairman is on a mission here, and that rates are going to continue to rise by 25bps every quarter at least through June 2019. That would put Fed Funds at 2.75% – 3.00%, a level that is currently seen as ‘neutral’. But what is still uncertain is how the Fed itself expects the economy to evolve beyond the end of the previous forecast period. Any indication that their models point to faster growth would be quite surprising and have a market impact. In fact, the most recent Fed forecasts have been for the economy to peak soon and begin to slow back to a 2.0% GDP growth rate by 2020. It is changes in this trajectory that will be of the most interest. That and Chairman Powell’s comments and answers at the press conference. But at this point, all we can do is wait.

Looking around the rest of the world, we see that central banks everywhere continue to have their policy dictated by the Fed. Two examples are Indonesia and the Philippines, both of whom are expected to raise rates this week (Indonesia by 25bps, Philippines by 50bps) as both of these nations continue to run current account deficits and have seen their currencies erode in value faster than any of their Asian peers other than India. The nature of these two countries, which is quite common in the emerging market sphere, is that currency weakness passes through quickly to higher inflation, and so the dollar strength that we have seen since the beginning of Q2 has already had a significant impact. It is this issue that has prompted a number of emerging market central bankers to caution Chairman Powell of the negative consequences of the current Fed policy trajectory. However, Powell has dismissed these out of hand and the Fed continues on its course.

The other notable movement in the EMG bloc was in Argentina, where the central bank president resigned after just three months on the job. Luis Caputo was both liked and respected by markets and the FX market responded by pushing the peso lower by 2.5% on the news. Of course, in the broad scheme of things, this is not very much compared to the currency’s 50% decline this year.

Pivoting to the G10, FX movement has been modest overall, with the biggest movers AUD and NZD, both of which seem to be benefitting from the recent revival in commodity prices. There has been no new Brexit news and so the pound remains relatively unscathed. Meanwhile, after Monday’s excitement in the euro following Signor Draghi’s “relatively vigorous” comments, it seems that ECB member Peter Prâet was trotted out to explain that there was no change in the committee’s view and that rates would not be rising until much later next year. Ultimately, however, the euro is essentially unchanged on the day, with the market having drawn that conclusion shortly after the comments were made.

Yesterday’s US data showed that Consumer Confidence was approaching all time highs but House prices seemed to display some weakness. This is the perfect mix for the Fed, lessening price pressures along with optimism on economic growth. I assure you this will not deter the Fed from continuing on its path. Before the FOMC meeting ends this afternoon, New Home Sales data will print, expected to be 630K, which looks right about in line with the longer term trend, albeit showing some softness from the situation earlier this year.

I see no reason to expect that the market will move significantly before the FOMC, and of course, can only watch with the rest of the market to see what actually comes from the meeting as well as what the Chairman says. Until then, look for a quiet session.

Good luck
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Just How He Feels

On Wednesday the Chairman reveals
To all of us, just how he feels
If dovish expect
Bulls to genuflect
If hawkish, prepare for some squeals

This is an early note as I will be in transit during my normal time tomorrow.

On Friday, the dollar continued its early morning rebound and was generally firmer all day long. The worst performer was the British pound, which fell more than 1.0% after Friday’s note was sent. It seems that the Brexit story is seen as increasingly tendentious, and much of the optimism that we had seen develop during the past three weeks has dissipated. While the pound remains above its lowest levels from earlier in the month, it certainly appears that those levels, and lower ones, are within reach if there is not some new, positive news on the topic. This appears to be an enormous game of chicken, and at this point, it is not clear who is going to blink first. But every indication is that the pound’s value will remain closely tied to the perceptions of movement on a daily basis. Hedgers need to be vigilant in maintaining appropriate hedge levels as one cannot rule out a significant move in either direction depending on the next piece of news.

But away from the pound, the story was much more about lightening positions ahead of the weekend, and arguably ahead of this week’s FOMC meeting. The pattern from earlier in the week; a weaker dollar along with higher equity prices around the world and higher government bond yields, was reversed in a modest way. US equity markets closed slightly softer, the dollar, net, edged higher, and 10-year Treasury yields fell 2bps.

The big question remains was the dollar’s recent weakness simply a small correction that led to the other market moves, or are we at the beginning of a new, more significant trend of dollar weakness? And there is no easy answer to that one.

Looking ahead to this week shows the following data will be released:

Tuesday Case-Shiller House Prices 6.2%
  Consumer Confidence 312.2
Wednesday New Home Sales 630K
  FOMC Decision 2.25%
Thursday Initial Claims 208K
  Goods Trade Balance -$70.6B
  Q2 GDP 4.2%
Friday PCE 0.2% (2.3% Y/Y)
  Core PCE 0.1% (2.0% Y/Y)
  Personal Income 0.4%
  Personal Spending 0.3%
  Chicago PMI 62.5
  Michigan Sentiment 100.8

So clearly, the FOMC is the big issue. It is universally expected that they will raise the Fed funds rate by 25bps to 2.25%. The real question will be with the dot plot, and the analysis as to whether the sentiment in the room is getting even more hawkish, or if the CPI data from two weeks ago was enough to take some of the edge off their collective thinking, and perhaps even change the median expectations of the path of rate hikes. I can virtually guarantee you that if the dot plot shows a lower median, even if it is because of a change by just one FOMC member, equity markets will explode higher around the world, the dollar will fall and government bond yields will rise. However, my own view is that the data since we have last heard from any Fed speaker has not been nearly soft enough to consider changing one’s view. Instead, I expect a neutral to hawkish statement, and a little pressure on equities.

But the big picture narrative does seem to be starting to change, and so any dollar benefit is likely to be short lived. Be ready to hear a great deal more about the structural deficits and how that will force the dollar lower. One last thing, tariffs on $200 billion of Chinese imports go into effect on Monday, which will only serve to add upward pressure to inflation data, and ultimately keep the FOMC quite vigilant. I remain committed to the idea that the cyclical factors will regain their preeminence, but it just may take a few weeks or months for that to be apparent. In the meantime, look for the dollar to slowly slide lower.

Good luck
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Little Fear

Much to all Free Traders’ chagrin
More tariffs are set to begin
But markets appear
To have little fear
This madness will cause a tailspin

As NY walks in this morning, there has been very limited movement in the dollar overall. While yesterday saw a modicum of dollar weakness, at least against the G10 currencies, we remain range bound with no immediate prospects for a breakout. It does appear that US data is turning more mixed than clearly bullish, as evidenced by yesterday’s Empire Manufacturing Survey data, which printed at 19, still solid but down from last month’s reading of 25.6 as well as below expectations of 23.0. A quick look at the recent history of this indicator shows that it appears to be rolling over from its recent high levels, perhaps signaling that peak growth is behind us.

At this point, it is fair to question what is causing this change in tone. During the summer, US data was unambiguously strong, with most releases beating expectations, but lately that dynamic has changed. The most obvious catalyst is the ongoing trade situation, which if anything worsened yesterday when President Trump announced that the US would be imposing 10% tariffs on an additional $200 billion of Chinese imports. In addition, these are set to rise to 25% in January if there is no further progress in the trade negotiations. As well, Trump threatened to impose tariffs on an additional $267 billion of goods, meaning that everything imported from China would be impacted. As we have heard from several Fed speakers, this process has grown to be the largest source of uncertainty for the US economy, and by extension for financial markets.

Yet financial markets seem to be quite complacent with regard to the potential damage that the trade war can inflict on the economy and growth. As evidence I point to the modest declines in US equities yesterday, but more importantly, to the rally in Asian equities overnight. While it is fair to say that the impact of this tariff war will not be directly felt in earnings results for at least another quarter or two, it is still surprising that the market is not pricing the potential negative consequences more severely. This implies one of two things; either the market has already priced in this scenario and the risks are seen as minimal, or that the rise in passive investing, which has exploded to nearly 45% of equity market activity, has reduced the stock market’s historic role as a leading indicator of economic activity. If it is the former, my concern is that actual results will underperform current expectations and drive market declines later. However, I fear the latter situation is closer to the truth, which implies that one of the long-time functions of the equity market, anticipating and discounting future economic activity, is changing. The risk here is that policymakers will lose an important signal as to expectations, weakening their collective hands further. And let’s face it, they need all the help they can get!

Turning back to the dollar, not only has the G10 has been dull, but EMG currencies are generally benign as well. In fact, the only substantive movement has come from everybody’s favorite whipping boy, TRY. This morning it is back under pressure, down 1.3% and has now erased all the gains it made in the wake of last week’s surprising 625bp rate hike. But in truth, beyond that, I can’t find an important emerging market currency that has moved more than 20bps. There are two key central bank meetings this week, Brazil tomorrow and South Africa on Thursday. Right now, expectations are for both to stand pat, leaving interest rates in both nations at 6.50%. However, the whisper campaign is brewing that South Africa may raise rates, which has undoubtedly helped the rand over the past two weeks as it has rallied some 4.5% during that time. We will know more by Thursday.

This overall lack of activity implies that traders are waiting the next important catalyst for movement, which may well be next Wednesday’s FOMC meeting! That is a very long time in the market for treading water, however, given the US data the rest of this week is second tier, and the trade situation is widely understood at this time, it is a challenge to see what else will matter until we hear from the Fed. And remember, the market has already priced in a 100% probability that they will raise rates by 25bps, so this is really all about updated forecasts, the dot plot and the press conference. But until then, my sense is that we are in for a decided lack of movement in the FX world.

Good luck
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