Disgraced

Prime Minister May was disgraced
As Parliament calmly laid waste
To hopes that her deal
With Europe could heal
The schism that Brexit emplaced

Yesterday’s Parliamentary vote on the Brexit deal negotiated between PM May’s government and the EU resulted in a resounding rejection. While the UK remains fairly evenly divided on the absolute concept of Brexit, what was made clear was that the terms proposed were unacceptable to all sides. As I have maintained, the Irish border issue is an intractable one, where one side or the other simply must cede ground. There is no middle way. At this time, neither side is willing to do so, and quite frankly, unless Northern Ireland is willing to reunite with Ireland, (which seems highly unlikely any time soon), there can be no deal that will be acceptable to both sides. This leaves three potential outcomes; the UK could leave the EU with no deal in hand and go back to WTO tariff rules; the UK could opt not to leave at all (based on the European Court of Justice ruling from November); or there is a small possibility that the deadline could be delayed a number of months in order to reopen negotiations.

Let’s unpack those three choices.
1. In a no-deal Brexit, pretty much every published analysis by economists has forecast a nearly apocalyptic result for the UK economy, with a deep recession followed by much slower growth. Or course, every one of those economists likely voted to remain as the demographics of the vote showed professionals, especially financial industry professionals, overwhelmingly voted to remain. In other words, they are talking their book. Will the UK suffer? Almost certainly. Will the UK collapse into a depression? Absolutely not. The UK was a strong and viable nation before the EU came into existence and will certainly continue to be so going forward. The market impact of this outcome is likely to be quite negative in the short term, however, with both the pound and UK equity markets falling sharply if it becomes clear this will be the outcome. While both will recover eventually, the timing on that is unclear.

2. If the May government opted to remain in the EU, essentially repudiating the results of the referendum, I fear it would lead to riots in the streets, certainly in the Midlands which led the vote to leave. In fact, I could see an alliance between the French gilets jaune and the Brexiteers as both will be taking to the streets in an effort to change the government. A unilateral decision not to leave would have much deeper consequences with regard to the political system within the UK, as there would be whole swathes of the nation that would cease to trust the government entirely. I actually think this is the least likely scenario, although in the event it occurred, I would expect both the pound and the FTSE to rally sharply initially, but as the consequences of that act became clearer, I imagine both would suffer greatly.

3. Delaying the deadline seems like the best fudge available to both sides at this point, although the initial comments by EU officials followed the line that, given the depth of the defeat of the already negotiated deal, there seems little chance to make small changes and get a new result. This will also require unanimous approval by the remaining 27 members of the EU, which sounds daunting, although if there it was believed there was a serious chance of coming up with a better deal would get done. Here, too, the market response will be for a rally in the pound, and probably the FTSE, as investors would likely take the stance that the delay presages a deal.

However, for the time being, PM May’s first course of business is to fight off the no-confidence motion brought by Labour Leader Jeremy Corbyn in his attempt to bring down the government and force a general election. Pundits believe that while the deal was unacceptable, May will hold on. The problem is, she has no ideas as to how to move the process forward. Certainly, the probability of a no-deal Brexit has increased somewhat after the vote. Interestingly, the FX markets have not really priced for that outcome. In fact, since the original vote date, December 11, when May pulled the bill to try to garner more support, the pound has rallied pretty steadily and is nearly 3% higher over the past month. It would seem that FX traders believe a deal will be found.

The other story of note is that the Chinese government is now set to cut taxes in an effort to add fiscal stimulus to their ongoing monetary stimulus efforts. Remember, they have already cut bank reserve requirements by another 1% this year, adding to 2% cuts from last year, and they have created a loan targeting policy for SME’s. Now income tax cuts are to be included as well. This highlights just how poorly the Chinese economy is performing right now, and how critical President Xi believes it is to continue publishing GDP growth above 6%. While the FX market has shown little response to these actions, they have had a much more positive impact on equity markets, with yesterday’s rallies easily attributed to the announcement. The one thing that is certain is that Xi will continue to do whatever he things is necessary to support economic growth in the short run, regardless of the potential longer-term negative consequences. After all, despite being President for life, he is still a politician!

Pivoting to the data story, yesterday Germany reported 2018 GDP growth of just 1.5%, its weakest performance in 5 years, although there was no report on Q4 growth. Given the surprise decline in Q3, pundits were watching to see if Germany had entered a technical recession, although it appears not to be the case. However, it is clear that growth in the engine of Europe is continuing to slow which doesn’t bode well for the entire Eurozone. Nor does it bode well for the ECB’s nascent attempts to remove policy accommodation. In fact, their biggest fear has to be that growth slows further there and they have basically no monetary tools left to combat the situation. This morning’s data has shown that inflation continues to ebb in Europe (France 1.6%, Germany 1.7%, Spain 1.2%, Italy 1.1%), and the UK (2.1%) as well, which reduces pressure to tighten policy at all. While US inflation is also softening, it continues to puzzle me that there is any belief the ECB (or the BOE for that matter) will consider raising interest rates any time soon. So even if the Fed is more dovish (and given remarks from the always hawkish KC President Esther George yesterday, it is clear that there is no rate hike in the near future in the US), the idea that any other central bank is going to be tightening policy is absurd.

In fact, I would argue that the dollar’s recent weakness has been predicated solely on the idea that the Fed will back off on previously forecast rate hikes. But if the Fed is stopping, you can be 100% certain that any thoughts of tighter policy elsewhere are also out the window, and so relatively speaking, the US remains the tightest policy around. I still like the dollar for that reason.

Good luck
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Naught But Fool’s Gold

There once was a story, oft told
That growth round the world would be bold
But data of late
Has shown that the fate
Of that tale was naught but fool’s gold

Instead round the world what we see
Are signs that the future will be
Somewhat less robust
Than had been discussed
Since money is no longer free!

The dollar is strong this morning, rising vs. essentially every other currency after a series of weak data points from China and the EU reinforced the idea that global growth is slowing. As I type my last note of the year, the euro is lower by 0.65%, the pound -0.7% and Aussie has fallen -0.9%. In the emerging market space, the damage is generally less severe, with both CNY and BRL falling -0.4% while MXN and INR have both slipped -0.3%. There are two notable exceptions to this, however, as ZAAR has tumbled 1.5% and KRW fallen -0.8%. In other words, the dollar is in the ascendant today.

What, you may ask, is driving this movement? It started early last evening when China released some closely watched economic indicators, all of which disappointed and indicated further slowing of the economy there. Fixed Asset Investment rose just 5.9%, IP rose just 5.4% and Retail Sales rose just 8.1%. As Chinese data continue to fall below estimates, it increases the odds that the PBOC will ease monetary policy further, thus undermining the renminbi somewhat. But the knock on effect of weakening Chinese growth is that the rest of Asia, which relies on China as a key market for their exports, will also suffer. Hence the sharp decline in AUD and NZD (-1.0%), along with KRW and the rest of the APAC currencies. It certainly appears as though the trade tensions with the US are having a deleterious effect on the Chinese economy, and that may well be the reason that we have heard of more concessions on their part in the discussions. Today’s story is that corn purchases will be restarting in January, yet another rollback of Chinese trade barriers.

But it was not just China that undermined the global growth story; Eurozone data was equally dismal in the form of PMI releases. In this case, Germany’s Manufacturing PMI printed at 51.5, France at 49.7 and the Eurozone as a whole at 51.4. Each of these was substantially below expectations and point to Q4 growth in the Eurozone slowing further. While the French story is directly related to the ongoing gilets jaune protests, Germany is a bigger issue. If you recall, Q3 growth there was negative (-0.2%) but was explained away as a one-off problem related to retooling auto plants for emissions changes in regulations. However, the data thus far in Q4 have not shown any substantive improvement and now call into question the idea that a Q4 rebound will even occur, let alone offset the weak Q3 data.

Adding to the Eurozone questions is the fact that the ECB yesterday confirmed it was ending QE this month, although it has explained that it will be maintaining the size of the balance sheet for “an extended period of time” after its first interest rate rise. Currently, the market is pricing in an ECB rate hike for September 2019, but I am very skeptical. The fact that Signor Draghi characterized economic risks as to the downside rather than balanced should come as no surprise (they are) but calls into question why they ended QE. Adding to the confusion is the fact that the ECB reduced its forecasts for both growth and inflation for 2018 and 2019, hardly the backdrop to be tightening policy. In the end, much of this was expected, although Draghi’s tone at the press conference was clearly more dovish than had been anticipated, and the euro fell all day yesterday and has continued on this morning in the wake of the weak data. And this doesn’t even include the Italian budget mess where Italy’s latest figures show a smaller deficit despite no adjustments in either spending or taxes. Magical thinking for sure!

Meanwhile, the UK continues to hurtle toward a hard Brexit as PM May was rebuffed by the EU in her attempts to gain some conciliatory language to bring back to her Parliament. While I don’t believe in the apocalyptic projections being made about the UK economy come April 1st next year, I do believe that the market will severely punish the pound when it becomes clear there will be no deal, which is likely to be some time in January.

As to the US-China trade situation, this morning there is more fear of tariffs by the US, but the negotiation is ongoing. Funnily enough, my reading of the signs is that China is, in fact, blinking here and beginning to make some concessions. The last thing President Xi can afford is for the Chinese economy to slow sharply and put millions of young men out of work. Historically, excessive unemployed youth can lead to revolution, a situation he will seek to avoid at all costs. If it means he must spin some concessions to the US into a story of strengthening the Chinese economy, that is what he will do. It would certainly be ironic if President Trump’s hardball negotiating tactics turned out to be successful in opening up the Chinese economy and broadly pushing forward a more internationalist agenda, but arguably, it cannot be ruled out. Consider the ramifications on the political debate in the US if that were to be the case!! As to the market implications, I would expect that risk would be quickly embraced, equity markets would rally sharply as would the dollar, while expectations for the Fed would revert to tighter policy in 2019 and beyond. Treasuries, on the other hand, would fall sharply and yields on the 10-year would likely test their highs from early November. We shall see.

This morning brings Retail Sales (exp 0.2%, ex autos 0.2%), IP (0.3%) and Capacity Utilization (78.6%). Data that continues to show the US growing, especially in the wake of the weakness seen elsewhere in the world, should continue to underpin the dollar going forward. While I understand the structural issues like the massive budget and current account deficits should lead to dollar weakness, we are still in a cyclical phase of the market, and the US remains the best place to be for investment, so it remains premature to write off further dollar strength.

Good luck, good weekend and happy holidays to you all.

FX Poetry will return on January 2nd with forecasts for next year, and in regular format starting January 3rd.

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Into the Tank

The German economy shrank
Japan’s heading into the tank
Italians declared
The budget prepared
Is gospel, and oil just sank

There are a number of stories this morning competing for market attention as investors and traders continue to try to get a reading on growth prospects going forward. Perhaps the most surprising story is that German GDP, which had been expected to print at 0.0% in Q3, actually fell -0.2%, significantly worse than expected. While every pundit and economist has highlighted that it was a confluence of one-time events that drove the data and that expectations for Q4 are far more robust, the fact remains that Q3 growth in Germany, and the whole of Europe, has been much weaker than anticipated. The euro has not benefitted from the news, falling 0.25%, and broadly continuing its recent downtrend.

Adding to the single currency’s woes is the ongoing Italian budget opera, where the EU huffed and puffed and demanded the Italians change their plans. The Italians, formally, told the EU to pound salt yesterday evening, and now the EU is at a crossroads. Either the emperor has no clothes (EU does nothing and loses its fiscal oversight capability) or is in fact well dressed and willing to flaunt it (initiates procedures to sanction and fine Italy). The problem with the former is obvious, but the problem with the latter is the potential impact on EU Parliamentary elections to be held in the spring. Attacking Italy could easily result in a far more antiestablishment parliament with many of the current leadership finding themselves in the minority. (And the one thing we absolutely know is that incumbency is THE most important aspect of leadership, right?) The point is that there are ample reasons for the euro to remain under pressure going forward.

At the same time, Japanese economic data continues to disappoint, with IP declining -2.5% Y/Y in September and Capacity Utilization falling 1.5%. At the same time, we find out that the BOJ’s balance sheet is now officially larger than the Japanese economy! Think about that, Japan’s debt/GDP ratio has long been over 200%, but now the BOJ has printed money and bought assets equivalent to the entire annual output of the nation. And despite the extraordinary efforts that the BOJ has made, growth remains lackluster and inflation nonexistent meaning the BOJ has failed to achieve either of its key aims. At some point in time, and it appears to be approaching sooner rather than later, central banks around the world will completely lose the ability to adjust market behavior through either words or action. And while it is not clear which central bank will lose that power first, the BOJ has to be the frontrunner, although the ECB is certainly trying to make a run at the title.

Meanwhile, from Merry Olde Englande we have news that a draft Brexit deal has been agreed between PM May and the EU. The problem remains that her cabinet has not yet seen nor signed off on it, and there is the little matter of getting the deal through Parliament, which will be dicey no matter what. On the one hand, it is not wholly surprising that some type of agreement was reached, but as is often the case in a situation as fraught as Brexit, nobody is satisfied, and quite frankly, it is not clear that it will gather sufficient support from either the UK Parliament, or the EU’s other nations. This is made evident by the fact that the pound has actually fallen today, -0.2%, despite the announcement. I maintain that a Brexit deal will clearly help the pound’s value, so the market does not yet believe the story. At the same time, UK inflation data was released at a softer than expected 2.4% in October, thus reducing potential pressure on the BOE to consider raising rates, even if a Brexit deal is agreed. After all, if inflation falls to 2.0%, their concerns will be much allayed.

One other story getting a lot of press has been the sharp decline in the price of oil, which yesterday fell 7.1% in the US, and is now down more than 26% since its high in the beginning of October, just six weeks ago. There is clearly a relationship between commodity prices and the dollar given the fact that most commodities are priced in dollars, and that relationship is consistently an inverse one. The question, that I have yet to seen answered effectively, is the direction of the causality. Does a stronger dollar lead to weaker commodity prices? Or do weaker commodity prices drive the dollar higher? While I am inclined to believe in the first scenario, there are arguments on both sides and no research has yet been able to answer the question effectively. However, it should be no surprise that the dollar continues to rally coincidentally with the decline in oil, and other commodity, prices.

I didn’t even get a chance to discuss the ongoing slowdown in Chinese economic growth, but we can touch on that tomorrow. As for today’s session, this morning we see the latest CPI readings (exp 0.3%, 2.5% Y/Y headline, 0.2% 2.2% core) and then as the FX market gets set to go home, Chairman Powell speaks, although it is hard to believe that his views on anything will have changed that much. In the end, the big picture remains that the dollar should continue to benefit from the Fed’s ongoing monetary policy activities as well as the self-inflicted wounds of both the euro and the yen.

Good luck
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