The Next Year Or So

Said Williams, “the next year or so”
Should see rates reach neutral, you know
At that point we’ll see
If our GDP
Is humming or soon set to slow

The dollar is under very modest pressure this morning, although in reality it is simply continuing to consolidate its recent gains. While there have been individual currency stories, the big picture continues apace.

As I write, the IMF is holding its annual meeting in Indonesia and so we are hearing much commentary from key financial officials around the world. Yesterday, IMF Managing Director Lagarde told us that the ongoing trade tensions were set to slow global growth. Overnight, we heard from NY Fed President John Williams, who said that the US economy continued to be strong and that while there is no preset course, it seemed likely that the Fed would continue to adjust policy until rates reached ‘neutral’. Of course, as nobody knows exactly where neutral is, there was no way to determine just how high rates might go. However, there was no indication that the Fed was going to pause anytime soon. Dallas Fed President Robert Kaplan, who said that he foresaw three more rate hikes before any pause, corroborated this idea. According to the dot plot, 3.00% seems to be the current thinking of where the neutral rate lies as long as inflation doesn’t push significantly higher than currently expected. All this points to the idea that the Fed remains on course to continued policy tightening, with the risks seemingly that if inflation rises more than expected, they will respond accordingly.

The other truly noteworthy news was from the UK, where it appears that a compromise is in sight for the Brexit negotiations. As expected, there is some fudge involved, with semantic definitions of the difference between customs and regulatory checks, but in the end, this cannot be a great surprise. The impetus for change came from Germany, who has lately become more concerned that a no-deal Brexit would severely impact their export industries, and by extension their economy. The currency impact was just as would be expected with the pound jumping one penny on the report and having continued to drift higher from there. This seems an appropriate response as no deal is yet signed, but at least it appears things are moving in the right direction. In the meantime, UK data showed that Q3 GDP growth is on track for a slightly better than expected outcome of 0.7% for the quarter (not an annualized figure).

As to the other ongoing story, there has been no change in the tone of rhetoric from the Italian government regarding its budget, but there are still five days before they have to actually submit it to their EU masters. It remains to be seen how this plays out. As I type, the euro has edged up 0.15% from yesterday’s close, but taking a step back, it is essentially unchanged for the past week. If you recall, back in August there was a great deal of discussion about how the dollar had peaked and that its decline at that time portended a more significant fall going forward. At this point, after the dollar recouped all those losses, that line of discussion has been moved to the back pages.

Turning to the emerging markets, Brazil remains a hot topic with investors piling into the real in expectations (hopes?) of a Bolsonaro win in the runoff election. That reflected itself in yet another 1.5% rise in the currency, which is now higher by more than 10% over the past month. The China story remains one where the renminbi seems to be on the cusp of a dangerous level, but has not yet fallen below. Equity markets there took a breather from recent sharp declines, ending the session essentially flat, but there is still great concern that further weakness in the CNY could lead to a sharp rise in capital outflows, or correspondingly, more draconian measures by the PBOC to prevent capital movement.

But after those two stories, it is harder to find something that has had a significant impact on markets. While Pakistan just reached out to the IMF for a $12 billion loan, the Pakistani rupee is not a relevant currency unless you live there. However, this issue is emblematic of the problems faced by many emerging economies as the Fed continues to tighten policy. Excessive dollar borrowing when rates were low has come back to haunt many of these countries, and there is no reason to think this process will end soon. Continue to look for the dollar to strengthen vs. the EMG bloc as a whole.

This morning brings our first real data of the week, PPI (exp 2.8%, 2.5% ex food & energy). However, PPI is typically not a market mover. Tomorrow’s CPI data, on the other hand, will be closely watched for signs that inflation is starting to test the Fed’s patience. But for now, other than the Brexit news, which is the first truly positive non-dollar news we have seen in a while, my money is on a quiet session with limited FX movement. The only caveat is if we see significant equity market movement, whereby a dollar reaction would be normal. This is especially so if equities fall and so risk mitigation leads to further dollar buying.

Good luck

Growth Would Be Marred

The IMF’s Christine Lagarde
Explained global growth would be marred
By tariffs imposed
Which keep borders closed
To products that ought not be barred

The dollar has continued its recent ascent this morning, edging higher still against most of its counterparts as US interest rates continue to climb. In fact, as I type, the 10-year Treasury has breached 3.25% for the first time in more than seven years, and quite frankly, there is no reason to think this trend is going to stop. Rather, given the significant amount of new issuance that will be required by the Treasury Department, and the fact that the Fed is reducing the amount of bonds that it purchases as it shrinks its balance sheet, we should expect to see yields continue higher. Back in January I forecast that the 10-year yield would reach 4.00% by the end of the year. For the longest time that seemed impossible, but while still a difficult conclusion, given the speed with which yields have risen recently, it doesn’t seem quite as far-fetched as it used to.

At any rate, the market stories today are largely the same as those from yesterday. Perhaps the key headline was the IMF announcement that they had reduced their estimates for global growth for 2018 and 2019 by 0.2% to 3.7% for both years. The key change since their last estimate was the increased trade tensions between the US and China and the estimated impact those will have on nations around the globe. However, they did not adjust their estimate of US growth, which is likely to encourage the Trump Administration to continue down the path of further tariffs in their negotiation strategy.

Beyond that story, we are still in the grips of the Italian budget situation, where there has been no indication that the coalition government is going to adjust policy to reduce the projected deficit. Given that every one of these situations in Europe turns into a game of chicken, it is probably too early to assume no solution will be found. However, it is important to remember that DiMaio and Salvini, the heads of the 5-Star and League parties respectively, and the real power in the government, are both anti-establishment, and there appears to be a very real chance that they ignore the European Commission and the EU rules. Certainly the Italian stock and bond markets are concerned over that outcome, as 10-year yields there have risen another 10bps while the FTSE MIB has fallen a further 0.5%. This process will continue to weigh on the euro for now so it should be no surprise that the single currency has fallen by 0.5% this morning. But arguably it is not only the Italian situation impacting the euro, we also saw German trade data, which reported a significant decline in imports, -2.7%. While this did result in an increased trade surplus, sharply falling imports is not a sign of economic strength, and so this was likely not seen as a positive. Net, the combination of ongoing tighter US monetary policy and stalling growth in Europe should help underpin the dollar going forward.

Looking at the rest of the G10 space, the dollar is firmer virtually across the board, with the only exception the Japanese yen, which is flat on the day. Though some may argue that slightly better than expected Economy Wathers Survey data helped, this appears to me to be a consequence of a broader risk-off sentiment that is sweeping the markets. A stronger dollar and a stronger yen are natural consequences of this mentality. What is interesting, however, is that two other natural haven assets, gold and Treasuries, are not performing in the same way. I think the explanation for both is the same: higher US short term rates, now above 2.0% across products, is of sufficient attraction to draw frightened investors into Treasury bills rather than taking the risk of a 10-year note. As well, now that cash earns a return, the opportunity cost of holding gold has increased substantially. Given this situation, it appears there is much further to go for the dollar, as fear will drive investors to short term dollar holdings. With this in mind, I suspect we will hear much less about an inverting yield curve for a time. After all, given the sharp rise in 10-year yields and the increased demand for short term assets, it will be very hard for that to occur.

Flipping to emerging markets, the dollar is broadly stronger here as well, across all three regions. In fact, the only noteworthy exception is BRL, which rallied 1.5% yesterday in the wake of the results of Sunday’s presidential election. It is clear that the market remains highly in favor of a President Bolsonaro there, and I expect that as we approach the run-off vote in three weeks’ time the real will continue to perform well. However, this movement has all the earmarks of a ‘buy the rumor, sell the news’ scenario, which means that a sharp dollar rally could well result in the wake of the run-off vote no matter who wins. Granted, if Fernando Haddad, the left wing candidate wins, I would expect the real’s decline to be much sharper.

Away from that, USDCNY is trading above 6.93 today as the Chinese continue to try to ease policy domestically without causing too much market turmoil. While the Trump Administration is apparently looking at naming China a currency manipulator in the latest report due shortly, given the dollar’s overall strength, it appears to me that the movement is entirely within the confines of the overall market. Quite frankly, it still seems as though the Chinese are quite concerned about a ‘too-weak’ renminbi as a trigger to an increase in capital outflows, and so will prevent excessive weakness for now. That said, I expect CNY will continue to weaken going forward.

And that’s really it for today. The NFIB Small Business Optimism Report was released at 107.9, softer than expected but still tied for the second highest reading of all time. Confidence in the economy remains strong. All we have for the rest of the day are speeches by Chicago Fed President Evans and NY’s John Williams. However, given what we have heard lately and the dearth of new news likely to change opinions, it beggars belief to think that anything new will come from these comments. In other words, there is nothing standing in the way of the dollar continuing to rise on the back of ever tighter US monetary policy.

Good luck