Inspired

It seems that inflation here’s not
Exploding, nor running too hot
That news has inspired
Stocks getting acquired
The dollar, meanwhile, went to pot

Yesterday’s CPI reading was surprisingly mild, with the headline rate rising 2.7% and the core just 2.2%. Both those readings were 0.1% below expectations and the market reaction was swift. Equity futures rallied immediately, with those gains maintained, and actually increased, throughout the session. At the same time the euro jumped 0.6%, as the CPI data moderated expectations of an ever more aggressive Fed. In other words, Goldilocks is still alive and well.

The employment situation in the US remains remarkably robust (Initial Claims were just 204K, the lowest level since December 1969!), while inflation seems to be under control. If you recall Chairman Powell’s comments from Jackson Hole, he remains data dependent, and clearly does not feel beholden to any particular economic model that defines where interest rates ought to be based on historical constructs. Rather, he seems willing to be patient if patience is required. Certainly the market understands that to be his view, as this data has helped flatten the trajectory of rate hikes further out the curve. While there is no doubt that the Fed will move later this month, and the probability of a December move remains high, next year suddenly looks much less certain, at least right now. Given this new information, it is no surprise that the dollar remains under modest pressure. And if the data starts to point to a slowdown in US growth and continued moderation in inflation, then the dollar ought to continue to suffer. But one data point does not make a trend, so let’s be careful about extrapolating this too far.

Beyond the CPI data, we also heard from Signor Draghi at the ECB press conference. He was remarkably consistent despite the reduction in GDP growth forecasts made by his staff economists. QE will wind down as advertised, with €30 billion of purchases this month and then €15 billion for the rest of the year, ending in December. And rates will remain where they are “through summer” which has widely been interpreted to mean until September 2019. Consider that one year from now, US interest rates are very likely to be at least 75bps higher than the current 2.00% and possibly as much as 150bps higher, which means that the spread will be at least 315bps in favor of the dollar. I understand that markets are forward looking, but boy, that is a very wide spread to ignore, and I expect that the dollar will continue to benefit accordingly.

Last night we also saw important data from China, where Fixed Asset Investment rose at its slowest pace (5.3%) since the data series began in 1996. This is somewhat surprising given Beijing’s recent instructions to regional governments to increase infrastructure investment as President Xi attempts to address a slowing economy. From the Chinese perspective, this is also an unwelcome outcome for the ongoing trade dispute with the US as it may give the appearance that China is more motivated for a deal and encourage President Trump to press harder. But for our purposes, the risk is that a slowing Chinese economy results in a weaker renminbi and there is clearly concern in Beijing that if USDCNY trades to 7.00, it could well encourage a more significant capital flight from the country, something that the PBOC wants to avoid at all costs. Now, last night it fell just 0.2% on the news and has actually recouped those losses since then, but that fear remains a driving force in Chinese policy.

The other stories that continue are in Turkey, where it should be no surprise that President Erdogan was extremely disappointed in the central bank for its surprisingly large rate hike yesterday morning. While the lira has held on to the bulk of its early gains, given Erdogan’s unpredictability, it is easy to contemplate further changes in the central bank governance that would be seen as quite negative for TRY. In Italy, the budget battles continue with no outcome yet, but this morning’s spin being somewhat less positive than yesterday’s, with concerns FinMin Tria will not be able to prevent a breech of the EU’s 3.0% budget deficit limit. And finally, BOE Governor Carney, in a closed door briefing with the PM and her cabinet, indicated that one possible scenario if there is no Brexit deal would be for crashing house prices but rising interest rates, a true double whammy. And on that subject, there has been no indication that a deal is any closer at this time. But all of these have been secondary to the CPI story, which seemed to change the tone of the markets.

This morning brings a raft of US data as follows: Retail Sales (exp 0.4%, 0.5% ex autos); IP (0.3%); Capacity Utilization (78.3%); Business Inventories (0.6%); and Michigan Consumer Sentiment (96.7). Arguably, the Retail Sales data will be the most closely watched as investors try to get a better understanding of just how the US economy is performing, but quite frankly, that number would need to be quite strong to alter the impressions from yesterday. Finally, we hear from Chicago Fed President Charles Evans, which could be interesting based on the CPI data’s change to impressions. In the end, though, I expect a relatively quiet session. It’s Friday and traders will want to reduce exposures.

Good luck and good weekend
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A Charade

The news there was movement on trade
Twixt China and us helped persuade
Investors to buy
Though prices are high
And it could well be a charade

We also learned wholesale inflation
Was lower across the whole nation
Thus fears that the Fed
Might still move ahead
Aggressively lost their foundation

The dollar is little changed overall this morning, although there are a few outlier moves to note. However, the big picture is that we remain range bound as traders and investors try to determine what the path forward is going to look like. Yesterday’s clues were twofold. First was the story that Treasury Secretary Mnuchin has reached out to his Chinese counterpart, Liu He, and requested a ministerial level meeting in the coming weeks to discuss the trade situation more actively ahead of the potential imposition of tariffs on $200 billion of Chinese imports. This apparent thawing in the trade story was extremely well received by markets, pushing most equity prices higher around the world as well as sapping a portion of dollar strength in the FX markets. Remember, the cycle of higher tariffs leading to higher inflation and therefore higher US interest rates has been one of the factors underpinning the dollar’s broad strength.

But the other piece of news that seemed to impact the dollar was a bit more surprising, PPI. Generally, this is not a data point that FX traders care about, but given the overall focus on inflation and the fact that it printed lower than expected (-0.1%, 2.8% Y/Y for the headline number and -0.1%, 2.3% Y/Y for the core number) it encouraged traders to believe that this morning’s CPI data would be softer than expected and therefore reduce some of the Fed’s hawkishness. However, it is important to understand that PPI and CPI measure very different things in somewhat different manners and are actually not that tightly correlated. In fact, the BLS has an entire discussion about the differences on their website (https://www.bls.gov/ppi/ppicpippi.htm). The point is that PPI’s surprising decline is unlikely to be mirrored by CPI today. Nonetheless, upon the release, the dollar softened across the board.

This morning, however, the dollar has edged slightly higher, essentially unwinding yesterday’s weakness. As the market awaits news from three key central banks, ECB, BOE and Bank of Turkey, traders have played things pretty close to the vest. Expectations are that neither the BOE or the ECB will change policy in any manner, and in fact, the BOE doesn’t even have a press conference scheduled so there is likely to be very little there. As to Draghi’s presser at 8:30, assuming there is no new guidance as expected, questions will almost certainly focus on the fact that the ECB staff economists have reduced their GDP growth forecasts and how that is likely to impact policy going forward. It will be very interesting to hear Draghi dance around the idea that softer growth still requires tighter policy.

But certainly the most interesting meeting will be from Istanbul, where current economist forecasts are for a 325bp rate rise to 22.0% in order to stem the decline of the lira as well as try to address rampant inflation. The problem is that President Erdogan was out this morning lambasting higher interest rates as he was implementing new domestic rules on FX. In the past, many transactions in Turkey were denominated in either USD or EUR (things like building leases) as the financing was in those currencies, and so landlords were pushing the FX risk onto the tenants. But Erdogan decreed that transactions like that are now illegal, everything must be priced in lira, and that existing contracts need to be converted within 30 days at an agreed upon rate. All this means is that if the currency continues to weaken, the landlords will go bust, not the tenants. But it will still be a problem.

Elsewhere, momentum for a Brexit fudge deal seems to be building, although there is also talk of a rebellion in the Tory party amongst Brexit hardliners and an incipient vote of no confidence for PM May to be held next month. Certainly, if she is ousted it would throw the negotiations into turmoil and likely drive the pound significantly lower. But that is all speculation as of now, and the market is ascribing a relatively low probability to that outcome.

FLASH! In the meantime, the BOE left rates on hold, in, as expected, a unanimous vote, and the Bank of Turkey surprised one and all, raising rates 525bps to 24.0%, apparently willing to suffer the wrath of Erdogan. And TRY has rallied more than 5% on the news, and is now trading just around 6.00, its strongest level since late August. While it is early days, perhaps this will be enough to help stabilize the lira. However, history points to this as likely being a short reprieve unless other policies are enacted that will help stabilize the economy. And that seems a much more daunting task with Erdogan at the helm.

Elsewhere in the EMG bloc we have seen both RUB and ZAR continue their recent hot streaks with the former clearly rising on the back of rising oil prices while the latter is responding to a report from Moody’s that they are unlikely to cut South Africa to a junk rating, thus averting the prospect of wholesale debt liquidation by foreign investors.

As mentioned before, this morning brings us CPI (exp 0.3%, 2.8% Y/Y for headline, 0.2%, 2.4% Y/Y for core). Certainly, anything on the high side is likely to have a strong impact on markets, unwinding yesterday’s mild dollar weakness as well as equity market strength. This morning we hear from Fed governor Randy Quarles, but he is likely to focus on regulation not policy. Meanwhile, yesterday we heard from Lael Brainerd and she was quite clear that the Fed was on the correct path and that two more rate hikes this year were appropriate, as well as at least two more next year with the possibility of more than that. So Brainerd, who had been one of the most dovish members for a long time, has turned hawkish.

All in all, traders will be focused on two things at 8:30, CPI and Draghi, with both of them important enough to move markets if they surprise. However, the big picture remains one where the Fed is the central bank with the highest probability of tightening faster than anticipated, while the ECB, given the slowing data from Europe, seems like the one most likely to falter. All that adds up to continued dollar strength over time.

Good luck
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Investor Frustrations

There once was a wide group of nations
Whose growth was built on weak foundations
Their policy actions
Are seen as subtractions
Increasing investor frustrations

Boy, I go away for a few days and world virtually collapses!!!

Needless to say, a lot has happened since I last wrote on Thursday, with a number of emerging market currencies and their respective equity markets really coming under pressure. It was the usual suspects; Turkey, Argentina, Indonesia, Brazil, Mexico, Russia and China, all of whom had felt significant pressure at various times during the year. But this new wave seems a bit more stressful in that prior to the past few days, each one had experienced a problem of its own, but since Friday, markets have pummeled them all together. This appears to be the contagion that had been feared by both investors and policymakers. The thing is, the unifying theme to pretty much all these markets is the stronger dollar. As the dollar resumes its strengthening trend, both companies and governments in those nations are finding it increasingly difficult to handle their debt loads. And given the near certainty that the Fed is going to continue its steady policy tightening alongside consistently stronger US economic data, the dollar strengthening trend seems likely to remain in tact for a while yet.

Could this be one of the ‘unexpected’ consequences of ten years of QE, ZIRP and NIRP? Apparently, despite assurances from esteemed central bankers like Ben Bernanke, Janet Yellen and Mario Draghi (as dovish a triumvirate as has ever been seen), there ARE negative consequences to dramatically changing the way monetary policy is handled, massively expanding balance sheets and driving real interest rates to significant negative levels. While there is no doubt that developed economy stock markets have benefitted generally, it seems like some of those risks are becoming more apparent.

These risks include things like the central bankers’ loss of control over markets. After all, markets around the world have basically danced to the tune of free money for the past decade. As that tune changes, investor behavior is sure to change as well. Another systemic risk has been the increasing inability of investors to adequately diversify their portfolios. If every market rises due to exogenous variables, like zero interest rates, then how can prudent investors manage their risk? Many took comfort in the fact that market volatility had declined so significantly, implying that systemic risk was reduced on net. However, what we have observed in 2018 is that volatility is not, in fact, dead, but had merely been anaesthetized by that free money.

The worrying thing is there is no reason to believe that this process is going to end soon. Rather, I fear that it may just be beginning. There are a significant number of excesses to wring out of the markets, and however much central bankers around the world try to prevent that from happening, they cannot hold back the tide forever. At some point, and it could be coming sooner than you think, markets are going adjust despite all the efforts of Powell, Draghi, Carney, Kuroda and their brethren. Never forget that the market is far bigger than any one nation.

We are already seeing how this can play out in some of the above-mentioned countries. Argentina, for example, has short-term interest rates of 60%, inflation of ‘only’ 31%, and therefore real interest rates are now +29%! But the economy is back in recession, having shrunk 6.7% last quarter, and the current account deficit remains a significant problem. So despite jacking rates to 60%, the currency has fallen 22% this week and 120% this year! And they are following orthodox monetary policy. Turkey, on the other hand, has been unwilling to bend to orthodoxy (when it comes to monetary policy) and has kept rates low such that real interest rates are near zero and heading negative as inflation continues its climb (17.9% in September) while rates remain on hold. So the fact that the lira is down 9% this week and 95% this year should be less surprising.

The point is that the market is losing its taste for discrimination and is beginning to treat all currencies under the rubric ‘emerging markets’ as the same. And they are selling them all. As long as the Fed continues its grind higher in rates, there is no reason to believe that this will end. And if these declines are steady, rather than sharp crashes, it will go on for a while. Chairman Powell will have no reason to stop if a few random EMG markets trend lower. If, however, the S&P 500 starts to suffer, that may be a different story, and one we will all watch with great interest!

In the meantime, turning to G10 currencies, the dollar is stronger here as well this morning, although it has fallen back from its best levels of the morning. In fact, while the pound has been consistently undermined (-0.3% today, -1.5% since Thursday) by what seems to be a worsening saga regarding Brexit, the euro has stabilized for now, although it is down about 1% since Thursday as well. Apparently, CAD is not taking the ongoing NAFTA negotiations that well, as it has fallen 2% since Thursday amid pressure on PM Trudeau to cave into US demands. The BOC meets today and while there had been previous expectations that they may raise rates, that has been pushed back to October now in view of the NAFTA process. This is despite the fact that inflation in Canada is running at 2.9%, well above target.

In the end, as long as the Fed continues along its recent path, expect market volatility to increase further, with more and more dominoes likely to fall.

As to today, the only noteworthy data is the Balance of Trade, where expectations are for a $50.3B outcome, not exactly what the president is hoping for, I’m sure. And as far as the dollar goes, there is no reason to believe that its recent strength is going to turn around anytime soon.

Good luck
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The Tempo of Growth

The President keeps on complaining
That higher Fed rates are constraining
The tempo of growth
But Powell is loath
To change things til prices are waning

Over the weekend, the President registered his dismay over recent Fed policy moves, apparently calling out Chairman Powell for raising rates too swiftly. His complaints centered on the fact that the Fed’s gradual removal of policy accommodation is helping to support the dollar and has been responsible for its recent strength. Recall that since the middle of April the dollar had rallied more than 8% before its recent modest pullback. So even with a 2% decline in the past week, the dollar remains far stronger than earlier this year. And that is what has the President upset. He sees the dollar’s strength through the lens of his trade policy and it is effectively undermining the tariff process.

Now, this is not the first time that the President has complained about the strong dollar (that occurred shortly after his election in 2016), but for some reason, the market has become far more concerned this time that it may impact the Fed’s actions. Perhaps adding to that sentiment was a speech yesterday by Atlanta Fed President, Rafael Bostic, where he explicitly stated that he would not knowingly vote for rate hike that would invert the yield curve. He is now the fourth Fed President to discuss that issue, although he is the only member of that group with voting privileges this year. The point is that there has been an increase in the discussion of whether the Fed will continue on its current rate hiking path which still seems slated for a hike in both September and December of this year and three more next year. Interestingly, though the dollar responded to the discussion, Fed funds futures remain unmoved and are still pricing in the same probabilities as last week, 90% for September and 60% for December.

So the question has become, will Powell ignore the President and act as he sees fit, or will he bow to political pressure? My money, at this point, remains on Powell. There has been no indication, as yet, that the US economy is doing anything but expanding at a solid clip. And more importantly, when looking at the Fed’s dual mandate, the current issue is clearly on the stable prices side rather than the unemployment side. While the Fed has decreed PCE is the key policy data point, there can be no mistake that Powell, an experienced pragmatist, is abundantly aware that CPI is running at its hottest level in more than a decade. The point is that inflation pressures continue to build and the Fed is not likely to ignore that situation. In fact, that is why Powell’s speech on Friday in Jackson Hole is arguably the most important news for the week. Everyone is waiting to hear if he has changed his tone, let alone his tune, about the economy and the proper Fed policy going forward.

Until then, though we will have to make do with tomorrow’s FOMC Minutes, where analysts will be looking for how much the trade story impacted their deliberations, and housing data tomorrow and Thursday.

Turning to the overnight session, the dollar has continued yesterday’s weakness and is lower by a further 0.35% this morning. The movement has been fairly uniform through the G10, with all of those currencies rallying between 0.2%-0.5%. And this has been a dollar story as there has been virtually no data of note from any one of those nations. In truth, the only G10 news of any sort came from Australia, where the Minutes from the last RBA meeting highlighted that increasing trade tensions could have a negative impact on the economy and currency, and that interest rates Down Under were unlikely to move at all during the next year.

Turning to the EMG bloc, we also see generic dollar weakness with just a few outliers. The Turkish lira continues to suffer, falling just under 1% this morning despite the dollar’s overall weakness, and we saw the Korean won slide 0.5% as well. But the rule has been a softer dollar today.

Given there is no US data to be released this morning, and there are no scheduled Fed speakers, it seems that the day is likely to follow the overnight pattern of mild further dollar weakness. Of course, given the apparent catalyst for this move, and the President’s penchant for doubling down, it would not be surprising to hear more from him if he felt it could push the dollar lower. However, history has shown that political wishes are just that, and the market will respond to policy changes, not talk. So even though further commentary by President Trump could lead to modest extra dollar weakness, as long as Chairman Powell maintains his current stance, this dollar move should be faded. Hedgers, take advantage of the opportunity to add to hedges at current levels, as my sense is that nothing at the Mariner Eccles building has changed. Higher US rates are on the way.

Good luck
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