Here To Stay

Fed speakers are starting to say
That lower rates are here to stay
It’s not about trade
Instead they’re dismayed
Inflation just won’t go their way

Since the FOMC meeting two weeks ago, we have heard a steady stream of Fed speakers with one main theme, current interest rate policy is appropriate for the economy right now. While the market continues to price in another rate cut for later this year, and economists and analysts are starting to lean in that direction as well, the Fed remains resolute in their conviction that they don’t need to do anything. When asked about the trade situation, they mouth platitudes about how free trade helps everyone. When asked about political pressures, they insist they are immune to any such thing. These responses cannot be any surprise and are what every FOMC member would have said any time during the past century. However, there is one theme that is starting to coalesce that is different; the idea that interest rates are going to be permanently lower in the future than they have been in the past.

NY Fed President John Williams has highlighted the fact that recent research indicates r* (the theoretical neutral rate of interest) for the five main economies (US, UK, Japan, Eurozone and Canada) has fallen to just 0.5% from something more like 2.5% prior to the financial crisis. The implication is that there is no reason for interest rates to rise much further, if at all, from current levels as that would result in tightening monetary policy with a corresponding slowing of economic activity. If this is correct, it bodes ill for central banks abilities to help moderate future economic downturns. After all, if rates are near zero when an economy slows down, interest rate cuts are unlikely to have a material impact on the situation. Of course, this is what led to unconventional policies like QE and forward guidance, and we can only assume that every central bank is trying to think up new unconventional policies as those lose their efficacy. Do not be surprised if legislation appears that allows the Fed to purchase any assets it deems appropriate (stocks, real estate, etc.) in its efforts to address the next downturn. This is also why MMT has gained favor in so many places (although not the Fed) as it removes virtually all restrictions on spending and fiscal policy and reduces the role of monetary policy.

One other thing that seems incongruous is the precision with which the Fed believes is should be able to manage inflation. Inflation is a broad reading of price pressures over millions of items ranging from houses to pencils. Its measurement remains controversial and imperfect, at best. Pricing decisions continue to be made by the sellers of products, not by government fiat, and so the idea that the Fed can use a blunt tool like the general level of interest rates, to fine-tune price changes is, on the face of it, absurd. Is there really a difference between 1.6% and 2.0% inflation? I understand the implications regarding compounding, and of course the biggest issue is that cost of living adjustments in programs like Social Security and Medicare have enormous fiscal consequences and are entirely dependent on these measurements. But really, precision is a mistake in this case. It would be far more sensible, and achievable, for the Fed to target an inflation range like 1.5%-2.5% and be happy to focus on that rather than aiming for a target and miss it consistently in the seven years since it was defined.

Now back to markets. While Asian equity markets continued the US sell-off, it seems that the course has been run for now elsewhere. European shares are higher by between 0.5% and 1.0% this morning, while US futures are pointing to a 0.75% or so rebound at the open. At this point, all the tariff news seems to be in the market, and there continues to be a strong belief that a deal will get done, most likely in June when President’s Xi and Trump meet on the sidelines of the G20 meetings in Japan. The dollar continues to hold its own, although it has not been able to make any general headway higher lately.

In the currency market, this morning shows that risk is being tentatively reacquired as the yen falls (-0.35%) while EMG currencies edge higher (MXN +0.25%, INR +0.3%). The G10 beyond the yen is little changed, although most of those currencies suffered during yesterday’s equity rout. One thing that appears to be ongoing lately is that central banks have been slowly reducing the dollar portion of their holdings, taking advantage of the dollar’s recent strength to diversify their portfolios. That would certainly be a valid explanation for the dollar’s inability to make any substantive gains lately.

On the data front, overnight saw a disappointing German ZEW Index reading of -2.1 (exp +5.0), which implies that the hoped for rebound in Germany may still be a bit further away than the ECB is counting on. At the same time, UK labor markets continue to show robust strength with another 99K jobs created and average earnings continuing to grow at a solid 3.3% pace. However, neither of these data points had any impact on the FX market. In the US, the NFIB Business Index rose to 103.5, slightly better than forecast and demonstrating a resiliency in the small business psyche in this country. However, we don’t see any further data here today, and so if pressed, I would expect the FX market to be uninspiring. If equity markets manage to maintain their rebound, then I would expect a modicum of dollar weakness as investors rush back into the EMG bloc, but I think it far more likely that there is little movement overall.

Good luck
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Rather Wrong

While Powell said growth may be strong
He still thinks it seems rather wrong
That prices won’t rise
So it’s no surprise
That rates will go lower ‘ere long

After the FOMC left policy largely unchanged yesterday (they did tweak the IOER down by 5bps) and the statement was parsed, it appeared that the Fed’s clear dovish bias continues to drive the overall tone of policy. Growth is solid but inflation remains confusingly soft and it appeared that the Fed was moving closer to the ‘insurance’ rate cut markets have been looking hoping for to prevent weakness from showing up. Stocks rallied and so did bonds with the yield on the 10yr falling to 2.45% just before the press conference while stock markets were higher by 0.5% or so. But then…

According to Powell the story
Is price declines are transitory
So patience remains
The thought in Fed brains
With traders stuck in purgatory

Powell indicated that the majority view at the Fed was that the reason we have seen such weak price data lately is because of transitory issues. These include reduced investment management fees in the wake of the sharp equity market declines in Q4 of last year and the change in the way the Fed gathered price data at retail stores where they now collect significantly greater amounts of data digitally, rather than having ‘shoppers’ go to stores and look at price tags. The upshot is that while he was hardly hawkish in any sense of the word, trying to maintain as neutral a stance as possible, he was far more hawkish than the market had anticipated. Not surprisingly, markets reversed their earlier moves with 10yr yields shooting higher by 6bps, closing higher than the previous day’s close, while equity markets ceded all their early gains and wound up falling about 0.7% on average between the three major indices.

What about the dollar? Well, it followed the same type of trajectory as other assets, softening on the dovish ideas throughout the session before rallying a sharp 0.55% in the wake of Powell’s press conference opening statement. Since then, it has largely maintained the rebound, although this morning it is softer by about 0.1% across the board.

Looking ahead, markets are going to continue to focus on the interplay between the data releases and the central bank comments. Nothing has changed with regard to the overarching dovish bias evident in almost all central banks, but in order for them to act, rather than merely talk, the data will have to be clearly deteriorating. And lately, the best description of the data releases has been mixed. For example, yesterday saw a huge ADP Employment number, 275K, boding well for tomorrow’s NFP report. However, ISM Manufacturing fell sharply to 52.8, well below last month’s 55.3 reading as well as far below the 55.0 market expectation. So, which one is more important? That’s the thing. As long as we see strength in some areas of the economy along with weakness in others, the Fed is almost certainly going to sit on the sidelines. That is, of course, unless the inflation data starts to move more aggressively in either direction. I think it is far better than even money that Fed funds are 2.25%-2.50% on December 31.

But what about other places? Well, the ECB seems stuck between a rock and a hard place as Q1 data has been disappointing overall and they are running out of tools to fight a slowdown. Given the current rate structure, the question being debated in the halls in Frankfurt is just how low can rates go before having a net detrimental impact on the economy. If we see any further weakness from the Eurozone, we are going to find out. That brings us to this morning’s PMI data, where Bloomberg tried hard to put a positive spin on what remains lousy data. Germany (44.4), Italy (49.1) and France (50.0) remain desultory at best. The Eurozone print (47.2) is hardly the stuff of dreams, although in fairness, it was better than analysts had been expecting. So perhaps we are seeing the beginnings of a stabilization in the decline, rather than a continuing acceleration of such. But that hardly gives a rationale for tighter policy. The ECB remains stuck on hold on the rate front and is certainly going to see significant uptake of their new TLTRO’s when they come out. It remains difficult to see a reason for the euro to rebound given the underlying economic weakness in the Eurozone, especially with the ECB committed to negative rates for at least another year.

What about the UK? Well, the BOE met this morning and left rates on hold by a unanimous vote. They also released new economic forecasts that showed reduced expectations for inflation this year, down to 1.6%, with the out years remaining essentially unchanged. They indicated that the delay in Brexit would have a limited impact as they continue to plan on a smooth transition, and their growth forecasts changed with 2019 rising to 1.5% on the back of the inventory led gains in Q1, although the out years remain unchanged. Here, too, there is no urgency to raise rates, although they keep trying to imply that slightly higher rates would be appropriate. However, the market is having none of it, pricing a 30% chance of a 25bp rate cut before the end of next year. The pound chopped on the news, rallying at first, but falling subsequently and is now sitting at 1.3050, essentially unchanged on the day.

Of course, Brexit continues to influence the pound’s movements and recent hints from both PM May and Labour Leader Corbyn indicate that it is possible they are going to agree a deal that includes permanent membership of a customs union with the EU. Certainly, verification of that will help the pound rally back. But boy, if I voted for Brexit and this is what they delivered, it would be quite upsetting. In essence, it destroys one of the main benefits of Brexit, the ability to manage their own trade function. We shall see how it plays out.

This morning brings more data, starting with Initial Claims (exp 215K), Nonfarm Productivity (2.2%) and Unit Labor Costs (1.5%) at 8:30, then Factory Orders (1.5%) at 10:00. The onslaught of Fed speakers doesn’t start until tomorrow, so that’s really it for the day. Equity futures are rallying this morning as the idea that the markets fell yesterday seems more like a mirage than a market response to new information. In the end, you cannot fight city hall, and though Powell tried to sound tough, I didn’t see anything to change the view that the Fed remains biased toward cutting rates as their next move.

Good luck
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More Not Less

As markets return from vacation
The central banks’ tales of inflation
Continue to stress
They want more, not less
Thus, policy ease is salvation

With the market back to full strength this morning, after a long holiday weekend throughout much of the world, it seems that every story is about the overall change in tone by most major central banks. That tone, of course, is now all about the end of the nascent tightening cycle. Whether considering the Swedish Riksbank, which saw disturbingly higher Unemployment data at the end of last week thus putting the kibosh on their efforts to continue policy normalization and raise rates back up to 0.0%, or the weekend WSJ story that hypothesized how the Fed was reconsidering their framework and trying to determine new lower thresholds for easing policy, all stories point to one thing, central banks have looked in the mirror and decided that they are not going to take the blame for the next recession.

This means that we need to be prepared to hear more about allowing the economy to run hot with higher inflation and lower unemployment than previously deemed prudent. We need to be prepared to hear more about macroprudential measures being used to prevent asset bubbles in the future. But most importantly, we need to be prepared for the fact that asset bubbles have already been inflated and the current monetary policy stance is simply going to help them expand further. (Of course, central banks have proven particularly inept at addressing market bubbles in the past, so the idea that they will suddenly be able to manage them going forward seems unlikely.)

Naturally, there are calls for a switch in the mix of policy initiatives around the G10 with demands for more fiscal stimulus offset by less monetary stimulus. That idea comes right from page one of the Keynesian handbook, but interestingly, when the US implemented that policy last year (tax cuts and four rate hikes) both sets of policymakers got lambasted by the press. Fiscal stimulus at the end of a long growth cycle was seen as crazy and unprecedented while Fed hawkishness was undermining the recovery. These were the themes portrayed throughout the press and the market. When considered in that context, it seems that pundits really don’t care what happens, they simply want to be able to complain about the current policy and seem smart! At any rate, it has become abundantly clear that neither fiscal nor monetary policy is going to tighten anytime soon.

So, what does this mean for markets?

For equity markets, the world is looking incredibly bright. Despite the fact that equity markets have rebounded sharply already this year, (S&P +16%, DAX +15%, Shanghai + 28%, Nikkei +13%), given the clear signals we are hearing from global policymakers, there is no reason to think this should end. One of Keynes’ most important lessons was that ‘markets can remain irrational longer than you can remain solvent’. The point being that even if there is concern that markets have rallied to significantly overvalued levels, there is nothing to stop them from going further in the short run. Another interesting weekend article, this by Kevin Muir, highlighted the dichotomy between current retail enthusiasm for equity markets being so different from professional skepticism in the current situation. His point was one side of the argument is going to be really wrong. My take is that it is more a question of timing with an easily envisioned scenario of a further short-term rally to even more absurd valuation levels before an eventual reversal on some heretofore unseen concern (hard Brexit? US-China trade talks break down? Hot war after Iran tries to shut down the Strait of Hormuz?) The point is, there are still plenty of potential concerns that can derail things, but for now, it is all about easy money!

For bond markets, things are also looking great. After all, if there is no further policy tightening on the horizon, and inflation remains quiescent, government bonds should continue to rally. This is especially so if we see Eurozone economic weakness start to spread more widely. As to corporate bonds, low policy rates and ongoing solid economic activity point to spreads maintaining their current extremely tight levels. The hunt for yield will continue to dominate fixed income investing and that means tighter spreads across all asset classes.

Finally, for the currency markets this is a much more nuanced picture. This is because currencies remain a relative game, not an absolute one like stocks and bonds. So who’s policy is the tightest? Arguably, right now the US. Is that going to change in the near-term? While the Fed has clearly stopped raising rates, and will be ending QT shortly, the ECB is discussing further stimulus, the BOJ is actively adding stimulus, the PBOC is actively adding stimulus and the BOE remains mired in the Brexit uncertainty with no ability to tighten policy ahead of a conclusion there. In other words, the US is still the belle of the ball when it comes to currencies, and there is no reason to expect the dollar to start to decline anytime soon. In truth, given the idea that current policies are ostensibly priced into the market already, and that there are no changes seen in the medium term, I imagine that we are setting up for a pretty long period of limited movement in the G10 space, although specific EMG currencies could still surprise.

On the data front, it is particularly quiet this week, and with the Fed on the calendar for next week, there will be no more speakers until the meeting.

Today New Home Sales 650K
Thursday Initial Claims 200K
  Durable Goods 0.8%
  -ex Transport 0.2%
Friday Q1 GDP (revised) 2.1%
  Michigan Sentiment 97.0

We will see the final data point in this month’s housing story, which has been pretty lousy so far as both Housing Starts and Existing Home Sales disappointed last week. (Anecdotally, I see the slowdown in my neighborhood, where historically there have been fewer than 2 homes for sale at any given time, and there are currently 7, with some having been on the market for at least 9 months.) We also see the second look at Q1 GDP, with a modest downtick expected to 2.1%, still running at most economists’ view of potential, and clearly much faster than seen in either Europe or Japan. As I said, there is nothing that points to a weaker dollar, although significant dollar strength doesn’t seem likely either. I think we are in for some (more) quiet times in FX.

Good luck
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Clearly On Hold

Though policy’s clearly on hold
Most central banks feel they’ve controlled
The story on growth
And yet they’re still loath
To change their inflation threshold

Amidst generally dull market activity (at least in the FX market), traders and investors continue to look for the next key catalysts to drive markets. In US equity markets, we are now entering earnings season which should keep things going for a while. The early releases have shown declining earnings on a sequential basis, but thus far the results have bested estimates so continue to be seen as bullish. (As an aside, could someone please explain to me the bullish case on stocks trading at a 20+ multiple with economic growth in the US at 2% and globally at 3.5% alongside extremely limited policy leeway for further monetary ease? But I digress.) Overnight saw Chinese stocks rock, with Shanghai soaring 2.4% and the Hang Seng 1.1%. European stocks are a bit firmer as well (DAX +0.6%, FTSE +0.4%) and US futures are pointing higher.

Turning to the central banks, we continue to hear the following broad themes: policy is in a good place right now, but the opportunity for further ease exists. Depending on the central bank this is taking different forms. For example, the Minutes of the RBA meeting indicated a growing willingness to cut the base rate further, and market expectations are building for two more cuts this year, down to 1.00%. Meanwhile, the Fed has no ability to cut rates yet (they just stopped raising them in December) but continues to talk about how they achieve their inflation target. Yesterday, Boston Fed president Rosengren posited that a stronger commitment to the symmetry around their 2.0% target could be useful. Personally, I don’t believe that, but I’m just a gadfly, not a PhD economist. At any rate, the idea is that allowing the economy to run hot without tightening is tantamount to easing policy further. In the end, it has become apparent the Fed’s (and every central bank’s) problem is that their economic models no longer are a good representation of the inner workings of the economy. As such, they are essentially flying blind. Previous relationships between growth, inflation and employment have clearly changed. I make no claim that I know what the new relationships are like, just that 10 years of monetary policy experiments with subpar results is enough to demonstrate the central banks are lost.

This is true not just in the US and Europe, but in Japan, where they have been working on QE for nearly thirty years now.

More ETF’s bought
Will be followed by more and
More ETF’s bought

It’s vital for the Bank of Japan to continue persistently with powerful monetary easing,” Governor Haruhiko Kuroda said. As can be seen from Kuroda-san’s comments last night in the Diet, the BOJ is a one-trick pony. While it is currently illegal for the Fed to purchase equities, that is not the case in Japan, and they have been buying them with gusto. The thing is, the Japanese economy continues to stumble along with minimal growth and near zero inflation. As the sole mandate for the BOJ is to achieve their 2.0% inflation target, it is fair to say that they have been failing for decades. And yet, they too, have not considered a new model.

In the end, it seems the lesson to be learned is that the myth of omnipotence that the central banks would have us all believe is starting to crack. Once upon a time central banks monitored activity in the real economy and tried to adjust policy accordingly. Financial markets followed their lead and responded to those actions. But as the world has become more financially oriented during the past thirty years, it seems we now have the opposite situation. Now, financial markets trade on anticipation of central bank activity, and if central banks start to tighten policy, financial markets tend to throw tantrums. However, there is no tough love at central banks. Rather they are indulgent parents who cave quite quickly to the whims of declining markets. Regardless of their alleged targets for inflation or employment, the only number that really matters is the S&P 500, and that is generally true for every central bank.

Turning to this morning’s data story, the German ZEW survey was released at a better than expected 3.1. In fact, not only was this better than forecast, but it was the first positive reading in more than a year. It seems that the ongoing concerns over German growth may be easing slightly at this point. Certainly, if we see a better outcome in the Manufacturing PMI data at the end of April, you can look for policymakers to signal an all clear on growth, although they seem unlikely to actually tighten policy. Later this morning we see IP (exp 0.2%) and Capacity Utilization (79.1%) and then tonight, arguably more importantly, we see the first look at Chinese Q1 GDP (exp 6.3%).

If you consider the broad narrative, it posits that renewed Chinese monetary stimulus will prevent a significant slowdown there, thus helping economies like Germany to rebound. At the same time, the mooted successful conclusion of the US-China trade talks will lead to progress on US-EU and US-Japanese talks, and then everything will be right with the world as the previous world order is reincarnated. FWIW I am skeptical of this outcome, but clearly equity market bulls are all-in.

In the end, the dollar has been extremely quiet (volatility measures are back to historic lows) and it is hard to get excited about movement in the near-term. Nothing has yet changed my view that the US will ultimately remain the tightest policy around, and thus continue to draw investment and USD strength. But frankly, recent narrow ranges are likely to remain in place for a little while longer yet.

Good luck
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Progress Is Real

In Beijing, talks focused on trade
Continue as both sides conveyed
That progress is real
With hopes for a deal
Increasing, or so it’s portrayed

Once again, the market is embracing the idea that a trade deal is coming and coming soon. Talks in Beijing have restarted and while yesterday President Trump indicated he would not be meeting Chinese President Xi by month’s end, as had been suggested last week, this morning, Mr Trump expressed a desire to meet with him “very soon”. Investors have taken this to mean that while a deal may not be completed by the initial March 1st deadline, there will be an extension of the truce and no tariff increases at that time. It should be no surprise that the equity market has taken this news well, with Asian stocks generally rallying (Nikkei +2.6%, Shanghai +0.7%), European stocks following suit (DAX + 1.3%, CAC + 1.1%) and US equity futures pointing higher (DJIA + 0.8%, S&P + 0.7%). Adding to the bullishness has been the news that there is a tentative deal in Congress to avoid a second government shutdown. So, all the stars have aligned for the bulls today.

And yet, the data continues to be lackluster with limited prospect to improve in the short run. A random sampling of recent releases shows that UK growth (as mentioned yesterday) was the weakest in six years and shows no signs of picking up ahead of Brexit. But also, Norwegian inflation is sinking along with Mexican IP and the Australian housing market. South African Unemployment remains near a record 27.5% and even the NFIB Survey here at home has fallen to its lowest level since November 2016 (Trump’s election), although it remains much closer to its historic highs than its lows. The point is that despite soothing words from central bank officials that recent weaker data is temporary, it is looking nothing of the sort. I’m not sure when temporary morphs into long-term, but we are now pushing into our fifth consecutive month of slowing global data and the trend shows no signs of abating.

So, what is an investor or a hedger to conclude from all this? Is the trade deal more important? Or is it the ongoing data story? While both of those may have short-term impacts, the reality remains that it is still the central banks that exert the most influence on markets. The Fed’s complete conversion from hawk to dove in six weeks has been THE dominant force in markets since December. Not only has that conversion helped the US markets, but it has dramatically reduced pressure on other nations to maintain their own hawkishness. This can be seen in the BOE, where earlier talk of needing to hike rates in the event of Brexit has abated. It can be seen in the ECB where the conversation has changed from raising rates in the autumn to what other measures of stimulus can they provide given the current negative rates and bloated balance sheet. (TLTRO’s will absolutely be rolled over.) In Scandinavia, both Norway and Sweden have seen inflation data decline and are now seen as far more likely to leave rates on hold rather than raising them as had been expected just a few months ago. And not to be outdone, the PBOC, which had been in the midst of a two-year program to reduce excess leverage in China, has handily turned far more dovish, injecting significant liquidity and ‘encouraging’ banks to make loans to SME’s there. So, in the end, while the trade story may garner headlines for a few more weeks, it remains a central bank controlled world.

As to today, the dollar is dipping slightly after a continued solid rally during yesterday’s session. This has been more evident in the EMG space than in G10. For example, MXN (+0.4%) and BRL (+0.95%) are leading the way in LATAM while INR (+0.7%) and CNY (+0.3%) have benefitted from the dollar’s lackluster performance. And of course, the dovish turn by the Fed has had an especially beneficial impact on EMG currencies since so many companies located there borrow in dollars. The idea that US rates have stopped rising has been one of the biggest changes we have seen.

However, it is important to remember that on a relative basis, US policy remains tighter than that anywhere else in the world, and as it becomes clearer that other central banks will turn more dovish, the dollar should retain its footing.

We have already seen the NFIB data print weaker than expected, and the only other data point today is the JOLT’s Jobs report (exp 6.90M), however, we do hear from Chairman Powell at 12:45 this afternoon, so all eyes will be on him. The thing is, given the data we have seen since the Fed changed course has continue to be weak, I would argue the only surprise can be dovish. In other words, comments hinting that the Fed will end the balance sheet roll-off, or a reevaluation of the neutral rate lower would be the type of thing to start a big rally. In the event that something like that were to occur, look for equities to rocket and the dollar to fall. But given the sudden increase in stories about prices rising in consumer products (yesterday’s WSJ talking about cat litter and detergent, today’s about Whole Foods raising prices), it seems hard to believe that a more dovish tone is likely.

In the end, the dollar has had a good run over the past two weeks. If that is ending, it is entirely reasonable, but don’t look for a collapse.

Good luck
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Conditions Have Tightened

The Treasury market is frightened
As risk of inflation has heightened
So 10-year yields jumped
The dollar got pumped
And credit conditions have tightened

The dollar rallied yesterday on the back of a sharp rise in US Treasury yields. The 10-year rose 13bps, jumping to its highest level since 2014. The 30-year rose even more, 15bps, and both have seen those yield rallies continue this morning. The catalyst was much stronger than expected US data, both ADP and ISM Non-Manufacturing were quite strong, and further comments by Chairman Powell that indicated the Fed would remain data dependent and while they didn’t expect inflation to rise sharply, effectively they are prepared to act if it does.

Adding to the inflation story was the Amazon news about raising the minimum wage at the company to $15/hour, and don’t forget the trade war with China, where tariffs will clearly add upward pressure on prices. All this makes tomorrow’s payroll report that much more important, as all eyes will be on the Average Hourly Earnings number. We have a fairly recent analogy of this type of market condition, the first two weeks of February this year, when the January AHE number jumped unexpectedly, and within a week, equities had fallen 10% while the dollar rallied sharply as risk was jettisoned with abandon. While I am not forecasting a repeat of those events, it is best to be aware of the possibility.

And quite frankly, that has been THE story of the market. It cannot be that surprising that the dollar has been the big beneficiary, as this has turned into a classic risk-off scenario. EMG currencies are under increasing pressure, and even the G10 is suffering, save the yen, which has rallied slightly vs. the dollar. At this point, there is no obvious reason for this trend to stop until tomorrow’s data release. If AHE data is firm (current expectations are for a 0.3% rise on the month translating into a 2.8% Y/Y rise), look for this bond rout to continue, with the concurrent impact of a stronger dollar and weaker equities. But since that is not until tomorrow, my sense is that today is going to be a session of modest further movement as positions get squared ahead of the big news.

Good luck
Adf

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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