I’m Concerned

Said Madame Lagarde, ‘I’m concerned
That strength in the euro’s returned
If that is the case
We’ll simply debase
The currency many have earned

Christine Lagarde, in a wide-ranging interview last week, but just released this morning, indicated several things were at the top of her agenda.  First is the fact that the containment measures now reappearing throughout the continent, notably in France, Spain and Germany, will weaken the recovery that started to gather steam during the summer. This cannot be a surprise as the key reason for the economic devastation, to begin with, was the dramatic lockdowns seen throughout Europe, and truthfully around the world.  But her second key concern, one about which I have written numerous times in the past, is that the euro’s recent strength is damaging the ECB’s efforts to support a recovery.  The new euphemism from ECB members is they are “very attentive” to the exchange rate.  The implication seems to be that if the euro starts to head back to the levels seen in early September, when it touched 1.20, they might act.  Clearly, the preferred action will be more verbal intervention.  But after that, I expect to see an increase in the PEPP program followed by a potential cut in the deposit rate and lastly actual intervention.

To be fair, most economists are already anticipating the PEPP will be expanded in December, when the ECB next publishes its economic forecasts.  Currently, the program has allocated €1.35 trillion to purchase assets on an unencumbered basis.  Recall, one of the issues with the original QE program, the APP, was that it followed the capital key, meaning the ECB would only purchase government bonds in amounts corresponding with a given economy’s size in the region.  So German bunds were the largest holdings, as Germany has the largest economy.  The problem with this was that Italy and Spain were the two large nations that needed the most help, and the ECB could not overweight their purchases there.  Enter PEPP, which has no such restrictions, and the ECB is now funding more purchases of Italian government bonds than any other nation’s.  Of course, there are more Italian government bonds than any other nation in Europe, and in fact Italy is the fourth largest issuer worldwide, following only the US, Japan and China.

As to further interest rate cuts, the futures market is already pricing in a 0.10% cut next year, so in truth, for the ECB to have an impact, they would need to either surprise by cutting sooner, or cut by a larger amount.  While the former is possible, the concern is it would induce fear that the ECB knows something negative about the economy that the rest of the market does not and could well induce a sharp asset sell-off.  As to cutting by a larger amount, European financial institutions are already suffering mightily from NIRP, and some may not be able to withstand further downward pressure there.

What about actual intervention?  Well, that would clearly be the last resort.  The first concern is that intervention tends not to work unless it is a concerted effort by multiple central banks together (think of the Plaza Agreement in 1985), so its efficacy is in doubt, at least in the medium and long term.  But second, depending on who occupies the White House, ECB intervention could be seen as a major problem for the US inspiring some type of retaliation.

In the end, for all those dollar bears, it must be remembered that the Fed does not operate in a vacuum, and in the current global crisis, (almost) every country would like to see their currency weaken on a relative basis in order to both support their export industries as well as goose inflation readings.  As such, nobody should be surprised that other central banks will become explicit with respect to managing currency appreciation, otherwise known as dollar depreciation.

Keeping this in mind, a look at markets this morning shows a somewhat mixed picture.  Yesterday’s strong US equity performance, ostensibly on the back of President Trump’s release from the hospital, was enough to help Asian markets rally with strength in the Nikkei (+0.5%) and Hang Seng (+0.9%).  China remains closed until Friday.  European markets started the day a bit under the weather, as virtually all of them were lower earlier in the session, but in the past hour, have climbed back toward flat, with some (Spain’s IBEX +0.95%) even showing solid gains.  However, the DAX (+0.1%) and CAC (+0.3%) are not quite following along.  Perhaps Madame Lagarde’s comments have encouraged equity investors that the ECB is going to add further support.  As to US futures markets, only NASDAQ futures are showing any movement, and that is actually a -0.4% decline at this time.

The bond market, on the other hand, has been a bit more exciting recently, as yesterday saw 10-year Treasury yields trade to their highest level, 0.782%, since June.  While this morning’s price action has seen a modest decline in yields, activity lately speaks to a trend higher.  Two potential reasons are the ever increasing amount of US debt being issued and the diminishing appetite for bonds by investors other than the Fed; and the potential that the recent trend in inflation, which while still below the Fed’s targeted level, has investors concerned that there are much higher readings to come.  After all, core PCE has risen from 0.9% to 1.6% over the past five months.  With the Fed making it clear they will not even consider responding until that number is well above 2.0%, perhaps investors are beginning to become a bit less comfortable that the Fed has things under control.  Inflation, after all, has a history of being much more difficult to contain than generally expected.

Finally, looking at the dollar, it is the least interesting market this morning, at least in terms of price action.  In the G10, the biggest mover has ben AUD, which has declined 0.4%, as traders focus on the ongoing accommodation of the RBA as stated in their meeting last night.  But away from Aussie, the rest of the G10 is +/- 0.2% or less from yesterday’s closing levels, with nothing of note to discuss.  In the emerging markets. THB (+0.7%) was the big winner overnight as figures showed an uptick in foreign purchases of Thai bonds.  But away from that, again, the movement overnight was both two-way and modest at best.  Clearly, the FX market is biding its time for the next big thing.

On the data front, this morning brings the Trade Balance (exp -$66.2B) and JOLTS Job Openings (6.5M).  Yesterday’s ISM Services number was a bit better than expected at 57.8, indicating that the pace of growth in the US remains fairly solid.  In fact, the Atlanta Fed GDPNow forecast is up to 34.6% for Q3.  But arguably, Chairman Powell is today’s attraction as he speaks at 10:40 this morning.    I imagine he will once again explain how important it is for fiscal stimulus to complement everything they have done, but as data of late has been reasonably solid, I would not expect to hear anything new.  In the end, the dollar remains range-bound for now, but I expect that the bottom has been seen for quite a while into the future.

Good luck and stay safe
Adf

We Won’t Acquiesce

Said Madame Lagarde to the press
In Frankfurt, we won’t acquiesce
To prices not rising
So, it’s not surprising
That average inflation we’ll stress

Raise your hand if you had, ‘the ECB will copy the Fed’s average inflation framework’ when announcing their own policy initiatives.  That’s right folks, I’m sure you are all shocked to learn that the ECB is now considering (read has already decided) to follow in the Fed’s footsteps and target an average inflation rate over an indeterminate time in their own policy review.  As Lagarde pointed out, “If credible, such a strategy can strengthen the capacity of monetary policy to stabilize the economy when faced with the lower bound.”  Perhaps the key words to this statement are the first two, if credible.  After all, given the ECB’s demonstrated futility at achieving their targeted inflation rate since its creation in 1997, why would it be credible that the ECB is going to generate inflation now that will run above target.  In fact, over the entire history of ECB policymaking, there was a single stretch of 15 months (October 2001 – December 2002) where their favorite measure, Core CPI, rose above 2.0%.  Otherwise, during the other 270 months, they have seen inflation below their target, oftentimes well below.  The average inflation rate since the ECB’s founding has been 1.4%.  But now we are supposed to believe that because they claim they will allow inflation to run hot, suddenly that makes policy easier.  Personally, I don’t find their claim credible.

But from the market perspective, the importance of her comments, as well as agreement by other ECB members on the subject, is that the Fed has ceased to be the central bank with the easiest money around.  With the ECB and the Fed now both following the same path on inflation targeting, there is not much to choose between the two.  This is especially so given that neither one has been able to approach their current target, let alone exceed it in more than a decade.  But for dollar bears, this is bad news because a key part of the bearish thesis was the idea that the Fed was the easiest money around.  Average inflation targeting meant interest rates would remain near zero for at least three more years.  Well I have news for you, ECB rates will remain negative far longer than that.  Just as a man with a hammer sees every problem as a nail, a central bank with a single policy tool (QE) sees every problem solvable by more bond purchases.

Adding to the euro’s medium-term woes is the situation in Italy, where despite more than €209 billion euros of EU aid, the debt/GDP ratio is destined to head ever higher, rising to 158% this year.  That cements its current third place worldwide status (Japan 234%, Greece 182%) and starts to bring Greece’s number two slot into sight.  With a history of slow growth and a rapidly aging population, it becomes ever harder to envision a solution to Italy’s macroeconomic woes that doesn’t include either debt relief or debt monetization.  And I assure you, that is not a currency positive for the euro.  The point here is that the many negatives that underlie the euro’s construction are likely to become a greater topic of market conversation going forward, and it appears the odds of a significant rally from current levels has greatly diminished, regardless of your views of US policies.

Speaking of US policies, I will admit that I could only tolerate a few minutes of last night’s presidential debate, as the name-calling and interruptions became far too annoying.  Equity futures declined, seemingly on the view that Biden cemented his lead, at least so that’s what the punditry is explaining this morning.  Perhaps equity futures declined as investors decided that no outcome is positive for the US.  But while clearly the presidential campaign will have some market impact over the next five weeks, at this point, it seems unlikely the polls will change much, nor the betting markets.  And yet, we cannot forget that in 2016, the polls and betting markets were pointing to the exact same outcome and turned out to be spectacularly wrong.  In the end, regardless of who wins the election, the Fed is going to continue their current policy mix and more fiscal stimulus is destined to arrive.  As such, I am hard-pressed to say it will impact the dollar.

One other thing of note overnight was Chinese PMI data (Mfg 51.5, Services 55.9), which showed that growth on the mainland continued to expand moderately on the strength of increases across both manufacturing and services sectors.  Even the Caixin PMI (53.0), which focuses on small companies, put in a solid performance.  Interestingly, neither the Shanghai Composite (-0.2%) nor the renminbi (unchanged) reflected any positivity in the outcome.  And neither was that news sufficient to generate any risk taking elsewhere in the world, at least on any sustained basis.

Looking at the rest of the equity markets, we see the Nikkei (-1.5%) fell sharply although the Hang Seng (+0.8%) managed to show the only rise amongst major equity indices.  European bourses are all in the red (DAX -0.5%, CAC -0.6%, FTSE 100 -0.3%) and US futures continue to point lower, with all three indices down about -0.6% at this hour.  Bond market movement continues to largely be absent as 10-year Treasury yields are still 0.65%, unchanged, and both Bunds and Gilts are less than 1 basis point different than yesterday’s levels.  Even Italian BTP’s are unchanged despite the increasing concerns over their fiscal situation.  In other words, the central banks have done an excellent job in controlling yield curves and thus preventing the bond market from offering any economic signals.

As to the dollar, it is broadly, albeit mildly, stronger this morning against its G10 counterparts.  NOK and SEK (both -0.5%) are the leading decliners with Norway suffering from oil’s slide back below $40/bbl, while SEK is simply demonstrating its higher beta to broad movements.  But the whole space is feeling it today, with the exception of CAD, which is essentially unchanged.  Clearly, the Lagarde comments have served to soften the euro (-0.3%) at the margin.

As to the emerging market bloc, things are a bit more mixed.  The notable movers include RUB (+0.9%) and TRY (+0.5%) on what appears to be the first attempts by both nations to de-escalate the Armenian-Azerbaijani conflict.  As well, we see MXN (+0.8%) and ZAR (+0.7%) on the positive side, which is more difficult to justify given the lack of risk appetite, but is likely related to the calendar, as investors rebalance positions into month-end, and so are reducing shorts in those currencies.  On the negative side sits the CE4, following the euro’s decline with their usual ability to outpace the single currency.  Interestingly, APAC currencies have done little overnight, with most movement less than 10 basis points.

On the data front this morning we get ADP Employment (exp 649K), Q2 GDP’s final revision (-31.7%) and Chicago PMI (52.0).  Arguably, the market will be more concerned with the ADP data than anything else as investors try to get a picture of the employment situation.  We also have three more Fed speakers, Kashkari, Bowman and Bullard, but based on yesterday’s outcome, where the message is that the Fed is moderately optimistic that growth will continue but that more fiscal support would be useful, it seems unlikely that these comments will interest many people.

Overall, the big story remains the indication that the ECB is going to match the Fed every step of the way going forward, as will, eventually, every other key central bank, and so the dollar’s value will need to be determined by other means.  But for now, it points to a bit more dollar strength as short positions start to get unwound.

Good luck and stay safe
Adf

The New Weasel Word

The bulk of the FOMC
Explained their preferred policy
More government spending,
Perhaps never ending,
Is what almost all want to see

Meanwhile, ‘cross the pond, what we heard
Is ‘bove 2% is preferred
They’ll soon change their stance
To give growth a chance
Inflation’s the new weasel word

Another day, another central bank explanation that higher inflation is just what the doctor ordered to improve the economy.  This time, Banque de France’s Governor, Francois Villeroy de Galhau, explained that the current formulation used by the ECB, “below, but close to, 2%”, is misunderstood.  Rather than 2% being a ceiling, what they have meant all along is that it is a symmetrical target.  Uh huh!  I’ve been around long enough to remember that back in 1988, when the ECB was first being considered, Germany was adamant that they would not accept a central bank that would allow inflation, and so forced the ECB to look just like the Bundesbank.  That meant closely monitoring price pressures and preventing them from ever getting out of hand.  Hence, the ECB remit, was absolutely designed as a ceiling, with the Germans reluctant to even allow 2% inflation.  Of course, for most of the rest of Europe, inflation was the saving grace for their economies.  Higher inflation begat weaker currencies which allowed France, Italy, Spain, et.al. to continue to compete with a German economy that became ever more efficient.

But twenty-some years into the experiment of the single currency, and despite the fact that the German economy remains the largest and most important in the Eurozone, the inflationistas of Southern Europe are gaining the upper hand.  These comments by Villeroy are just the latest sign that the ECB is going to abandon its price stability rules, although you can be sure that they will never say that.  Of course, the problem the ECB has is similar to that of Japan and the US, goosing measured inflation has been beyond their capabilities for the past decade (more than two decades for the BOJ), so simply changing their target hardly seems like it will be sufficient to do the job.  My fear, and that of all of Germany, is that one day they will be successful in achieving this new goal and will not be able to stop inflation at their preferred level, but instead will see it rise much higher.  But that is not today’s problem.  Just be aware that we are likely to begin hearing many other ECB members start discussing how inflation running hot for a while is a good thing.  Arguably, the only exceptions to this will be the Bundesbank and Dutch central bank.

And once again, I will remind you all that there is literally no chance that the ECB will sit back and watch, rather than act, if the Fed actually succeeds in raising inflation and weakening the dollar.

Speaking of the Fed, this week has seen a significant amount of Fedspeak already, with Chairman Powell on the stand in Congress for the past three days.  What he, and virtually every other Fed speaker explained, was that more fiscal stimulus was required if the government wanted to help boost growth.  The Fed has done all they can, and to listen to Powell, they have been extremely effective, but the next step was Congress’s to take.  The exception to this thought process came from St Louis Fed President Bullard, who explained that based on his forecasts, the worst is behind us and no further fiscal stimulus is needed.  What makes this so surprising is that he has been one of the most dovish of all Fed members, while this is a distinctly hawkish sentiment.  But he is the outlier and will not affect the ultimate outcome at this stage.

Powell was on the stand next to Treasury Secretary Mnuchin, who made the comment with the biggest impact on markets.  He mentioned that he and House Speaker Pelosi were back to negotiating on a new stimulus package, which the equity market took as a sign a deal would be reached quickly.  We shall see.  Clearly, there is a great deal of angst in Congress right now, so the ability to agree on anything across the aisle is highly questionable.

With that in mind, a look at markets shows what had been a mixed opening is turning into a more negative session.  Overnight saw Asian equity markets with minimal gains and losses (Nikkei +0.5%, Hang Seng -0.3%, Shanghai -0.2%), but Europe, which had been behaving in a similar manner early in the session has turned sharply lower.  At this time, the DAX (-1.95%) and CAC (-2.0%) are leading the way lower, with the FTSE 100 (-0.8%) having a relatively better day.  At the same time, US futures turned from flat to lower, with all three indices now pointing to -0.6% losses at the open.

It is difficult to point to a specific comment or piece of news driving this new sentiment, but it appears that the bond market is in the same camp as stocks.  Treasury yields, while they remain in a narrow range, have slipped 1bp, to 0.65%, and we are seeing Bunds (-2bps) and Gilts (-3bps) also garner demand as havens are in play.  Apparently, central bank desire for inflation is not seen as a serious situation quite yet.

Commodity prices have turned around as well, with oil falling 2% from morning highs, and gold dropping 1%.  In other words, this is a uniform risk reduction, although I would suspect that gold prices should lag the decline elsewhere.

As to the dollar, it is starting to pick up a more substantial bid with EUR (-0.3%) and GBP (-0.35%) sliding from earlier levels.  NOK (-1.15%) remains the worst performer in the G10, which given the decline in oil prices and evolving risk sentiment should be no surprise.  But at this point in the day, the entire bloc is weaker vs. the buck.  EMG currencies, too, have completely reversed some modest early morning strength, and, once again, ZAR (-1.2%) and MXN (-1.0%) lead the way lower.  One must be impressed with the increased volatility in those currencies, as they start to approach levels seen in the initial stages of the Covid crisis.  For anyone who thought that the dollar had lost its haven status, recent price action should put paid to that notion.

On the data front, today brings Durable Goods (exp 1.4%, 1.0% ex Transport) and we hear from two more Fed speakers, Williams and Esther George.  While Williams is almost certain to repeat Powell’s current mantra of more fiscal support, Ms George is one of the more hawkish Fed members and could well sound more like James Bullard than Jay Powell.  We shall see.

This has been a risk-off week, with equity markets down across the board and the dollar higher vs. every major currency in the world.  It seems highly unlikely that the Durable Goods number will change that broader sentiment, and so the ongoing equity market correction, as well as USD rebound seems likely to continue into the weekend.  Remember, short USD positions are still the rule, so there is plenty of ammunition for a further short covering.

Good luck, good weekend and stay safe
Adf

Waiting for Jay

Investors are waiting for Jay
Their fears, about rates, to allay
They want it made clear
That rates will be here
From now ‘til we reach judgement day

From the market’s perspective, the world has essentially stopped spinning, at least until we finally hear the words of wisdom due from Chairman Powell beginning at 9:10 this morning.  Trading volumes across products are currently running at 50%-70% of recent average activity, highlighting just how little is ongoing.  And remember, too, as it is the last week of August, summer holidays are in full swing with most trading desks, on both the buy and sell sides, more lightly staffed than usual.  In other words, liquidity is clearly impaired right now, although by 10:00 this morning I expect that things will be back closer to normal.

As discussed yesterday, the working assumption of most analysts and investors is that Jay is going to explain the benefits of targeting average inflation over time.  The implication being that the Fed’s new policy framework, when officially announced later this year, is going to include that as a KPI.  Of course, the big question about this policy is the average over exactly which period.

Consider, it has been 102 months since then-Chairman Bernanke established the target for core PCE at 2.0%.  During that time, core PCE has been between 1.9% and 2.1% just 12 times with 89 of the other 90 readings below 1.9% and a single print above 2.1%, which happens to have been the first print after the announcement.  Meanwhile, this past April’s reading of 0.931% is the lowest reading.  The average of the two extremes is 1.53%.  Is the Fed going to be happy if core PCE jumps to 2.47% and stays there for a while?  The average of all periods since January 2012 is 1.633%, does that mean we can expect the Fed to target 2.367% core PCE readings for the next eight plus years? The point is, without some specificity on what average inflation means, it is very difficult to understand how to incorporate the idea into investment and trading decisions.

But what if Chairman Powell does not bring clarity to the discussion, merely saying that average inflation over time seems like a good future benchmark.  How might different markets react to such a lack of specificity?

Starting with equity markets, certainly those in the US will rally because…well that’s all they do these days.  Good news, bad news, no news, none of that matters.  The rationale will be stocks are a good inflation hedge if inflation goes higher (they’re not) or stocks will benefit from ongoing low interest rates if inflation remains below target.  Parabolic markets are frightening, but there is no indication that Powell’s comments are going to change that situation.  We need a different catalyst here.

Now let’s look at the bond market and what might happen there.  Specificity on how much higher the Fed is going to target inflation is going to be a pretty distinct negative.  If you own 10-year Treasuries that are yielding 0.68% (today -1bp), and the Fed explains that they are going to push inflation above 2.0%, there is going to be a pretty spectacular decline in the price of your bond should they achieve their goal.  Will investors be willing to hold paper through that type of decline?  It would not be a surprise to see a pretty sharp sell-off in Treasuries on that type of news.  Remember, too, that Treasury yields have backed up nearly 20 basis points in the past three weeks, perhaps in anticipation of today’s comments.  If Powell delivers, there is likely far more room to run.  If he doesn’t, and there is no clarity, bond investors will be back to reading the economic tea leaves, which continues to be remarkably difficult at this time.

How about the gold market?  Well, here I think the case is quite straight forward.  Clarity as to the Fed’s efforts to drive inflation higher will result in anticipation of lower real yields, and that will be an unalloyed benefit (pun intended).  A lack of clarity and gold will likely continue to consolidate its recent gains.

And finally, what about the dollar?  How will it respond to the Chairman’s speech?  Consider that despite the dollar’s recent rebound, short dollar positions remain at near record levels against both the euro and the DXY futures.  The market scuttlebutt is that the hedge fund community, which was instrumental in the dollar’s recent modest strength as they pared short dollar positions, is ready and raring to buy euros on the idea that higher US inflation will lead to a weaker dollar à la economic theory.  Certainly, if Treasuries sell off, the dollar will see some downward pressure, but one of the things that does not get as much press in the FX market is the equity market impact.  Namely, as long as US equity indices continue to set records, international investors are going to continue to buy them, which will underpin the dollar.

But what if the speech is a dud?  If there is no clarity forthcoming, then the dollar story will revert to its recent past. The bear case continues to be that the Fed’s largesse will dwarf all other nations’ policy easing and so the dollar should resume its decline.  The bull case is that the US economy, at least by recent data, appears to continue to be outperforming its major counterparts, and thus inward investment flows will continue.  That current account deficit is only a problem if international investors don’t want to fund it, and with US equity markets amongst the best performing asset classes globally, that funding is easy to find.  I know I’m not a technician, but recent price action certainly appears to have created a top at the highs from last week, and a further pullback toward 1.1650 seems quite viable.

It is difficult to draw many conclusions from today’s market activity, which is why I have largely ignored it.  Equity markets are leaning a bit lower, although the movement is not large, less than 1%, and the dollar is mixed against both the G10 and EMG blocs.

Arguably, the biggest market risk is that Powell doesn’t tip his hand at all, and that we are no wiser at 10:10 than we are now.  If that is the case, I think the dollar’s consolidation will continue, and by the end of the day, I imagine stock prices will have recouped their early losses.

But for today, it is all about Jay.

Good luck and stay safe
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