What’s Most Feared

For almost two days it appeared
That havens were to be revered
But with rates so low
Investors still know
That selling risk is what’s most feared

By yesterday afternoon it had become clear that market participants were no longer concerned over any immediate retaliation by Iran. While there have been a number of comments and threats, the current belief set is that anything that occurs is far more likely to be executed via Iranian proxies, like Hezbollah, rather than any direct attack on the US. And so as the probability of a hot war quickly receded in the minds of the global investment community, all eyes turned back toward what is truly important…central bank largesse!

As I briefly mentioned yesterday, there was a large gathering of economists, including many central bankers past and present, this past weekend in San Diego. The issue that seemed to generate the most interest was the idea of negative interest rates and whether their implementation had been successful, and more importantly, whether they ever might appear as part of the Fed’s policy toolkit.

Chairman Powell has made clear a number of times that there is no place for negative rates in the US. This sentiment has been echoed by most of the current FOMC membership, even the most dovish members like Kashkari and Bullard. And since the US economy is continuing to grow, albeit pretty slowly, it seems unlikely that this will be more than an academic exercise anytime soon. However, a paper presented by some San Francisco Fed economists described how negative rates would have been quite effective during the throes of the financial crisis in 2008-2009, and that stopping at zero likely elongated the pain. Ironically, former Fed chair Bernanke also presented a paper saying negative rates should definitely be part of the toolkit going forward. This is ironic given he was the one in charge when the Fed went to zero and had the opportunity to go negative at what has now been deemed the appropriate time. (Something I have observed of late is that former Fed chairs are quite adept at describing things that should be done by the Fed, but were not enacted when they were in the chair. It seems that the actuality of making decisions, rather than sniping from the peanut gallery, is a lot harder than they make out.)

At any rate, as investors and analysts turn their focus away from a potential war to more mundane issues like growth and earnings, the current situation remains one of positive momentum. The one thing that is abundantly clear is that the central bank community is not about to start tightening policy anytime soon. In fact, arguably the question is when the next bout of policy ease is implemented. The PBOC has already cut the RRR, effective yesterday, and analysts everywhere anticipate further policy ease from China going forward as the government tries to reignite higher growth. While Chairman Powell has indicated the Fed is on hold all year, the reality is that they are continuing to regrow the balance sheet to the tune of $60 billion / month of outright purchases as well as the ongoing repo extravaganza, where yesterday more than $76 billion was taken up. And although this is more of a stealth easing than a process of cutting interest rates, it is liquidity addition nonetheless. Once again, it is this process, which shows no signs of abating, which leads me to believe that the dollar will underperform all year.

Turning to today’s session we have seen equity markets climb around the world following the US markets’ turn higher yesterday afternoon. Bond prices are little changed overall, with 10-year Treasury yields right at 1.80%, and both oil and gold have edged a bit lower on the day. Certainly, to the extent that there was fear of a quick reprisal from Iran, the oil market has discounted that activity dramatically.

Meanwhile, the dollar is actually having a pretty good session today, rallying against the entire G10 space despite some solid data from the Eurozone, and performing well against the bulk of the EMG bloc. The dollar’s largest gains overnight have come vs. the Australian dollar, which is down nearly 1.0% this morning after weak employment data (ANZ Job Adverts -6.7%) reignited fears that the RBA was going to be forced to cut rates further in Q1. But the greenback has outperformed the entire G10 space. The other noteworthy data were Eurozone Retail Sales (+1.0%) and CPI (+1.3% headline and core) with the former beating expectations but the latter merely meeting expectations and the core data showing no impetus toward the ECB’s ‘just below 2.0%’ target. Alas, the euro is lower by 0.15% this morning, dragging its tightly linked EEMEA buddies down by at least that much, and in some cases more. Finally, the pound has dipped 0.3%, but given the dearth of data, that seems more like a simple reaction to its inexplicable two-day rally.

In the EMG space, APAC currencies were the clear winners, with CNY rallying 0.5% as investment flows picked up with one of this year’s growing themes being that China is going to rebound sharply, especially with the trade situation seeming to settle down. It can be no surprise that both KRW and IDR, both countries that rely on stronger Chinese growth for their own growth, have rallied by similar amounts this morning. Meanwhile, EEMEA currencies have been under pressure, as mentioned above, despite the little data released (Hungarian and Romanian Retail Sales) being quite robust.

As to this morning’s session we get our first data of the week with the Trade Balance (exp -$43.6B), ISM Non-Manufacturing (54.5) and Factory Orders (-0.8%). Mercifully, there are no Fed speakers scheduled, so my sense is the market will be focused on the ISM data as well as the equity market. As things currently stand, it is all systems go for a stock market rally and assuming the ISM data simply meets expectations, the narrative is likely to shift toward stabilizing US growth. Of course, with the Fed pumping money into the economy in the background, that should be the worst case no matter what. FWIW it seems the dollar’s rally is a touch overdone here. My sense is that we are going to see it give back some of this morning’s gains as the session progresses.

Good luck
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More Clear

The contrast could not be more clear
Twixt growth over there and right here
While Europe is slowing
The US is growing
So how come a rate cut is near?

It seems likely that by the time markets close Friday afternoon, investors and traders will have changed some of their opinions on the future given the extraordinary amount of data and the number of policy statements that will be released this week. Three major central banks meet, starting with the BOJ tonight, the Fed tomorrow and Wednesday and then the BOE on Thursday. And then there’s the data download, which includes Eurozone growth and inflation, Chinese PMI and concludes with US payrolls on Friday morning. And those are just the highlights. The point is that this week offers the opportunity for some significant changes of view if things don’t happen as currently forecast.

But before we talk about what is upcoming, perhaps the question at hand is what is driving the Fed to cut rates Wednesday despite a run of better than expected US economic data? The last that we heard from Fed members was a combination of slowing global growth and business uncertainty due to trade friction has been seen as a negative for future US activity. Granted, US GDP grew more slowly in Q2 at 2.1%, than Q1’s 3.1%, but Friday’s data was still better than expected. The reduction was caused by a combination of inventory reduction and a widening trade gap, with consumption maintaining its Q1 pace and even speeding up a bit. The point is that things in the US are hardly collapsing. But there is no doubt that growth elsewhere in the world is slowing down and that prospects for a quick rebound seem limited. And apparently, that is now the driving force. The Fed, which had been described as the world’s central bank in the past, seems to have officially taken on that mantle now.

One fear of this action is that it will essentially synchronize all major economies’ growth cycles, which means that the amplitude of those cycles will increase. In other words, look for higher highs and lower lows over time. Alas, it appears that the first step of that cycle is lower which means that the depths of the next recession will be wider and worse than currently expected. (And likely worse than the last one, which as we all remember was pretty bad.) And it is this prognosis that is driving global rates to zero and below. Phenomenally, more than 25% of all developed market government bonds outstanding now have negative yields, something over $13.4 Trillion worth. And that number is going to continue to grow, especially given the fact that we are about to enter an entirely new rate cutting cycle despite not having finished the last one! It is a strange world indeed!

Looking at markets this morning, ahead of the data onslaught, shows that the dollar continues its winning ways, with the pound the worst performer as more and more traders and investors begin bracing for a no-deal Brexit. As I type, Sterling is lower by 0.55%, taking it near 1.23 and its lowest point since January 2017. As long as PM BoJo continues to approach the EU with a hard-line stance, I expect the pound to remain under pressure. However, I think that at some point the Irish are going to start to scream much louder about just how negative things will be in Ireland if there is no deal, and the EU will buckle. At that point, look for the pound to turn around, but until then, it feels like it can easily breech the 1.20 level before summer’s out.

But the dollar is generally performing well everywhere, albeit not quite to the same extent. Rather we are seeing continued modest strength, on the order of 0.1%-0.2% against most other currencies. This has been the pattern for the past several weeks and it is starting to add up to real movement overall. It is no wonder that the White House has been complaining about currency manipulation elsewhere, but I have to say that doesn’t appear to be the case. Rather, I think despite the international community’s general dislike of President Trump, at least according to the press, investors continue to see the US as the destination with the most profit opportunity and best prospects overall. And that will continue to drive dollar based investment and strengthen the buck.

Away from the FX markets, we have seen pretty inconsequential movement in most equity markets with two exceptions (FTSE +1.50% on the weak pound and KOSPI -1.8% on increasing trade issues and correspondingly weaker growth in South Korea). As to US futures markets, they are pointing to essentially flat openings here this morning, although the earnings data will continue to drive things. And bond markets have seen similarly modest movement with most yields within a basis point or two of Friday’s levels. Consider two bonds in Europe in particular; Italian 10-year BTP’s yield 1.54%, more than 50bps less than Treasuries, and this despite the fact that the government coalition is on the rocks and the country’s fiscal situation continues to deteriorate amid a recession with no ability to cut rates directly; and Greek 10-year yields are 2.05% vs. 2.08% for US Treasuries! Yes, Greek yields are lower than those in the US, despite having defaulted on their debt just 7 years ago! It is a strange world indeed.

A look at the data this week shows a huge amount of information is coming our way as follows:

Tuesday BOJ Rate Decision -0.10% (unchanged)
  Personal Income 0.4%
  Personal Spending 0.3%
  Core PCE 1.7%
  Case-Shiller Home Prices 2.4%
  Consumer Confidence 125.0
Wednesday ADP Employment 150K
  Chicago PMI 50.5
  FOMC Rate Decision 2.25% (-25bps)
Thursday BOE Rate Decision 0.75% (unchanged)
  Initial Claims 214K
  ISM Manufacturing 52.0
  ISM Prices Paid 49.6
  Construction Spending 0.3%
Friday Trade Balance -$54.6B
  Nonfarm Payrolls 165K
  Private Payrolls 160K
  Manufacturing Payrolls 5K
  Unemployment Rate 3.6%
  Average Hourly Earnings 0.2% (3.2% Y/Y)
  Average Weekly Hours 34.4
  Factory Orders 0.8%
  Michigan Sentiment 98.5

And on top of that we see Chinese PMI data Tuesday night, Eurozone GDP and Inflation on Wednesday and a host of other Eurozone and Asian data releases. The point is it is quite possible that the current view of the world changes if the data shows a trend, especially if that trend is faster growth. Right now, the default view is global growth is slowing with the question just how quickly. However, a series of strong prints could well stop that narrative in its tracks. And ironically, that is likely the best opportunity for the dollar to stop what has been an inexorable, if slow, climb higher. However, the prospects of weak data elsewhere are likely to see an acceleration of central bank easing around the world with the dollar benefitting accordingly.

In sum, there is an awful lot happening this week, so be prepared for potentially sharp moves on missed expectations. But unless the data all points to faster growth away from the US while the US is slowing, the dollar’s path of least resistance remains higher.

Good luck
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Constant Hyperbole

On Wednesday the FOMC
Will offer their latest decree
Will Fed funds be pared?
Or will Jay be scared
By Trump’s constant hyperbole?

The one thing that’s patently clear
Is rates will go lower this year
And lately some clues
Show Powell’s new views
Imply NIRP he’ll soon engineer

Once again, market movement overnight has been muted as traders and investors look ahead to Wednesday’s FOMC meeting and Chairman Powell’s press conference afterwards. Current expectations are for the removal of the word ‘patient’ from the statement and some verbiage that implies rates will be adjusted as necessary to maintain the US growth trajectory. Futures markets are pricing just a 25% probability of a rate cut on Wednesday, but a virtual certainty of one at the July meeting in six weeks’ time. With that said, there are several bank analysts calling for a cut today, or a 50bp cut in July. The one thing that seems abundantly clear is that interest rates in the US have reached their short-term peak, with the next move lower.

However, in the Mariner Eccles building, they have another dilemma, the fact that Fed funds are just 2.50%, the lowest cyclical peak in history. It has been widely recounted that the average amount of rate cutting by the Fed when fighting a recession has been a bit more than 500bps, which given the current rate, results in two possibilities: either they will have to quickly move to use other policy tools, like QE; or interest rates in the US are going to go negative before long! And quite frankly, I expect that it will be a combination of both.

Consider, while the Fed did purchase some $3.5 trillion of assets starting with QE1 in 2009, the Fed balance sheet still represents just 19% of US GDP. This compares quite favorably with the ECB (45%) and the BOJ (103%), but still represents a huge increase from its level prior to the financial crisis. Funnily enough, while there was a great deal of carping in Congress about QE by the (dwindling) hard-money set of Republicans, if the choice comes down to NIRP (Negative Interest Rate Policy) or a larger balance sheet, I assure you the politicians will opt for a larger balance sheet. The thing is, if the economy truly begins to slow, it won’t be a choice, it will be a combination of both, NIRP and QE, as the Fed pulls out all the stops in an effort to prevent a downturn.

And NIRP, in the US, will require an entirely new communications effort because, as in Europe and Japan, investors will find themselves on the wrong side of the curve when looking for short term investments. Money market funds are going to get crushed, and corporate treasuries are going to have to find new places to invest. It will truly change the landscape, and it is not clear it will do so in a net positive way. But regardless, NIRP is coming to a screen near you once the Fed starts cutting, although we are still a number of months away from that.

With that in mind, the obvious next question is how it will impact other markets. I expect that the initial reaction will be for a sharp equity rally, as that is still the default response to rate cuts. However, if the Fed is looking ahead and sees trouble on the horizon, that cannot be a long-term positive for equities. It implies that earnings numbers are going to decline, and no matter how ‘bullish’ interest rate cuts may seem, declining earnings are hard to overcome.

Bonds, on the other hand, are easy to forecast, with a massive rally in Treasuries, a lagging rally in corporates, as spreads widen into a weakening economy, but for high-yield bonds, I would expect significant underperformance. Remember, during the financial crisis, junk bond yield spreads rose to 20.0% over Treasuries. In another economic slowdown, I would look for at least the same, which compares to the current level of about 5.50%.

Finally, the dollar becomes a difficult question. Given the Fed has far more room to ease policy than does the ECB, the BOJ, the BOE or the BOC, it certainly seems as though the first move would be lower in the buck. However, if the Fed is easing policy that aggressively, you can be sure that every other central bank is going to quickly follow. Net I expect that we could see a pretty sharp initial decline, maybe 5%-7%, but that once the rest of the world gets into gear, the dollar will find plenty of support.

A quick look at markets overnight shows that the dollar is little changed overall, with some currencies slightly firmer and others slightly softer. However, there is no trend today, nor likely until we hear from the Fed on Wednesday.

Looking at data this week, it is much less interesting than last week’s and unlikely to sway views.

Today Empire Manufacturing 10.0
Tuesday Housing Starts 1.239M
  Building Permits 1.296M
Wednesday FOMC Rates 2.50% (unchanged)
Thursday BOJ Rates -0.10% (unchanged)
  Initial Claims 220K
  Philly Fed 11.0
  Leading Indicators 0.1%
Friday Existing Home Sales 5.25M

As I said, not too interesting. And of course, once the Fed meeting is done, we will get to hear more from the various Fed members, with two speakers on Friday afternoon (Brainard and Mester) likely to be the beginning of a new onslaught.

Yes, the trade situation still matters, but there is little chance of any change there until the G20 meeting next week, and that assumes President’s Trump and Xi agree to meet. So, for now, it is all about the Fed. One last thing, the ECB has their Sintra meeting (their answer to Jackson Hole) this week, and it is likely that we will hear more about their thinking when it comes to easing policy further given their current policy settings include NIRP and a much larger balance sheet already. Any hint that new policies are coming soon will certainly undermine the single currency. Look for that beginning on Wednesday as well.

Good luck
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A Major Mistake

There once was a pundit named Fately
Who asked, is Fed policy lately
A major mistake
Or did Yellen break
The mold? If she did t’was sedately

Please sanction my poetic license by listing Janet Yellen as the primary suspect in my inquiry; it was simply that her name fit within the rhyme scheme better than her fellow central bankers, all of whom acted in the same manner. Of course, I am really discussing the group of Bernanke, Draghi, Kuroda and Carney as well as Yellen, the cabal that decided ZIRP (zero interest rate policy), NIRP (negative interest rate policy) and QE (quantitative easing) made sense.

Recently, there has been a decided uptick in warnings from pundits about how current Fed Chair, Jay Powell, is on the verge of a catastrophic policy mistake by raising interest rates consistently. There are complaints about his plainspoken manner lacking the subtleties necessary to ‘guide’ the market to the correct outcome. In this case, the correct outcome does not mean sustainable economic growth and valuation but rather ever higher equity prices. There are complaints that his autonomic methodology (which if you recall was actually instituted by Yellen herself and simply has been followed by Powell), does not take into account other key issues such as wiggles in the data, or more importantly the ongoing rout in non-US equity markets. And of course, there is the constant complaint from the current denizen of the White House that Powell is undermining the economy, and by extension the stock market, by raising rates. You may have noticed a pattern about all the complaints coming back to the fact that Powell’s policy actions are no longer supporting the stock markets around the world. Curious, no?

But I think it is fair to ask if Powell’s policies are the mistake, or if perhaps, those policies he is unwinding, namely QE and ZIRP, were the mistakes. After all, in the scope of history, today’s interest rates remain exceedingly low, somewhere in the bottom decile of all time as can be seen in Chart 1 below.

5000 yr interest rate chart

So maybe the mistake was that the illustrious group of central bankers mentioned above chose to maintain these extraordinary monetary policies for nearly a decade, rather than begin the unwinding process when growth had recovered several years after the recession ended. As the second chart shows, the Fed waited seven years into a recovery before beginning the process of slowly unwinding what had been declared emergency policy measures. Was it really still an emergency in 2015, six years after the end of the recession amid 2.0% GDP growth, which caused the Fed to maintain a policy stance designed to address a severe recession?

Chart 2

real gdp growth

My point is simply that any analysis of the current stance of the Federal Reserve and its current policy trajectory must be seen in the broader context of not only where it is heading, but from whence it came. Ten years of extraordinarily easy monetary policy has served to build up significant imbalances and excesses throughout financial markets. Consider the growth in leveraged loans, especially covenant lite ones, corporate debt or government debt, all of which are now at record levels, as key indicators of the current excesses. The history of economics is replete with examples of excesses leading to shakeouts throughout the world. The boom and bust cycle is the very essence of Schumpeterian capitalism, and as long as we maintain a capitalist economy, those cycles will be with us.

The simple fact is that every central bank is ‘owned’ by its government, and has been for the past thirty years at least. (Paul Volcker is likely the last truly independent Fed Chair we have had, although Chairman Powell is starting to make a name for himself.) And because of that ownership, every central bank has sought to keep rates as low as possible for as long as possible to goose growth above trend. In the past, although that led to excesses, the downturns tended to be fairly short, and the rebounds quite robust. However, the advent of financial engineering has resulted in greater and greater leverage throughout the economy and correspondingly bigger potential problems in the next downturn. The financial crisis was a doozy, but I fear the next one, given the massive growth in debt outstanding, will be much worse.

At that point, I assure you that the first person who will be named as the culprit for ‘causing’ the recession will be Jay Powell. My point here is that, those fingers need to be pointed at Bernanke, Yellen, Draghi, Carney and Kuroda, as it was their actions that led to the current significantly imbalanced economy. The next recession will have us longing for the good old days of 2008 right after Lehman Brothers went bankrupt, and the political upheaval that will accompany it, or perhaps follow immediately afterwards, is likely to make what we are seeing now seem mild. While my crystal ball does not give me a date, it is becoming abundantly clear that the date is approaching far faster than most appreciate.

Be careful out there. Markets and politics are going to become much more volatile over the next several years.

One poet’s view!

Trembling With Fear

The one thing increasingly clear
Is markets are trembling with fear
As stock markets tumble
Most central banks fumble
Their message, then get a Bronx cheer

Being a central banker has become much more difficult recently, especially in the wake of yesterday’s global equity market rout. It seems that policies that they have collectively promulgated, QE and ZIRP/NIRP are now quite long in the tooth, and no longer having the positive impact desired. Let’s recap quickly.

The Great recession in 2008 called for an extraordinary monetary response by central banks around the world, and rightly so. The deepest recession since the Great Depression saw liquidity across many markets completely dry up. Even FX, arguably the most liquid market of them all, had structural problems. So the combination of QE and USD swap lines offered by the Fed to the rest of the world’s central banks was an appropriate response to help untangle the mess. Alas, fiscal policy never chipped in to the recovery and central banks took it upon themselves to do all the lifting, thus relieving governments of the need to make hard decisions. In hindsight, this was a key mistake!

Fast forward ten years to today and the situation, remarkably, is that most of that extraordinary monetary stimulus is still sloshing around the world as other than the Fed and the Bank of Canada (who raised rates yesterday and indicated they would be quickening the pace of doing so in the future), no other major central bank has done anything of note. The ECB, the BOJ and the PBOC are all still adding liquidity to their systems, while the BOE has raised rates just 25bps, net, from the lows established after the crisis. And the same is true of peripheral nations like Switzerland, Sweden and Australia, where interest rates remain at their post crisis nadirs (-0.75%, -0.50% and 1.50% respectively).

The problem for these central banks is that growth is starting to slow on a global basis. Whether it is the increased trade friction between the US and China, concerns over Brexit or simply that the US recovery (which still arguably drives most of the global economy) is now the longest on record and due to end, the situation is increasingly fraught. And that’s the rub. If interest rates are already negative, what can central banks do to stimulate the economy in the event of a recession? The answer, of course, is not much. More QE and even deeper negative interest rates are unlikely to have the same positive impact the first efforts had, in fact they could have the opposite effect by generating greater concern amongst investors and causing a more severe sell-off in markets. But politically, no central bank will be able to sit by and do nothing if a recession does appear. As I said, central banking has become much more difficult lately.

That is all a preamble to discuss what is going on in markets right now. FX is a backburner issue with equities front and center around the world. While European markets have stabilized at this time, one session of stability is not sufficient to declare an end to the rout. In the end, markets remain beholden to broad sentiment, the narrative if you will, and for the past ten years that narrative was that continued low inflation combined with steady growth would allow the central banks to maintain ultra easy monetary policy with no negative side effects. But in the past year, the cracks in that narrative have grown to the point where it is no longer seen as viable. First, inflation has begun to creep higher in certain areas around the world, notably the US and China. At the same time, growth data appears to have peaked last quarter. Tomorrow we will see the first estimate of Q3 GDP growth in the US (exp 3.3%), which is already considerably lower than Q2. In addition, we have seen Chinese growth slow more than expected and German growth fall to 0.0% in Q3. The combination of rising inflation and slower growth has put central banks in a bind forcing them to choose which issue to address first. The problem is by addressing one they are likely to exacerbate the other. So as the Fed fights threats of higher inflation, it impedes growth. Meanwhile, China has opted to support growth, thus feeding faster inflation. In the end, as the next recession looms closer, central banks will find themselves with fewer policy arrows in their quiver.

But this is an FX note, so let’s take a quick look at the market this morning. The dollar is a touch softer, with both the euro and the pound higher by 0.15% while we are seeing similar moves in most emerging market currencies. Activity in the market seems muted relative to the excitement in equities, but my sense is this will not last. Rather, if the equity sell-off continues, the dollar should find itself in a much stronger position. As to the stories that have been driving things in FX, the Italian budget, Brexit, central bank policies, there have been no real changes in the past twenty-four hours. The possible exception is that the interest rate futures market in the US has removed one price hike from the Fed’s expected path as concern grows that a continues slide in the stock market will lead to weaker growth and less need to keep driving rates higher. It seems that the Fed realizes that it began its tightening process far too late (thank you Chair Yellen!) and is now desperately trying to catch up so they can respond to the next downturn. But hey, the ECB is MUCH further behind.

Looking forward to today’s session, we start with the ECB meeting, where they announced no change in policy rates, but we still await Signor Draghi’s press conference at 8:30. It will be interesting if he continues to characterize the Eurozone economy risks as balanced, or if the downside risks are now elevated. If the latter, look for the euro to decline sharply! We also get US data including Durable Goods (exp -1.0%, ex transport +0.5%) and the Goods Trade Balance (-$74.9B). Yesterday’s New Home Sales data was awful, just 553K, well below expectations, and another sign that parts of the economy here are rolling over. I still don’t believe that the data turn has been enough to change the Fed’s mind about a December rate hike, but if numbers start to fall, watch out. Tomorrow’s GDP print will be quite important to the market. But today, I think the ECB dominates the story.

Good luck
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