Willing to Meet

The latest from 10 Downing Street
Is Boris is willing to meet
Midway twixt the stance
Of England and France
In order, the talks, to complete

Meanwhile, from the Far East we heard
That growth was strong in, quarter, third
They’re now set to be
The only country
Where year on year growth has occurred

The weekend has brought a few stories of note, all of them with bullish overtones, and so it should be no surprise that the week is starting with a risk-on tone.  The first place to look is in China, which released its Q3 GDP data last night at a slightly worse than expected 4.9% Y/Y.  While the market was looking for 5.5%, given that China is the first nation to achieve positive year over year growth, it was still seen as a market plus.  At least to the broad market. Interestingly, the Shanghai stock market fell 0.7%.  But, between the GDP data, Retail Sales rising 3.3% Y/Y and the Surveyed Jobless Rate falling a bit more than expected to 5.4%, the Chinese are painting a picture of a solid recovery.  And while this is well below the levels seen prior to the pandemic, it is still well ahead of the rest of the world.

Next up is the UK, where optimism has grown that a Brexit deal will, in fact, be reached. Boris, playing to both his constituents and the Europeans, has said that the UK is preparing for a no-deal outcome, but is happy to continue to talk if the Europeans would consider some compromises.  As well, in the House of Lords, word is they are prepared to remove the offending language from the UK government’s proposed Internal Market Bill, the one that caused all the concern since it was published in July.  In this bill, the UK sets out the relationship between the four nations in the UK; England, Scotland, Wales and Northern Ireland.  However, it was written in such a way as to render part of the Withdrawal Agreement moot, essentially overturning international law unilaterally.  Hence the issue.  In fact, the EU has sued the UK in the ICJ to prevent the law from being enacted.  This has been a major sticking point for the EU and has undermined a great deal of trust between the two sides.  Hence, the removal of that language is seen as a clear positive.  Certainly, FX traders saw it that way as the pound has rallied 0.75% since the news first was reported and is now back to 1.30.  While I believe the probability of a deal being completed remains above 50% (neither side wants a no-deal outcome), I also believe that the pound will fall after a deal is reached.  Sell the news remains the most likely situation in my view.

Adding to these two positive stories, the never-ending US stimulus talks continue to garner headlines despite a distinct lack of progress.  Yet, optimism on a stimulus bill seems to be a key driver in US equity markets, and in fact, in global ones as they are all, save Shanghai, propelled higher.  Given the proximity to the election, it seems unlikely that either side will allow the other to have a political victory, and so I remain skeptical a deal will be reached soon.  Of course, that merely means we can have a whole bunch of rallies on optimism that one will be reached!

With all that in mind, let’s take a look at the markets this morning.  Aside from Shanghai’s negative outcome in Asia, we saw strength with the Nikkei (+1.1%) and Hang Seng (+0.65%) both rallying nicely.  Europe as seen modest strength with the CAC (+0.6%) leading the way although the rest of the continent has seen far less love with the DAX (+0.1%), for instance, barely positive.  In fact, as I write, the FTSE 100 is actually slightly lower, down -0.15%.  US futures, though, have taken the stimulus story to heart and are much higher, between 0.8% (DOW) and 1.1% (NASDAQ).

Bond markets are feeling the risk-on mood as well, as they have fallen across the board with yields rising in every developed market.  Treasury yields are higher by 3.2 basis points, while bunds have seen a more modest 1.2 basis point rise.  Interestingly, the PIGS are seeing their bonds tossed overboard with an average rise of 4.5 basis points in their 10-year yields.

Oil prices (WTI -0.35%) are little changed, surprisingly, as one would expect commodities to rally on a positive risk day, while gold (+0.7%) and silver (+2.6%) are both quite strong, again somewhat surprising given higher yields and positive risk.  There are still many market relationships which have broken down compared to long-term trends.

Finally, the dollar is under pressure across the board this morning, with every G10 currency higher led by NOK (+0.95%) despite oil’s decline.  One of the drivers appears to be the unwinding of some large short positions in commodity currencies, a view that had been gaining credence amongst the leveraged community set.  This has helped SEK (+0.6%) and NZD (+0.55%) today as well.  The rest of the bloc, while higher, has been far less interesting.

On the EMG front, ZAR (+0.65%) is the leader with KRW (+0.5%) next in line.  After that, the gains are far less significant.  Korea’s won clearly benefitted from the Chinese GDP news, as China remains South Korea’s largest export destination.  Meanwhile, any gain in gold is likely to help support the rand given the gold mining industry’s importance to the economy there.  And as you consider the fact that the dollar is weak against virtually every currency, it is far more understandable that gold and silver have rallied as well.

On the data front, this week is not terribly interesting with only a handful of releases:

Tuesday Housing Starts 1455K
Building Permits 1506K
Wednesday Fed’s Beige Book
Thursday Initial Claims 865K
Continuing Claims 9.85M
Leading Indicators 0.7%
Existing Home Sales 6.30M
Friday Manufacturing PMI 53.5
Services PMI 54.6

Source: Bloomberg

However, despite a lack of data, there is no lack of Fedspeak this week, with six speeches just today, led by Chairman Powell at 8:00 on an IMF panel.  One of the themes of this week seems to be the discussion of central bank digital currencies, an idea that seems to be gaining traction around the world.  The other central bank tidbit comes from Madame Lagarde, who, not surprisingly, said she thought it made sense the PEPP (Pandemic EMERGENCY Purchase Program) be made a permanent vehicle.  This is perfectly in keeping with central bank actions where policies implemented to address an emergency morph into permanent policy tools as central bank mandates expand.  Once again, I will point out that the idea that other G10 central banks will allow the Fed to expand their balance sheet and undermine the dollar’s value without a response is categorically wrong. Every central bank will respond to additional Fed ease with their own package, thus this argument for a weaker dollar is extremely short-sighted.

But with all that said, there is no reason to believe the positive risk attitude will change today, unless there is a categorical denial by one of the parties discussing the stimulus bill.  As such, look for the dollar to continue to slide on the session.

Good luck and stay safe
Adf

Not So Amused

While Covid continues to spread
Chair Jay, for more stimulus pled
But President Trump
Said talks hit a bump
And ‘til the election they’re dead

The market was not so amused
With stock prices terribly bruised
So, as of today
Investors must weigh
The odds more Fed help is infused

Although nobody would characterize today as risk-on, the shock the market received yesterday afternoon does not seem to have had much follow through either.  Of course, I’m referring to President Trump’s tweet that all stimulus negotiations are off until after the election.  One need only look at the chart of the Dow Jones to know the exact timing of the comment, 2:48 yesterday afternoon.  The ensuing twenty minutes saw that index fall more than 2%, with similar moves in both the S&P 500 and the NASDAQ.  And this was hot on the heels of Chairman Powell pleading, once again, for more fiscal stimulus to help the economy and predicting dire consequences if none is forthcoming.

At this point, it is impossible to say how this scenario will play out largely because of the political calculations being made by both sides ahead of the presidential election next month.  On the one hand, it seems hard to believe that a sitting politician would refuse the opportunity to spend more money ahead of an election.  On the other hand, the particular politician in question is unlike any other seen in our lifetimes, and clearly walks to the beat of a different drummer.  The one thing I will say is that despite the forecasts of impending doom without further stimulus, the US data continues to show a recovering economy.  For instance, yesterday’s record trade deficit of -$67.2 billion was driven by an increase in imports, not something that typically occurs when the economy is slowing down.  One thing we have learned throughout the Covid crisis is that the econometric models used by virtually every central bank have proven themselves to be out of sync with the real economy.  As such, it is entirely possible that the central bank pleas for more stimulus are based on the idea that monetary policy has done all it can, and central bankers are terrified of being blamed for the economic problems extant.

Speaking of central bank activities and comments, the Old Lady of Threadneedle Street has been getting some press lately as the UK economy continues to deal with not merely Covid-19, but the impending exit from the EU.  Last month, the BOE mentioned they were investigating negative interest rates, but comments since then seem to highlight that there are but two of the nine members of the MPC who believe there is a place for NIRP.  That said, the Gilt market is pricing in negative interest rates from two to five years in maturity, so there is clearly a bigger community of believers.  While UK economic activity has also rebounded from the depths of the Q2 collapse, there is a huge concern that a no-deal Brexit will add another layer of difficulty to the situation there and require significantly more government action.  The BOE will almost certainly increase its QE, with a bump from the current £745 billion up to £1 trillion or more.  But, unlike the US, the UK does not have the advantage of issuing debt in the world’s reserve currency, and at some point, the cost of further fiscal stimulus may prove too steep.  As to the probability of a Brexit deal, it seems that much rides on French President Macron’s willingness to allow the French fishing fleet to sink shrink and allow the UK to manage their own territorial waters.

With this as the backdrop, a look at markets this morning shows a mixed bag on the risk front.  Asian equity markets saw the Nikkei (-0.05%) essentially unchanged although the Hang Seng (+1.1%) got along just fine.  Shanghai remains closed for holidays.  European bourses seem to be taking their cues from the Nikkei, as modest declines are the rule of the day.  The DAX (-0.35%) and the CAC (-0.2%) are both edging lower, and although the FTSE 100 is unchanged, the rest of the continent is following the German lead.  Interestingly, US futures are higher by between 0.3%-0.5%, not necessarily what one would expect.

Bond markets, once again, seem to be trading based on different market cues than either equities or FX, as this morning the 10-year Treasury yield has risen 4 basis points, and is trading back to the recent highs seen Monday.  One would be hard-pressed to characterize today as a risk-on session, where one might typically see investors sell bonds as they rotate into equities, so clearly there is something else afoot.  Yesterday’s 3-year Treasury auction seemed to be pretty well-received, so there is, as yet, no sign of fatigue in buying US debt.  There is much discussion here about the possibility of a contested election, yet I would have thought that is a risk scenario that would drive Treasury buying.  To my inexpert eyes, this appears to be driven by more inflation concerns.  Next week we see CPI again, and based on the recent trend, as well as personal experience, there has been no abatement in price pressures.  And unless the Fed starts buying the long end of the Treasury curve (something Cleveland’s Loretta Mester suggested yesterday), or announces yield curve control, there is ample room for the back end to sell off further with yields moving correspondingly higher, regardless of Fed activity.  And that would bring a whole set of new problems for the US.

Finally, one would have to characterize the dollar as on its back foot this morning.  While not universally lower, there are certainly more gainers than losers vs. the greenback.  In the G10 space, NOK (+0.5%) and SEK (+0.4%) are leading the way, which given oil’s 2.5% decline certainly seems odd for the Nocky.  As for the Stocky, there is no news nor data that would have encouraged buying, and so I attribute the movement to an extension of the currency’s recent modest strength which has seen the krona gain about 2% in the past two weeks.  Meanwhile, JPY (-0.4%) continues to sell off, much to the delight of Kuroda-san and new PM Suga.  Here, too, there is no news or data driving the story, but rather this feels like position adjustments.  It was only a few weeks ago where there was a great deal of excitement about the possibility of the yen breaking out and heading toward par.  That discussion has ended for now.

Emerging markets are generally better this morning as well, led by MXN (+0.85%) which is gaining despite oil’s decline and the landfall of Hurricane Delta, a category 3 storm.  If anything, comments from Banxico’s Governor De Leon, calling for more stimulus and explaining that the recovery will be uneven because of the lack of fiscal action, as well as the IMF castigating AMLO for underspending on stimulus, would have seemed to undermine the currency.  But apparently not.  Elsewhere, the gains are less impressive with HUF (+0.5%) and ZAR (+0.35%) the next best performers with the former getting a little love based on increased expectations for tighter monetary policy before year end, while ZAR continues to benefit, on days when fear is in the background, from its still very high real interest rates.

The only data of note today is the FOMC Minutes this afternoon, but are they really going to tell us more than we have heard recently from virtually the entire FOMC?  I don’t think so.  Instead, today will be a tale of the vagaries of the politics of stimulus as the market will await the next move to see if/when something will be agreed.  Just remember one thing; the Fed has already explained pretty much all the easing it is going to be implementing, but we have more to come from both the ECB and BOE.  That divergence ought to weigh on both the euro and the pound going forward.

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

Further To Go

The contrast could not be more clear
Twixt Powell and Christine this year
The Fed jumped in first
But now they’ve disbursed
As much aid as like to appear

Meanwhile Ms Lagarde in Berlin
Was clearly quite slow to begin
But Europe depends
On banks to extend
Its aid, so can still underpin

More growth by increasing the flow
Of cash, through TLTRO
Thus, traders now see
The buck vis-à-vis
The euro, has further to go

It was less than two months ago when the most prominent theme in the market was the imminent demise of the dollar, not merely in the short-term, but in the long run.  The idea that was being circulated was that because of the US’s excessive and growing twin deficits (Budget and Current Account), investors would soon decide that holding dollar’s would be too risky and thus demand a different unit of account and store of value.  During this period, we did see the dollar sell off, with the greenback falling nearly 6.5% vs. the euro during the month of July.  But that was basically that.  It was a great story, and probably a good trade for some early movers, but explaining short term market volatility by referring to ultra-long-term financial theory was always destined to fail.  And fail it has.  After all, since then, the dollar has actually appreciated (+2.2% vs. the euro) and yet, if anything, the US has seen its budget and current account deficits widen further.

Rather, short-term dollar movement tends to be driven by things like relative monetary policy and relative macroeconomic performance.  Looking back at that time, the prevailing sentiment was that the Fed, despite having already implemented an unfathomable amount of monetary ease already, was preparing to do even more.  Recall, leading up to, and through, the Jackson Hole symposium, market participants were sure that the Fed was going to not merely allow inflation to run hot, but help it do so.  Meanwhile, the ECB, in its typical plodding manner, was very quiet and the punditry saw little in the way of additional ease on the horizon.  In fact, there were complaints that the ECB was not doing nearly enough.

However, as seems to happen quite frequently, the punditry turns out to have gotten things backwards.  Last week, the Fed announced their new policy goals, counting on average inflation targeting to help them achieve significantly lower unemployment, although they still couldn’t didn’t explain how they were going to achieve said higher inflation.  And then earlier this week, Chairman Powell, in as much, admitted that the Fed has done all they can and that it was up to Congress to expand fiscal stimulus in order to give the economy the support it needed to cope with the Covid inspired recession.  In other words, the Fed is out of bullets.

One of the problems the Fed has is that transmission of monetary policy is effected by banks, that is the way the system is designed.  But the bulk of the Fed programs have only supported markets, by them buying Treasuries, Mortgage-backed securities, Corporates (IG and Junk) and Munis.  But for small companies who don’t access the capital markets directly, virtually none of the Fed’s activities have had an impact as the bank’s are reluctant to lend in this environment of economic uncertainty.  Europe, on the other hand, relies on banks for the majority of capital flow to its economy, as European corporate debt markets remain much smaller and more fragmented across countries.  So, when the ECB created the TLTRO, targeted lending facility, where they PAY banks 1.00% to lend money to companies, who also pay the banks interest, it turns out to be a more efficient way to prosecute monetary policy ease.  And this morning, the latest tranche of this program saw an additional €174.5 billion taken up.  This is on top of the €1.3 trillion that was taken up last time there was a tender, three months ago.

The point is, suddenly investors and traders are figuring out that the ECB has the ability to promulgate policy ease more effectively than the Fed, and just as importantly, are doing so.  Add it all up and you have ECB policy looking easier than Fed policy at the margin, a clear recipe for the euro’s decline.  This move in the euro is just beginning, and it would not be surprising to see the single currency head back toward 1.12 before the end of the year.  As I have written in the past, there was no way the ECB would sit back and allow the dollar to fall unhindered.  They simply cannot afford that outcome to occur.

Which brings us to today’s session, where risk is being jettisoned across equity markets globally, although several European markets are starting to turn things around.  Overnight, following a very weak US session, Asia was red across the board led by the Hang Seng (-1.8%), but with weakness in Shanghai (-1.7%) and the Nikkei (-1.1%). Europe, however, while starting lower in every market has now seen a little positivity as the DAX (+0.15%) and Italy’s FTSE MIB (+0.7%) are offsetting increasingly modest weakness in the CAC (-0.1%) and FTSE 100 (-0.4%).  Finally, US futures, which had also been lower by more than 0.5% earlier in the session, have rebounded to flat.

The bond market, however, remains enigmatic lately, with yields continuing to trade in extremely tight ranges regardless of the movement in risk assets.  At this time, Treasury yields are unchanged, after remaining essentially unchanged during yesterday’s US equity sell-off.  Bunds have seen yields edge lower by 1.5 basis points, while Gilt yields have edged higher by less than a basis point.  It seems that the bond markets, globally, are unwilling to follow every twist and turn of the recent stock market manias.

As to the dollar, it is firmer vs. most of its counterparts, but just like we are seeing in European equities, we are beginning to see a bit of a rebound in some currencies as well.  In the G10, the biggest story is NOK (-0.65%) where the Norgesbank disappointed one and all by seeming to be more dovish than anticipated.  Many had come to believe they would be putting a timeline on raising interest rates, but they did no such thing, thus the krone has continued its recent poor performance (-5.8% vs. the dollar in the past month).  But we are seeing weakness elsewhere with SEK (-0.8%) actually the worst performer, albeit absent any specific news, and both NZD (-0.5%) and AUD (-0.3%) suffering at this point.

In the EMG bloc, overnight saw weakness across the Asian currencies led by KRW (-0.7%) and THB, IDR and TWD (all -0.5%) as risk was shed across the board.  But with the recent turn in events, early losses by ZAR (+0.7%) and MXN (+0.3%) have turned to gains.  It is those two currencies, however, which remain the most volatile around, so be careful if hedging there.

On the data front, yesterday’s US PMI data was right on expectations and showed continued progress in the economy, a sharp contrast to the European situation.  This morning saw modestly weaker than expected German IFO data (Expectations 97.7), which is not helping the euro.  Later today we see Initial Claims (exp 840K), Continuing Claims (12.275M) and finally New Home Sales (890K) at 10:00.  Once again, the tapes will be painted with Fedspeak, led by Powell at 10:00 in front of the Senate Banking Committee, but also hearing from six more FOMC members. While I would not be surprised if Powell tried to walk back his comments about the Fed being done, it’s not clear he will be able to do so.

For now, the dollar’s trend remains pretty solid, and I expect that it will continue to grind higher until we get a substantive change in policies.

Good luck and stay safe
Adf

Congressional Sloth

The Chairman is set to appear
Near Mnuchin, and both will make clear
Congressional sloth
Is killing off growth
Thus, action’s required this year

The subtext, though, is that the Chair
Has realized his cupboard is bare
No ammo remains
To prop up the gains
That stocks have made ‘midst much fanfare

Yesterday’s risk-off session may well have set the tone for the week, as there has been precious little rebound yet seen.  In addition to the virus story, and the news of large bank misdeeds, the US election story remains a critical factor, although at this point, any impact remains difficult to discern.  The one thing that is quite clear is that there is a very stark choice between candidates.  Given the prevailing meme that it is going to be a very close election, and the outcome could be in doubt for weeks following November 3rd, and assuming that the market response will be quite different depending on who eventually wins, one cannot blame traders and investors for omitting the issue from their current calculations.  While eventually, there is likely to be a significant market response, at this point, it seems there is little to be gained by positioning early.

In the meantime, however, the current administration continues to seek to do what it thinks best for the economy, and today we will get to hear from Chairman Powell, as well as Treasury Secretary Mnuchin, in Congressional testimony.  As is always the case in these situations, the text of Powell’s speech has been pre-released and it continues to focus on the one (apparently only) thing that is out of his control, more fiscal stimulus.  In his opening remarks he will describe the economy as improving but with still many problems ongoing.  He will also explain that monetary stimulus needs the help of fiscal stimulus to be truly effective.  In other words, he will explain that the Fed is now ‘pushing on a string’ and if Congress doesn’t enact new stimulus measures, there is little the Fed will be able to do to achieve their statutory goals.  Of course, he won’t actually use those words, but that will be the meaning.  It is abundantly clear that the Fed’s ability to support the real economy, as opposed to financial markets, has reached its end.

However, it is not just the Fed that has reached its limit, essentially every G10 central bank has reached the limit of effective central banking.  It has been argued, and I agree with the sentiment, that the difference between ‘normal’ positive interest rates and the zero and negative rates we currently see around the world is similar to the difference between Newtonian and Quantum mechanics in Physics.  In the positive rate environment, things are exactly as they seem.  Investment decisions are based on estimated returns, and risk of repayment is factored into the rate charged. There is a concept called the time value of money, where one dollar today is worth more than that same dollar in the future.  It is the basis on which Economics, the subject, was formulated.  This is akin to Newton’s well-known laws like; Every action has an equal and opposite reaction, or a body in motion will stay in motion unless acted on by another force.  They are even, dare I say, intuitive.

But in the zero (or negative) interest rate world, investment decisions are completely different.  First, the time value of money doesn’t make sense as it becomes, a dollar today is worth less than a dollar in the future.  As well, the addition of forward guidance is self-defeating.  After all, if they know that interest rates are going to remain zero for the next three years, what is the hurry for a company to borrow money now? Especially given the extreme lack of demand for so many products.  Instead, managements have realized that there is no need to worry about increasing production, they will always be able to do that when demand increases.  Rather, their time can be better spent reconfiguring their capital structure to reduce equity (lever up) and show ever increasing EPS growth without risking a poor investment decision.  This is akin to the difficulty in understanding the quantum realm, where uncertainty reigns (thank you Heisenberg) and the accuracy of measuring the position (EPS) and momentum (growth) of a particle are inversely related.

The problem is that central bankers are all Newtonians (or Keynesians), and so simply plug zero and negative numbers into their models and expect the same reactions as when they plug in positive numbers. And the output is garbage, which is a key reason they have been unable to stimulate economic activity effectively.  Alas, as long as problems persist, central bankers will feel compelled to “do something” when doing nothing may be the best course of action.  In the end, look for more monetary stimulus as it is the only tool they have.  Unfortunately, its effectiveness has been diminished to near zero, like their interest rates.

In the meantime, a look around markets shows that risk is neither off nor on this morning, but mostly confused.  Asian equity markets followed yesterday’s US losses, with declines of around 1% in those markets open.  (The Nikkei remained closed).  But European bourses have turned modestly higher on the day as the results of some regional elections in Italy have been taken quite positively.  There, the League’s Matteo Salvini lost seats to the current government, thus reducing the probability of a toppling government and easing pressure on Italian assets.  In fact, the FTSE MIB is the leading gainer today, higher by 1.2%, but we also see the DAX (+1.0%) and CAC (+0.5%) shaking off early losses to turn up.  US futures are mixed at this time, although well off the lows seen during the Asia session.

In the bond market, yesterday saw Treasury yields decline about 3 basis points amidst the ongoing risk reduction, but this morning, prices are edging lower and the yield has backed up just about 1bp.  In Europe, things have been much more interesting as Italian BTP’s have rallied sharply during the day, with yields now down 3.5 basis points, after opening with a similar sized rise in yields.  Bunds, meanwhile, are selling off a bit, as fears of an eruption of Italian trouble recede.

And finally, the dollar, which had been firmer much of the evening, is now ceding much of those gains, and at this hour I would have to describe as mixed.  In the G10, NOK (-0.5%) remains under the most pressure as oil prices continue to soften and there is now a controversy brewing with respect to the investment strategy of the Norwegian oil fund.  But away from NOK, the G10 is +/- 0.15%, which means it is hard to describe the situation as significant.

In the emerging markets, ZAR (+1.1%) continues to be the most volatile currency around, with daily movements in excess of 1%.  It has become, perhaps, the best sentiment gauge out there.  When investors are feeling good, ZAR is in demand, and it is quick to be sold in the event that risk is under pressure.  CNY (+0.45%) is the next best performer.  This is at odds with what appears to be the PBOC’s intentions as they set the fix at a much weaker than expected 6.7872, or 0.4% weaker than yesterday.  It seems the PBOC may be getting concerned over the speed with which the renminbi has been rising, as in the end, they cannot afford for the currency to appreciate too far.  On the red side of the ledger, KRW and IDR both fell 0.6% last night as risk mitigation was the story at the time.

Aside from Chairman Powell speaking today, we also see Existing Home Sales (exp 6.0M), which if it reaches expectations would be the highest print since 2007.  If risk is back in vogue, then I would look for the dollar to continue to edge lower.  And you can be sure that Chairman Powell will not do anything to upset that apple cart.

Good luck and stay safe
Adf

Absent Demand

With Autumn’s arrival at hand
The virus has taken a stand
It won’t be defeated
Nor barely depleted
Thus, markets are absent demand

Risk is definitely on the back foot this morning as concerns grow over the increase in Covid-19 cases around the world.  Adding to the downward pressure on risk assets is the news that a number of major global banks are under increased scrutiny for their inability (unwillingness?) to stop aiding and abetting money laundering.  And, of course, in the background is the growing sense that monetary authorities around the world, notably the Fed, have run out of ammunition in their ongoing efforts to support economic growth in the wake of the government imposed shutdowns.  All in all, things look pretty dire this morning.

Starting with the virus, you may recall that one of the fears voiced early on was that, like the flu, it would fade somewhat in the summer and then reassert itself as the weather cooled.  Well, it appears that was a pretty accurate analysis as we have definitely seen the number of new cases rising in numerous countries around the world.  Europe finds itself in particularly difficult straits as the early self-congratulatory talk about how well they handled things vis-à-vis the US seems to be coming undone.  India has taken the lead with respect to the growth in cases, with more than 130,000 reported in the past two days.  The big concern is that government’s around the world are going to reimpose new lockdowns to try to stifle growth in the number of cases, but we all know how severely that can impact the economy.  So, the question with which the markets are grappling is, will the potential long-term benefit of a lockdown, which may reduce the overall caseload outweigh the short-term distress to the economy, profits and solvency?

At least for today, investors and traders are coming down on the side that the lockdowns are more destructive than the disease and so we have seen equity markets around the world come under pressure, with Europe really feeling the pain.  Last night saw the Hang Seng (-2.1%) and Shanghai (-0.6%) sell off pretty steadily.  (The Nikkei was closed for Autumnal Equinox Day.)  But the situation in Europe has been far more severe with the DAX (-3.2%), CAC (-3.1%) and FTSE 100 (-3.5%) all under severe pressure.  All three of those nations are stressing from an increase in Covid cases, but this is where we are seeing a second catalyst, the story about major banks and their money laundering habits.  A new report has been released that describes movement of more than $2 trillion in illicit funds by major (many European) banks, even after sanctions and fines have been imposed.  It can be no surprise that bank stocks throughout Europe are lower, nor that pre-market activity in the US is pointing in the same direction.  As such, US future markets showing declines of 1.5%-2.0% are right in line with reasonable expectations.

And finally, we cannot ignore Chairman Powell and the Fed.  The Chairman will be speaking before Congress three times this week, on both the need for more fiscal stimulus as well as the impact of Covid on the economy.  Now we already know that the Fed has implemented “powerful” new tools to help support the US, after all, Powell told us that about ten times last week in his press conference.  Unfortunately, the market is a bit less confident in the power of those tools.  At the same time, it seems the ECB has launched a review of its PEPP program, to try to determine if it has been effective and how much longer it should continue.  One other question they will address is whether the original QE program, APP, should be modified to be more like PEPP.  It is not hard to guess what the answers will be; PEPP has been a huge success, it should be expanded and extended because of its success, and more consideration will be given to changing APP to be like PEPP (no capital key).  After all, the ECB cannot sit by idly and watch the Fed ease policy more aggressively and allow the euro to appreciate in value, that would be truly catastrophic to their stated goal of raising the cost of living inflation on the Continent.

With all that in mind, a look at FX markets highlights that the traditional risk-off movement is the order of the day.  In other words, the dollar is broadly stronger vs. just about everything except the yen.  For instance, in the G10 space, NOK (-1.45%) is falling sharply as the combination of risk aversion and a sharply lower oil price (WTI -2.5%) has taken the wind out of the krone’s sails.  But the weakness here is across the board as SEK (-0.8%) and the big two, GBP (-0.5%) and EUR (-0.45%) are all under pressure.  It’s funny, it wasn’t that long ago when the entire world was convinced that the dollar was about to collapse.  Perhaps that attitude was a bit premature.  In fact, the euro bulls need to hope that 1.1765 (50-day moving average) holds because if the technicians jump in, we could see the single currency fall a lot more.

As to the emerging markets, the story is the same, the dollar is broadly higher with recent large gainers; ZAR (-2.0%) and MXN (-1.4%), leading the way lower.  But the weakness is broad-based as the CE4 are all under pressure (CZK -1.3%, HUF -1.1%, PLN -0.95%) and even CNY (-0.2%) which has been rallying steadily since its nadir at the end of May, has suffered.  In fact, the only positive was KRW (+0.2%) which benefitted from data showing that exports finally grew, rising above 0.0% for the first time since before Covid.

As to the data this week, it is quite light with just the following to watch:

Tuesday Existing Home Sales 6.01M
Wednesday PMI Manufacturing (Prelim) 53.3
Thursday Initial Claims 840K
Continuing Claims 12.45M
New Home Sales 890K
Friday Durable Goods 1.1%
-ex Transport 1.0%

Source: Bloomberg

The market will be far more interested in Powell’s statements, as well as his answers in the Q&A from both the House and Senate.  The thing is, we already know what he is going to say.  The Fed has plenty of ammunition, but with interest rates already at zero, monetary policy needs help from fiscal policy.  In addition to Powell, nine other Fed members speak a total of twelve times this week.  But with Powell as the headliner, it is unlikely they will have an impact.

The risk meme is today’s story.  If US equity markets play out as the futures indicate, and follow Europe lower, there is no reason to expect the dollar to do anything but continue to rally.  After all, while short dollar positions are not at record highs, they are within spitting distance of being so, which means there is plenty of ammunition for a dollar rally as shorts get covered.

Good luck and stay safe
Adf

Whom He Must Obey

The question is, what can he say?
You know, course, I’m talkin’ ‘bout Jay
Can he still, more, ease?
In order to please
The markets whom he must obey

Fed day has arrived, and all eyes are on the virtual Marriner Eccles Building in Washington, where the FOMC used to meet, prior to the current pandemic.  In the wake of Chairman Powell’s speech at the end of August, during the virtual Jackson Hole symposium, where he outlined the new Fed framework; analysts, economists and market participants have been trying to guess when there will be more details forthcoming regarding how the Fed plans to achieve their new goals.  Recall, stable prices have been redefined as ‘an average inflation rate of 2.0% over time’.  However, Powell gave no indication as to what timeline was considered, whether it was fixed or variable, and how wide a dispersion around their target they are willing to countenance.  So generally, we don’t know anything about this policy tweak other than the fact that, by definition, inflation above 2.0% will not be considered a sufficient reason to tighten monetary policy.  There are as many theories of what they are going to do as there are analysts propagating them, which is why this meeting is seen as so important.

As it is a quarterly meeting, we will also see new Fed economic forecasts and the dot plot will be extended to include the FOMC membership’s views of rates through 2023.  As to the latter, the working assumption is that virtually the entire committee expects rates to remain at current levels throughout the period.  Reinforcing this view is the futures market, where Fed Funds futures are essentially flat at current levels through the last listed contract in August 2023.  Eurodollar futures show the first full rise in rates priced for June 2024.  In other words, market participants are not looking for any policy tightening anytime soon.

Which begs the question, exactly what can Jay say that could be considered dovish at this point?  Certainly, he could explain that they are going to increase QE, but that is already defined as whatever is deemed necessary to smooth the functioning of markets.  Perhaps if he defines it as more than that, meaning it is supposed to help support economic activity, that would be interpreted as more dovish.  But isn’t infinite QE already as much as they can do?

It seems highly unlikely that the committee will give a fixed date as to when policy may eventually tighten.  But it is possible, though I think highly unlikely as well, that they define what level of inflation may require a change in policy.  The problem with that theory is there are too many potential paths down which inflation can wander.  For instance, if core PCE increased to 2.5% (a BIG if) and remained stable there for six months, would that be enough to force an adjustment to policy?  Would one year be the right amount?  Five years?  After all, core PCE has averaged 1.6% for the past ten years.  For the past twenty, the average has been 1.72%.  In fact, you have to go back over the past 32 years in order to calculate the average core PCE at 2.0%.  And of course, this is the problem with the Fed’s new framework, it doesn’t really tell us much about the future of policy other than, it is going to be ultra-easy for a long, long time.

It is with this in mind that the market has embraced the idea that the dollar must naturally fall as a consequence.  And that is a fair point.  If the Fed continues to out-ease all other central banks, then the dollar is quite likely to continue to soften.  But as we have seen already from numerous ECB speakers, and are likely to see from the BOE tomorrow, the Fed is not acting in a vacuum.  FX continues to be a relative game, as the differential in policies between currencies is the driving factor.  And while Madame Lagarde did say she was not concerned about the euro’s strength, you may recall that she also indicated, once upon a time, that it was not the ECB’s job to worry about Italian government bond yields.  That was her position for at least a day before the ECB figured out that was their entire job and created the PEPP.  My point is, if Jay comes across as more dovish somehow, you can be certain that every other central bank will double down on their own policy ease.  No country wants to be the one with the strong currency these days.

But for now, the market is still of the opinion that the Fed is out in the lead, and so the dollar continues to drift lower.  This morning, we see the dollar weaker against the entire G10 bloc with NOK (+0.6%) the leader on the back of oil’s 2.5% rally, although GBP (+0.5%) is also firmer after UK inflation data showed smaller declines than forecast, perhaps alleviating some of the pressure on the BOE to ease further.  At least that’s the thought right now.  But even the euro, after ultimately slipping yesterday, has rallied a modest 0.15% although it remains below 1.19 as I type.

Emerging market currencies are behaving in a similar manner, as the entire bloc is firmer vs. the greenback.  Once again ZAR (+0.95%) leads the pack on the combination of firmer commodity prices (gold +0.5%), the highest real yields around and faith that the Fed will continue to ease further.  But we are seeing MXN (+0.5%) gaining on oil’s rally and CNY (+0.35%) following up yesterday’s gains with a further boost as expectations grow that China’s economy is truly going to be back to pre-Covid levels before the end of the year.  Overall, it is a day of dollar weakness.

Other markets have shown less exuberance as Asian equity markets were essentially flat (Nikkei +0.1%, Hang Seng 0.0%, Shanghai -0.3%) and European bourses are also either side of flat (DAX -0.1%, CAC +0.1%, FTSE 100 -0.1%).  US futures, naturally, continue to rally, with all three indices looking at gains of 0.4%-0.6% at this time.

Government bond markets remain dull, with another large US auction easily absorbed yesterday and 10-year yields less than a basis point different than yesterday’s levels.  In Europe, actually, most bond yields have edged a bit lower, but only one to two basis points’ worth, so hardly a sign of panic.

As to the data story, yesterday saw a much better than forecast Empire Manufacturing number (+17.0) boding well for the recovery.  This morning brings Retail Sales (exp 1.0% headline, 1.0% ex autos) at 8:30, and then the long wait until the FOMC statement is released at 2:00pm.  Chairman Powell will hold his press conference at 2:30, and if he manages to sound dovish, perhaps we see further dollar declines and equity rallies.  But I sense the opportunity for some disappointment and perhaps a short-term reversal if he doesn’t invent a new dovish theme.  In that case, look for the dollar to recoup today’s losses at least.

Good luck and stay safe
Adf

Nations Regress

When two weeks ago I last wrote
The narrative was to promote
A dollar decline
Which did intertwine
With hatred for Trump ere the vote

But since then the dollar’s rebounded
While experts galore are confounded
Poor Europe’s a mess
While nations regress
On Covid, where hope had been founded

I told you so?  Before my mandatory leave began, the market narrative was that the dollar was not merely falling, but “collapsing” as everything about the US was deemed negative.  The background story continued to be about US politics and how global investors were steadily exiting the US, ostensibly because of the current administration.  Adding to that was Chairman Powell’s speech at the virtual Jackson Hole symposium outlining average inflation targeting, which implied that the Fed was not going to respond to incipient inflation by raising rates until measured inflation was significantly higher and remained there sufficiently long to offset the past decade’s period of undershooting inflation.  In other words, if (when) inflation rises, US interest rates will remain pegged to the floor, thus offering no support for the dollar.  While there were a few voices in the wilderness arguing the point, this outcome seemed assured.

And the dollar did decline with the euro finally breeching the 1.20 level, ever so briefly, back on September 1st.  But as I argued before leaving, there was no way the ECB was going to sit by idly and watch the euro continue to rally without a policy response.  ECB Chief economist Philip Lane was the first to start verbal intervention, which was sufficient to take the wind out of the euro’s sails right after it touched 1.20.  Since then, the ECB meeting last week was noteworthy for not discussing the euro at all, with market participants, once again, quickly accepting that the ECB would allow the single currency to rally further.  But this weekend saw the second volley of verbal intervention, this time by Madame Lagarde, VP Guindos, Ollie Rehn and Mr Lane, yet again.  Expect this pattern to be repeated regularly, every euro rally will be met with more verbal intervention.

Of course, over time, verbal intervention will not be enough to do the job, which implies that at some point in the future, we will see a more intensive effort by the ECB to help pump up inflation.  In order of appearance look for a significant increase in QE via the PEPP program, stronger forward guidance regarding the timing of any incipient rate hikes (never!), a further cut to interest rates and finally, actual intervention.  In the end, there is absolutely no way that the ECB is going to allow the euro to rally very much further than it already has.  After all, CPI in the Eurozone is sitting at -0.2% (core +0.4%), so far below target that they must do more.  And a stronger euro is not going to help the cause.

Speaking of inflation, I think it is worth mentioning the US situation, where for the second straight month, CPI data was much higher than expected.  While many analysts are convinced that the Fed’s rampant asset purchases and expansion of the money supply are unlikely to drive inflation going forward, I beg to differ.  The lesson we learned from the GFC and the Fed’s first gargantuan expansion of money supply and their balance sheet was that if all that money sits in excess reserves on commercial bank balance sheets, velocity of money declines and inflation is absent.  This time, however, the new funds are not simply sitting on the banks’ collective balance sheets but are rather being spent by the recipients of Federal government largesse.  This is driving velocity higher, and with it, inflation.  Now, whatever one may think of Chairman Powell and his Fed brethren, they are not stupid.  The Jackson Hole speech, I believe, served two purposes.  First, it was to help investors understand the Fed’s reaction function going forward, i.e. higher inflation does not mean higher interest rates.  But second, and something that has seen a lot less press, is that the Fed has just moved the goalposts ahead of what they see as a rising tide of inflation.  Now, if (when) inflation runs hot over the next 12-24 months, the Fed will have already explained that they do not need to respond as the average inflation rate has not yet achieved 2.0%.  It is this outcome that will eventually undermine the dollar’s value, higher inflation with no monetary response, but we are still many months away from that outcome.

Turning to today’s activity, after two weeks of broad dollar strength, as well as some equity market pyrotechnics, we are seeing a bit of a dollar sell-off today.  It would be hard to characterize the markets as risk-on given the fact that European bourses are essentially flat on the day (DAX -0.1%, CAC +0.1%) while Asian equity markets showed only modest strength at best (Nikkei, Hang Seng and Shanghai all +0.6%).  Yes, US futures are pointing higher by 1.0%, but that seems more to do with the two large M&A deals announced than anything else.

In the meantime, bond markets have shown no indication of risk being on, with 10-year Treasury yields essentially unchanged since Friday at 0.67%, and effectively unchanged since I last wrote on August 28!  The same is largely true across European government bond markets, with, if anything, a bias for risk-off as most of those have seen yields slide one to two basis points.

And finally, the dollar’s specifics show GBP (+0.6%) to be the top G10 performer, which given its recent performance, down more than 4% since I last wrote, seems to be a bit of a breather rather than anything positive per se.  In the UK, today sees the beginning of the Parliamentary debate regarding PM Johnson’s proposed rewrite of aspects of Brexit legislation, which many think, if passed, will insure a hard Brexit.  As to the rest of the bloc, gains are mostly in the 0.25% range, with the most common theme the uptick in economists’ collective forecasts for economic prospects compared with last month.

Interestingly, in the EMG bloc, movement is less pronounced, with MXN (+0.4%) the biggest gainer, while RUB (-0.4%) is the laggard.  Clearly, as both are oil related, oil is not the driver.  However, when EMG currencies move less than 0.5%, it is hard to get too excited overall.

On the data front this week, the big story is, of course, the FOMC meeting on Wednesday, but we have a bunch of things to absorb.

Tuesday Empire Manufacturing 6.0
IP 1.0%
Capacity Utilization 71.4%
Wednesday Retail Sales 1.0%
-ex autos 1.0%
Business Inventories 0.2%
FOMC Rate Decision 0.00%-0.25%
Thursday Initial Claims 850K
Continuing Claims 13.0M
Housing Starts 1480K
Building Permits 1520K
Friday Leading Indicators 1.3%
Michigan Sentiment 75.0

Source: Bloomberg

What we have seen lately is the lagging indicators showing that the bounce after the reopening of the economy was stronger than expected, but there is growing concern that it may not be sustainable.  At the same time, the only thing interesting about the FOMC meeting will be the new forecasts as well as the dot plot.  After all, Jay just told us what they are going to do for the foreseeable future (nothing) two weeks ago.

Good luck and stay safe
Adf

Casting a Pall

The Chairman explained to us all
Deflation is casting a pall
On future advances
While NIRP’s what enhances
Our prospects throughout the long haul

The bond market listened to Jay
And hammered the long end all day
The dollar was sold
While buyers of gold
Returned, with aplomb, to the fray

An announcement to begin the day; I will be taking my mandatory two-week leave starting on Monday, so the next poetry will be in your inbox on September 14th.

Ultimately, the market was completely correct to focus all their attention on Chairman Powell’s speech yesterday because he established a new set of ground rules as to how the Fed will behave going forward.  By now, most of you are aware that the Fed will be targeting average inflation over time, meaning that they are happy to accept periods of higher than 2.0% inflation in order to make up for the last eight years of lower than 2.0% inflation.

In Mr. Powell’s own words, “…our new statement indicates that we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

You may have noticed that Powell adds no specificity to this new policy, with absolutely no definition of ‘some time’ nor what ‘moderately above’ means.  But there was more for us, which many may have missed because it was a) subtle, and b) not directly about inflation.

“In addition, our revised statement says that our policy decision will be informed by our “assessments of the shortfalls of employment from its maximum level” rather than by “deviations from its maximum level” as in our previous statement.”

This is the rationale for their new willingness to let inflation run hot, the fact that the benefits of full employment outweigh those of stable prices.  The lesson they learned from the aftermath of the GFC in 2008-9 was that declining unemployment did not lead to higher general inflation.  Of course, they, along with many mainstream economists, attribute that to the breakdown of the Phillips curve relationship.  But the Phillips curve was not about general inflation, rather it was about wage inflation.  Phillips noted the relationship between falling unemployment and rising wages in the UK for the century from 1861-1957.  In fact, Phillips never claimed there was a causality, that was done by Paul Samuelson later and Samuelson extended the idea from wage to general inflation.  Eventually Milton Friedman created a theoretical underpinning for the claim unemployment and general inflation were inversely related.

Arguably, the question must be asked whether the labor market situation in the UK a century ago was really a valid model for the current US economy.  As it turns out, the time of Downton Abbey may not be a viable analogy.  Who would’ve thought that?

Regardless, Powell made it clear that with this new framework, the Fed has more flexibility to address what they perceive as any problems in the economy, and they will use that flexibility as they see fit.  In the end, the market response was only to be expected.

Starting with the bond market, apparently, I wasn’t the only one who thought that owning a fixed income instrument yielding just 1.4% for 30 years when the Fed has explicitly stated they are going to seek to drive inflation above 2.0% for some time was a bad idea.  The Treasury curve steepened sharply yesterday with the 10-year falling one point (yield higher by 6.5bps) while the 30-year fell more than three points and the yield jumped by more than 10 basis points.  My sense is we will continue to see the back end of the Treasury curve sell off, arguably until the 30-year yields at least 2.0% and probably more.  This morning the steepening is continuing, albeit at a bit slower pace.

As to the dollar, it took a while for traders to figure out what they should do.  As soon as Powell started speaking, the euro jumped 0.75%, but about 5 minutes into the speech, it plummeted nearly 1.2% as traders were uncertain how to proceed.  In the end, the euro recouped its losses slowly during the rest of the day, and has risen smartly overnight, up 0.7% as I type.  In fact, this is a solid representation of the entire FX market.  Essentially, FX traders and investors have parsed the Chairman’s words and decided that US monetary policy is going to remain uber easy for as far in the future as they can imagine.  And if that is true, a weaker dollar is a natural response.  So, today’s broad-based dollar decline should be no surprise.  In fact, it makes no sense to try to explain specific currency movements as the dollar story is the clear driver.

However, that does not mean there is not another important story, this time in Japan.

Abe has ulcers
Who can blame him with Japan’s
Second wave rising?

PM Shinzo Abe has announced that he has ulcerative colitis and will be stepping down as PM after a record long run in the role.  Initially, there was a great deal of excitement about his Abe-nomics plan to reflate the Japanese economy, but essentially, the only thing it accomplished was a weakening of the yen from 85.00 to 105.00 during the past eight years.  Otherwise, inflation remains MIA and the economy remains highly regulated.  The market reaction to the announcement was to buy yen, and it is higher by 1.15% this morning, although much of that is in response to the Fed.  However, it does appear that one of the frontrunners for his replacement (former Defense Minister Shigeru Ishiba) has populist tendencies, which may result in risk aversion and a stronger yen.

As to the equity market, the Nikkei (-1.4%) did not appreciate the Abe news, but Shanghai (+1.6%) seemed to feel that a more dovish Fed was a net benefit, especially for all those Chinese companies with USD debt.  Europe has been a little less positive (DAX -0.3%, CAC -0.1%) as there is now a growing concern that the euro will have much further to run.  Remember, most Eurozone economies are far more reliant on exports than the US, and a strong euro will have definite repercussions across the continent.  My forecast is that Madame Lagarde will be announcing the ECB’s policy framework review in the near future, perhaps as soon as their September meeting, and there will be an extremely dovish tone.  As I have written before, the absolute last thing the ECB wants or needs is a strong euro.  If they perceive that the Fed has just insured further dollar weakness, they will respond in kind.

Turning to the data, we see a plethora of numbers this morning.  Personal Income (exp -0.2%), Personal Spending (1.6%) and Core PCE (1.2%) lead us off at 8:30.  Then later, we see Chicago PMI (52.6) and Michigan Sentiment (72.8).  The thing is, none of these matters for now.  In fact, arguably, the only number that matters going forward is Core PCE.  If it remains mired near its current levels, the dollar will continue to suffer as not only will there be no tightening, but it seems possible the Fed will look to do more to drive it higher.  On the other hand, if it starts to climb, until it is over 2.0%, the Fed will be standing pat.  And as we have seen, getting Core PCE above 2.0% is not something at which the Fed has had much success.  For now, the dollar is likely to follow its recent path and soften further.  At least until the ECB has its say!

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
Adf