Percent Twenty-Five

The story, once more’s about trade
As Trump, a new threat, has conveyed
Percent twenty-five
This fall may arrive
Lest progress in trade talks is made

President Trump shook things up yesterday by threatening 25% tariffs on $200 billion of Chinese imports unless a trade deal can be reached. This is up from the initial discussion of a 10% tariff on those goods, and would almost certainly have a larger negative impact on GDP growth while pushing inflation higher in both the US and China, and by extension the rest of the world. It appears that the combination of strong US growth and already weakening Chinese growth, has led the President to believe he is in a stronger position to obtain a better deal. Not surprisingly the Chinese weren’t amused, loudly claiming they would not be blackmailed. In the background, it appears that efforts to restart trade talks between the two nations have thus far been unsuccessful, although those efforts continue.

Clearly, this is not good news for the global economy, nor is it good news for financial markets, which have no way to determine just how big an impact trade ructions are going to have on equities, currencies, commodities and interest rates. In other words, things are likely more uncertain now than in more ‘normal’ times. And that means that market volatility across markets is likely to increase. After all, not only is there the potential for greater surprises, but the uncertainty prevailing has reduced liquidity overall as many investors and traders hew to the sidelines until they have a better idea of what to do. And, of course, it is August 1st, a period where summer vacations leave trading desks with reduced staffing levels and so liquidity is generally less robust in any event.

Moving past trade brings us straight to the central bank story, where the relative hawkishness or dovishnes of yesterday’s BOJ announcement continues to be debated. There are those who believe it was a stealth tightening, allowing higher 10-year yields (JGB yields rose 8bps last night to their highest level in more than 18 months) and cutting in half the amount of reserves subject to earning -0.10%. And there are those who believe the increased flexibility and addition of forward guidance are signals that the BOJ is keen to ease further. Yesterday’s price action in USDJPY clearly favored the doves, as the yen fell a solid 0.8% in the session. But there has been no follow-through this morning.

As to the other G10 currencies, the dollar is modestly firmer against most of them this morning in the wake of PMI data from around the world showing that the overall growth picture remains mixed, but more troubling, the trend appears to be continuing toward slower growth.

The emerging market picture is similar, with the dollar performing reasonably well this morning, although, here too, there are few outliers. The most notable is KRW, which has fallen 0.75% overnight despite strong trade data as inflation unexpectedly fell and views of an additional rate hike by the BOK dimmed. However, beyond that, modest dollar strength was the general rule.

At this point in the session, the focus will turn to some US data including; ADP Employment (exp 185K), ISM Manufacturing (59.5) and its Prices Paid indicator (75.8), before the 2:00pm release of the FOMC statement as the Fed concludes its two day meeting. As there is no press conference, and the Fed has not made any changes to policy without a press conference following the meeting in years, I think it is safe to say there is a vanishingly small probability that anything new will come from the meeting. The statement will be heavily parsed, but given that we heard from Chairman Powell just two weeks ago, and the biggest data point, Q2 GDP, was released right on expectations, it seems unlikely that they will make any substantive changes.

It feels far more likely that this meeting will have been focused on technical questions about how future Fed policies will be enacted. Consider that QE has completely warped the old framework, where the Fed would actually adjust reserves in order to drive interest rates. Now, however, given the trillions of dollars of excess reserves, they can no longer use that strategy. The question that has been raised is will they try to go back to the old way, or is the new, much larger balance sheet going to remain with us forever. For hard money advocates, I fear the answer will not be to their liking, as it appears increasingly likely that QE is with us to stay. Of course, since this is a global phenomenon, I expect the impact on the relative value of any one currency is likely to be muted. After all, if everybody has changed the way they manage their economy in the same manner, then relative values are unlikely to change.

Flash, ADP Employment prints at a better than expected 219K, but the initial dollar impact is limited. Friday’s NFP report is of far more interest, but for today, all eyes will wait for the Fed. I expect very limited movement in the dollar ahead of then, and afterwards to be truthful.

Good luck
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Is That Despair?

Forward guidance is
Kuroda-san’s newest hope
Or is that despair?

The BOJ has committed to keep the current extremely low levels for short- and long-term interest rates for an “extended period of time.” Many of you will recognize this phrase as Ben Bernanke’s iteration of forward guidance. This is the effort by central banks to explain to the market that even though rates cannot seemingly go any lower, they promise to prevent them from going higher for the foreseeable future. Alas, forward guidance is akin to Hotel California, from which, as The Eagles famously sang back in 1976, “you can check out but you can never leave.” As the Fed found out, and the ECB will learn once they finally end QE (assuming they actually do so), changing tack once you have promised zero rates forever can have market ramifications. The first indication that forward guidance might be a problem came with the ‘taper tantrum’ in 2013, but I’m confident it won’t be the last.

However, for the BOJ, now trumps the future, and they needed to do something now. But forward guidance was not the only thing they added last night. It was the cover for their attempts to adjust policy without actually tightening. So, yield curve control now has a +/- 20bp range around 0.0% for the 10-year JGB, double the previous level, and thus somewhat more flexible. And they reduced the amount of reserves subject to the -0.10% deposit rate in order to alleviate some of the local banks’ profit issues. In the end, their commitment to maintaining zero interest rates for that extended period of time was sufficient for FX traders to sell the yen (it fell -0.40%), and JGB yields actually fell a few bps, closing at 0.065%, which is down from 0.11% ahead of the meeting. All in all, I guess the BOJ did a good job last night.

There is, however, one other thing to mention, and that is they reduced their own inflation forecasts (to 1.1% in 2019, 1.5% in 2020 and 1.6% in 2021) for the next three years, indicating that even they don’t expect to achieve that elusive 2.0% target before 2022 at the earliest. In the end, the BOJ will continue to buy JGB’s and equity ETF’s and unless there is a substantial acceleration in global growth, (something which seems increasingly unlikely) they will continue to miss their inflation target for a very long time. As to the yen, I expect that while it fell a bit last night, it is still likely to drift higher over time.

In Europe the story is still
That growth there is starting to chill
The data last night
Did naught to delight
Poor Mario, testing his will

Beyond the BOJ, and ahead of the FOMC announcement tomorrow, the major news was from the Eurozone where GDP and Inflation data was released. What we learned was that, on the whole, growth continued to slow while inflation edged higher than expected. Eurozone GDP rose 0.3% in Q2, its slowest pace in a year, while headline inflation rose 2.1%, its fastest rate since early 2013. Of course the latter was predicated on higher energy prices with core CPI rising only 1.1%, still a long way from the ECB’s target. The point is that given the slowing growth trajectory in the Eurozone, it seems that Draghi’s confidence in faster growth causing inflation to pick up on the continent may be unwarranted. But that remains the official line, and it appears that the FX market has accepted it as gospel as the euro has traded higher for a third consecutive day (+0.3%) and is now back in the top half of its trading range. If Q3 growth continues the trajectory that Q2 has extended, it will call into question whether the ECB can stop buying bonds, or at the very least, just how long rates will remain at -0.4%, with those looking for a September 2019 rate hike sure to be disappointed.

There is one country in Europe, however, that is performing well, Sweden. GDP growth there surprised the market yesterday, rising 1.0% in Q2 and 3.3% Y/Y. This has encouraged speculation that the Riksbank will be raising rates fairly soon and supported the krone, which has rallied 1.0% since the announcement.

The final piece of news to discuss from last night was from China, where the PMI readings all fell below expectations. The official Manufacturing data was released at 51.2, down from last month’s 51.5 and the third consecutive monthly decline. The non-manufacturing number fell to 54.0, its weakest print since October 2016. These are the first data from China that include the impact of the US tariffs, and so are an indication that the Chinese economy is feeling some effects. I expect that the government there will add more stimulus to offset any more severe impact, but that will simply further complicate their efforts at reducing excess leverage in the economy. Meanwhile, the renminbi slid 0.25% overnight.

This morning’s data releases bring us Personal Income (exp 0.4%), Personal Spending (0.4%) and PCE (2.3% headline, 2.0% core), as well as the Case-Shiller Home price index (6.4%), Chicago PMI (62.0) and Consumer Confidence (126.0). In other words, there is much for us to learn about the economy. While I believe the PCE data could be market moving, especially if it is stronger than expected, I continue to believe that traders and investors remain far more focused on Friday’s payroll report than this data. Recent weakness in equity markets has some folks on edge, although futures this morning look benign. But if we do see that weakness continue, the chances of a full-blown risk off scenario materializing will grow substantially. And that means, the dollar has the potential to rally quite sharply. Keep that in mind as a tail risk, one where the tail grows fatter each day that equity markets disappoint.

Good luck
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Lighthearted

At this point one must be impressed
Investors have not become stressed
A trade war has started
Yet they are lighthearted
With willingness still to invest

On top of that word from the Fed
Is they will keep pushing ahead
With rate hikes until
Our growth starts to chill
Or when markets start to bleed red

There has certainly been a lot to digest in the past twenty-four hours. Arguably the biggest story is the imposition of tariffs by the US on $34 billion worth of Chinese goods, which began at midnight last night. China is responding in kind and the Trump administration is determining whether they want to up the ante by an additional $200 billion. Now that the trade war is ‘officially’ underway, the key questions are just how far it will go and how long it will last. While there has been nothing in the press indicating that background negotiations are ongoing and that things can be resolved soon, based on the US equity market’s insouciance, it certainly seems that many investors feel that is the case. I hope they are correct, and soon, because otherwise I expect that we will see a more substantial correction in stocks. As to the dollar in this case, I expect that it will continue to benefit from its safe haven status in a time of market turmoil.

A second fear for equity investors has to be the Fed, which explained in yesterday’s release of the June meeting minutes, that while the trade situation could well become a concern in the future, for now they are much more focused on the potential for the US economy to overheat. The upshot is that the Fed is bound and determined to continue normalizing policy by gradually raising rates and by allowing the balance sheet to continue to gradually shrink. Speaking of the balance sheet, starting this month, they are going to allow $40 billion per month to roll off, and then beginning in October, it will be $50 billion per month until they reach whatever size they determine is appropriate. That means that $270 billion of bids for Treasury’s are going missing for the rest of the year. As the Fed continues to drain liquidity from the economy, I expect that the dollar will continue to benefit across the board, and that the US equity market will face additional headwinds. After all, QE was effective in its goal of forcing investors further out the risk curve and driving equity prices around the world higher as central banks everywhere hoovered up government bonds. Well, with yields rising and central banks backing away from the market (all while equity prices remain robustly valued) it seems there is ample opportunity for a substantial correction in stocks.

You may have noticed I said exactly the same thing when discussing the trade war situation. My point is that we are starting to see multiple catalysts align for a potential change in tone. A higher dollar and lower US (and likely global) equity prices seem like an increasingly possible outcome. Be prepared.

This leaves us at our third big story for the day, the payroll report this morning. Yesterday’s ADP Employment number was a mild disappointment, rising 177K rather than the 190K expected, but the reason appeared to be a lack of available workers rather than a lack of demand for hiring. In other words, the labor market in the US remains extremely strong. Or so it seems. Here are this morning’s expectations:

Nonfarm Payrolls 195K
Private Payrolls 190K
Manufacturing Payrolls 18K
Unemployment Rate 3.8%
Average Hourly Earnings 0.3% (2.8% Y/Y)
Average Weekly Hours 34.5
Trade Balance -$43.7B

It strikes me that this is a potential third catalyst that will line up with the trade war and Fed story in that a strong print today will encourage the Fed to continue or even accelerate their activities; it will encourage the administration that they can outlast the Chinese in this war of attrition, and so the dollar is likely to firm up while equity markets suffer. In the event payrolls disappoint, I think we could see the dollar’s modest correction lower continue and I expect that equity markets will be fine, at least in the US.

Remarkably, I don’t have space to more fully discuss what appears to be a euro positive, where Chancellor Merkel has averted disaster in Germany by getting the third coalition partner, the SPD, to agree to her immigration reforms thus keeping her government intact. As long as this internal truce lasts, there should be no further impact on the euro, but if the problem arises again (and I’m pretty sure it will soon) the euro is likely to suffer. At the same time, the pound is on tenterhooks as PM May is meeting with her cabinet today to finalize a negotiating stance regarding Brexit. If she cannot get the cabinet to agree, I expect the pound will feel the heat as concern over the fall of the May government will rise and an election campaign just nine months before the deadline for leaving the EU cannot be seen as a positive, especially with the chance that Jeremy Corbyn, the far-left Labour Party leader could become the next PM. Investors will not appreciate him in that seat, at least not at first.

As to the overnight session, the dollar is slightly softer and equity markets are under modest pressure, including US futures, as the market awaits the labor situation report. Remember, too, that many trading desks remain lightly staffed because of the holiday, and so liquidity is going to be a bit less robust than normal. If pressed my thought is that NFP will print near consensus, around 200K. I just wonder if the Unemployment Rate doesn’t tick even lower. And keep an eye on AHE, where my gut tells me it will be 0.4% enough to get Fed tongues wagging again. Net, I like the dollar to end the week on a strong note.

Good luck and good weekend
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