A Lack of Well-Being

Down Under the RBA eased
And Aussie bulls have gotten squeezed
In Europe they’re seeing
A lack of well-being
Which has politicians displeased

The RBA cut rates by 25bps last night, as fully expected by the interest rate markets, and they indicated that despite the fact that their base rate was now at a record low of 0.75%, they were considering further easing in the future. The Aussie dollar suffered on the news and is the worst performer in the G10 today, down 0.80%. In fact, Aussie is now at its lowest level since the financial crisis and, in truth, the trend certainly looks like it has further to fall. Australia continues to suffer from the combination of China’s slowing growth as well as the fall-out from the US-China trade war. Alas for the Australians, there is precious little they can do to insulate themselves from those things given they have literally built their economy over the past twenty-five years on the back of Chinese growth. Given the US dollar’s overall trend higher, I see nothing that would change this in the near term. Receivables hedgers beware.

Adding to the global gloom was the release of the Eurozone Manufacturing PMI data which continues to point to a manufacturing recession there. Germany’s was actually slightly better than forecast, but at 41.7 remains far and away the worst of the bunch. The overall Eurozone reading was at 45.7, essentially unchanged from last month and showing no signs of improvement whatsoever. In fact, the sub-indices showed that both new orders and prices paid are falling even faster. Given this news it can be no surprise that Eurozone CPI was released at a weaker than forecast 0.9% this morning as well. It is easy to see why Signor Draghi has been keen to add stimulus to the Eurozone economy, but it will take some time for the most recent activities to work their way into the data, which implies that things are going to get worse before they get better. Interestingly, after an early dip on the data, the euro has clawed back those losses and is now essentially unchanged on the day. Of course, the euro remains in a very clear downtrend and is lower by 1.9% since the ECB’s last policy meeting where they cut rates and restarted QE. Looking back a bit further into the summer, since last June, the single currency has fallen more than 4.6%. This trend, too, has legs.

As a harbinger of the narrative, the WTO released updated forecasts for growth in global trade this morning and the reading was not pretty. The new forecast is for global trade to grow just 1.2% in 2019 and 2.7% in 2020. This compares to growth of 3.0% in 2018, and its last forecasts of 2.6% and 3.0% for this year and next. At this point, the market is sharpening its focus on the upcoming trade negotiations due to begin in Washington on October 10th. Everybody is hoping for a positive outcome, but from everything that has been reported so far, it appears the two sides remain far apart on a number of issues, and though a deal will be beneficial for both, it remains a distant prospect I fear.

Turning our attention to Japan, last night the government auctioned a new tranche of 10-year JGB’s with pretty disastrous results. A day after explaining they will be reducing the amount of purchases in the back end in order to steepen the yield curve, they were true to their word. Yields there climbed 5bps with the bid-to-cover ratio a very weak 3.42, the lowest since 2016. This price action had a knock-on effect everywhere in the world as Treasury prices fell (yields +6bps) with a similar story in Germany (+4.5bps) and the UK (+7bps). For our purposes, the impact was in USDJPY, which is higher by 0.25% this morning, extending its bounce of the last month. Once again, the current market does not appear to be risk sensitive per se, this is simply dollar outperformance.

A quick look at the rest of the FX world shows SEK a key underperformer this morning, falling 0.55% as the market continues to focus on the change in tone from the Riksbank. They had been working hard to ‘normalize’ interest rates over the past year, but the data there continues to undermine their case with this morning’s PMI release of 46.3 dramatically lower than forecasts and the weakest reading since 2012. Instead, they are far more likely going to need to cut rates again, hence the krone’s weakness.

In the EMG sphere, ZAR is the biggest loser today, falling 1.0% on the back of two related stories; first Fitch cut the credit rating of Eskom, the troubled government-owned utility, to CCC-, essentially dead. This situation has been weighing on economic growth there for quite a while, and the bigger concern is that it forces a countrywide credit downgrade. South Africa is currently under review by Moody’s, and another cut would put them in junk territory forcing a significant amount of ZAR bond sales by international investors (with some estimates as high as $15 billion worth), and correspondingly, driving the rand even lower. But if you look across the board, while ZAR is the worst performer, the dollar is higher against virtually the entire space.

Turning to the upcoming session, we are looking forward to ISM Manufacturing data (exp 50.0) after a very weak Chicago PMI number yesterday (47.1). We also get to hear from three Fed speakers, Evans, Clarida and Bowman, although the last of these, Governor Bowman, rarely speaks of monetary policy with her focus on community banking. Beyond this, the bigger trend remains a higher dollar and there is nothing to indicate that trend is changing.

Good luck
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Be Prepare for Mayhem

Next week when the former PM
Steps down be prepared for mayhem
Both Johnson and Hunt
Are willing to punt
May’s deal, which they’re quick to condemn

Remember, back in the day, when I suggested that the probability of a hard Brexit was much higher than the market was assuming? In fact, I have been highlighting this fact pretty consistently since, at least, January heading up to the original deadline. Well, now, it appears that the market is figuring out that the probability of a hard Brexit is higher than they previously assumed. Last night, in a debate between the two candidates for PM, front-runner Boris Johnson and Jeremy Hunt, both were clear that the Irish backstop was dead in the water, and both were clear that they would be willing to walk away with no deal. Ongoing negotiations have become more difficult as the UK is making more demands and the EU is now complaining that the UK is trying to “bully” them! This is the funniest statement that I have ever seen. For two years, the EU essentially bullied PM May into agreeing to things that were unpalatable, including the Irish backstop. Now all of a sudden, the EU’s tender feelings have been hurt by the UK pushing back!

Since the original vote, pundits around the world have assumed that the UK would bear the brunt of the fallout from Brexit. After all, the rest of the EU is the UK’s largest trading partner, and the UK only represents something like 10% of EU exports. But as the EU dips back into recession with monetary policy already stretched, it is becoming clearer that the EU will suffer greatly in a no-deal Brexit. Just ask Germany how its auto manufacturers will be impacted when suddenly there are tariffs on BMW’s in the UK. The point is that both sides are likely to feel pain, although it seems the UK has already absorbed part of it, while the rest of the EU has been laboring under the assumption that the UK would cave in eventually. My view is there is no chance of a deal at this point and there are only two possible outcomes; no-deal Brexit or no Brexit. However, there seems to be limited willingness to hold a second referendum to try to overturn the first one, with major splits within both main parties there. And that leads to a no-deal Brexit. Be prepared.

It should be no surprise that this has had a pretty big impact on the pound this morning, which has fallen by 0.75% to its lowest level since January 2017. And this is despite better than expected employment data where wages grew a stronger than expected 3.6% in May, while the Unemployment rate remained at 45-year lows of 3.8%. While the UK economy seems to be holding up reasonably well, I continue to look for the BOE to cut rates in November after the hard Brexit occurs, if only as a precaution for a quick slowdown. Meanwhile, the pound is likely to continue to decline between now and then, testing 1.20 before long. However, vs. the euro, where the pound has also been sliding, I expect that trend to stabilize and even reverse. This is due to the fact that the Eurozone is going to suffer far more than currently anticipated from a hard Brexit. Right now, the cross is trading at 0.9030. I would look for a move in the euro to 1.05-1.06 and the cross to head down to 0.88.

Away from the Brexit story, things are a bit less exciting on the currency front. Broadly the dollar is strong today, as weaker Eurozone data (German ZEW Sentiment fell more than expected to -24.5) has pundits discussing a recession in Germany and confirming a more aggressive policy ease from the ECB. As such, the euro is lower by 0.3% this morning, as all the dovishness from the Fed is being offset by all the dovishness from ECB members.

Down Under, the RBA Minutes continue to highlight the need to keep policy accommodative as they, too, recognize that their old models need tweaking and that lower rates will not lead directly to further inflation. Aussie, which has actually performed pretty well overall since Powell’s first testimony last week, is lower by 0.2%. While the RBA is likely to remain on hold for now, look for more cuts as soon as the Fed starts to cut.

And those have really been the key drivers in the market today. Looking at the CE4, all of them have fallen roughly the same 0.3% as the euro meaning there is no new information to be gleaned. LATAM currencies are barely budged and APAC has also seen very limited movement overnight. The same can be said of global equity markets, which have seen very limited movement, on the order of 0.2% as investors await the next big story. Arguably, that story will start to be told next week by the ECB, with the punchline added by the FOMC at the end of the month. In the meantime, earnings season is beginning, so individual equity prices are likely to see movement, but it is hard to get excited about a macro move in the near term. And bonds? Well, they have stopped falling as the overly aggressive long positions seem to have been unwound. I expect they will start to rally again, albeit at a slower pace than we saw at the beginning of the month.

This morning brings the most interesting data of the week, Retail Sales (exp 0.1%, 0.1% ex autos), as well as a spate of Fed speakers including Chairman Powell at 1:00 this afternoon. If Retail Sales disappoint already low expectations, look for bonds to rally along with stocks as the dollar falls. If they are quite strong, I think the market is far less prone to react as the July rate cut is still a done deal. It just will have a much smaller probability of being a 50bp cut.

Good luck
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Still Writing Obits

The Germans, the Chinese and Brits
Have seen manufacturing hits
But in the US
There’s been more success
Though bears are still writing obits

It is fair to say that the global economic growth rate continues to slow. We have seen weaker data as the norm, whether in manufacturing, housing or agriculture; we have seen a never-ending stream of central bankers expressing concern over this slowing growth and promising to respond appropriately; and we continue to see equity markets trade to new highs. Something seems amiss.

Yesterday was a perfect example of this phenomenon with an ISM print of 51.7, its fourth consecutive decline and the weakest reading since October 2016. In fairness, it was better than consensus estimates of 51.0, and the US was the only major economy to show continued expansion in the sector, but the trend is foreboding. The new orders component was exceptionally weak, and highlights those concerns going forward. And yet, equity prices traded to new highs yesterday afternoon, before ceding some ground into the close.

There has been a pretty complete disconnect between the fundamentals of stock valuation (at least the theories we learned in finance class about discounted future cash flows) and the actual price of stocks. And this is a global phenomenon, not merely a US outlier.

Of course, the missing link in this puzzle is central bank activities. Markets have become entirely dependent on central bank largesse to justify their valuations. Central bankers, after a decade of ZIRP and NIRP led to a huge increase in the financialization of the global economy, are now beholden to markets when they make decisions. This was made plain in January, when the Fed pivoted after equity markets plummeted following their last rate increase. They literally could not stand the pressure for even two weeks before reversing course.

So, the question becomes, will equity markets now dictate every central bank action going forward? While rhetorical, it is not hard to believe that the answer is yes. Despite all the current conversation regarding an uncomfortably low inflation rate as the driver for policy ease, it is abundantly clear that the only data point on which every central bank focuses, is their domestic stock market. I fear this is a situation that will result in extremely negative outcomes at some point in the future. However, there is no way to determine, ex ante, when those negative outcomes will manifest themselves. That is why bulls are happy, they buy every dip and have been rewarded, and why bears are miserable, because despite their certainty they are correct, thus far the central banks have been able to delay the pain.

In the end, though, the story on global growth remains one of a slowdown throughout the world. For all their largesse to date, central banks have not yet been able to reverse that trend.

With that out of the way, let’s see what those central bank activities have wrought in the FX markets. The first thing to note was that the dollar actually had an impressive day yesterday, rallying 0.7% vs. the euro and 0.5% vs. the pound after the ISM data. Given the better than expected print, market participants decided that the Fed may not be as aggressive cutting rates after all, and so the key recent driver of dollar weakness was reevaluated. Of course, one day’s reaction does not a trend make, and this morning, the dollar is backing off yesterday’s rally slightly.

Last night the RBA cut rates another 25bps, to a record low of 1.00%, and left the door open for further rate cuts in the future. Aussie, however, is higher by 0.4% this morning on a classic, sell the rumor, buy the news reaction. In the end, Australia remains entirely dependent on growth in China and as that economy slows, which is clearly happening, it will weigh on the Australian economy. While Australia managed to avoid ZIRP in the wake of the financial crisis, this time around I think it is inevitable, and we will see AUD resume its multiyear weakening trend.

Weighing on the pound further this morning were two data points, the Construction PMI at 43.1, its weakest in more than ten years, as well as the ongoing malaise in housing prices in the UK. Brexit continues to garner headlines locally, although it has not been front page news elsewhere in the world because of all the other concerns like trade, OPEC, North Korea, and in the US, the beginnings of the presidential campaigns.

But there is a very interesting change ongoing in the Brexit discussion. Throughout the process, the EU has appeared to have the upper hand in the negotiations, forcing their views on outgoing PM May. But with all signs pointing to a new PM, Boris Johnson, who has made clear he will leave with or without a deal, suddenly Ireland is finding itself under extreme pressure. A recent report by the central bank there indicated that a hard Brexit could result in a 4.0% decline in Irish GDP! That is HUGE. At the same time, the EU will require Ireland to uphold the border controls that are involved in the new separate relationship. This means they will need to perform any inspections necessary as well as arrange to collect tariffs to be charged. And the UK has made it clear that they will not contribute a penny to that process. Suddenly, Ireland is in a bad situation. In fact, it is entirely realistic that the EU needs to step in to delay the impact and cave to an interim deal that has nothing to do with PM May’s deal. At least that is the case if they want to maintain the integrity of their borders, something which has been given short shrift until now. My point is that there is still plenty of Brexit mischief ahead, and the pound is going to continue to react to all of it. In the end, I continue to believe that a hard Brexit will result in a weaker pound, but I am not so sure it will be as weak as I had previously believed. Maybe 1.20-1.25 is the right price.

In the US today there is no data to be released although we do hear from NY Fed president Williams and Cleveland Fed President Mester this morning. If the Fed is serious about staying on hold at the end of this month, rather than cutting the 25bps that the market has already priced, they better start to speak more aggressively about that fact. Otherwise, they are going to find themselves in a situation where a disappointed equity market sells off sharply, and the pressure ratchets even higher on them to respond. Food for thought as we hear from different Fed speakers during the month.

Good luck
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Cold Sweats

The President’s tactic of threats
On trade talks gave some the cold sweats
So equities fell
But then by the bell
Those sellers had many regrets

Stock prices rebounded with verve
But bonds, if you look at the curve
Continue to price
A fools’ paradise
And cuts by the Federal Reserve

One of the most interesting dichotomies that we see these days is the completely different views of the global economy by stock markets and bond markets. Stock prices continue to see every glass as at least three-quarters full, willing to look past any potential bad news and rally. Yesterday saw a rout in the Far East after the President’s tweets regarding the raising of tariff rates by the end of this week. Europe continued the trend, closing down sharply as concerns grew that a change in tactics by the US could result in a renewed focus on the European auto sector and, not surprisingly, US equity markets opened sharply lower. But within a few hours, buyers emerged as the story morphed from ‘the US-China trade talks were about to collapse’ to ‘this is just a negotiating tactic by President Trump and everything is still on track for a successful (and fully priced) completion of these negotiations.’ And overnight, equity markets in Asia steadied with generally modest gains, although not nearly enough to offset Monday’s price action. Overall, equity markets remain quite optimistic.

At the same time, Treasury yields have fallen further and are back below 2.50% in the 10-year for the first time in a month. The implication is that bond investors and traders are now far less sanguine over the outcome of these talks. Certainly, if the trade talks do collapse, markets would be severely impacted with equity prices likely to see sharp declines and risk assets, in general under pressure. Treasuries (and Bunds) however, would very likely see a significant uptick in demand and it would not be hard to envision another period of a yield curve inversion. My point is it almost appears as if equity investors and bond investors are reading different stories about current events. I guess the reality is that bond investors are inherently more risk averse, so any hint of trouble forces a response. And of course, equity investors are the ones who continue to highly value ‘zombie’ companies, those firms whose profits cannot cover interest payments and who stay in business by the grace of Federal Reserve largesse.

The upshot is that risk seeking behavior remains the dominant theme in markets. As long as central banks continue to add liquidity to the mix (which despite the Fed having stopped, the BOJ and ECB continue to add as does the PBOC), that money needs to find a home somewhere. And stock markets have been the primary destination for the past ten years.

The interesting thing about the willingness to seek risk is that the dollar continues to outperform most other currencies. For the longest time, during periods of strong global growth, the dollar would soften as investment flowed to other nations and drove economic activity. However, the current situation shows a willingness to take risk and yet a simultaneous desire to hold dollars. For instance, a look at the Dollar Index (DXY) which is a broad measure against a number of currencies, shows that the dollar remains near its highest level in two years and the trend remains higher. All I’m saying is that there seems to be a disconnect between the three key global markets with both FX and bonds seeing a much darker future than equity markets.

Looking at the overnight activity, the RBA left rates on hold, which was mildly surprising as at least half the analyst community was looking for a rate cut. In the end, AUD rallied 0.4% and is, by far, the best performer of the day. As it happens, the RBNZ meets tonight and is widely expected to cut rates by 25bps thus the kiwi is lower by 0.25%. The euro and pound are essentially unchanged as there has been precious little in the way of new information either data wise or regarding the ongoing Brexit fiasco. And the rest of the G10 seems to be under very modest pressure with CAD and CHF both softer by about 0.15%.

In the emerging market space, CNY continues to fall, down a further 0.15% this morning and we continue to see pressure on LATAM currencies (MXN -0.2%). TRY is also under pressure (-1.0%) as the investors exit both stock and bond markets there in the wake of the decision to rerun the Istanbul mayoral election and the further erosion of democracy in Turkey. In APAC, MYR is little changed in the wake of the widely anticipated 25bp rate cut by the central bank there, although it has been falling steadily for the past two weeks in anticipation. But otherwise, in truth, it has been quiet.

Data today brings just the JOLTs Jobs Report (exp 7.24M) and we hear from Randal Quarles, the Fed governor overseeing regulations. Yesterday’s Fed talk was largely in line with the view that the recent dip in inflation is ‘transitory’ and that they continue to watch the data for information to help them make their next move. Overall, it is shaping up as a pretty dull session, and unless we hear something else on the trade front, I expect limited movement in most markets.

Good luck
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