Two Countries that Fought

There once were two countries that fought
‘bout trade as each one of them thought
The other was cheating
Preventing competing
By champions both of them sought

They sat down to seek a solution
So both could avoid retribution
But talks have been tough
And not yet enough
To get a deal for execution

The US-China trade talks continued overnight, and though progress in some areas has been made, clearly it has not yet been enough to bring in the leadership. The good news is that the talks are set to continue next week back in Washington. The bad news is that the information coming out shows that two of the key issues President Trump has highlighted, forced technology transfer and subsidies for SOE’s, are nowhere near agreement. The problem continues to be that those are pillars of the Chinese economic model, and they are going to be loath to cede them. As of this morning, increased tariffs are still on the docket for midnight, March 2, but perhaps next week enough progress will be made to support a delay.

Equity markets around the world seemed to notice that a deal wasn’t a slam dunk, and have sold off, starting with a dull session in the US yesterday, followed by weakness throughout Asia (Nikkei -1.1%, Shanghai -1.4%). Interestingly, the European markets have taken a different view of things this morning, apparently attaching their hopes to the fact that talks will continue next week, and equity markets there are quite strong (DAX +1/0%, FTSE +0.4%). And the dollar? Modestly higher at this time, but overall movement has been muted.

Asian markets also felt the impact of Chinese inflation data showing CPI fell to 1.7% last month, below expectations and another indication that growth is slowing there. However, the loan data from China showed that the PBOC is certainly making every effort to add liquidity to the economy, although it has not yet had the desired impact. As to the renminbi, it really hasn’t done anything for the past month, and it appears that traders are biding their time as they wait for some resolution on the trade situation. One would expect that a trade deal could lead to modest CNY strength, but if the talks fall apart, and tariffs are raised further, look for CNY to fall pretty aggressively.

As to Europe, the biggest news from the continent was political, not economic, as Spain’s PM was forced to call a snap election after he lost support of the Catalan separatists. This will be the nation’s third vote in the past four years, and there is no obvious coalition, based on the current polls, that would be able to form. In other words, Spain, which has been one of the brighter lights in the Eurozone economically, may see some political, and by extension, economic ructions coming up.

Something else to consider on this issue is how it will impact the Brexit negotiations, which have made no headway at all. PM May lost yet another Parliamentary vote to get the right to go back and try to renegotiate terms, so is weakened further. The EU does not want a hard Brexit but feels they cannot even respond to the UK as the UK has not put forth any new ideas. At this point, I would argue the market is expecting a delay in the process and an eventual deal of some sort. But a delay requires the assent of all 27 members that are remaining in the bloc. With Spain now in political flux, and the subject of the future of Gibraltar a political opportunity for domestic politics, perhaps a delay will not be so easy to obtain. All I know is that I continue to see a non-zero probability for a policy blunder on one or both sides, and a hard Brexit.

A quick look at the currency markets here shows the euro slipping 0.2% while the pound has edged higher by 0.1% this morning. Arguably, despite the Brexit mess, the pound has been the beneficiary of much stronger than expected Retail Sales data (+1.0% vs. exp +0.2%), but in the end, the pound is still all about Brexit. The sum total of the new economic information received in the past 24 hours reaffirms that global growth is slowing. Not only are inflation pressures easing in China, but US Retail Sales data was shockingly awful, with December numbers falling -1.2%. This is certainly at odds with the tune most retail companies have been singing in their earnings reports, and given the data was delayed by the shutdown, many are wondering if the data is mistaken. But for the doves on the Fed, it is simply another point in their favor to maintain the status quo.

Recapping, we see trade talks dragging on with marginal progress, political pressure growing in Spain, mixed economic data, but more bad news than good news, and most importantly, a slow shift in the narrative to a story of slowing growth will beget the end of monetary tightening and could well presage monetary ease in the not too distant future. After all, markets are pricing in rate cuts by the Fed this year and no rate movement in the ECB (as opposed to Draghi’s mooted rate hikes later this year) until at least 2020. The obvious response to this is…add risk!

A quick look at today’s data shows Empire State Manufacturing (exp 7.0), IP (0.1%), Capacity Utilization (78.7%) and Michigan Sentiment (94.5). We also have one last Fed speaker, Raphael Bostic from Atlanta. Virtually all the recent Fed talk has been about when to stop the balance sheet runoff, with Brainerd and Mester the latest to discuss the idea that it should stop soon. And my guess is it will do just that. I would be surprised if they continue running down the balance sheet come summer. The changes going forward will be to the composition, less mortgages and more Treasuries, but not the size. And while some might suggest that will remove a dollar support, I assure you, if the Fed has stopped tightening, no other nation is going to continue. Ironically, this is not going to be a dollar negative, either today or going forward.

Good luck and good weekend
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Weaker Yuan Now Abided

Apparently China’s decided
Their strong money stance was misguided
So look for, ahead
More easing instead
And weaker yuan now abided

Arguably, the biggest story in the FX markets overnight was the sharp decline in the Chinese yuan. For the first time in more than a year, the PBOC set the fixing rate for the dollar above 6.70, which seemed to signal a willingness to allow the currency to fall much further. As I type, the offshore version is trading near 6.80, having fallen 0.8% on the session. As I have discussed over the past months, even absent the trade situation, there are ample reasons to see the renminbi decline further. However, it now seems likely that the ongoing trade dispute with the US is starting to have a bigger impact on the Chinese economy (remember we already saw weak data last week) and that a simple response is to allow the currency to fall.

The trade dispute with the US has come at a bad time for China. They have been tightening liquidity standards for the past two years in an effort to reduce leverage in their economy and the housing bubbles that resulted. But now, the slower growth precipitated by that policy combined with restrictions on their exports is forcing that policy to be reconsidered. So far the PBOC has not actually cut rates, but they have reduced bank reserve requirements by one full percent and encouraged significantly more lending to SME’s. However, in the end, given their still mercantilist economy, a weaker currency is likely to be the best policy available for their conflicting goals of less leverage and strong growth. I’m beginning to think that 7.00 is a conservative estimate for USDCNY at year-end. What is abundantly clear is that there will be further weakness in the near term.

Meanwhile, Carney’s plan to raise rates
In August is in dire straits
The data keeps showing
That UK growth’s slowing
My bet now is he hesitates

This morning’s UK Retail Sales data was the last big data point of the week, and completed a picture of an economy that is not expanding quite so rapidly as had been previously thought. While things aren’t as dire as the Q1 data implied, Retail Sales fell -0.5% in Jun with the -ex fuel number -0.6%. Both were significantly lower than forecast and added to the softer inflation and wage growth data seen earlier this week. As such, none of this data really supports the idea that the BOE needs to raise rates next month, despite a clearly articulated desire by Governor Carney to do so. The problem he faces, along with many other central bankers, is that policy rates remain at emergency settings deep into a recovery, and the concern now is that they won’t have any policy tools available when the next downturn comes. In other words, they are out of ammo and need to reload, which means they need higher policy rates. But if the data don’t warrant that stance, they run the risk of causing a recession in order to be able to fight one. It is an unenviable position, but one that they brought upon themselves with their gigantic monetary policy experiment. When the softening data trend is added to the ongoing Brexit uncertainty, I have a hard time seeing a rationale for the BOE to move next month. The market continues to price a >70% probability, but I think that will ebb over the next few weeks.

One thing that is not surprising is that the pound has fallen below 1.30, down a further 0.6% this morning (and 2.0% on the week) and is now trading at its lowest level since last September. While it no longer appears that PM May is going to be ousted, it does seem as though the odds of the UK leaving the EU with no deal in place are growing shorter. I continue to look for the pound to fall further.

Away from those two stories, yesterday brought the second day of Chairman Powell’s Congressional testimony, this time to the House Financial Services Committee. The comment getting the most press has been “[the rate setting committee] believes that, for now, the best way forward is to keep gradually raising” rates. The idea is that the highlighted words are a strong indication that the Fed remains policy dependent, and so will carefully evaluate the situation at each meeting. That said, expectations remain that they will raise rates in September and December, and that data would need to be significantly worse, or the trade dispute clearly become a bigger problem, to change that view.

In the end, those Fed expectations should continue to support the dollar. In fact, the dollar has rallied pretty sharply across the board this morning, with the Dollar Index up 0.5%. That breadth of strength is indicative of the fact that the market continues to expect divergent monetary policies between the US and the rest of the world for now. We will need to see much weaker US data to change that view, and the dollar’s trajectory.

This morning brings the last data of the week, with Initial Claims (exp 220K), Philly Fed (21.5) and Leading Indicators (0.4%). We also hear from Fed Governor Randall Quarles, although given that we just got two days of Powell, it is hard to believe that he will be saying something different. While yesterday’s Housing data was disappointing, it was not enough to change any views on the US economy, especially given that Housing Starts is a known volatile series, and so easily dismissed. It is hard to view the current market and economic situation without concluding that the dollar’s rally has further to go. Hedgers keep that in mind, especially as you begin to look at your 2019 exposures.

Good luck
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Waiting For Jay

The markets are waiting for Jay
To testify later today
The hawks are excited
As they feel united
More hawkishness he will convey

Yesterday’s Retail Sales data was the latest data point highlighting the US economy’s continued robust expansion. The 0.5% headline gain matched expectations, but it was the revision higher of last month’s 0.8% reading (which if you recall was much higher than expectations then) to 1.3% that really got tongues wagging. Several analysts raised their expectations for Q2 GDP to above 5.0% in the wake of the report, although the market response seems somewhat puzzling. Both equity and bond markets yesterday were essentially flat, oil prices tumbled more than 4% and the dollar was slightly softer. Arguably, after robust data, one would have expected higher stocks, higher bond yields (lower prices) and a stronger dollar. This should serve to remind everyone that while trends remain in place, there is rarely a one-for-one reaction from data to market prices.

However, what the data does accomplish is paint a picture of a still quite strong economy as a backdrop to Chairman Powell’s testimony to the Senate Banking Committee later this morning. If we have learned one thing about Powell, it is that he is willing to use plain English to describe his views, rather than couch those views in the obfuscation of economic jargon. But perhaps far more importantly, he consistently reminds his audience that there are many important concepts (e.g. the neutral interest rate or the natural rate of unemployment, NAIRU) that are not observable and where the Fed relies on estimates from its models. And while these variables are seen as critical to the PhD set, Chairman Powell recognizes that they cannot be used to fine tune the economy. It is this trait that sets Powell apart from his recent predecessors, and I personally believe, in a good way. At any rate, while the prepared remarks are fairly neutral in tone, there is a growing belief that the Q&A is likely to lean hawkish when it comes to monetary policy questions. However, I imagine that there will also be a significant amount of preening by certain Senators when they lambaste the Fed’s actions regarding banks and the recent stress tests. In fact, my sense is that he will not get to speak too much about the economy, and as such, I don’t expect his testimony to have much market impact at all.

With that said, there is certainly nothing from the recent data that would indicate the Fed is about to slow down its tightening, and the market is now pricing a 62% probability of two more rate hikes this year. In the end, this remains dollar supportive in my view.

Moving on to another economy that seems to be getting ready to tighten policy, UK employment data was released this morning and it was quite strong yet again. The Unemployment Rate remained at its 42-year lows of 4.2%, as 137K more jobs were created in the past three months. Not only that, but Average Earnings at 2.7% continue to print above recent inflation, resulting in real wage gains and a further clue that the UK economy, despite the ongoing Brexit drama and uncertainty, remains fairly solid. Certainly the market expects Governor Carney to raise rates next month, with futures pricing in a greater than 80% probability at this time, and so we will have to see some much weaker data on Q2 GDP or inflation later this week to change that view. The pound has benefitted this morning, edging up a further 0.1%, which makes about 0.5% of gains over the past four sessions. Not that inspiring, but at least logical today.

Overall, the dollar is marginally lower this morning, although it is a mixed picture vs. individual currencies. For example, MXN is weaker by 0.7% on the back of the decline in oil prices with RUB similarly lower by 0.4%. However, other currencies have shown modest strength vs. the dollar, notably CHF, INR and NZD, each with their own idiosyncratic story. The point is there is no overriding theme in the FX market this morning.

One thing I think worth pointing out is that the yen has recently lost some of its safe haven luster. Ever since the financial crisis, the yen had become seen as a haven in the face of market turmoil, rallying when nervousness was evident. I have always thought that characterization misplaced. Prior to the crisis, being short yen to fund other assets was a hugely prevalent position, known as the carry trade. When those assets started to decline sharply during the crisis, all that we saw was those carry trades unwind, which, by definition, included yen purchases. Investors weren’t indicating they preferred yen to other assets; they were closing outstanding positions. But the haven narrative stuck and so we have lived with it for a decade now. Perhaps we are finally coming round to a period where that narrative will diminish, and old havens, notably the dollar and gold, will make a comeback. Certainly the dollar is holding up its end of the bargain overall, so my sense is that gold may not be too far behind if we see another market disruption. In the meantime, the yen has fallen 0.2% this morning and is actually trading back at its lowest level since early January. It would not be surprising to see further yen weakness over the coming months, especially if my thesis on the haven issue is true.

Before we hear from the Chairman, Capacity Utilization (exp 78.3%) and IP (0.6%) are to be released. However, unless something extraordinary prints there, I expect that markets will remain quiet until Powell starts. At that point, it is all up to him.

Good luck
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The Beast of the East

This weekend the data released
By China showed growth had decreased
Investment has slowed
And that doesn’t bode
Too well for the Beast of the East

It has been a fairly quiet session overnight, as the weekend news cycle seems to have reverted back toward the summer doldrums of the past. While traders and investors remain on edge over the brewing trade conflict between the US and China, and how that may impact the rest of the world, the only actual news was Chinese data out last night.

It can be no surprise that the GDP figure, at 6.7%, was exactly as forecast [Woe betide the statistician in China who releases a GDP number less than President Xi declares], but it was somewhat surprising that both IP (6.0%) and Fixed Asset Investment (6.0%) were both released at levels softer than expected, and more importantly, at the softest levels in 15-20 years. Given that it is too early for the trade situation to have impacted the Chinese data, the most likely situation is that even the Chinese are beginning to recognize that growth on the mainland is set to slow further. In fairness, China has made a big deal about their pivot away from mercantilist policies to a more domestically focused economy, and given that Retail Sales (9.0%) were actually slightly firmer than expected, perhaps they are moving in that direction. However, unlike most developed countries, China’s domestic consumption is only around 50% of the economy (it is between 70% and 80% for OECD nations), and so that modestly better performance is not likely to be enough to maintain the growth trajectory that Xi wants over time.

In the end, though, there was only limited market reaction to the news, with Chinese equity markets slightly softer (Shanghai -0.25%) and the renminbi, though initially falling slightly, has since rebounded and is firmer by 0.3% as I type. Of course, in context, the dollar is softer across the board this morning with most major currencies appreciating by a similar amount.

Aside from the Chinese news, there was precious little of interest to drive trading. Oil prices have been sliding as Saudi Arabia has agreed to pump more oil and the US and other nations are considering tapping their strategic reserves in an effort to lower prices. Earnings season is underway with continued high hopes for US companies and less robust ones for the rest of the world. However, US equity futures are barely higher at this time, <0.1%, indicating a wait-and-see attitude has developed. And rounding things out, Treasury yields have edged higher by about 1bp although they remain well below levels seen back in May.

Pivoting to the data for the week, it is a mixed bag, with arguably the most important events Chairman Powell’s testimony to the Senate on Tuesday and House on Wednesday.

Today Empire Manufacturing 22
  Retail Sales 0.5%
  -ex autos 0.4%
  Business Inventories 0.4%
Tuesday Capacity Utilization 78.3%
  IP 0.6%
  Powell Testimony  
  TIC Flows $34.3B
Wednesday Housing Starts 1.32M
  Building Permits 1.333M
  Powell Testimony  
  Fed Beige Book  
Thursday Initial Claims 220K
  Philly Fed 22

However, we cannot ignore Retail Sales this morning, which is seen as a descriptor of the current economic situation. This has been one of the highlights of the economic story in the US, especially in the wake of the tax cuts and stimulus spending bills at the beginning of the year.

As long as growth in the US continues above its estimated long term trend (which is often pegged just below 2.0%), the Fed is going to continue to tighten policy via both rate hikes and a shrinking balance sheet, and the dollar should remain relatively well bid. While there is a case to be made that added fiscal stimulus at this stage in the economic cycle is a mistake (classical economics indicates tighter fiscal policy is warranted), there is no mistaking that the US economy remains the key engine of growth for the world, and that as the Fed tightens policy further, the dollar is set to benefit more.

Good luck
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