Caused by the Other

With tariffs now firmly in place
The market’s been keen to embrace
The idea that Xi
And Trump will agree
To terms when they meet face-to-face

But rhetoric lately has shown
That both Trump and Xi will condone
A slowdown in trade
That both men portrayed
As caused by the other, alone

Risk is, once again, in tatters as the fallout from the US increase in tariffs starts to feed through the market. As of midnight last Thursday, US tariffs on $200 billion of goods rose to 25%. This morning, a list of the other $325 billion of goods that may be subject to tariffs will be published with a target date of 30-days before imposition. Meanwhile, China continues to try to figure out how best to respond. Their problem, in this scenario, is they don’t import that much stuff from the US, and so trying to determine what is an ‘equal’ offset is complicated. However, I am confident that within the next day or two, they will publish their response. Markets around the world have felt the fallout, with equity prices everywhere under pressure, EMG currencies, especially, feeling the heat, and Treasury bonds and German bunds remaining in vogue.

As of now, it appears the situation is unlikely to improve in the short-term. The US remains miffed that the Chinese seemingly reneged on previously agreed terms. Meanwhile, the Chinese are adamant that they will not kowtow to the US and be forced to legislate the agreed changes, instead insisting that administrative guidance is all that is needed to insure compliance with any terms. They deem this desire for a legislated outcome as impinging on their sovereignty. Once again, the issue falls back to the idea that while the US consistently accused the Chinese of IP theft and forced technology transfer, the Chinese don’t see it that way, and as such, don’t believe they need to change laws that don’t exist. Whatever the merits of either sides views, the end result is that it seems far less clear that a trade deal between the two is going to be signed anytime soon.

The markets question is just how much of this year’s global equity market rally has been driven by the assumption that trade issues would disappear and how much was based on a response to easier central bank policies. The risk for markets is not only that growth is negatively impacted, but that inflation starts to rise due to the tariffs. This would put the central banks in a tough spot, trying to determine which problem to address first. Famously, in 1979, when Paul Volcker was appointed Fed Chairman, he immediately took on inflation, raising short term interest rates significantly to slay that demon, but taking the US (and global) economy into recession as a result. It strikes me that today’s crop of central bank heads does not have the wherewithal to attack that problem in the same manner as Volcker. Rather, the much easier, and politically expedient, response will be to try to revive the economy while allowing inflation to run hot. This is especially the case since we continue to see serious discussions as to whether inflation is ‘dead’. FWIW, inflation is not dead!

At any rate, for now, the trade story is going to be the key story in every market, and the upshot is that the odds of any central bank turning more hawkish have diminished even further.

Looking at overnight activity, there was virtually no data to absorb with just Norwegian GDP growth printing slightly softer than expected, although not enough to change views that the Norgesbank is going to be raising rates next month. Broadly speaking, the dollar is quite firm, with the biggest loser being the Chinese yuan, down 0.9%, and that movement dragging down AUD (-0.45%) as a G10 proxy. But while other G10 currencies have seen more limited movement, the EMG bloc is really under pressure. For instance, MXN has fallen 0.6%, INR 0.75%, RUB, 0.5% and KRW 1.2%. All of this is trade related and is likely just the beginning of the fallout. Once China publishes its list of retaliatory efforts, I would expect further weakness in this space.

Equity markets are suffering everywhere, with Shanghai (-1.2%) and the Nikkei (-0.7%) starting the process, the DAX (-0.8%) and CAC (-0.6%) following in their footsteps and US futures pointing lower as well (both Dow and S&P futures -1.3%). Treasury yields have fallen to 2.43% and are now flat with 3-month Treasury bill rates, reigniting concerns over future US growth, and commodity prices are feeling the strain as well on overall growth concerns.

Turning to the data this week, there is a modicum of news, with Retail Sales likely to be seen as the most important:

Tuesday NFIB Business Optimism 102.3
Wednesday Retail Sales 0.2%
  -ex autos 0.7%
  Capacity Utilization 78.7%
  IP 0.1%
  Empire State Mfg 8.5
Thursday Initial Claims 220K
  Housing Starts 1.205M
  Building Permits 1.29M
  Philly Fed 9.0
Friday Michigan Sentiment 97.5

We also see the housing story and hear from another five Fed speakers across seven speeches this week. However, as we learned last week, pretty much the entire Fed is comfortable with their patient stance in the belief that growth is solid and inflation will eventually head to their target of 2.0%.

Add it all up and there is no reason to believe that the trends from last week will change, namely further pressure on equity markets and commodities, with the dollar and Treasuries the beneficiaries.

Good luck
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Growing Concern

The trade talks have taken a turn
Amidst markets growing concern
The story today
Is China won’t play
By rules which trade partners all yearn

The trade talks narrative is shifting, and markets are not taking kindly to the change. Prior assumptions had been that the talks were progressing well and that this week’s meetings in Washington were going to produce the final agreement. However, this morning the tone has changed dramatically. President Trump tweeted that the Chinese “broke the deal”, implying that items previously agreed by the two sides are no longer acceptable to China. To my reading, the key issue is the Chinese refusal to codify into law the changes being agreed regarding IP and forced technology transfer. It appears that the Chinese believe this too onerous and difficult to accomplish and instead will be giving guidance to local governments. (Perhaps somebody can explain to me how it is too onerous for a dictatorship to change its own laws.) Essentially, they want the US to trust that they will perform as expected. Simultaneously, it appears the Chinese have interpreted President Trump’s hectoring of the Fed to cut rates as an admission that the US economy is not strong, and that Trump needs to cut the deal. This has encouraged the Chinese to play hardball as they believe they have the upper hand now.

The upshot is that the odds of a successful conclusion of the talks have fallen sharply. At this point, my read is they are no more than 50:50, which is far lower than the virtual certainty the market had been pricing as recently as last Friday, and quite frankly far lower than the market is currently pricing. In fact, it is easy to make the case that at least half of the equity rebound since Christmas is due to the growing belief a trade deal would be agreed, so if that is no longer the case, a further repricing (read decline) is in the cards. As such, it should be no surprise that equities in Asia continue to retreat (Nikkei -0.95%, Shanghai -1.5%, Hang Seng 2.4%) and we are seeing weakness throughout Europe as well (DAX -0.9%, CAC -1.3%, FTSE -0.4%) given concerns that a failure in these talks will have a much wider impact spread across the investment community. Not surprisingly, US futures are pointing lower with both Dow and S&P futures -0.75% as I type.

Continuing with the risk-off theme, Treasury yields continue to decline, falling two basis points even after a very weak 10-year auction yesterday, while German bund yields have fallen another bp to -0.06%, their lowest level in two months. The flight to safety is beginning to gain some momentum here.

Finally, looking at the dollar, it should be no surprise it is having another good day. While it is little changed vs. the euro, it continues to trade near the lower end of its recent trading range. However, the pound has fallen a further 0.2% hindered not only by the modest dollar strength but by the realization that there will be no grand deal between the Tories and Labour regarding Brexit. Adding to the risk-off mood is the yen’s further appreciation, another 0.2%, taking it below 110 for the first time in three months.

In the EMG bloc, one cannot be surprised that CNY is weaker, pushing back toward 6.85 and touching its weakest level since January. On top of that, the offshore CNH is even weaker as speculation grows that a collapse in the trade talks will result in the Chinese allowing the renminbi to fall much more sharply. But it’s not just China under pressure here; we are seeing weakness in every area. For example, the Mexican peso has fallen 0.5%, Indian Rupee 0.3% and Korean won 0.85%. In other words, the carry trade is under pressure as the first investors search for a safe place to hide. Unless the talks get back on track, I expect that we will see further weakness in the EMG bloc especially.

On the data front, overnight we saw Chinese financing data which demonstrated that despite the PBOC’s efforts to add liquidity to the market, financing is not growing as rapidly as they would like. For example, New Yuan Loans increased a much less than expected CNY 1trillion (exp CNY 1.2 trillion), while Outstanding Loan Growth ebbed as well. The point is that like every other central bank, the PBOC is finding that their ability to control the economy is slipping.

This morning brings Initial Claims (exp 220K) along with the Trade Balance (-$50.2B) and PPI (2.3%, core 2.5%) all at 8:30. Also at that time, we hear from Chairman Powell, followed by speeches from Atlanta’s Rafael Bostic and Chicago’s Charles Evans later in the day. The thing is, it beggars belief that any of them are going to change their tune regarding the Fed’s patience as they watch the economy develop. At this point, the key question is, if the trade talks completely fall apart and new tariffs are imposed by both sides leading to a severe decline in the equity market, will the Fed start to contemplate cutting rates? At this point I am sure they would vehemently deny that is their thought process. But if recent history is any guide, the financialization of the US economy has forced the Fed to respond to any significant movement in the S&P. So I would answer, yes they will! But that is a story for another day. Unless there is positive news from the trade front today, look for the overnight trends to continue; weaker equities, stronger Treasuries and a stronger dollar.

Good luck
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Incessant Whining

Can someone help me understand
Why euros remain in demand?
Theira growth rate’s declining
While incessant whining
Is constant from Rome to Rhineland

Another day, another failure in Eurozone data. This morning’s culprits were German and Spanish IP, both of which fell sharply. The German outcome was a fourth consecutive monthly decline, with a surprise fall of 0.4%, as compared to expectations for a 0.7% rise. Not only that, November’s release was revised lower to -1.3%. It seems pretty clear that positive growth momentum in Germany has faded. At the same time, Spain, which had been the best growth story in the entire Eurozone, also released surprisingly weak IP data, -6.2%, its largest decline in seven years, and significantly lower than the -2.3% expected. This marks two consecutive months of decline, and three of the past four. It appears that the Spanish growth story is also ebbing.

It should be no surprise that the euro has fallen further, down another 0.3% this morning and back to its lowest levels in two weeks. As I have consistently maintained, FX movements rely on two stories, with the relative strength of one currency’s economy and monetary policy stance compared to the other’s. And while the Fed’s U-turn at the end of January, marked an important point in the market’s collective eyes, thus helping to undermine the dollar strength story, the fact that the European growth story seems to be diminishing so rapidly is now having that same impact on the euro. The EU has reduced, yet again, its growth forecasts for the EU and virtually every one of its member nations. Italy’s forecast was cut to just 0.2% GDP growth in 2019. Germany’s has been cut to 1.1% from a previous forecast of 1.9% in 2019. As I have written repeatedly, the idea that the ECB can tighten policy any further given the economic outlook is fantasy. Look for a reversal by June and either a reinstatement of QE, or forward guidance eliminating any chance of a rate hike before 2021! Rolling over TLTRO’s is a given.

But the euro is not the only currency under pressure this morning, in fact, the dollar, once again, is on the move. The pound, for example, is also down by 0.3% as the market awaits the BOE’s rate decision. There is no expectation for a rate move, but there is a great deal of interest in Governor Carney’s comments regarding the future. Given the ongoing uncertainty with Brexit (which shows no signs of becoming clearer anytime soon), it remains difficult to believe that the BOE can raise rates. This is especially true because the economic indicators of late have all shown signs of a substantial slowdown of UK growth. The PMI data was awful, and growth forecasts by both private and government bodies continue to be reduced. However, despite the fact that the measured inflation rate has been falling back to the 2.0% target more quickly than expected, there is a great deal of discussion amongst BOE members that wages are growing quite quickly and thus are set to push up overall inflation. This continues to be the default mindset of central bankers around the world, as it is built into their models, despite the fact that there is scant evidence in the past ten years that rising wages has fed into measured price inflation. And while it is entirely possible that inflation is coming soon to a store near you, the recent evidence has pointed in the opposite direction. Inflation data around the world continues to decline. Despite Carney’s claims that Brexit may force the BOE to raise rates after a sudden spike higher in inflation, I think that is an extremely low probability event.

In the meantime, the Brexit saga continues with no obvious answers, increasing frustration on both sides, and just fifty days until the UK is slated to exit the EU. Parliament is due to vote on PM May’s Plan B next week, although it now appears that might be delayed until the end of the month. But in the end, Plan B is just Plan A, which was already soundly rejected. At this point, it is delay or crash, and as the pound’s recent decline implies, there are more and more folks thinking it is crash.

Other currency news saw the RBI cut rates 25bps last night in what was a mild surprise. If you recall I mentioned the possibility yesterday, although the majority of analysts were looking for no movement. Interestingly, the rupee actually rallied on the news (+0.2%), apparently on the belief that the new RBI Governor, Shaktikanta Das, has a more dovish outlook which is going to support both growth and the current market friendly government of PM Modi. However, beyond that, the dollar is broadly higher this morning. This is of a piece with the fact that equity markets are generally under pressure after a lackluster decline yesterday in the US; commodity prices have continued their recent slide, and government bonds are firming up with yields in the havens, like Treasuries and Bunds, declining. In addition, the one other currency performing well this morning is the yen. In other words, it appears we are seeing a mild risk-off session

Turning to the data, yesterday’s Trade deficit was significantly smaller than expected at ‘just’ -$49.7B with lower imports the driving force there. Arguably, we would rather see that number shrink on higher exports, but I guess tariffs are having their intended effect. This morning, the only scheduled data is Initial Claims (exp 221K), which jumped sharply last week, but have been averaging about 225K for the past several months. However, given what might be a turn in the Unemployment Rate trend, it is entirely possible that this number starts trending slightly higher. We will need to keep watch.

At this point, the dollar has continued to perform well for the past several sessions and there is no reason to believe that will change. The initial dollar weakness in the wake of the Fed’s more dovish commentary is now being offset by what appears to be ongoing weakness elsewhere in the world. I admit I expected to see the dollar remain under pressure for a longer period than a week, but so far, that’s been the case, one week of softening followed by a rebound with no obvious reason to see it stop. If equity markets continue to underperform, then it seems likely the dollar will remain bid.

Good luck
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A Few Tweaks

Ms May explained that her Plan B
Was really a wonder, you see
She’d get a few tweaks
And then in ten weeks
The UK would finally be free!

The way I see it, Plan B is essentially a game of chicken. To date, the EU has said that they are firm and will not cede any more ground than that already outlined in the deal on the table. However, with ten weeks to go, the reality that the UK could exit with no deal is starting to hit home. Regardless of what they have said to date, a hard Brexit is going to have real negative impacts on the EU, especially Germany, the Netherlands and France, as they are the biggest trading partners of the UK. So, PM May went back to Parliament and explained that she would go back to the EU and explain that there needed to be some changes or else it was no deal. The first cracks appeared on the EU side with Poland discussing a 5-year transition period as a possibility, although so far, no other EU nation has piped up.

But consider the situation for the ECB. Signor Draghi is desperate to move further down the road of reducing the extraordinary monetary ease that the ECB has implemented. Stopping QE was to be the beginning of the process with the next steps to be slow and steady rate increases. Now, it is already looking like a questionable call, and a hard Brexit will definitely result in even slower Eurozone growth, thus ratcheting up the pressure on Draghi to do something. Remember, this is the man who did ‘whatever it took’ to save the euro during the sovereign debt crisis in 2012. But interest rates are already negative, and they just ended QE last month. Will they really start it up again in a few months’ time? There is significant pressure building on the EU to blink, although whether or not they do is still unclear.

Yesterday I discussed the idea that Parliament would try to take matters into its own hands given its dissatisfaction with PM May’s deal, but that would be an extraordinary outcome, and is in no way certain to be achieved. This morning, the pound has edged higher (just 0.2%) after surprisingly good employment data with the Unemployment Rate falling to 4.0%. Sterling continues to trade well above the lows seen in December though well below most economist estimates of ‘fair value.’ The thing is, given the possibility that there is no Brexit, which would arguably result in a very sharp Sterling rally, as well as the possibility there is a hard Brexit, which would result in a very sharp decline, maybe the pound is in the right place after all. And for hedgers, 50/50 is the best I can offer. If pressed, I would say the odds of no Brexit have increased, but there is still no way to know at this point in time.

Other than this story, however, there is precious little new news of interest to the FX world. The trade situation continues to percolate, as does the US government shutdown, but neither one has seen any change of note overnight. In both cases, there doesn’t appear to be a deal in the near future.

Broadly speaking, risk is off today, with the dollar modestly higher against most counterparts, equity markets softening somewhat along with commodities and Treasury and Bund yields declining slightly. There are still many problems extant in the world, it’s just that none of them are acute right now. However, the odds of another significant disruption appear to be increasing, hence the risk reduction we are witnessing today.

This morning’s data is Existing Home Sales (exp 5.25M), which is unlikely to impact the dollar very much unless it misses by a lot. Otherwise, the market is likely to continue this modest risk aversion unless we hear something about either Trade or the shutdown. In other words, look for a quiet FX session today.

Good luck
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