A deal Has Been Made

The story is once again trade
As news that a deal has been made
Twixt Mex and DC
Helped traders agree
The dollar would slowly degrade

Right now, there are two essential stories that the market is following; the Fed and US trade negotiations. While Friday’s news was all about the Fed (with a small dose of PBOC), yesterday we turned back to trade as the key market driver. The announcement that a tentative agreement had been reached between the US and Mexico regarding NAFTA negotiations was hailed in, most quarters, as a positive event. It is beyond the scope of this discussion to opine on the merits of the actual negotiation, only on its market impact. And that was unambiguous. Equity markets rallied everywhere while the dollar continued its recent decline. In fact, the dollar has now fallen for seven of the past eight sessions and is trading back at levels not seen in four weeks. So much for my thesis that continued tighter policy by the Fed would support the buck.

But I think it is worth examining why things are moving the way they are, and more importantly, if they are likely to continue the recent trend, or more likely to revert to the longer run story.

Earlier this year, as the narrative evolved from synchronous global growth to the US leading the way and policy divergence, buying dollars became a favored trade, especially in the hedge fund community. In fact, it grew to be so favored that positioning, at least based on CFTC figures, showed that it was near record levels. And while the dollar continued to rally right up until early last week, everybody carrying that position was happy. This was not only because their view was correct, but also because the current interest rate market paid them to maintain the position, a true win-win situation.

In the meantime, another situation was playing out at the same time; the increasingly bombastic trade rhetoric, notably between the US and China, but also between the US and Mexico, Canada and Europe. With the imposition of tariffs on $50 billion of Chinese imports by the US, and the reciprocal tariffs by China, the situation was seen as quite precarious. While there was a mild reprieve when the US delayed imposing tariffs on imported European autos last month, a key issue had continued to be the ongoing NAFTA renegotiations. These stories, when highlighted in the press, typically led to risk-off market reactions, one of which included further USD strength.

So between the two stories, higher US rates and increasing risk on the trade front, there were two good reasons to remain long dollars. However, one of the oft-mentioned consequences of the stronger dollar has been the pressure it applies to EMG economies that were heavy dollar borrowers over the past ten years. Suddenly, their prospects dimmed greatly because they felt the double whammy of less inward investment (as USD investments became more attractive due to higher US rates) and a weaker currency eating up a greater proportion of local currency revenues needed to repay dollar debt and its interest. This led to increasing angst over the Fed’s stated views that gradual rate hikes were appropriate regardless of the international repercussions. This also led to significant underperformance by EMG equity markets as well as their currencies, forced the hands of several EMG central banks to raise rates to protect their currencies, and completely decimated a few places, notably Argentina and Turkey.

But that all started to change in earnest last Friday. While the dollar had been retracing some of its recent gains prior to the Jackson Hole meeting, when Chairman Powell hinted that he saw no reason that inflation would continue much beyond the Fed’s target level (although without the benefit of a rationale for that view), the market interpreted that as the Fed ‘s rate hiking trajectory would be shallower than previously thought, and that four rate hikes this year was no longer a given. In fact there are those who now believe that September may be the last rate hike for several quarters (I am not in the group!) Now adding to that the positive news regarding trade with Mexico, with the implication that there is an opportunity to avoid a truly damaging trade war, all of those long dollar positions are feeling far less confident and slowly unwinding. And my sense is that will continue for a bit longer, continuing to add pressure to the dollar. What is interesting to me is that the euro, for example, has retraced back above 1.17 so quickly (remember, it was trading at 1.13 just two weeks ago) and it is not clear that many positions have been cleared out. That implies that we could see further dollar weakness ahead as long as there is no other risk-off catalyst that arises.

The thing is, I don’t think this has changed the long run picture for the dollar, which I think will continue to outperform over time, as while the Fed may slow its trajectory, it is not stopping any time soon. And the reality is that the ECB is still well over a year away from raising rates, with Japan further behind than that. Meanwhile, the PBOC is actively easing as the Chinese economy continues to slow. In the end, the dollar remains the best bet in the medium term. But in the short run, I think the euro could well trade toward 1.19 before stalling, with other currencies moving a similar amount.

As to today’s session, there has been a decided lack of data from either Asia or Europe, and nothing really on the cards for the US. We remain in a lackluster holiday week, as US trading desks remain lightly staffed ahead of the Labor Day holiday next Monday. So to me, momentum is pointing to continued dollar weakness for now, and I expect that is what we will see for the rest of the week.

Good luck
Adf

And what has happened as that angst has grown, and fears of a repeat of the EMG crisis of 1998-9 were raised?

 

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
Adf

 

Twixt Juncker and Trump

The meeting today in DC
Twixt Juncker and Trump will be key
In helping determine
If cars that are German
Are hit with a new import fee

Markets overnight have been relatively muted as today’s big story revolves around EU President Jean-Claude Juncker’s meeting with President Tump in Washington. The agenda is focused on tariffs and trade as Juncker seeks to de-escalate the current trade policy differences. At this point, while most market participants would love to see signs that the US is backing off its recent threats, and that progress is made in adjusting the terms of trade, I don’t sense that there is a lot of optimism that will be the case. Remarkably, the US equity market has been able to virtually ignore the trade story, with only a few individual companies suffering due to direct impacts from the situation (or poor quarterly numbers), but that has not been true elsewhere in the world. Other equity markets have fared far worse in the wake of the trade battle, and I see no reason for those prospects to improve until there is a resolution. At the same time, while the dollar has fallen from its highs seen early last week, it remains significantly stronger than it was three months ago. In fact, during the recent escalation in Presidential rhetoric, while we saw a reaction last Friday, the reality is that there has been little overall movement.

While the value of the dollar clearly has an impact on trade, historically the reverse has been far less clear. In other words, although there have been knee-jerk reactions to a particular trade number that missed expectations, or similar to Friday’s movement, knee-jerk reactions to political statements about trade policy, generally speaking, trade’s impact on the dollar has been very hard to discern. Several months ago I highlighted the tension between short-term and long-term drivers of the dollar. On the short-term side, which is what I believe has been dominant this year, is monetary policy and interest rate differentials. These have clearly been moving aggressively in the dollar’s favor. On the long-term side is the US’ fiscal account, namely its current account deficit and trade deficit. Economic theory tells us that a country that runs significant deficits in these accounts will see its currency decline over time in order to help balance things. In fact, this has been the crux of the view that the dollar will fall in the long run. However, given the US’ unique situation as the global reserve currency, and the fact that so much global trade is priced in dollars as opposed to other currencies, there remains an underlying demand for dollars that is not likely to disappear anytime soon.

The point here is that if the current trade situation deteriorates further, with additional tariffs imposed on all sides, and growth slows correspondingly, it is still not clear to me that the dollar will suffer. In fact, most other countries will seek to weaken their own currencies in order to offset the tariffs, which means the dollar will likely continue to outperform. In other words, in addition to the US monetary policy benefit, it seems likely that the dollar will be the beneficiary of policy adjustments elsewhere designed to weaken other currencies. And ironically, in the current political situation, that is only likely to generate even more Presidential rhetoric on the subject. Quite frankly, I feel the dollar has potentially much further to climb as long as trade is the topic du jour.

Of course, that doesn’t mean it will rally ever day. In fact, today the dollar is very modestly softer vs. most of its counterparts. The biggest gainer has been CNY, which is firmer by 0.55% overnight, as China appears very interested in calming things down. But away from that move, most currency gains have been on the order of 0.1% or so. The most notable data overnight was the German IFO report, which declined for the eighth consecutive month and is now back to levels last seen in March 2017. While the ECB continues to look ahead to the ending of their extraordinary monetary policy, the economy does not seem to be cooperating with their views of a sustainable recovery. While I think there is very little chance that the ECB changes its stance on bond buying, meaning come December, they will be done, it remains an open question as to when they might start to raise rates. This is especially true given the potential for an escalating trade conflict between the US and the EU resulting in slower growth on both sides of the Atlantic. If that is the case, the ECB will have a much harder time normalizing policy. At this time, however, it is still way too early to make any determinations, and I suspect that tomorrow’s ECB meeting will give us very little new information.

Meanwhile, the market is still extremely focused on the BOJ meeting early next week, with varying views as to the potential for any policy shifts there. What does seem clear is there has at least been discussion of the timing of ending QE, but no decisions have been made. The problem for the BOJ is that after more than five years of aggressive bond buying, not only have they broken the JGB market, but they have not been able to achieve anywhere near the results they had sought. Given that the BOJ balance sheet is now essentially the same size as the Japanese economy (for comparison, in the US despite its remarkable growth during QE, it remains ~20% of the US economy), there are growing concerns that current policy may be doing more harm than good. Apparently there are limits to just how much a central bank can do to address inflation. As to the yen, if the market perception turns to the BOJ stepping back from constant injections of funds, it is very likely that the yen will find itself in great demand and USDJPY will fall steadily. I maintain my view that 100.00 is a viable target for the end of the year.

Today brings just New Home Sales data (exp 670K, a 2.8% decline from last month) but this is generally not a key figure for markets. Rather, today’s price action will be dependent on the outcome of the Trump-Juncker meeting and whatever comments follow at the press conference. A conciliatory tone by President Trump would almost certainly result in a stock market rally and modest dollar strength. Continued combativeness is likely to see stocks under pressure and the dollar, at least initially, falling as well.

Good luck
Adf

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
Adf