Beggar Thy Neighbor

A story that’s making the rounds
Although, it, so far, lacks real grounds
Is that the US
Might try to depress
The dollar ‘gainst euros and pounds

If so, that’s incredible news
And dollar bulls need change their views
But beggar thy neighbor
Does naught but belabor
The trade war, instead, it, defuse

The most interesting story that has started to gain traction is the idea that the Trump administration is considering direct intervention in the FX markets. While most pundits and investors focus on the Fed and how its monetary policy impacts the value of the dollar (which is completely appropriate), the legal framework in the US is that the Treasury is the department that has oversight of the currency. This means that dollar policy, such as it is beyond benign neglect, is formulated by the Secretary of the Treasury, not the FOMC. This is why the Treasury produces the report about other countries and currency manipulation every six months. Also, this is not a new situation, it has been the case since the abandonment of the Bretton Woods Agreement in 1971.

Since the Clinton Administration, the US policy has been a ‘strong dollar is in the US best interest’. This was made clear by then Treasury Secretary Robert Rubin and has been an accepted part of the monetary framework ever since. The issue with a strong dollar, of course, is that it can be an impediment for US exporters as their goods and services may become uncompetitively priced. Now, during the time when the US’s large trade deficits were not seen as problematic, the strong dollar was not seen as an issue. Clearly, earnings results from multinational corporations were impacted, but the government was not running policy with that as a priority. However, the current administration is far more mercantilist than the previous three or four, and as we have seen from the President’s Twitter feed, dollar strength has moved up the list of priorities.

It is this set of circumstances that has analysts and economists pondering the idea that the Treasury may direct the Fed to intervene directly in the FX market, selling dollars. History has shown that when a country intervenes by itself in the FX market, whether to prevent strength or weakness, it has generally been a failure. The only times when intervention has worked has been when there has been a general agreement amongst a large group of nations that a currency is either too strong or too weak and that intervention is appropriate. The best known examples are the Plaza Accord and the Louvre Accord from the mid-1980’s, where the G7 first agreed that the dollar was overvalued, then that it had reached an appropriate level. The initial announcement alone was able to drive the dollar lower by upwards of 10%, and the active intervention was worth another 5%. The result was a longer term weakening of nearly 40% before it was halted by the Louvre Accord. But other than those situations, for the large freely floating currencies, intervention has been effective at slowing a trend, but not reversing one. And the current dollar trend remains higher.

If the US does decide to intervene directly, this will have an enormous short-term impact on the FX market (and probably all markets) as it represents a significant policy reversal. However, in the end, macroeconomic fundamentals and relative monetary policy stances are still going to drive the value of every currency. With that in mind, it could be a long time before those influences become dominant again. Of course, the other thing is that the history of beggar-thy-neighbor FX policy is one of abject failure, with all nations seeking the same advantage, and none receiving any. Certainly, this is something to keep on your radar.

Away from that story, the dollar is actually stronger this morning, with the euro having breached 1.12, the pound tumbling toward 1.24 and most currencies, both G10 and EMG on the back foot. In fact, this is the problem for the Trump administration on this front, the growth situation elsewhere in the world continues to deteriorate more rapidly than in the US. Not only did Friday’s employment data help support the dollar, but this morning we saw very weak UK and Italian Retail Sales data to add to the economic malaise in those areas. In fact, economists are now forecasting negative GDP growth in the UK for Q2, and markets are pricing in a 25bp rate cut by the BOE before the end of the year. Meanwhile, in the Eurozone, all the talk is about how quickly the ECB is going to restart QE, with new estimates it could happen as soon as September with amounts up to €40 billion per month. While that seems to be a remarkably quick reversal (remember, they just ended QE six months ago), with the prospect of an ECB President Lagarde, who has lauded QE as an excellent policy tool, it cannot be ruled out.

Pivoting to the trade story, the latest news is that senior officials will be speaking by phone this week and the chances of a meeting, probably in Beijing in the next few weeks are rising. The problem is that there are still fundamental differences in world views and unless one side caves, which seems unlikely right now, I don’t see a short-term resolution. What is more remarkable is the fact that the lack of any discernible progress on trade is no longer seen as an issue by any markets. Or at least not a major one. While equity markets have softened over the past two sessions, the declines have been muted and, at least in the US, indices remain near record highs. Bond yields have risen a bit, implying the worst of the fear has passed, although in fairness, they remain incredibly low. But most importantly, the dialog has moved on, with trade no longer seen as the key fundamental factor it appeared to be just two months ago.

Turning to this morning’s news, there is only one data point, JOLT’s Job Openings (exp 7.47M) but of much more importance we hear from Chairman Powell at 8:45 this morning, followed by Bullard, Bostic and Quarles later in the day. Powell begins his testimony to Congress tomorrow morning, but everyone will be listening carefully to see if he is going to try to walk back expectations for the July rate cut that is fully priced into the market. My money is on confirming the cut on the basis of continued low inflation readings. However, given that is the market expectation, there is no reason to believe the dollar will suffer on the news, unless he is hyper dovish. So, the current strong stance of the buck seems likely to continue for the rest of the day.

Good luck
Adf

Cow’ring In Fear

Tis coming increasingly clear
That growth is at ebb tide this year
The PMI data
When looked at, pro rata
Shows industry cow’ring in fear

Meanwhile in Osaka, the meet
Twixt Trump and Xi lowered the heat
On tariffs and trade
Which most have portrayed
As bullish, though some are downbeat

With all the buildup about the meeting between President’s Trump and Xi, one might have thought that a cure for cancer was to be revealed. In the end, the outcome was what was widely hoped for, and largely expected, that the trade talks would resume between the two nations. Two addenda were part of the discussion, with Huawei no longer being shut out of US technology and the Chinese promising to buy significantly more US agricultural products. Perhaps it was the two addenda that have gotten the market so excited, but despite the results being largely in line with expectations, equity markets around the world have all exploded higher, with both Shanghai and Tokyo rallying more than 2.2%, Europe seeing strong gains, (DAX +1.35%, FTSE + 1.15%) and US futures pointing sharply higher (DJIA +1.1%, NASDAQ +1.75%). In other words, everybody’s happy! Oil prices spiked higher as well, with WTI back over $60 due to a combination of an extension of the OPEC+ production cuts and the boost from anticipated economic growth after the trade truce. Gold, on the other hand, is lower by 1.4% as haven assets have suffered. After all, if the apocalypse has been delayed, there is no need to seek shelter.

But a funny thing happened on the way to market salvation, Manufacturing PMI data was released, and not only was it worse than expected pretty much everywhere around the world, it was also below the 50 level pretty much everywhere around the world. Here are the data for the world’s major nations; China 49.4, Japan 49.3, Korea 47.5, Germany 45.0, and the UK 48.0. We are awaiting this morning’s US ISM report (exp 51.0), but remember, that Friday’s Chicago PMI, often seen as a harbinger of the national scene, printed at a disastrous 49.7, more than 3 points below expectations and down 4.5 points from last month.

Taking all this into account, the most important question becomes, what do you do if you are the Fed? After all, the Fed remains the single most important actor in financial markets, if not in the global economy. Markets are still pricing in a 25bp rate cut at the end of this month, and about 100bps of cuts by the end of the year. In the meantime, the most recent comments from Fed speakers indicate that they may not be that anxious to cut rates so soon. (see Richmond Fed President Thomas Barkin’s Friday WSJ interview.) If you recall, part of the July rate cut story was the collapse of the trade talks and the negative impact that would result accordingly. But they didn’t collapse. Now granted, the PMI data is pointing to widespread economic weakness, which may be enough to convince the Fed to cut rates anyway. But was some of that weakness attributable to the uncertainty over the trade situation? After all, if global trade is shrinking, and it is, then manufacturing plans are probably suffering as well, even without the threat of tariffs. All I’m saying is that now that there is a trade truce, will that be sufficient for the Fed to remain on hold?

Of course, there is plenty of other data for the Fed to study before their next meeting, perhaps most notably this Friday’s payroll report. And there is the fact that with the market still fully priced for a rate cut, it will be extremely difficult for the Fed to stand on the side as the equity market reaction would likely be quite negative. I have a feeling that the markets are going to drive the Fed’s activities, and quite frankly, that is not an enviable position. But we have a long time between now and the next meeting, and so much can, and likely will, change in the interim.

As to the FX market, the dollar has been a huge beneficiary of the trade truce, rallying nicely against most currencies, although the Chinese yuan has also performed well. As an example, we see the euro lower by 0.3%, the pound by 0.45% and the yen by 0.35%. In fact, all G10 currencies are weaker this morning, with the true outliers those most likely to benefit from lessening trade tensions, namely CNY and MXN, both of which have rallied by 0.35% vs. the dollar.

Turning to the data this week, there is plenty, culminating in Friday’s payrolls:

Today ISM Manufacturing 51.0
  ISM Prices Paid 53.0
Wednesday ADP Employment 140K
  Trade Balance -$54.0B
  Initial Claims 223K
  ISM Non-Manufacturing 55.9
  Factory Orders -0.5%
Friday Nonfarm Payrolls 160K
  Private Payrolls 153K
  Manufacturing Payrolls 0K
  Unemployment Rate 3.6%
  Average Hourly Earnings 0.3% (3.2% Y/Y)
  Average Weekly Hours 34.4

So, there will be lots to learn about the state of the economy, as well as the latest pearls of wisdom from Fed members Clarida, Williams and Mester in the first part of the week. And remember, with Thursday’s July 4th holiday, trading desks in every product are likely to be thinly staffed, especially Friday when payrolls hit. Also remember, last month’s payroll data was a massive disappointment, coming in at just 75K, well below expectations of 200K. This was one of the key themes underpinning the idea that the Fed was going to cut in July. Under the bad news is good framework, another weak data point will virtually guaranty that the Fed cuts rates, so look for an equity market rally in that event.

In the meantime, though, the evolving sentiment in the FX market is that the Fed is going to cut more aggressively than everywhere else, and that the dollar will suffer accordingly. I have been clear in my view that any dollar weakness will be limited as the rest of the world follows the Fed down the rate cutting path. Back in the beginning of the year, I was a non-consensus view of lower interest rates for 2019, calling for Treasuries at 2.40% and Bunds at 0.0% by December. And while we could still wind up there, certainly the consensus view is for much lower rates as we go forward. Things really have changed dramatically in the past six months. Don’t assume anything for the next six!

Good luck
Adf

Absent Deceit

Two presidents are set to meet
From nations that fiercely compete
The issue at hand
Is how to expand
The trade twixt them absent deceit

For markets, this issue is key
And so far, today, what we see
Is traders complacent
A deal is now nascent
So buyers have been on a spree

The upcoming meeting between President’s Trump and Xi, due to be held on Saturday, has drawn the most focus amid financial markets in the past twenty-four hours. Yesterday we heard Treasury Secretary Mnuchin express confidence a deal could be completed and that “we were about 90% of the way there…” prior to the abrupt end of discussions last month. If you recall, the US claimed China reneged on their willingness to enshrine the deal details into their canon of law, which the US demanded to insure the deal was followed. However, shortly thereafter, President Trump, in a Fox News interview, talked about raising tariffs if necessary and seemed quite unconcerned over the talks falling apart. In fact, he turned his ire on India and Vietnam for adding to trade troubles. While Asian markets all rallied as the vibes seemed to be improving, a short time ago China announced they would have a set of conditions to present to Mr Trump in order to reach a deal. These include an end to the ban on Huawei products and purchases as well as an immediate end to all tariffs.

Given the importance of reaching a deal for both sides, my take is these comments and terms are simply being used to establish the baseline for the negotiations between the two men, and that some middle ground will be reached. However, markets (wisely I think) took the Chinese demands as a sign that a deal is far less certain than optimists believe, and European equities, as well as US futures, have sold off since their release. I have maintained throughout this process that a deal was always going to be extremely difficult to achieve given the fundamental problem that the Chinese have yet to admit to IP theft or forced technology transfers while the US sees those as critical issues. In addition, the question of enshrinement of terms into local law describes one of the fundamental differences between the two nations. After all, the US is a nation based on its laws, while China is a nation entirely in thrall to one man. Quite frankly, I think the odds of completing a deal are 50:50 at best, and if the luncheon between the two men does not result in the resumption of talks, be prepared for a pretty significant risk-off event.

In the meantime, the global economic picture continues to fade as data releases point to slowing growth everywhere. Yesterday’s Durable Goods numbers were much worse than expected at -1.3%, although that was largely due to the reduction in aircraft orders on the back of the ongoing travails of Boeing’s 737 Max jet. But even absent transport, the 0.3% increase, while better than expected, is hardly the stuff of a strong expansion. In fact, economists have begun adjusting their GDP forecasts lower due to the absence of manufacturing production. Yesterday I highlighted the sharp decline in all of the regional Fed manufacturing surveys, so the Durables data should be no real surprise. But surprise or not, it bodes ill for GDP growth in Q2 and Q3.

Of course, the US is not alone in seeing weaker data. For example, this morning the Eurozone published its monthly Confidence indices with Business Confidence falling to 0.17, the lowest level in five years, while Economic Sentiment fell to 103.3 (different type of scale), its lowest level in three years and continuing the steep trend lower since a recent peak in the autumn of last year. Economists have been watching the ongoing deterioration in Eurozone data and have adjusted their forecasts for the ECB’s future policy initiatives as follows: 10bp rate cut in September and December as well as a 50% probability of restarting QE. The latter is more difficult as that requires the ECB to change their self-imposed rules regarding ownership of government debt and the appearance of the ECB financing Eurozone governments directly. Naturally, it is the Germans who are most concerned over this issue, with lawsuits ongoing over the last series of QE. However, I think its quaint that politicians try to believe that central banks haven’t been directly funding governments for the past ten years!

So, what has all this done for the FX markets? Frankly, not much. The dollar is little changed across the board this morning, with nary a currency having moved even 0.20% in either direction. The issue in FX is that the competing problems (trade, weakening growth, central bank policy adjustments) are pulling traders in different directions with no clarity as to longer term trends. Lately, a common theme emerging has been that the dollar’s bull run is over, with a number of large speculators (read hedge funds) starting to establish short dollar positions against numerous currencies. This is based on the idea that the Fed will be forced to begin easing policy and that they have far more room to do so than any other central bank. As such, the dollar’s interest rate advantage will quickly disappear, and the dollar will fall accordingly. While I agree that will be a short-term impact, I remain unconvinced that the longer-term trend is turning. After all, there is scant evidence that things are getting better elsewhere in the world. Remember, the ongoing twin deficits in the US are hardly unique. Governments continue to spend far more than they receive in tax revenues and that is unlikely to stop anytime soon. Rather, ultimately, we are going to see more and more discussion on MMT, with the idea that printing money is without risk. And in a world of deflating currencies and halting growth, the US will still be the place where capital is best treated, thus drawing investment and dollar demand.

This morning brings some more data as follows: Initial Claims (exp 220K) and the third look at Q1 GDP (3.1%). Later, we also see our 6th regional Fed manufacturing index, this time from KC and while there is no official consensus view, given the trend we have seen, one has to believe it will fall sharply from last month’s reading of 2.0. There are no Fed speakers on the docket, so FX markets ought to take their cues from the equity and bond markets, which as the morning progressed, are starting to point to a bit of risk aversion.

Good luck
Adf

 

Another Bad Day

Consider Prime Minister May
Who’s having another bad day
Her party is seeking
Her ouster ere leaking
Support, and keep Corbyn at bay

The pound is now bearing the brunt
Of pressure as sellers all punt
On Brexit disaster
Occurring much faster
Thus moving back burner to front

While the rest of the world continues to focus on the US-China trade situation, or perhaps more accurately on the volatility of US trade policy, which has certainly increased lately, the UK continues to muddle along on its painfully slow path to a Brexit resolution of some sort. The latest news is that the Tory party is seeking to change their own parliamentary rules so they can bring another vote of no-confidence against PM May as a growing number in the party seek her resignation. Meanwhile, the odds of a deal with the Labour party continue to shrink given May’s unwillingness to accept a permanent membership in a customs union, a key demand for Labour. This is the current backdrop heading into the EU elections next week. The Brexit party, a new concoction of Nigel Farage, is leading the race in the UK according to recent polls, with their platform as, essentially, leave the EU now! And to top it all off, PM May is seeking to bring her much despised Brexit bill back to the floor for its fourth vote in early June. In other words, while it has probably been a month since Brexit was the hot topic, as the cracks begin to show in UK politics, it is coming back to the fore. The upshot is the pound has been under very steady pressure for the past two weeks, having fallen 2.7% during that time (0.2% overnight), and is now at its lowest point since mid-February.

When the delay was agreed by the EU and the UK, pushing the new date to October 31, the market basically assumed that either Labour would come on-board and a deal agreed, or that a second referendum would be held which is widely expected to point to Remain. (Of course, that was widely expected in the first referendum as well!) However, given that politics is such a messy endeavor, there is no clarity on the outcome. I think what we are observing is the market pricing in much higher odds of a hard Brexit, which remains the law of the land given there are no other alternatives at this time. Virtually every pundit believes that some deal will be struck preventing that outcome, but it is becoming increasingly clear that the FX market, at least, is far less certain of that outcome. For the FX market punditry, this has created a situation where not only trade politics are clouding the view, but local UK politics are doing the same.

Speaking of trade politics, while there is continued bluster on both sides of the US-China spat, the lines of communication clearly remain open as Treasury Secretary Mnuchin seems likely to head back to Beijing again soon for further discussions. At the same time, President Trump has delayed the decision on imposing 25% tariffs on imported autos from Europe and Japan while negotiations there continue, thus helping kindle a rebound in yesterday’s equity markets. As to the FX impact on this news, it was ever so mildly euro positive, with the single currency rebounding a total of 0.2% from its lows before the announcement. Of course, part of the euro’s rally could be pinned on the much weaker than expected US Retail Sales and IP data released yesterday, but given the modesty of movement, it really doesn’t matter the driver.

Stepping back a bit, the dollar’s longer-term trend remains higher. Versus the euro, it remains 5% higher than May 2018, while the broader based Dollar Index (DXY) has rallied 3.5% in that period. And the thing is, despite yesterday’s US data, the US situation appears to be far more supportive of growth than the situation virtually everywhere else in the world. Global activity measures continue to point to a slowing trend which is merely being exacerbated by the trade problems.

Turning to market specifics, Aussie is a touch lower this morning after weaker than expected employment data has helped cement the market’s view that the RBA is going to cut rates at least once this year with a decent probability of two cuts before December. While thus far Governor Lowe has been reluctant to lean in that direction, the collapse in housing prices is clearly starting to weigh elsewhere Down Under. I think Aussie has further to decline.

However, away from that news, there has been much less of interest to drive markets, and so, not surprisingly, markets remain extremely quiet. Something that gets a great deal of press lately has been the decline in volatility and how selling vol has turned into a new favorite trade. (As a career options trader, I would caution against selling when levels have reached a nadir like this. It is not that they can’t decline further, clearly they can, but in a reversal, the pain will be excruciating).
As to the data story, aside from the Australian employment situation, there has been nothing of note overnight. This morning brings Initial Claims (exp 220K) and Housing Starts (1.205M) and Building Permits (1.29M) along with Philly Fed (9.0) all at 8:30. I mentioned the weak Retail Sales and IP data above, but we also saw Empire Manufacturing which was shockingly high at 18.5, once again showing that there is no strong trend in the US data. While there are no Fed speakers today, yesterday we heard from Richmond President Barkin and not surprisingly, he said he thought that patience was the right stance for now. There is no doubt they are all singing from the same hymnal.

Arguably, as long as we continue to get mixed data, there is no reason to change the view. With that in mind, it is hard to get excited about the prospects of a large currency move until those views change. So, for the time being, I believe the longer-term trend of dollar strength remains in place, but it will be choppy and slow until further notice.

Good luck
Adf

 

“Talks” Become “War”

At what point do “talks” become “war”?
And how long can traders ignore
The signs that a truce
Are, at best, abstruse?
It seems bulls don’t care any more

So, markets continue to shine
But something’s a bit out of line
If problems have past
Then why the forecast
By bonds of a further decline

I can’t help being struck this morning by the simultaneous rebound in equity markets alongside the strong rally in bond markets. They seem to be telling us conflicting stories or are perhaps simply focusing on different things.

After Monday’s equity market rout set nerves on edge, and not just among the investor set, but also in the White House, it was no surprise to hear a bit more conciliatory language from the President regarding the prospects of completing the trade negotiations successfully. That seemed to be enough to cool the bears’ collective ardor and brought bargain hunters dip buyers back into the market. (Are there any bargains left at these valuations?) This sequence of events led to a solid equity performance in Asia despite the fact that Chinese data released last night was, in a word, awful. Retail Sales there fell to 7.2%, the lowest in 16 years and well below forecasts of 8.6% growth. IP fell to 5.4%, significantly below the 6.5% forecast, let alone last month’s 8.5% outturn. And Fixed Asset Investment fell to 6.1%, another solid miss, with the result being that April’s economic performance in the Middle Kingdom was generally lousy. We have already seen a number of reductions in GDP forecasts for Q2 with new expectations centering on 6.2%.

But the market reaction was not as might have been expected as the Shanghai composite rose a solid 1.9%. It seems that China is moving into the ‘bad news is good’ scenario, where weak data drives expectations of further monetary stimulus thus supporting stock prices. The other interesting story has been the change in tone in the official Chinese media for domestic Chinese consumption, where they have become more stridently nationalist and are actively discussing a trade “war”, rather than trade “talks”. It seems the Chinese are girding for a more prolonged fight on the trade front and are marshaling all the resources they can. Of course, at the end of the day, they remain vulnerable to significant pain if the second set of tariffs proposed by the US is enacted.

One consequence of this process has been a weakening Chinese yuan, which has fallen 2.7% since its close on Friday May 3rd, and is now at its weakest point since mid-December. At 6.9150 it is also less than 2% from the 7.00 level that has been repeatedly touted by analysts as a no-go zone for the PBOC. This is due to concerns that the Chinese people would be far more active in their efforts to protect their capital by moving it offshore. This is also the reason there are such tight capital flow restrictions in China. It doesn’t help the trade talks that the yuan has been falling as that has been a favorite talking point of President Trump, China’s manipulation of their currency.

This process has also renewed pundit talk of the Chinese selling all their Treasury holdings, some $1.1 trillion, as retaliation to US tariffs. The last idea makes no sense whatsoever, as I have mentioned in the past, if only because the question of what they will do with $1.1 trillion in cash has yet to be answered. They will still need to own something and replacing Treasuries with other USD assets doesn’t achieve anything. Selling dollars to buy other currencies will simply weaken the dollar, which is the opposite of the idea they are trying to manipulate their currency to their advantage, so also makes no sense. And finally, given the huge bid for Treasuries, with yields on the 10-year below 2.40%, it seems there is plenty of demand elsewhere.

Speaking of the Treasury bid, it seems bond investors are looking ahead for weaker overall growth, hence the declining yields. But how does that square with equity investors bidding stocks back up on expectations that a trade solution will help boost the economy. This is a conundrum that will only be resolved when there is more clarity on the trade outcome.

(Here’s a conspiracy theory for you: what if President Trump is purposely sabotaging the talks for now, seeking a sharp enough equity market decline to force the Fed to ease policy further. At that point, he can turn around and agree a deal which would result in a monster rally, something for which we can be sure he would take credit. I’m not saying it’s true, just not out of the question!)

At any rate, nothing in the past several sessions has changed the view that the trade situation is going to continue to be one of the key drivers for market activity across all markets for the foreseeable future.

After that prolonged diatribe, let’s look at the other overnight data and developments. German GDP rose 0.4%, as expected, in Q1. This was a significant uptick from the second half of last year but appears to be the beneficiary of some one-off issues, with slower growth still forecast for the rest of the year. Given expectations were built in, the fact that the euro has softened a bit further, down 0.1% and back below 1.12, ought not be too surprising. Meanwhile, the pound is little changed on the day, but has drifted down to 1.2900 quietly over the past two sessions. Despite solid employment data yesterday, it seems that traders remain unconvinced that a viable solution will be found for Brexit. This morning the word is that PM May is going to bring her thrice-defeated Brexit deal to Parliament yet again in June. One can only imagine how well that will go.

Elsewhere in the G10 we have the what looks like a risk-off session. The dollar is modestly stronger against pretty much all of that bloc except for the yen (+0.2%) and the Swiss franc (+0.1%), the classic haven assets. So, bonds (Bund yields are -0.10%, their lowest since 2016) and currencies are shunning risk, while equity traders continue to lap it up. As I said, there is a conundrum.

This morning we finally get some US data led by Retail Sales (exp 0.2%, 0.7% ex autos) as well as Empire Manufacturing (8.5), IP (0.0%) and Capacity Utilization (78.7%) all at 8:30. Business Inventories (0.0%) are released at 10:00 and we also hear from two more Fed speakers, Governor Quarles and Richmond Fed President Barkin. However, it seems unlikely that, given the consistency of message we have heard from every Fed speaker since their last meeting, with Williams and George yesterday reinforcing the idea that there is no urgency for the Fed to change policy in the near term and politics is irrelevant to the decision process, that we will hear anything new from these two.

In the end, it feels like yesterday’s equity rebound was more dead-cat than a start of something new. Risks still abound and slowing economic growth remains the number one issue. As long as US data continues to outperform, the case for dollar weakness remains missing. For now, the path of least resistance is for a mildly firmer buck.

Good luck
Adf

Waiting to See

At midnight the US imposed
The tariffs that Trump had disclosed
We’re waiting to see
How President Xi
Responds, or if China’s now hosed

It’s all about the tariffs this morning as the US increased the tariff rate on $200 billion of Chinese imports to 25% as of midnight last night. China has promised to retaliate but has not yet announced what they will do. One of the problems they have is they don’t import that much stuff from the US, so they cannot match it exactly. There was an unintentionally humorous article in Bloomberg this morning that tried to outline the ‘powerful’ tools China has to respond; namely selling US Treasuries, allowing the CNY to weaken further, or stop buying US soybeans. The humor stemmed from the fact that they basically destroyed their own arguments on the first two, leaving just the soybean restriction as potentially viable and even that is problematic.

Consider the Treasury sales first. As the Chinese own ~$1.1 trillion, if they sold a significant chunk, they would almost certainly drive US yields higher as Treasury prices fell. But two problems with this are; they would undermine the value of whatever bonds they retained and more problematically, what else would they do with the dollars? After all, the Treasury market is pretty much the only one that is large enough to handle that type of volume on a low risk basis. I guess they could convert the dollars to euros and buy Italian BTP’s (there are a lot of those outstanding) but their risk profile would get significantly worse. And of course, selling all those dollars would certainly weaken the dollar, which would not help the Chinese economy one bit.

On the flip side, allowing the renminbi to weaken sharply presents an entirely different problem, the fact that the Chinese are terrified that they would lose control of the capital flow situation if it weakened too far. Remember in 2015, when the Chinese created a mini-devaluation of just 1.5%, it triggered a massive outflow as USDCNY approached 7.00. The Chinese people have no interest in holding their assets in a sharply depreciating currency, and so were quick to sell as much as they could. The resultant capital flows cost China $1 trillion in FX reserves to prevent further weakness in the currency. Given we are only 2% below that level in the dollar right now, it seems to me the Chinese will either need to accept massive outflows and a destabilizing weakening in the renminbi, or more likely, look for another response.

The final thought was to further restrict soybean imports from the US. While the Chinese can certainly stop that trade instantly, the problems here are twofold. First, they need to find replacement supplies, as they need the soybeans regardless of where they are sourced, and second, given the Swine virus that has decimated the pig herds in China, they need to find more sources of protein for their people, not fewer. So, no pork and less soybeans is not a winning combination for Xi. The point is, while US consumers will likely feel the pressure from increased tariff rates via higher prices, the Chinese don’t have many easy responses.

And let’s talk about US prices for a moment. Shouldn’t the Fed be ecstatic to see something driving prices higher? After all, they have been castigating themselves for ‘too low’ inflation for the past seven years. They should be cheering on the President at this stage! But seriously, yesterday’s PPI data was released softer than expected (2.2%, 2.4% core) and as much as both Fed speakers and analysts try to convince us that recently declining measured inflation is transitory, the market continues to price rate cuts into the futures curve. This morning brings the CPI data (exp 2.1%, 2.1% core) but based on data we have seen consistently from around the world, aside from the oil price rally, there is scant evidence that inflation is rising. The only true exceptions are Norway, where the oil driven economy is benefitting greatly from higher oil prices, and the disasters of Argentina and Turkey, both of which have tipped into classic demand-pull inflation, where too much money is chasing too few goods.

Turning to market performance, last night saw the Shanghai Composite rally 3.1% after the imposition of tariffs, which is an odd response until you understand that the government aggressively bought stocks to prevent a further decline. The rest of Asia was mixed with the Nikkei lower by a bit and the KOSPI higher by a bit. European shares are modestly higher this morning, on average about 0.5%, in what appears to be a ‘bad news is good’ scenario. After all, French IP fell more than expected (-0.9%) and Italian IP fell more than expected (-1.4%). Yes, German Trade data was solid, but there is still scant evidence that the Eurozone is pulling out of its recent malaise so weaker data encourages traders to believe further policy ease is coming.

In the FX market, there has been relatively little movement in any currency. The euro continues to trade either side of 1.12, the pound either side of 1.30 and the yen either side of 110.00. It is very difficult to get excited about the FX market given there is every indication that the big central banks are well ensconced in their current policy mix with no changes on the horizon. That means that both the Fed and the ECB are on hold (although we will be finding out about those TLTRO’s soon) while both the BOJ and PBOC continue to ease policy. In the end, it turns out the increased tariffs were not that much of a shock to the system, although if the US imposes tariffs on the rest of Chinese imports, I expect that would be a different story.

This morning we hear from Brainerd, Bostic and Williams, although at this point, patience in policy remains the story. The inflation data mentioned above is the only data we get (although Canadian employment data is released for those of you with exposures there), and while US equity futures are tilted slightly lower at this time, it feels like the market is going to remain in the doldrums through the weekend. That is, of course, unless there is a shocking outturn from the CPI data. Or a trade deal, but that seems pretty remote right now.

Good luck and good weekend
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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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