Cash Is Undoubtedly King!

Historically bonds were the thing
To own in a market downswing
But lately it seems
Those days were just dreams
Now cash is undoubtedly king!

While this note is focused on the FX markets, where once again the dollar is top dog, I think a quick discussion of government bonds is in order to help try to make some sense of the overall market situation.

Clearly, the lead story in financial markets has been equities, which have proven that volatility is not dead. In fact, these constant +/- 5% days are exhausting for both investors and traders. And of course, most of us have at least some portion of our investment in the equity markets and are afraid to look at our accounts these days. But the behavior that has really been at odds with what had become the overriding narrative is the incredibly abrupt sell-off in Treasuries and other government bond markets during the past week. The idea that government bonds are a safe haven has been underpinning financial markets since long before the financial crisis in 2008. Yesterday I highlighted two of the issues that I think are driving recent price action; the prospect of staggeringly high new issuance to pay for all the proposed and enacted fiscal stimulus that is coming; and the fact that when yields reach a low enough point, the idea that holding bonds will guarantee the return of principal starts to diminish.

But I don’t think those explanations are sufficient to explain the speed and size of the movement that we have experienced since last Monday. Instead, movement like that can only be caused by massive position liquidation. Consider, 10-year Treasury yields rallied 36bps on Monday while 30-year yields closed 40bps higher after touching levels a further 15bps higher than that earlier in the session. So the real question is; who is liquidating their position(s)?

To answer that question we have to consider who holds large positions in Treasuries. The largest holder is likely the Fed, but obviously, they are not sellers. China and Japan come next on the list of holders, and while Japan would never be selling, there continue to be rumors that China has wanted to do that. I have never been a believer that China would sell their holdings for two reasons; first that they couldn’t get rid of them all at once, so a large sale would devalue their remaining holdings; and second because they would still have USD in their account and need to find something to do with them. Now that rates are back to 0.0%, what would they do with the money? After all, that’s a really big mattress they would need. And given the fact that the price of gold has fallen sharply through all this, it would imply there is no big bid for gold either. This leads me to believe that the Chinese have not touched their Treasury portfolio.

After those central banks, the biggest holders are leveraged fund managers with Risk Parity strategies having been an extremely popular investment product for the past decade. The idea was that by holding a certain percentage of different asset classes (e.g. 60% stocks/40% bonds), one could target a specific risk/return ratio. But nothing is simple these days, and as bond yields continued to grind lower over time, hedge fund managers started levering up to buy more and more Treasuries to hold against a given portfolio of stocks. However, what appears to have happened in the past week is that many of those highly levered Treasury positions needed to be reduced given the dramatic decline in the equity portion of the portfolio. Thus, the only explanation that I can see to explain this type of unprecedented Treasury bond movement is a massive liquidation trade by the hedge fund community. My sense is that we will hear of a number of funds closing shop over the next month or so. As an aside, this reinforces the idea that we are still paying the price for the Fed’s actions in 2008-09 and the fact that they never returned market conditions to pre-crisis settings. In the end, once these positions are liquidated, we are likely to see bonds show a little more stability and perhaps, they will regain their haven status. But for now, they are as tough a place to be as stocks.

Now to today’s session. The equity euphoria felt after the US announcement of substantial stimulus coming, measured right now at $1.2 trillion, and very likely taking the shape of true helicopter money with checks cut to all Americans earning less than a given amount, has ended as quickly as it formed. Asian equities got killed (Nikkei -1.7%, Hang Seng -4.2%, Australia -6.4%) and European indices are also tumbling (DAX -5.5%, CAC -5.5%, FTSE100 -5.0%). US equity futures are limit down (-5.0%) at this point, so a lower opening seems likely.

In the FX world, as I mentioned, the dollar is top dog. Today’s worst performer is MXN, which has fallen a further 4% to yet another new low (dollar high) with USDMXN now trading near 24.00. Vacations there will be cheap when we can travel again! But RUB is lower by 3.6% as oil continues to slide, and ZAR is down 2.0% on the weakness in gold and all metals. APAC currencies were all weaker by between 0.2% and 0.6% except for PHP, which actually rallied 0.7% today after the government reopened the Philippine stock market. Yesterday, they had closed trading completely and the decision was not well received at all, so now they are all working remotely and that seemed to cheer the FX market as some funds flowed back into the country.

In the G10, the pound is the leading decliner, down 1.5% as I type and looking for all the world like it is going to test its historic 1985 lows of 1.06! Today was the day that Brexit negotiations were to begin with the EU, with plans for a large group of negotiators on both sides. Obviously, in the current situation, that is no longer viable and it seems inevitable that Boris is going to need to postpone the eventual exit. Of course, he will pay no political price for that given the circumstance. But the rest of the G10 is also sliding, and the slide has accelerated since NY walked in at 7:00. For instance, the euro had actually been a bit higher earlier this morning, but is now down 0.25%. But it is Aussie and Kiwi (-1.4% each) as well as SEK (-1.3%) and CAD (-0.8%) that are pacing the blocs decline. The only exception is the one we would expect, JPY which has edged 0.2% higher this morning. While dollar needs remain substantial worldwide, yen investors continue to liquidate internationally and bring home their money.

On the data front, we do see Housing Starts (exp 1500K) and Building Permits (1500K), but again, nobody really cares. The focus will remain on Fed and Administration policies and market responses to those announcements will continue to be the primary drivers going forward.

Good luck and stay safe
Adf

 

Times of Trouble

In times of trouble
The yen continues to be
Mighty like an oak

Pop quiz! What percentage of the workforce is working at their primary site vs. home or an alternate site? Please respond with where you’re working and your guesstimates. Will publish results of this (completely unscientific) survey on Monday, March 16.

As markets around the world continue to melt down, investors everywhere are looking for a haven to retain capital. For the past 100 years, US Treasuries have been the number one destination in markets. Interestingly, the past two days saw Treasuries sell off aggressively. I think the move was initially based on the relief rally seen on Tuesday, but at this point, the fact that Treasury prices fell alongside yesterday’s stock rout can only be explained by the idea that institutions that need cash are selling the only liquid assets they have, and Treasuries remain quite liquid. And to be clear, 10-year yields are lower by 18bps this morning as that bout of selling seems to have passed and the haven demand has returned in spades.

But since the financial crisis, the second most powerful haven asset has been the Japanese yen. Despite the fact that the nation has basically been in an economic funk for two decades, it continues to run a significant current account surplus. As a consequence, Japanese external investment is huge and when fear is in the air, that money comes running back home. The evolution of the coronavirus spread can be seen in the yen’s movement as in the middle of February, when Japan itself was dealing with the growth in infections, the yen weakened to a point not seen in nearly a year. Since then, however, the yen has strengthened 7.5% (with a peak gain of 9.8% seen Monday) as flows have been decidedly one way. This morning the yen has appreciated 0.7% from yesterday’s close and quite frankly, until the pandemic starts to ebb, I see no reason for it to stop appreciating. Par will pose a short-term psychological support for the dollar, but if this goes on for another two months, 95 is in the cards. With that in mind, though, for all yen receivables hedgers, zero premium collars are looking awfully good here. Let’s talk, at the very least you should be apprised of the pricing.

Interestingly, the Swiss franc has had a somewhat less impressive performance despite its historic haven characteristics. While it has appreciated 4.5% in the same time frame, it has been having much more trouble during the latest equity market decline. And I think that is the reason why. Famously, the Swiss National Bank has 20% of its balance sheet invested in individual equities. This is a very different investment philosophy than virtually every other central bank. The genesis of this came about when the SNB was intervening on a daily basis while trying to cap the franc and ultimately needed a place to put the dollars and euros they were buying. I guess the view was stocks only go up, so let’s make some money too. Whatever the reason, as of December 31 the USD value of their equity portfolio was about $97.6 billion. I’m pretty confident that number is a lot lower today, and perhaps the idea about Swiss franc strength is being called into question. The franc is unchanged today and has been generally unimpressive for the past week.

Meanwhile, all eyes this morning are on Madame Lagarde and the ECB who will be announcing their latest policy initiatives shortly. While it is clearly expected they will do something, other than a 10bp cut in the deposit rate, to -0.60%, there is a great deal of uncertainty. Expectations range from expanding the TLTRO program with much more aggressive rates, as low as -2.00%, to a significant increase in QE to capping government bond yields. All of that would be remarkably dramatic and likely have a short-term positive impact on markets. But will it last? My sense is that until the Fed announces next week, and at this point I think they cut 100bps, markets will still be on edge. After all, the world continues to revolve around USD funding, and in times of crisis, foreign entities need access to USD liquidity. Look for more repo, more swap lines and maybe even a lending scheme although I don’t think the Fed can do something like that within their mandate.

Overall, the dollar is performing as the number two currency haven, after the yen, and has rallied sharply against commodity currencies in both the G10 and EMG spaces. For example, with oil down 5% this morning, NOK has fallen 3.6%, but both AUD and SEK are lower by 1.5% as well. In the emerging markets, Mexican peso continues to be the market’s whipping boy, falling a further 3.2% as I type, which takes its decline since the beginning of the month to 12.2%. meanwhile, the RUB is in similarly dire straits (-2.75% today, -11.5% in March) and we are seeing every single EMG currency lower vs. the dollar today. These are the nations that are desperate for USD liquidity and you can expect their currencies to continue to decline for the foreseeable future.

At this point, data is an afterthought, but it is still being released. Yesterday saw CPI rise a tick more than expected but the more interesting data point was Mortgage Applications, which jumped 55.4% as mortgage rates collapse alongside Treasury yields. This morning brings Initial Claims (exp 220K) and PPI (1.8%, 1.7% core) with far more interest in the former than the latter. Consider, given the enormous economic disruptions, it would be easy to see that number jump substantially, which would just be another signal for the Fed to act as aggressively as possible.

At this point, as the equity meltdown continues, the dollar should remain well supported vs. everything except the yen.

Good luck
Adf

Values Debase

It used to be bonds were so boring
That talk induced yawning and snoring
But Covid-19
Is now on the scene
And bonds are the asset that’s soaring

Meanwhile in the equity space
Investors are having a race
To see who has sold
Their stocks and bought gold
As equity values debase

It’s important to understand that Covid-19 is not the cause of the current hysteria in financial markets, it is merely the catalyst that revealed the underlying problems. Arguably, the most critical of these problems, excess leverage, has been building since the financial crisis response in 2009. In fact, it was an explicit part of the response package, cut rates to zero to encourage more borrowing. The unseen, at the time, problem with this strategy, however, is that the vicious cycle virtuous circle that resulted, where investors chasing yield moved up the risk ladder thus encouraging the issuance of more and more risky securities, seems to be reaching its denouement. Welcome to today’s volatility!

Briefly, financialization of the economy has been growing aggressively since the financial crisis. This is the process whereby the corporate sector spends more time and money on managing the balance sheet than on delivering products or services. Thus, banking and financial services grow relative to total economic output. In essence, we produce less stuff but pay more for it. And yes, that is the definition of inflation, which is exactly what we have seen in financial markets. It has just not (yet) appeared in measured inflation indices, as they don’t include stock prices. Financialization has manifested itself in the massive equity repurchase programs, funded by record-breaking issuance of corporate debt, which has been instrumental in driving equity markets to record highs. But when more money is spent on equity repurchase than on R&D, it bodes ill for the longer term. Perhaps Covid-19 is the catalyst that will help us understand the long term has arrived.

As the global economy now is trying to address both a supply and demand shock to the system simultaneously, investors have collectively decided that risk is not as tasty as it was just a few weeks ago. And while many have warned that when this market turned, it would be dramatic, I don’t believe the type of movements possible were well understood. I’m guessing they are a little better understood today.

This process has further to run, regardless of what the central banks or government leaders do or say. Markets that have rallied for ten years do not correct in ten days. It will take much longer and there will be many unforeseen movements by different asset classes going forward.

In fact, the dollar is going to be quite interesting throughout this process. I maintain that its current decline is entirely a result of the market repricing the US rate outlook. Futures markets are currently pricing in another 50bp rate cut by the Fed a week from Wednesday, with a further 37bps by the end of the summer. That is significantly more cutting than is being priced for the ECB (just 10bps) and the BOJ (also 10bps). In other words, as interest rate spreads between the dollar and other G10 economies compress, it is no surprise to see the dollar decline. In fact, this was the genesis of my views at the beginning of the year and what underpinned my calls for the euro to trade to 1.17, the yen to 95 and the pound to 1.40. Of course, I didn’t anticipate anything like this, rather a much more gradual approach.

However, the dollar is also still seen as one of the safest places to be, with Treasury bonds the ultimate safe haven today and one needs dollars to buy Treasuries. The rally in the bond market has been extraordinary with the 10-year falling another 15bps today to yet another new record low. It actually traded below 0.70% briefly this morning but sits at 0.76% as I type. And that is true across the Treasury curve. While other bond markets globally have seen rates decline, nothing has matched the Treasury performance. (And for those of you who did not understand how Greek 10-year yields could trade below US yields, that is no longer the case!)

Meanwhile, havens like the yen (+0.9% today, +6.1% in the past two weeks) and CHF (+1.05% today, 4.9% in two weeks) are the stars of the FX markets. In fact, this bout of risk aversion is beginning to approach what we saw in 2008 and 2009. Today, the dollar is the total underperformer in the G10 space, but that is not the case in the EMG space. There, MXN is the disaster du jour, down 2.1% as it is impacted by the collapse in oil prices, the uptick in coronavirus cases and its reliance on the US, which appears to be heading toward much slower growth, if not a recession. But BRL is lower by 1.0%, and we are seeing most of the APAC and LATAM currencies falling this morning. CE4 currencies are benefitting from their proximity to the euro, but I expect that will change as time passes.

Into all this excitement, we bring this morning’s payroll report with the following expectations:

Nonfarm Payrolls 175K
Private Payrolls 160K
Manufacturing Payrolls -3K
Unemployment Rate 3.6%
Average Hourly Earnings 0.3% (3.0% y/Y)
Average Weekly Hours 34.3
Participation Rate 63.4%
Trade Balance -$46.1B

Source: Bloomberg

The thing is, all this took place before Covid-19, so all it can do is give us a final benchmark as to how things were prior to the virus spreading. If we get a bad number, that will be a real problem.

It is hard to overstate just how fragile this market is right now, with liquidity significantly impaired, bid-ask spreads widening and options volatilities rising sharply. Patience is a true virtue in these conditions and leaving orders at levels can be very effective. I maintain that the dollar’s weakness will not be a permanent feature, but rather a transient situation until the rate situation stabilizes. So, receivables hedgers, leave orders to layer into your strategies, it will pay off over time.

Good luck and good weekend
Adf

An Aura of Fear

An aura of fear’s been created
By actions both past and debated
Investors are scared
As they’re unprepared
Since models they’ve built are outdated

There is certainly more red than green on the screens this morning as the weekend brought us further complications across the board. The headline issue of note is the increased anxiety in Hong Kong as the ongoing protests spread to the airport forcing the cancelation of all flights there today, clearly a problem for a nation(?) that is dependent on international business and travel. President Xi is attempting to address this crisis with economic weapons rather than real ones, with the first shot fired by a state-owned company, China Huarong International Holdings Ltd, which instructed its employees to boycott Cathay Pacific Airways, the Hong Kong based airline. Given Hong Kong’s status as an open trading economy, it will have a great deal of difficulty handling boycotts from its major market.

Adding to the Chinese anxiety was word from the White House that September’s mooted trade talks may not happen at all as President Trump appears convinced that the Chinese need a deal more than the US does. As most of the escalation occurred late in the Asia day, the impact on markets there was more muted than might be expected. While it’s true the Hang Seng fell, -0.4%, Chinese stocks rallied as did Korea and India. At the same time, currency activity was less benign with the dollar continuing its strengthening pattern against most EMG currencies in APAC. For example, both INR and KRW are weaker by 0.55% this morning and the renminbi continues its measured decline, falling a further 0.1% with the dollar now trading above 7.10.

However, Europe has felt the brunt of the negative impact with early 1% rallies in equity markets there completely wiped out and both the DAX and CAC down by 0.4% as I type. Currency markets in Europe have also been less impacted with the euro edging just slightly lower, -0.1%, and the pound actually rallying 0.5% after Friday’s sharp sell-off.

But arguably, the real action has been in the bond market where Treasuries have rallied nearly a full point with the yield down 5bps to 1.68%. German bund yields are also lower, falling back to their record low of -0.59%. And adding to the risk-off feel has been the yen’s 0.5% rally, despite the fact that Japan was closed for Mountain Day, a national holiday. Finally, it wouldn’t be complete if we didn’t see pressure on US equity futures which are pointing to a 0.5% decline on the opening right now.

All told, I think it is fair to say that in the waning days of summer, risk is seen as a growing concern for investors. With that in mind, we do see some important data this week as follows:

Tuesday NFIB Small Biz 104.9
  CPI 0.3% (2.1% Y/Y)
  -ex food & energy 0.2% (1.7%Y/Y)
Thursday Initial Claims 214K
  Retail Sales 0.3%
  -ex autos 0.4%
  Empire State Mfg 2.75
  Philly Fed 10.0
  IP 0.1%
  Capacity Utilization 77.8%
  Business Inventories 0.1%
Friday Housing Starts 1.257M
  Building Permits 1.27M
  Michigan Sentiment 97.3

So, as you can see, Thursday is the big day, with a significant amount of data to be released. The ongoing conundrum of weakening manufacturing and still robust sales will, hopefully, be better explained afterwards, but my fear is as the global economy continues to suffer under the twin pressures of trade issues and declining inflation, that the path forward is lower, not higher.

In addition to this data, we see some important data from elsewhere in the world, notably Chinese IP (exp 5.8%) and Retail Sales (exp 8.6%) with both data points to be released Tuesday night and notably lower than last month’s results. It is abundantly clear that China is suffering a pretty major economic slowdown. The other noteworthy data point will be German Q2 GDP growth on Wednesday, currently forecast to be -0.1%, a serious issue for the continent and ample reason for the ECB to be more aggressive in their September meeting.

Wrapping it all up, there seems little reason for optimism in the near term as the key global issues, namely trade and growth, continue to falter. Central banks are also very obviously stretched to the limits of their abilities to smooth the process which means that unless there is a major change in governmental views on increased fiscal stimulation, slower growth is on the horizon. With it will come reduced risk and corresponding strength in haven assets like the yen, gold, Treasuries, Bunds and the dollar. While today offers no new information, these trends remain intact and show no signs of abating any time soon.

Good luck
Adf

A New Plan

While all eyes are turned toward Japan
Most central banks made a new plan
If there’s no trade truce
They’ll quickly reduce
Their base rates, stock markets, to fan

As the week comes to a close, the G20 Summit, and more importantly, tomorrow’s meeting between President’s Trump and Xi are the primary focus of investors and traders everywhere. While there is still great uncertainty associated with the meeting, at this point I would characterize the broad sentiment as an expectation that the two leaders will agree to resurrect the talks that were abruptly ended last month, with neither side imposing additional tariffs at this time. And quite frankly, that does seem like a pretty reasonable expectation. However, that is not nearly the same thing as assuming that a deal will be forthcoming soon. The negotiations remain fraught based on the simple fact that both nations view the world in very different ways, and what is SOP in one is seen as outside the bounds in the other. But in the meantime, I expect that markets will take the news that the situation did not deteriorate as a massive bullish signal, if only because the market has taken virtually everything that does not guaranty an apocalypse as a massive bullish signal.

At the same time, it has become abundantly clear that the major central banks have prepared for the worst and are all standing by to ease policy further in the event the talks fall apart. Of course, the major central banks have all been pretty clear lately that they are becoming increasingly comfortable with the idea that interest rates can remain much lower than historical levels without stoking inflation. In fact, there are still several central bankers, notably Kuroda-san and Signor Draghi, who feel they are fighting deflation. In fairness, the latest data, released just last night, highlights that runaway inflation is hardly a cause for concern as Japan clocked in at 1.1%, with core at 0.9% and the Eurozone reported inflation at a rip roaring 1.2%, with core at 1.1%. It has been data of this nature that stokes the imagination for further policy ease, despite the fact that both these central banks are already working with negative interest rates.

Now, it must be remembered that there are 18 other national leaders attending the meeting, and many of them have their own concerns over their current relationship with the US. For example, the president has threatened 25% tariffs on imported autos, a move which would have a significantly negative impact on both Germany (and by extension the EU) and Japan. For now, those tariffs are on hold, but it is also clear that because of the intensity of the US-China trade situation, talks about that issue with both the EU and Japan have been relegated to lower level officials. The concern there is that the original six-month delay could simply run out without a serious effort to address the issue. If that were to be the case, the negative consequences on both economies would be significant, however, it is far too soon to make any judgements on the outcome there.

And quite frankly, that is pretty much the entire story for the day. Equity markets remain mixed, with Asia in the red, although the losses were relatively modest at between 0.25% and 0.50%. Europe, meanwhile, has taken a more positive view of the outcome, with markets there rising between 0.2% and 0.5%, which has left US futures pointing to modest, 0.2%, gains at the opening. Bond prices are actually slightly lower this morning (yields higher) but remain within scant basis points of the lows seen recently. For example, Bunds are trading at -0.319%, just 1.5bps from its recent historic low while Treasuries this morning are trading at 2.017%, just 4bps from its recent multi-year lows. Perhaps the most remarkable news from the sovereign bond market was yesterday’s issuance by Austria of 100-year bonds with a coupon of just 1.20%! To my mind, that does not seem like a reasonable return for the period involved, but then, that may be very backwards thinking.

Consider that the acceptance of two policy changes that have been mooted lately, although are still quite controversial, would result in the Austrian issue as being seen as a virtual high-yield bond. Those are the abolition of cash and the acceptance of MMT as the new monetary policy framework. I can assure you that if when cash is abolished, interest rates will turn permanently negative, thus making a yield of 1.20% seem quite attractive, despite the century tenor. As to MMT, it could play out in one of two ways, either government bonds issued as perpetual 0.0% coupons, or the end of issuing debt completely, since the central banks would merely need to print the currency and pay it as directed. In this case too, 1.20% would seem awfully good.

Finally, let’s look at the FX markets this morning, where the dollar is modestly softer against most of its counterparts. But when I say modestly, I am not kidding. Against G10 currencies, the largest movement overnight was NZD’s 0.14% appreciation, with everything else + or – 0.1% or less. In other words, the FX markets are looking at the Trump-Xi meeting and waiting for the outcome before taking a view. Positions remain longer, rather than shorter, USD, but as I have written recently, that view is beginning to change on the back of the idea that the Fed has much further to ease than other central banks. While I agree that is a short-term prospect, I see the losses as limited to the 3%-5% range overall before stability is found.

Turning to the data picture, yesterday saw GDP print as expected at 3.1%. This morning we get Personal Income (exp 0.3%), Personal Spending (0.4%), Core PCE (1.6%). Chicago PMI (53.1) and Michigan Sentiment (98.0). However, barring an outlandish miss in anything, it seems unlikely there will be too much movement ahead of tomorrow’s Trump-Xi meeting. Look for a quiet one.

Good luck and good weekend
Adf

 

Will Powell React?

The Treasury curve is implying
That growth as we knew it is dying
Will Powell react?
Or just be attacked
For stasis while claiming he’s trying?

Scanning markets this morning shows everything is a mess. Scanning headlines this morning shows that fear clearly outpolls greed as the driving force behind trading activity. The question at hand is, ‘Have things gone too far or is this just the beginning?’

Treasury and Bund yields are the best place to start when discussing the relative merits of fear and greed, and this morning, fear is in command. Yields on 10-year Treasuries have fallen to 2.23% and 10-year Bunds are down to -0.17%, both probing levels not seen in nearly two years. The proximate causes are numerous. First there is the continued concern over the trade war between the US and China with no sign that talks are ongoing and the market now focusing on a mooted meeting between President’s Trump and Xi at the G20 in June. While there is no chance the two of them will agree a deal, as we saw in December, it is entirely possible they can get the talks restarted, something that would help mitigate the current market stress.

However, this is not only about trade. Economic data around the world continues to drift broadly lower with the latest surprise being this morning’s German Unemployment rate rising to 5.0% as 60,000 more Germans than expected found themselves out of work. We have also been ‘treated’ to the news that layoffs by US companies (Ford and GE among others) are starting to increase. The auto sector looks like it is getting hit particularly hard as inventories build on dealer lots despite what appears to be robust consumer confidence. This dichotomy is also evident in the US housing market where despite strong employment, rising wages and declining mortgage rates, home prices are stagnant to falling, depending on the sector, and home sales have been declining for the past fourteen months in a row.

The point is that the economic fundamentals are no longer the reliable support for markets they had been in the recent past. Remember, the US is looking at its longest economic expansion in history, but its vigor is clearly waning.

Then there are the political ructions ongoing. Brexit is a well-worn story, yet one that has no end in sight. The pound remains under pressure (-0.1%, -3.0% in May) and UK stocks are falling sharply (-1.3%, -3.3% in May). As the Tory leadership contest takes shape, Boris Johnson remains the frontrunner, but Parliament will not easily cede any power to allow a no-deal Brexit if that is what Johnson wants. And to add to the mess, Scotland is aiming to hold a second independence referendum as they are very keen to remain within the EU. (Just think, the opportunity for another border issue could be coming our way soon!)

Then there is the aftermath of the EU elections where all the parties that currently are in power in EU nations did poorly, yet the current national leadership is tasked with finding new EU-wide leaders, including an ECB President as well as European Commission and European Council presidents. So, there is a great deal of horse-trading ongoing, with competence for the role seen as a distant fifth requirement compared to nationality, regional location (north vs. south), home country size (large vs. small) and gender. Meanwhile, Italy has been put on notice that its current financial plans for fiscal stimulus are outside the Eurozone stability framework but are not taking the news sitting down. It actually makes no sense that an economy crawling out of recession like Italy should be asked to tighten fiscal policy by raising taxes and cutting spending, rather than encouraged to reinvigorate growth. But hey, the Teutonic view of the world is austerity is always and everywhere the best policy! One cannot be surprised that Italian stocks are falling (-1.3%, -8.0% this month).

At any rate, the euro also remains under pressure, falling yesterday by 0.3%, a further 0.1% this morning and a little more than 1% this month. One point made by many is that whoever follows Signor Draghi in the ECB President’s chair is likely to be more hawkish, by default, than Draghi himself. With that in mind, later this year, when a new ECB leader is named, if not yet installed, the euro has the chance to rally. This is especially so if the Fed has begun to cut rates by then, something the futures market already has in its price.

Other mayhem can be seen in South Africa, where the rand has broken below its six-month trading range, having fallen nearly 3% this week as President Ramaphosa has yet to name a new cabinet, sowing concern in the market as to whether he will be able to pull the country out of its deep economic malaise (GDP -2.0% in Q1). And a last piece of news comes from Venezuela, where the central bank surprised one and all by publishing economic statistics showing that GDP shrank 19.2% in the first nine months of 2018 while inflation ran at 130,060% last year. That is not a misprint, that is the very definition of hyperinflation.

Turning to today’s session, there is no US data of note nor are any Fed members scheduled to speak. Given the overnight price action, with risk clearly being cast aside, it certainly appears that markets will open that way. Equity futures are pointing to losses of 0.6% in the US, and right now it appears things are going to remain in risk-off mode. Barring a surprise positive story (or Presidential tweet), it feels like investors are going to continue to pare back risk positions for now. As such, the dollar is likely to maintain its current bid, although I don’t see much cause for it to extend its gains at this time.

Finally, to answer the question I posed at the beginning, there is room for equity markets to continue to fall while haven bonds rally so things have not yet gone too far.

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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