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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Conditions Have Tightened

The Treasury market is frightened
As risk of inflation has heightened
So 10-year yields jumped
The dollar got pumped
And credit conditions have tightened

The dollar rallied yesterday on the back of a sharp rise in US Treasury yields. The 10-year rose 13bps, jumping to its highest level since 2014. The 30-year rose even more, 15bps, and both have seen those yield rallies continue this morning. The catalyst was much stronger than expected US data, both ADP and ISM Non-Manufacturing were quite strong, and further comments by Chairman Powell that indicated the Fed would remain data dependent and while they didn’t expect inflation to rise sharply, effectively they are prepared to act if it does.

Adding to the inflation story was the Amazon news about raising the minimum wage at the company to $15/hour, and don’t forget the trade war with China, where tariffs will clearly add upward pressure on prices. All this makes tomorrow’s payroll report that much more important, as all eyes will be on the Average Hourly Earnings number. We have a fairly recent analogy of this type of market condition, the first two weeks of February this year, when the January AHE number jumped unexpectedly, and within a week, equities had fallen 10% while the dollar rallied sharply as risk was jettisoned with abandon. While I am not forecasting a repeat of those events, it is best to be aware of the possibility.

And quite frankly, that has been THE story of the market. It cannot be that surprising that the dollar has been the big beneficiary, as this has turned into a classic risk-off scenario. EMG currencies are under increasing pressure, and even the G10 is suffering, save the yen, which has rallied slightly vs. the dollar. At this point, there is no obvious reason for this trend to stop until tomorrow’s data release. If AHE data is firm (current expectations are for a 0.3% rise on the month translating into a 2.8% Y/Y rise), look for this bond rout to continue, with the concurrent impact of a stronger dollar and weaker equities. But since that is not until tomorrow, my sense is that today is going to be a session of modest further movement as positions get squared ahead of the big news.

Good luck
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Money More Dear

Next week, though it’s certainly clear
The Fed will price money more dear
The dollar’s incurred
Some selling and spurred
More weakness than seen since last year

The dollar remains under pressure this morning with a number of stories having a separate, but a cumulative impact on the buck. For example, overnight we learned that New Zealand’s GDP grew 1.0% in Q2, higher than the expected 0.7% outcome, and sufficient to get investors and traders to consider that the RBNZ, which just last month promised to maintain record low interest rates until at least 2020, may wind up raising rates sooner than that. A surprise of this nature usually leads to currency strength and so it is this morning with NZD higher by 0.8%.

Or consider the UK, where Retail Sales data surprised one and all by rising 0.3% in August (3.3% Y/Y), a much better performance than expected. This was enough to overcome the ongoing Brexit malaise and drive the pound higher by 0.7% and back to its highest level in two months. In truth, this is somewhat surprising given the quite disappointing outcome from the EU meeting Wednesday night in Brussels. Rather than more positive remarks about the viability of a deal being completed, we heard more of the hard-core negativity from the French and Irish, basically saying if the UK doesn’t cave, then there will be no deal. This is certainly not a welcome outcome, especially since there are only 190 days until Brexit will occur, deal or no. Meanwhile, PM May continues to fight a rearguard action against the avid pro-Brexiters in her party in order to retain her position.

Logically, I look at the situation and believe there is no real chance of a satisfactory deal being agreed on time. Frankly, the Irish border issue is intractable in my view. But given that this is entirely about politics, and the Europeans and British are both famous for kicking the can down the road, I suspect that something along the lines of a pure fudge, with neither side agreeing anything, will be achieved in order to prevent a complete disaster. However, there is a very real probability that the UK will simply leave the EU with no deal of any sort, and if that is the case, the initial market reaction will be for a sharp sell-off in the pound.

Interestingly, despite the fact that the little Eurozone data released was on the soft side, the euro has managed to continue its recent rally and is higher by 0.4% as I type. This seems more of a piece with the general dollar weakness that we have witnessed the past two sessions than anything else.

Another potential conundrum is US interest rates, where 10-year Treasury yields jumped to 3.08% yesterday, their highest level since early May, and now gathering momentum for the breakout that many pundits have been expecting for a while. Remember, short Treasury futures are one of the largest positions in the market. This thought process has been led by two concurrent features; the Fed continues to raise short term rates while the Treasury, due to increased fiscal policy stimulus and a growing budget deficit, will be forced to increase the amount of debt issued. When this is wrapped up with the fact that the Fed is reducing the size of its balance sheet, thus removing the one true price-insensitive bid from the market, it seemed a recipe for much higher 10-year yields. The fact that we remain at 3.08% nine months into the year is quite surprising, at least to me. But it is entirely possible that we see a much more aggressive sell-off in Treasuries going forward, especially if the Fed tweaks their message next week to one that is more hawkish.

In this context, let me give a concrete example of just how important the central bank message really is. This morning, Norgesbank raised interest rates in Norway by 25bps, as was universally expected. This was the first time in 7 years they raised rates, and are doing so because the economy there is expanding rapidly while inflation moves closer to their target. But in their policy discussion, they reduced the forecast pace of future interest rate hikes, surprising everyone, and the result was a sharp decline in NOK. Versus the euro it fell more than 1%, which translated into a 0.7% decline vs. the dollar. The point is the market is highly focused on the policy statements as well as the actual moves.

This is equally true, if not more so, with regard to the Fed. Current expectations are that the Fed will raise rates 25bps next week and another 25bps in December. Where things get cloudier is what next year will look like, and how fast they will continue to tighten policy. It is for this reason that next week’s meeting is so widely anticipated, because the Fed will release its updated dot plot, the effective forecasts of each Fed member as to where Fed funds will be at various points in the future. If the dot plot implies higher rates than the last iteration in June, you can expect the dollar to benefit from the outcome. Any implication of a slower pace of rate hikes will certainly undermine the dollar.

In the end, the mixture of new information has been sufficient to push the dollar lower by 0.3% when looking at the broad dollar index. Interestingly, despite its recent weakness, it remains within the trading range that has defined its movement since it stopped appreciating in April. Frankly, I expect this range trading to continue unless the Fed significantly changes its tune.

This morning brings a bit more data with Initial Claims (exp 210K) and Philly Fed (17.0) due at 8:30 while Existing Home Sales (5.35M) are released at 10:00. Yesterday’s housing data was mixed with New Home Sales rising more than expected, but Building Permits plunging. And remember that both of those data points tend to have a great deal of volatility. With that in mind, looking at the longer term trend shows that while Housing Starts seem to be rebounding from a bad spot, the trend in Permits is clearly downward, which doesn’t speak well for the housing market in the medium term.

In the end, as I wrote yesterday, continued modest dollar weakness seems the most likely outcome for now, but I suspect that we are coming to the end of this soft patch, and that the dollar will find its legs soon. I remain confused as to why there is so much bullishness attached to the Eurozone economy given the data continues to underperform. And there is no indication that the ECB is going to suddenly turn truly hawkish. Current levels strike me as attractive for dollar buyers.

Good luck
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