Will We Understand?

The current Fed Chairman named Jay
Will speak to us later today
The question at hand
Will we understand
The message that he will relay?

Meanwhile, nearby trade talks resume
Midst fears that a failure spells doom
For Trump and for Xi
They need victory
To help both economies boom

Three main stories continue to dominate the headlines; Brexit, the Fed and US-China trade talks. Given that all three remain unsettled, it should not be surprising that markets have shown little direction of late. This is evidenced by the fact that, once again, the dollar is little changed this morning against the bulk of its counterparts while both Treasury yields and equity prices remain rangebound.

Starting with the Fed, this afternoon at 2:00 the policy statement is released and then at 2:30 Chairman Powell holds his first of eight press conferences this year. We all know about the change in tone from Fed speakers since the December meeting where the Fed funds rate was raised 25bps to 2.50%. Since then, we have seen every Fed speaker back away from the previous narrative of slow and steady rate hikes to the new watchword, ‘patience’. In other words, previous expectations of two or three rate hikes this year have been moderated and will only occur if the data supports them. At this point, it seems pretty clear that the Fed will not raise rates in March, and likely not in June either, unless the data between now and then brightens significantly. As to the second half of the year, based on the slowing trajectory of global growth, it is becoming harder to believe they will push rates higher at all this year.

This is a significant change of expectations and will certainly impact other markets, notably the dollar. Given the view that any dollar strength was predicated on tighter Fed policy, the absence of such tightening should negatively impact the buck. But as I frequently point out, the dollar is a two-sided coin, and if the Fed is tightening less than expected, you can be certain that so is every other central bank, with the possibility of easing elsewhere coming into play. On a relative basis, I continue to see the dollar being the beneficiary of the tightest monetary policy around.

Moving to the trade talks, while hopes remain high, it seems expectations need to be moderated. The US is seeking major structural changes from China, including the reduction of subsidies for SOE’s and changes in terms for partnerships between US and Chinese firms. China built its economic model on those terms and seems unlikely to give them up. And that doesn’t include the IP theft issue, which the Chinese deny while the US continues to maintain is the reality. I think the best case scenario is that the talks continue and that any tariff increases remain on hold for another 90 days to try to achieve a settlement. But I would not rule out the chance that the talks break down and that higher tariffs are put into place come March 2nd. If the former occurs, I expect equity markets to rally on hope, while the dollar comes under modest pressure. However, if they break down, equities will suffer around the world and I expect to see safe havens, including the dollar, rally.

Finally, to Brexit, where yesterday Parliament voted to have PM May go back and reopen negotiations but did not vote to prevent a no-deal Brexit. This is what May wanted, but it is not clear it will solve any problems. The EU has been adamant that they will not reopen negotiations on the deal, although they seem willing to discuss the ‘political’ issues like the nature and timing of the backstop deal regarding Ireland. At this point, it seems May is playing chicken with her own party, as well as Labour, and trying to force them to vote for the current deal as the best they can get. But with time running out and the requirement that a unanimous vote of the EU is needed in order to delay the timeline, the chance of a no-deal Brexit is certainly increasing. The pound suffered yesterday after the vote, falling about 1%, although this morning it has bounced 0.25% from those levels. It is very clear that the market has ascribed a diminishing probability to a no-deal Brexit, but hedgers need to be careful. That probability is definitely not zero! And if it does come about, the pound will fall very sharply very quickly. A 10% decline is not unreasonable under those circumstances.

Away from those stories, this morning brings us the ADP Employment report (exp 178K) and we cannot forget that NFP comes on Friday. Eurozone data was generally soft, as was Japanese data, but that has all become part of the new narrative of a temporary lull in the global economy before things pick up again when the big issues (trade and Brexit) are behind us. The risk is those issues don’t resolve in a positive manner, and the slowdown is not as temporary as hoped. If global growth keeps deteriorating, all ideas on monetary policy will need to be reconsidered, which will have a direct impact on views of the future of the dollar, equity markets and bonds. So far, things haven’t changed enough to bring that about, but beware a situation where economic data continues to slide.

Good luck
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I’m Not Thrilled

Said President Trump, “I’m not thrilled”
With how Chairman Powell’s fulfilled
Both job and price mandates
By raising Fed Fund rates
‘Cause soon the Dow Jones could get killed

“I’m not thrilled. I don’t like all of this work that we’re putting into the economy and then I see rates going up. I am not happy about it. But at the same time I’m letting them do what they feel is best.” So said President Trump in an interview on CNBC yesterday afternoon. It should be no surprise that the FX market response was immediate, with the dollar reversing earlier gains.

While this is not the first time that a US president has tried to persuade the Federal Reserve to cut rates (they never want higher rates, I assure you!), it is the first time since George H.W. Bush pushed then Chairman Greenspan to reduce rates more quickly in 1992 (he didn’t). This is a situation fraught with serious consequences as the independence of a nation’s central bank is seen as one of the keys to a developed economy’s success. For instance, recall just several weeks ago when Turkey’s President Erdogan essentially took over making monetary policy there, and how the market has behaved since, with TRY already significantly weaker.

As long as the Fed remains on course to continue raising rates, and despite the Trump comments, Fed Funds futures showed no change in the probability for two more rate hikes this year, I see little reason to change my stance on the dollar’s future strength. However, the bigger problem is if the Fed, independently, decides that slowing the pace of rate hikes is justified by the data, it could still appear to be politically motivated, and so reduce whatever credibility the Fed still maintains. This will remain a background story, at the very least, for a while. So far, there is no indication that Chairman Powell is going to change his stance, which means that policy divergence remains the lay of the land.

In the meantime, the other big FX story comes from China. We discussed yuan weakness yesterday and in the overnight session, the PBOC fixed the onshore currency at its weakest point in more than a year, which in fairness is simply following the dollar’s overall strength, but then when USDCNY made new highs for the year above 6.83, a large Chinese state-owned bank was seen aggressively selling dollars. This tacit intervention helped to steady the market and worked to support the Shanghai Stock Exchange as well, which ultimately rose 2.0% on the day. It is, however, difficult to follow all the twists and turns in the US-China relationship these days, as literally minutes ago, President Trump raised the ante yet again, by saying that he is “ready to go” with regard to imposing tariffs on $500 billion of Chinese goods. That represents all Chinese exports to the US and is considerably larger than ever mentioned before.

Tariffs and protectionism have a very poor history when it comes to enhancing any country’s economic situation, but it is very possible that this continuous ratcheting of pressure may actually be effective at achieving policy changes in this situation as China has plenty of domestically created economic problems already. Recall, President Xi has been on the warpath about excess leverage and the PBOC had been tightening policy in order to squeeze that out of the system. However, growth in China has suffered accordingly, and the recent data indicates that it may be slowing even more. With that in mind, a full-scale trade war with the US would likely be disastrous for China. The last thing they can afford is to see reduced production numbers, as well as loss of access to critical component and technology imports. It is not impossible that Xi blinks first, or that the two presidents recognize that a face-saving deal is in both their interests. It may take a little while, but I have a sense that could well be the outcome. However, until then, look for USDCNY to continue to rally sharply, with a move to 7.00 and beyond very viable. This morning, despite the intervention overnight, it has subsequently weakened 0.4% and shows no signs of stopping.

Finally, one last story has returned from the past to haunt markets, Italy. There appeared to be a push by Five-Star leader, Luigi di Maio, to have the Finmin, Giovanni Tria, removed from office. You may recall that back in May, things got very dicey in Italy before the current government was finally formed as President Mattarella rejected the first proposed cabinet because of the Euroskeptic proposed for the FinMin post. Tria was the compromise selection designed to calm markets down, and it worked. So, if he were forced out, and it has been denied by the Finance Ministry that is the situation, it could lead us right back into a euro area crisis. This is especially true since the populist coalition of the League and Five-Start has gained further strength in the interim. While Italian bond markets suffered on the news, it was not sufficient to impact the euro much. However, we need to keep an eye on this story as it could well resurface in a more malevolent manner.

And that is really today’s situation. Overall the dollar is mildly weaker, but given its performance all week, that has more to do with profit taking on a Friday than other news. Clearly the Trump comments undermined the dollar to some extent, but until policies are seen changing, I think that will only be a temporary situation. With no data due this morning, and no speakers on the agenda, it has all the feelings of a quiet day upcoming. It is, after all, a Friday in July, so the summer doldrums seem appropriate.

Good luck and good weekend
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Gone Terribly Wrong

Said Powell, the ‘conomy’s strong
And hence we’ll keep moving along
Our rate-raising path
Until the bond math
Proves that we’ve gone terribly wrong

The dollar responded by soaring
In markets no one would call boring
The question, of course
Is will the Fed force
The rest of the world to trade-warring?

The dollar is much stronger this morning after a combination of things helped underpin the current theme of the US economy leading global growth. Yesterday Chairman Powell was certainly upbeat, calling the US economy quite strong and indicating that the Fed, while not on autopilot, believes that their current path of gradual rate increases is the correct one. When pressed on how the current trade issues would impact the Fed’s actions, Powell demurred indicating that it was still too early to know what would occur. He did, however, highlight that historically nations that were open to trade fared better economically than those that chose a different, more protectionist path. After his testimony, the dollar turned in a solid performance rising 0.5% vs. the euro, 1.0% vs. the pound and 0.3% vs. the yen. The greenback’s strength was also evident in the emerging market space with USDCNY rising 0.3% by the end of the day. But that was yesterday and we are more interested in what is happening today.

The economic news of note this morning comes from the UK, where CPI failed to rise as expected and printed at 2.4%. The market’s immediate response was to sell the pound off further, another 0.7%, as futures markets reduced the probability that the BOE will raise rates next month. While that probability is still a touch over 70%; that is down 10 points from yesterday’s estimates. Obviously, despite the extremely low levels of interest rates in the UK (the base rate is 0.75%) and despite a continued robust employment picture, inflation in both wages and goods remains quiescent. In other words, the case for the August rate hike remains somewhat suspect, and that is before the discussion of the impact of Brexit. Speaking of Brexit, the Parliamentary maneuvers are apparently becoming quite rough as PM May is fighting to hold onto power. Apparently, though she won several key votes today, the tactics used resulted in some very hard feelings amongst MP’s on both sides of the aisle and could well result in less ability for the PM to continue in power going forward. In the end, given the recent data releases and the potential for Brexit to lead to a full-blown political crisis in the UK, it is still difficult for me to believe that the BOE moves next month. I feel like the combination of reaffirmation by the Fed and the disintegrating case in the UK means the pound is soon going to breach 1.30 and start to trade at much lower levels.

But it was not just the UK where inflation data disappointed, the EU also saw final CPI data for June released and the core number was revised downward to 0.9%, although the headline number of 2.0% was reaffirmed. While one data point will not be enough to change views, there is no question that Signor Draghi will have an increasingly difficult time remaining confident that inflation will be converging on the ECB’s target of ‘close to but below 2.0%.’ And remember, oil prices, which have been supporting the headline number, are now falling sharply, so it would not be surprising to see Eurozone CPI data print still lower next month. In the end, I continue to look for the euro to break its recent trading range to the downside. This morning has helped my cause with the euro declining a further 0.4% on top of yesterday’s fall.

But the story is similar everywhere in the world. Disappointing Chinese data has helped to twist the PBOC into tighter knots as they seek to reduce excess leverage in the economy while supporting growth. As I have highlighted time and again, the renminbi is going to be the relief valve for this process and is almost certain to head to 7.00. Of course, another key risk here is that President Xi decides that the only way to combat the mooted $200 billion of US tariffs is to actively weaken the currency, which would result in a much larger move, and likely one that was far less smooth. All I’m saying is that for those with CNY exposure, care must be taken. Paying the points to hedge here is, I believe, a very prudent step at this time.

Looking at today’s session, in addition to the second leg of Chairman Powell’s testimony, this time to the House Financial Services Committee, we see Housing Starts (exp 1.32M) and Building Permits (1.30M) at 8:30. However, all eyes will be on Powell to see if he has anything else to add to yesterday’s bullish sentiment. The data story continues to underpin my view that the dollar has further to run against all its counterparts. Today should not prove any different than yesterday.

Good luck
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The Beast of the East

This weekend the data released
By China showed growth had decreased
Investment has slowed
And that doesn’t bode
Too well for the Beast of the East

It has been a fairly quiet session overnight, as the weekend news cycle seems to have reverted back toward the summer doldrums of the past. While traders and investors remain on edge over the brewing trade conflict between the US and China, and how that may impact the rest of the world, the only actual news was Chinese data out last night.

It can be no surprise that the GDP figure, at 6.7%, was exactly as forecast [Woe betide the statistician in China who releases a GDP number less than President Xi declares], but it was somewhat surprising that both IP (6.0%) and Fixed Asset Investment (6.0%) were both released at levels softer than expected, and more importantly, at the softest levels in 15-20 years. Given that it is too early for the trade situation to have impacted the Chinese data, the most likely situation is that even the Chinese are beginning to recognize that growth on the mainland is set to slow further. In fairness, China has made a big deal about their pivot away from mercantilist policies to a more domestically focused economy, and given that Retail Sales (9.0%) were actually slightly firmer than expected, perhaps they are moving in that direction. However, unlike most developed countries, China’s domestic consumption is only around 50% of the economy (it is between 70% and 80% for OECD nations), and so that modestly better performance is not likely to be enough to maintain the growth trajectory that Xi wants over time.

In the end, though, there was only limited market reaction to the news, with Chinese equity markets slightly softer (Shanghai -0.25%) and the renminbi, though initially falling slightly, has since rebounded and is firmer by 0.3% as I type. Of course, in context, the dollar is softer across the board this morning with most major currencies appreciating by a similar amount.

Aside from the Chinese news, there was precious little of interest to drive trading. Oil prices have been sliding as Saudi Arabia has agreed to pump more oil and the US and other nations are considering tapping their strategic reserves in an effort to lower prices. Earnings season is underway with continued high hopes for US companies and less robust ones for the rest of the world. However, US equity futures are barely higher at this time, <0.1%, indicating a wait-and-see attitude has developed. And rounding things out, Treasury yields have edged higher by about 1bp although they remain well below levels seen back in May.

Pivoting to the data for the week, it is a mixed bag, with arguably the most important events Chairman Powell’s testimony to the Senate on Tuesday and House on Wednesday.

Today Empire Manufacturing 22
  Retail Sales 0.5%
  -ex autos 0.4%
  Business Inventories 0.4%
Tuesday Capacity Utilization 78.3%
  IP 0.6%
  Powell Testimony  
  TIC Flows $34.3B
Wednesday Housing Starts 1.32M
  Building Permits 1.333M
  Powell Testimony  
  Fed Beige Book  
Thursday Initial Claims 220K
  Philly Fed 22

However, we cannot ignore Retail Sales this morning, which is seen as a descriptor of the current economic situation. This has been one of the highlights of the economic story in the US, especially in the wake of the tax cuts and stimulus spending bills at the beginning of the year.

As long as growth in the US continues above its estimated long term trend (which is often pegged just below 2.0%), the Fed is going to continue to tighten policy via both rate hikes and a shrinking balance sheet, and the dollar should remain relatively well bid. While there is a case to be made that added fiscal stimulus at this stage in the economic cycle is a mistake (classical economics indicates tighter fiscal policy is warranted), there is no mistaking that the US economy remains the key engine of growth for the world, and that as the Fed tightens policy further, the dollar is set to benefit more.

Good luck
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