More Doubt He Is Sowing

In Beijing, the Chinese yuan
Fell sharply as it’s now been drawn
Into the trade fight
Much to the delight
Of bears, who had shorts layered on

For President Xi, though, the risk
Is money there exits the fisc
With growth there still slowing
More doubt he is sowing
So capital flight could be brisk

Things changed overnight as the PBOC fixed the renminbi below 6.90, much weaker than expected and then the currency fell sharply in subsequent trading in both the on-shore and offshore markets. As you will have no doubt seen, USDCNY is trading somewhere in the vicinity of 7.08 this morning, although the price has been quite volatile. While that represents a decline of more than 1.5% compared to Friday’s closing levels, the more important questions revolve around the PBOC’s new strategy going forward.

Recall, one of the reasons that there was a strong market belief in the sanctity of the 7.00 level was that four years ago, when the PBOC surprised markets with a mini-devaluation, locals took their cash and ran for the hills. Capital outflows were so great, in excess of $1 trillion, that the PBOC needed to institute strict new rules preventing further flight. That was a distinct loss of face for an institution that was trying to modernize and prove that it could manage things like G10 countries where capital flows more freely. Ever since, the assumption was that the Chinese population would get nervous if the renminbi weakened beyond that level and correspondingly, the PBOC would not allow that outcome to occur.

But that was then, in the days when trade was simply a talking point rather than the focus of policy. As the trade war intensifies, the Chinese have fewer tools with which to fight given the massive imbalance that exists. The result of this is that increases in US tariffs cannot be matched and so other weapons must be used, with changes in the exchange rate the most obvious. While the PBOC claims they can continue to manage the currency and maintain its stability, the one thing I have learned throughout my career is that markets have a way of abusing claims of that nature, at least for a while. Back in January I forecast USDCNY to reach 7.40 by the end of this year and, as of this morning, that seems quite realistic.

But the impact on markets is far greater than simply the USDCNY exchange rate. This has been the catalyst for a significant amount of risk-off behavior with equity markets throughout Asia (Nikkei -1.75%, Shanghai -1.6%, Hang Seng -2.85%) and Europe (DAX -1.85%, CAC -2.25%, FTSE -2.25%) sharply lower; Treasury (1.76%) and Bund (-0.51%) yields sharply lower, the Japanese yen (+0.6%) and Swiss franc (+0.75%) both sharply higher and most emerging market currencies (e.g. MXN -1.5%, INR -1.4%, ZAR -1.2%, KRW -0.9%) falling alongside the renminbi. It should be no surprise that gold is higher by 1.0%, to a 6-year high, as well this morning and oil prices (-1.1%) are falling amid concerns of waning demand from the slowing global growth story.

So, what’s a hedger to do? The first thing to consider is whether these moves are temporary fluctuations that will quickly be reversed, or the start of longer-term trends. Given the imbalances that have been building within markets for the past decade and given that central banks have a greatly reduced set of monetary tools with which to manage things, despite their comments otherwise, this could well be the tipping point where markets start to unwind significant positions. After all, the one thing that truly underpinned gains in both equity and bond markets, especially corporate and high-yield bond markets, was confidence that regardless of fiscal policy failures, the central banks would be able to maintain a level of stability.

However, this morning that belief seems a little less secure. It will not take much for investors to decide that, ‘it’s been a good run and now might be a good time to take some money off the table’, at least figuratively. Last week saw equity markets suffer their worst week of the year and this week is not starting any better. Yes, the Fed has room to cut rates further, but will 200bps be enough to stop a global recession? Arguably, that’s the question that needs to be answered. From where I sit, that answer is no, but then I am a cynic. Of course, that cynicism is born of a long career in financial markets.

Thus, my take is that there is further to run in most of these currencies, and that assuming a quick reversion would be a mistake. While option prices are clearly higher this morning than last week, they remain low by historic standards and should be considered for their value in uncertain times. Just sayin’.

What else does this week have to offer? Well, the US data set is not that substantial, but we do hear from a number of Fed speakers, which given last week’s confusion will be extremely important and closely watched. There are also a number of foreign central bank meetings that will be interesting regarding their rate maneuvers.

Today ISM Non-Manufacturing 55.5
Tuesday JOLT’s Job Openings 7.317M
Wednesday RBNZ Rate Decision 1.25% (25bp cut)
  RBI Rate Decision 5.50% (25bpcut)
  Consumer Credit $16.0B
Thursday Philippine Rate Decision 4.25% (25bp cut)
  Initial Claims 215K
Friday PPI 0.2% (1.7% Y/Y)
  -ex food & energy 0.2% (2.4% Y/Y)

We also hear from three dovish Fed speakers; Brainerd, Bullard and Evans, who are likely to give more reasons for further rate cuts, especially if markets continue to fall. As to the three central banks with decisions to make, they find themselves in a difficult place. All three are extremely concerned about their currencies’ value and don’t want to exert further downward pressure on them, yet all three are facing slowing economies and need to do something to boost demand. In fact, this is going to be the central bank conundrum for some time to come across both developing and G10 countries as they try to continually manage the impossible trilateral of exchange rates, interest rates and growth.

All of this adds up to yet more reasons for higher volatility across all asset classes in the near future. It appears that these are the first cracks in the old economic order, and there is no way to know how everything will play out going forward. As long as risk is being jettisoned though, Treasuries, the yen, the Swiss franc and the dollar will see demand. Keep that in mind as you manage your risks.

Good luck
Adf

Shocked and Surprised

Delivering just twenty-five
Did not satisfy Donald’s drive
To boost US growth
So he made an oath
That tariffs he’d quickly revive

Investors were shocked and surprised
As trade talks had seemed civilized
Thus stocks quickly fell
And yields did as well
Seems risk assets are now despised

Just when you thought it was safe to go back in the water…

Obviously, the big news yesterday was President Trump’s decision to impose a 10% tariff on the remaining $300 billion of Chinese imports starting September 1st. Arguably, this was driven by two things; first was the fact that he has been increasingly frustrated with the Chinese slow-walking the trade discussions and wants to push that along faster. Second is he realizes that if he escalates the trade threats, the Fed may be forced to cut rates further and more quickly. After all, one of their stated reasons for cutting rates Wednesday was the uncertainty over global growth and trade. That situation just got more uncertain. So in President Trump’s calculation, he addresses two key issues with one action.

Not surprisingly, given the shocking nature of the move, something that not a single analyst had been forecasting, there was a significant market reaction. Risk was quickly jettisoned as US equity markets turned around and fell 1% on the day after having been higher by a similar amount in the morning. Asian equity markets saw falls of between 1.5% and 2.0% and Europe is being hit even harder, with a number of markets (DAX, CAC) down more than 2.5%. But even more impressive was the decline in Treasury yields, which saw a 12bp fall in the 10-year and a 14bp fall in the 2-year. Those are the largest single day declines since May 2018, and the 10-year is now at its lowest level since October 2016. Of course, it wasn’t just Treasuries that rallied. Bund yields fell to a new record low of -0.498%, and we have seen similar declines throughout the developed markets. For example, Swiss 10-year yields are now -0.90%, having fallen 9bps and are the lowest in the world by far! In fact, the entire Swiss government yield curve is negative!

And in the FX market, haven number one, JPY rallied sharply. After weakening early in the session, it rebounded 1.7% yesterday and is stronger by a further 0.5% this morning. This has taken the yen back to its strongest level since April last year. Not surprisingly the Swiss franc saw similar price action and is now more than 1.0% stronger than yesterday. However, those are not the only currencies that saw movement, not by a long shot. For example, CNY has fallen 0.9% since the announcement and is now within spitting distance of the key 7.00 level. Significant concern remains in the market about that level as the last time the renminbi was that weak, it led to significant capital outflows and forced the PBOC to adjust policy and impose restrictions. However, there are many analysts who believe it is seen as less of a concern right now, and of course, a weaker renminbi will help offset the impact of US tariffs.

Commodity prices were also jolted, with oil tumbling 7% and oil related currencies feeling the brunt of that move. For example, RUB is lower by 1.2% this morning after a 0.5% fall yesterday. MXN is lower by a further 0.3% this morning after a 0.6% decline yesterday and even NOK, despite its G10 status, is lower by 1.0% since the tariff story hit the tape. In fact, looking at the broad dollar, it is actually little changed as there has been significant movement in both directions as traders and investors adjust their risk profiles.

With that as a prelude, we get one more key piece of data this morning, the payroll report. Current expectations are as follows:

Nonfarm Payrolls 164K
Private Payrolls 160K
Manufacturing Payrolls 5K
Unemployment Rate 3.6%
Average Hourly Earnings 0.2% (3.1% Y/Y)
Average Weekly Hours 34.4
Trade Balance -$54.6B
Michigan Sentiment 90.3

You can see the bind in which the Fed finds itself. The employment situation remains quite robust, with the Unemployment Rate expected to tick back to 50-year lows and steady growth in employment. This is hardly a classic set of statistics to drive a rate cut. But with the escalation of the trade situation, something they specifically highlighted on Wednesday, they are going to need to address that or lose even more credibility (although it’s not clear how much they have left to lose!) In a funny way, I would wager that Chairman Powell is secretly rooting for a weak number this morning which would allow further justification for rate cuts and correspondingly allow him to save some face.

In the end, the key to remember is that markets are beholden to many different forces with the data merely one of those, and increasingly a less and less important one. While historically, the US has generally allowed most market activity without interference, there has clearly been a change of heart since President Trump’s election. His increased focus on both the stock market and the dollar are something new, and we still don’t know the extent of the impact this will have over time. While volatility overall has been relatively low, it appears that is set to change with this increased focus. Hedgers keep that in mind as programs are implemented. All of this untested monetary policy is almost certainly building up problems for the future, and those problems will not be easily addressed by the central banks. So, my sense is that we could see a lot more volatility ahead.

In the meantime, today has the sense of a ‘bad news is good’ for stocks and vice versa as equity investors will be looking for confirmation that more rate cuts are on the way. As to the dollar, bad news will be bad!

Good luck and good weekend
Adf

A Bad Dream

According to pundits’ new theme
December was just a bad dream
Though Europe’s a mess
And China feels stress
The fallout was way too extreme

The thing is, the data of late
Worldwide has not really been great
The only thing growing
Is debt which is sowing
The seeds of a troubled debate

The dollar has been edging higher over the past several sessions which actually seems a bit incongruous based on other market movements. Equity investors continue to see a glass not half full, but overflowing. Bond yields are edging higher in sync with those moves as risk is being acquired ‘before it’s too late’. But the dollar, despite the Fed’s virtual assurance that we have seen the last of the rate hikes, has been climbing against most counterparts for the past two sessions.

Some of this is clearly because we are getting consistently bad economic data from other countries. For example, last night saw Services PMI data from around the world. In France, the index fell to 47.8, its worst showing in five years. German data printed a slightly worse than expected 53.0, while the Eurozone as a whole remained unchanged at 51.2 It should be no surprise that Italy, which is currently in recession, saw its number fall below 50 as well, down to 49.7. Thus, while Brexit swirls on in the background, the Eurozone economy is showing every sign of sliding toward ever slower growth and inflation. As I have been repeating for months, the ECB will not be tightening policy further. And as the Brexit deadline approaches, you can be sure that the EU will begin to make more concessions given the growing domestic pressure that already exists due to the weakening economy. Net, the euro has decline 0.2% this morning, and is ebbing back to the level seen before the Fed capitulated.

Speaking of Brexit, the UK Services PMI data fell to 50.1, its worst showing in two- and one-half years, simply highlighting the issues extant there. PM May’s strategy continues to consist of trying to renegotiate based on Parliament’s direction, but the EU continues to insist it cannot be done. While very few seem to want a hard Brexit, there has been very little accomplished of late that seems likely to prevent it. And the pound? It has fallen a further 0.2% and is trading back just above 1.30, its lowest level in two weeks and indicative of the fact that the certainty about a deal getting done, or at the very least a delay in any decision, is starting to erode.

With the Lunar New Year continuing in Asia, there is no new news on the trade front, just the ongoing impact of the tariffs playing out in earnings releases and economic reports. But this story is likely to be static until the mooted meeting between the two presidents later this month. My observation is that the market has priced in a great deal of certainty that a deal will be agreed and that the tariff regime will end. Quite frankly, that seems very optimistic to me, and I think there is a very real chance that things deteriorate further, despite the incentives on both sides to solve the problem. The issue is that the US’s trade concerns strike at the very heart of the Chinese economic model, and those will not be easily changed.

Elsewhere, the yen has been falling modestly of late, which is not surprising given the recent risk-on sentiment in markets, but the Japanese economy has not shown any signs that the key concern over inflation, or lack thereof, has been addressed. During December’s equity meltdown, the yen rallied ~4.5%. Since then, it has rebound about half way, and in truth, since equity markets stabilized in the middle of January, the yen has been in a tight trading range. At this point, given the complete lack of ability by the BOJ to impact its value based on monetary policy settings, and given the strong belief that it represents a safe haven in times of trouble (which is certainly true for Japanese investors), the yen is completely beholden to the market risk narrative going forward. As long as risk is embraced, the yen is likely to edge lower. But on risk off days, look for it to rebound sharply.

And that’s really all we have for today. This evening’s State of the Union address by President Trump has the potential to move markets given the contentious nature of his current relationship with the House of Representatives. There is growing talk of another Federal government shutdown in two weeks’ time, although as far as the FX market was concerned, I would say the last one had little impact. Arguably, the dollar’s weakness during that period was directly a result of the change in Fed rhetoric, not a temporary interruption of government services.

At 10:00 this morning the ISM Non-Manufacturing data is released (exp 57.2), which while softer than last month remains considerably higher than its European and Chinese counterparts. Overall, as markets continue to reflect an optimistic attitude, I would expect that any further dollar strength is limited, but in the event that fear returns, the dollar should be in great demand. However, that doesn’t seem likely for today.

Good luck
Adf

A Statement, Acute

The company named for a fruit
Explained in a statement, acute
Though services grew
Its gross revenue
Was destined, not to follow suit

The impact ‘cross markets was vast
As traders, most havens, amassed
Thus Treasuries jumped
The dollar was dumped
While yen demand was unsurpassed

Happy New Year to all my readers. I hope it is a successful and prosperous 2019 for everyone.

But boy, has it gotten off to a rough start! Since I last wrote on December 14, volatility across markets has done nothing but increase as fear continues to pervade both the investor and trader communities. While some pundits point to the trade war and/or the US government shutdown, what has been apparent to me for the past several months is that central banking efforts around the world to normalize policy have begun to take their toll on economic activity and by extension on markets that have become completely dependent on that monetary buffer.

Ten years of extraordinary monetary support by central banks around the world has changed the way markets behave at a fundamental level. The dramatic increase in computer driven, algorithmic trading across markets, as well as passive investing and implicitly short volatility strategies has relegated fundamental analysis to the dust heap of history. Or so it seems. The problem with this situation is that when conditions change, meaning liquidity is no longer being continually added to markets, all those strategies suffer. It will be interesting to watch just how long the world’s central banks, who are desperately trying to normalize monetary policy before the next economic downturn, are able to continue on their present path before the pressure of slowing growth forces a reversion to ‘free’ money for all. (Despite all their claims of independence, I expect that before the summer comes, tighter monetary policy will be a historical footnote.)

In the meantime, last night’s volatility was triggered when a certain mega cap consumer electronics firm explained to investors that its sales in China would be much weaker than previously forecast. Blaming the outcome on a slowing Chinese economy, management tried to highlight growth elsewhere, but all for naught. The market response was immediate, with equity markets falling sharply, including futures in both Europe and the US, and the FX markets picking up where last year’s volatility left off. Notably, with Tokyo still on holiday, the yen exploded more 3.5% vs. the dollar during the twilight hours between New York’s close and Singapore’s open, trading to levels not seen since last March. While it has given back a large portion of those gains, it remains higher by 1.2% in the session, and is more than 5% stronger than when I last wrote. If ever there was a signal that fear continues to pervade markets, the yen’s performance over the past three weeks is surely that signal.

Speaking of slowing Chinese growth, the recent PMI data from China printed below that critical 50.0 level at a weaker than expected 49.4, simply confirming the fears of many. What has become quite clear is that thus far, the trade dispute is having a much more measurable negative impact on China’s economy than on the US economy. This has prompted the PBOC to ease policy further overnight, expanding the definition of a small company to encourage more lending to that sector. Banks there that increase their loans to SME’s will see their reserve requirements reduced by up to a full percentage point going forward. (One thing that is very clear is there is no pretense of independence by the PBOC, it is a wholly owned operation of the Chinese government and President Xi!) I guess China is the first central bank to back away from policy normalization as the PBOC’s previous efforts to wring excess leverage out of the system are now overwhelmed by trying to add back that leverage! Look for the ECB to crack soon, and the Fed not far behind.

And while the rest of the FX market saw some pretty fair activity, this was clearly the key story driving activity. The funny thing about the euro is that there are mixed views as to whether the euro or the dollar is a better safe haven, which means that in risk-off scenarios like we saw last night, EURUSD tends not to move very far. Arguably, its future will be determined by which of the two central banks capitulates to weaker data first. (My money continues to be on the ECB).

This week is a short one, but we still have much data to come, including the NFP report tomorrow. So here is a quick update of what to expect today and tomorrow:

Today ADP Employment 178K
  Initial Claims 220K
  ISM Manufacturing 57.9
  ISM Prices Paid 58.0
Friday Nonfarm Payrolls 177K
  Private Payrolls 175K
  Manufacturing Payrolls 20K
  Unemployment Rate 3.7%
  Average Hourly Earnings 0.3% (3.0% Y/Y)
  Average Weekly Hours 34.5

Tomorrow we also hear from Fed Chair Powell, as well as two other speakers (Bullard and Barkin) and then Saturday, Philly Fed President Harker speaks. At this point, all eyes will be on the Chairman tomorrow as market participants are desperate to understand if the Fed’s reaction function to data is set to change, or if they remain committed to their current policy course. One thing that is certain is if the Fed slows or stops the balance sheet shrinkage, equity markets around the world will rally sharply, the dollar and the yen will fall and risky assets, in general, should all benefit with havens under pressure. At least initially. But don’t be surprised if the central banks have lost the ability to drive markets in their preferred long-term direction, even when explicitly trying to do so!

Good luck
Adf

More Trouble is Brewing

The PMI data last night
From China highlighted their plight
More trouble is brewing
While Xi keeps pursuing
The policies to get things right

Any questions about whether the trade conflict between the US and China was having an impact on the Chinese economy were answered last night when the latest PMI readings were released. The Manufacturing PMI fell to 50.2, it’s lowest level in more than two years and barely above the expansion/contraction level of 50.0. Even more disconcertingly for the Chinese, a number of the sub-indices notably export sales and employment, fell further below that 50.0 level (to 46.9 and 48.1 respectively), pointing to a limited probability of a rebound any time soon. At the same time, the Services PMI was also released lower than expected, falling to 53.9, its lowest level since last summer. Here, too, export orders and employment numbers fell (to 47.8 and 48.9 respectively), indicating that the economic weakness is quite broad based.

Summing up, it seems safe to say that growth in China continues to slow. One question I have is how is it possible that when the Chinese release their GDP estimates, the quarter-to-quarter movement is restricted to 0.1% increments? After all, elsewhere in the world, despite much lower headline numbers (remember China is allegedly growing at 6.5% while Europe is growing at 2.0% and the US at 3.5%), the month-to-month variability is much greater. Simple probability would anticipate that the variance in China’s data would be higher than in the rest of the world. My point is that, as in most things to do with China, we don’t really know what is happening there other than what they tell us and that is like relying on a pharmaceutical salesman to prescribe your medicine. There are several independent attempts ongoing to get a more accurate reading of GDP growth in China, with measures of electricity utilization or copper imports seen as key data that is difficult to manipulate, but they all remain incomplete. And it seems highly unlikely that President Xi, who has been focused on improving the economic lot of his country, will ever admit that the growth figures are being manipulated. But I remain skeptical of pretty much all the data that they provide.

At any rate, the impact on the renminbi continues to be modestly negative, with the dollar touching another new high for the move, just below 6.9800, in the overnight session. This very gradual weakening trend seems to be the PBOC’s plan for now, perhaps in order to make a move through 7.00 appear less frightening if it happens very slowly. I expect that it will continue for the foreseeable future especially as long as the Fed remains on track to tighten policy further while the PBOC searches for more ways to ease policy without actually cutting interest rates. Look for another reserve requirement ratio cut before the end of the year as well as a 7 handle on USDCNY.

Turning to the euro, data this morning showed that Signor Draghi has a bit of a challenge ahead of him. Eurozone inflation rose to 2.2% with the core reading rising to 1.1%, both slightly firmer than expected. The difference continues to be driven by energy prices, but the concern comes from the fact that GDP growth in the Eurozone slowed more than expected last quarter. Facing a situation where growth is slowing and inflation rising is every central banker’s nightmare scenario, as the traditional remedies for each are exactly opposite policies. And while the fluctuations are hardly the stuff of a disaster, the implication is that Europe may be reaching its growth potential at a time when interest rates remain negative and QE is still extant. The risk is that the removal of those policies will drive the Eurozone back into a much slower growth scenario, if not a recession, while inflation continues to creep higher. It is data of this nature, as well as the ongoing political dramas, that inform my views that the ECB will maintain easier policy for far longer than the market currently believes. And this is why I remain bearish on the euro.

Yesterday the pound managed to trade to its lowest level since the post-Brexit vote period, but it has bounced a bit this morning, +0.35%. That said, the trend remains lower for the pound. We are now exactly five months away from Brexit and there is still no resolution for the Irish border issue. Every day that passes increases the risk that there will be no deal, which will certainly have a decidedly negative impact on the UK economy and the pound by extension. Remember, too, that even if the negotiators agree a deal, it still must be ratified by 28 separate parliaments, which will be no easy task in the space of a few months. As long as this is the trajectory, the risk of a sharp decline in the pound remains quite real. Hedgers take note.

Elsewhere, the BOJ met last night and left policy unchanged as they remain no closer to achieving their 2.0% inflation goal today than they were five years ago when they started this process. However, the market has become quite accustomed to the process and as such, the yen is unchanged this morning. At this time, yen movement will be dictated by the interplay between risk scenarios and the Fed’s rate hike trajectory. Yen remains a haven asset, and in periods of extreme market stress is likely to perform well, but at the same time, as the interest rate differential increasingly favors the dollar, yen strength is likely to be moderated. In other words, it is hard to make a case for a large move in either direction in the near term.

Away from those three currencies, the dollar appears generally firmer, but movement has not been large. Turning to the data front, yesterday’s releases showed that home prices continue to ebb slightly in the US while Consumer Confidence remains high. This morning brings the first inklings of the employment situation with the ADP report (exp 189K) and then Chicago PMI (60.0) coming at 9:45. Equity futures are pointing higher as the market looks to build on yesterday’s modest rally. All the talk remains about how October has been the worst month in equity markets all year, but in the broad scheme of things, I would contend that, at least in the US, prices remain elevated compared to traditional valuation benchmarks like P/E ratios. At any rate, it seems unlikely that either of today’s data points will drive much FX activity, meaning that the big trend of a higher dollar is likely to dominate, albeit in a gradual fashion.

Good luck
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For How Long?

The US economy’s strong
Denial of this would be wrong
It’s not too surprising
That rates will be rising
The question is just, for how long?

Despite the Trump administration’s recent discussion of imposing 25% tariffs on $200 billion of Chinese imports, rather than the 10% initially mooted, the Fed looked at the economic landscape and concluded that things continue apace. While they didn’t adjust rates yesterday, as was universally expected, the policy statement was quite positive, highlighting the strength in both economic growth and the labor market, while pointing out that inflation is at their objective of 2.0%. Market expectations for a September rate hike increased slightly, with futures traders now pricing in a nearly 90% probability. More interestingly, despite the increased trade rhetoric, those same traders have increased their expectations for a December hike as well, with that number now hovering near 70%. At this point, despite President Trump’s swipe at higher rates last week, it appears that the Fed is continuing to blaze its rate-hiking path undeterred.

The consequences of the Fed’s stance are starting to play out more clearly now, with the dollar once again benefitting from expectations of higher short term rates, and equity markets around the world, but especially in APAC, feeling the heat. The chain of events continues in the following manner. Higher US rates have led to a stronger US dollar, especially vs. many emerging market currencies. The companies in those countries impacted are those that borrowed heavily in USD over the past ten years when US rates were near zero. They now find themselves struggling to repay and refinance that debt. Repayment is impacted because their local revenues buy fewer dollars while refinancing is impacted by the fact that US rates are that much higher. With this cycle in mind, it should not be surprising that equity markets elsewhere in the world are struggling. And those struggles don’t even include the potential knock-on effects of further US tariff increases. Quite frankly, it appears that this trend has further to run.

Meanwhile, the week’s central bank meetings are coming to a close with this morning’s BOE decision, where they are widely touted to raise the Base rate by 25bps, up to 0.75%. It is actually quite amusing to read some of the UK headlines talking about the BOE raising rates to the ‘highest in a decade’, which while strictly true, seems to imply so much more than the reality of still exceptionally low interest rates. However, given the ongoing uncertainty due to the Brexit situation, I continue to believe that Governor Carney is extremely unlikely to raise rates again this year, and if we are headed to a ‘no-deal’ Brexit, which I believe is increasingly likely, UK rates will head back lower again. Early this morning the UK Construction PMI data printed at a better than expected 55.8, its highest since late 2016, but despite the strong data and rate expectations, the pound has fallen 0.35% on the day.

Other currency movement has been similar, with the euro down 0.35%, Aussie and Kiwi both falling more than 0.5% and every other G10 currency, save the yen declining. The yen has rallied slightly, 0.2%, as interest rates in Japan continue to respond to Tuesday’s BOJ policy tweaks. JGB’s seem to have quickly found a new home above the old 0.10% ceiling, and there is now a growing expectation that as the 10-year yield there approaches the new 0.2% cap, the longer end of the JGB curve will rise with it taking the 30-year JGB to 1.00%. While that may not seem like much to the naked eye, when considering the nature of international flows, it is potentially quite important. The reason stems from the fact that Japanese institutional investors tend to hedge the FX exposure that comes from foreign fixed income purchases thus reducing their net yield from the higher rates received overseas to something on the order of 1.0%. And if the Japanese 30-year reaches that 1.0% threshold (it is currently yielding 0.83%), there is a growing expectation that those same investors will sell Treasuries and other bonds and bring the money home. That will have two impacts. First, I would be far less concerned over an inverting yield curve in the US as yields across the back end of the US curve would rise on those sales, and second, the dollar would likely rally overall on higher rates, but decline further against the yen. These are the type of background flows that impact the FX market, but may not be obvious to most hedgers.

Turning to the emerging markets, the dollar is firmer against virtually all of these currencies as well. One of the biggest movers has been CNY, falling 0.5% and now trading at its weakest level since May 2017. The renminbi’s decline has been impressive since mid-April, clocking in at nearly 9%, and clearly offsetting some of the impact of the recent tariffs. But remember, the renminbi’s decline began well before any tariffs were in place, and has as much to do with a slowing Chinese economy forcing monetary policy ease in China as with the recent trade spat. At this point, capital outflows have not yet become a problem there, but if history is any guide, as we get closer to 7.00, we are likely to see more pressure on the system as both individuals and companies seek to get their money out of China and into a stronger currency. I expect that there are more fireworks in store here.

Aside from China, the usual suspects continue to fall, with TRY having blasted through 5.00 overnight and now down 1.5% on the day. But we have also seen significant weakness in ZAR (-1.75%), KRW (-1.15%), and MXN (-0.75%). Even INR is down 0.5% despite the RBI having raised rates 0.25% overnight to try to rein in rising inflation pressures there. So today’ story is clear, the dollar remains in the ascendancy on the back of optimism in the US vs. increasing pessimism elsewhere in the world.

A quick peek at today’s data shows that aside from the weekly Initial Claims (exp 220K) we see only Factory Orders (0.7%). Yesterday’s ADP Employment data was quite strong, rising 219K, while the ISM Manufacturing report fell to a still robust 58.1, albeit a larger fall than expected. However, given the Fed’s upbeat outlook, the market was able to shake off the news. At this point, however, I expect that eyes are turning toward tomorrow’s NFP report, which will be seen as taking a much more accurate reading on the economy. All in all, I see no reason for the dollar to give back its recent gains, and in fact, expect that modest further strength is in the cards.

Good luck
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Percent Twenty-Five

The story, once more’s about trade
As Trump, a new threat, has conveyed
Percent twenty-five
This fall may arrive
Lest progress in trade talks is made

President Trump shook things up yesterday by threatening 25% tariffs on $200 billion of Chinese imports unless a trade deal can be reached. This is up from the initial discussion of a 10% tariff on those goods, and would almost certainly have a larger negative impact on GDP growth while pushing inflation higher in both the US and China, and by extension the rest of the world. It appears that the combination of strong US growth and already weakening Chinese growth, has led the President to believe he is in a stronger position to obtain a better deal. Not surprisingly the Chinese weren’t amused, loudly claiming they would not be blackmailed. In the background, it appears that efforts to restart trade talks between the two nations have thus far been unsuccessful, although those efforts continue.

Clearly, this is not good news for the global economy, nor is it good news for financial markets, which have no way to determine just how big an impact trade ructions are going to have on equities, currencies, commodities and interest rates. In other words, things are likely more uncertain now than in more ‘normal’ times. And that means that market volatility across markets is likely to increase. After all, not only is there the potential for greater surprises, but the uncertainty prevailing has reduced liquidity overall as many investors and traders hew to the sidelines until they have a better idea of what to do. And, of course, it is August 1st, a period where summer vacations leave trading desks with reduced staffing levels and so liquidity is generally less robust in any event.

Moving past trade brings us straight to the central bank story, where the relative hawkishness or dovishnes of yesterday’s BOJ announcement continues to be debated. There are those who believe it was a stealth tightening, allowing higher 10-year yields (JGB yields rose 8bps last night to their highest level in more than 18 months) and cutting in half the amount of reserves subject to earning -0.10%. And there are those who believe the increased flexibility and addition of forward guidance are signals that the BOJ is keen to ease further. Yesterday’s price action in USDJPY clearly favored the doves, as the yen fell a solid 0.8% in the session. But there has been no follow-through this morning.

As to the other G10 currencies, the dollar is modestly firmer against most of them this morning in the wake of PMI data from around the world showing that the overall growth picture remains mixed, but more troubling, the trend appears to be continuing toward slower growth.

The emerging market picture is similar, with the dollar performing reasonably well this morning, although, here too, there are few outliers. The most notable is KRW, which has fallen 0.75% overnight despite strong trade data as inflation unexpectedly fell and views of an additional rate hike by the BOK dimmed. However, beyond that, modest dollar strength was the general rule.

At this point in the session, the focus will turn to some US data including; ADP Employment (exp 185K), ISM Manufacturing (59.5) and its Prices Paid indicator (75.8), before the 2:00pm release of the FOMC statement as the Fed concludes its two day meeting. As there is no press conference, and the Fed has not made any changes to policy without a press conference following the meeting in years, I think it is safe to say there is a vanishingly small probability that anything new will come from the meeting. The statement will be heavily parsed, but given that we heard from Chairman Powell just two weeks ago, and the biggest data point, Q2 GDP, was released right on expectations, it seems unlikely that they will make any substantive changes.

It feels far more likely that this meeting will have been focused on technical questions about how future Fed policies will be enacted. Consider that QE has completely warped the old framework, where the Fed would actually adjust reserves in order to drive interest rates. Now, however, given the trillions of dollars of excess reserves, they can no longer use that strategy. The question that has been raised is will they try to go back to the old way, or is the new, much larger balance sheet going to remain with us forever. For hard money advocates, I fear the answer will not be to their liking, as it appears increasingly likely that QE is with us to stay. Of course, since this is a global phenomenon, I expect the impact on the relative value of any one currency is likely to be muted. After all, if everybody has changed the way they manage their economy in the same manner, then relative values are unlikely to change.

Flash, ADP Employment prints at a better than expected 219K, but the initial dollar impact is limited. Friday’s NFP report is of far more interest, but for today, all eyes will wait for the Fed. I expect very limited movement in the dollar ahead of then, and afterwards to be truthful.

Good luck
Adf