Called Into Question

A key market gauge of recession,
The yield curve, has called into question
Growth’s pace up ahead
And whether the Fed
Will restart financial repression

While markets this morning have stopped falling, there is no question that investors are on heightened alert. Yesterday saw further declines in the major stock indices and a continuation of the dollar’s rally alongside demand for Treasuries and Bunds. Today’s pause is hardly enough to change the predominant current view which can best be summed up as, AAAAGGGHHHH!

In the Treasury market, 10-year yields reached their steepest inversion vs. 3-month yields, 14bps, since 2007. While many pundits and analysts focus on the 2-year vs. 10-year spread, which remains slightly positive, the Fed itself has published research showing the 3-month vs. 10-year spread is a better indicator of future recessions. So the combination of fears over a drawn out trade war between the US and China and ongoing uncertainty in Europe given the Brexit drama and the uptick in tensions between Italy and the European Commission regarding Italy’s mooted budget, have been enough to send many investors hunting for the safest assets they can find. In this classic risk-off scenario, the fact that the dollar and the yen remain the currencies of choice is no surprise.

But let’s unpack the stories to see if the fear is warranted. On the trade front, every indication of late is that both sides are preparing for a much longer conflict. Just this morning China halted all imports of US soybeans. The other chatter of note is the idea that the Chinese may soon halt shipments of rare-earth metals to US industry, an act that would have significant negative consequences for the US manufacturing capability in the technology and aerospace industries. Of course, the US ban on Huawei and its increased pressure to prevent any allies from buying their equipment strikes at the heart of China’s attempts to move up the value chain in manufacturing. All told, until the G20 meeting in about a month’s time, I cannot foresee any thaw in this battle, and so expect continued negative consequences for the market.

As to Brexit, given the timing is that there won’t be a new Prime Minister until September, it seems that very little will happen in this arena. After all, Boris Johnson is already the favorite and is on record as saying a hard Brexit suits him just fine. While my personal view is that the probability of that outcome is more than 30%, I am in the minority. In fact, I would argue the analyst community, although not yet the market, is coalescing around the idea that no Brexit at all has become the most likely outcome. We have heard more and more MP’s talk about a willingness to hold a second referendum and current polls show Remain well ahead in that event. Of course, the FX market has not embraced that view as evidenced by the fact the pound remains within spitting distance of its lowest levels in more than two years.

Finally, the resurrection of the Italy story is the newest addition to the market’s menu of pain, and this one seems like it has more legs. Remarkably, the European Commission, headed by Jean-Claude Juncker, is demanding that Italy reduce its fiscal spending by 1.5% of GDP despite the fact that it is just emerging from a recession and growth this year is forecast to be only 0.3%. This is remarkable given the Keynesian bent of almost all global policymakers. Meanwhile, Matteo Salvini, the leader of the League whose power is growing after his party had a very strong showing in last week’s EU elections, has categorically rejected that policy prescription.

But of more interest is the fact that the Italian Treasury is back to discussing the issuance of ‘minibots’ which are essentially short-term Italian notes used by the government to pay contractors, and which will be able to trade in the market as a parallel currency to the euro. While they will be completely domestic, they represent a grave threat to the sanctity of the single currency and will not be lightly tolerated by the ECB or any other Eurozone government. And yet, it is not clear what the rest of Europe can do to stop things. The threat of a fine is ludicrous, especially given that Italy’s budget deficit is forecast to be smaller than France’s, where no threats have been made. The thing is, introduction of a parallel currency is a step into the unknown, and one that, in the short-term, is likely to weigh on the euro significantly. However, longer term, if Italy, which is generally perceived as one of the weaker links in the Eurozone, were to leave, perhaps that would strengthen the remaining bloc on a macroeconomic basis and the euro with it.

With that as background, it is no surprise that investors have been shunning risk. While this morning markets are rebounding slightly, with equity indices higher by a few tenths of a percent and Treasury yields higher by 3bps, the trend remains firmly in the direction of less risk not more.

The final question to be asked is, how will the Fed respond to this widening array of economic issues? Arguably, they will continue to focus on the US story, which while slowing, remains the least problematic of the major economies. At least that has been the case thus far. But today we have the opportunity to change things. Data this morning includes the first revision of Q1 GDP (exp 3.1%) as well as Initial Claims (215K) and the Goods Trade Balance (-$72.0B) at 8:30. There are concerns that the Q1 data falls below 3.0% which would not only be politically inconvenient, but perhaps a harbinger of a faster slowdown in Q2. Then, throughout the next week we get a significant run of data culminating in the payroll report next Friday. So, for now, the Fed is going to be watching closely, as will all market participants.

The predominant view remains that growth around the world is slowing and that the next easing cycle is imminent (fed funds futures are pricing in 3 rate cuts by the end of 2020!) However, Fed commentary has not backed up that view as yet. We will need to see the data to have a better idea, but for now, with risk still being shunned, the dollar should remain bid overall.

Good luck
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Uncertainty Reigns

Concerns over trade still remain,
For bullish investors, a bane
They want to believe
That Trump will achieve
His goals, so investments can gain

But right now uncertainty reigns
Resulting in stock market pains
When risk is reduced
Then bonds get a boost
While euros and pounds feel the strains

The one thing we know for sure is that the trade situation continues to be a major topic on investor minds, whether those investors are of the equity or fixed income persuasion. Despite the ostensible good news that Chinese vice-premier Liu He would still be coming to Washington later this week to continue the trade talks with Mnuchin and Lighthizer, it seems the market has become a bit less convinced that a deal is coming soon. As I have written several times over the past few weeks, it seems clear the market had fully priced in a successful completion of the trade talks and an (eventual) end to tariffs. But the President’s tweets on Sunday has caused a serious reconsideration of that pricing. Arguably, the 2% decline we have seen in US equity indices over the past two sessions is not nearly enough to offset the full risk, but it is a start. Ironically, I think the constant reiteration by financial heavyweights like Christine Lagarde and Mario Draghi, of how important it is to avoid a trade war, has set up a situation where in the event no deal is reached, the market reaction will be worse than if they had never piped up in the first place.

At any rate, the increased tensions have certainly reduced risk appetites across the board. Not only have equity markets suffered (Nikkei -1.5%, Shanghai -1.1% after yesterday’s US declines) but Treasury yields continue to fall. This morning 10-year Treasury yields have fallen to 2.43%, their lowest since late March and essentially flat to the 3-month T-Bill. Expect to hear more discussion about an inverted yield curve and the omens of a recession in the near future.

Away from the trade situation, it seems most other market stories are treading water. For example, the Brexit situation has been back page news for the past two weeks. PM May continues to negotiate with opposition leader Jeremy Corbyn, but there is no consistency to the reports of progress. Labour wants to join the customs union which is something the pro-Brexiteers are fiercely against. Depending on the source of the article you read, a deal is either imminent or increasingly unlikely, which tells me that nobody really knows anything. The pound, which had seen some strength last week, especially on Friday when rumors of a deal were rife, has fallen a further 0.45% this morning and is back near the 1.30 level. It seems increasingly likely to me there will be no solution before the EU elections, and that there will be no solution before the October 31 deadline. Parliament remains riven and leadership there has been completely absent. I expect this to be exhibit A in the long tradition of muddling through by European nations.

Elsewhere in the FX markets, the RBNZ did cut rates last night by 25bps, unlike their Australian brethren who stayed on hold. Kiwi is softer by 0.25% this morning on the back of the news and has helped drag the Aussie with it. Of course, part of the malaise in these currencies is the ongoing uncertainty over the trade talks, as well as the suspect Chinese data.

Speaking of that data, last night China released much worse than expected trade results with exports falling 2.7% and imports rising just 4.0% resulting in a trade surplus of ‘just’ $13.8B, well below expectations. It seems that the tariffs are starting to have a real impact now that inventories need to be replenished. Aside from the impact on the Shanghai exchange noted above, the renminbi also drifted modestly lower, -0.1%, and continues to push toward levels last seen in January. One thing of which I am confident is that if the trade talks fall apart completely, CNY will weaken sharply and test the 7.00 level in short order. Part of the recent stability in the currency has been due to a general malaise in the FX market as evidenced by the extremely low volatility across the board. But part of it, no doubt, is the result of the PBOC managing the currency and absorbing any significant selling in order to demonstrate they are not manipulating the currency lower to enhance their trade. But that will surely end if the talks end unsuccessfully.

Away from those stories it is much more about a modest risk-off scenario today with both JPY and CHF stronger by 0.2%, while EMG currencies are suffering (MXN -0.4%, TRY -0.5%). However, the overall market tone is, not unlike the Fed, one of patience for the next catalyst to arrive. Given the dearth of important data until Friday’s CPI, that should be no real surprise.

In fact, this morning there are no data releases in the US although we do hear from Fed Governor Lael Brainerd at 8:30. Yesterday’s comments from Governor Clarida were generally unenlightening, toeing the line that waiting was the best idea for now and that there were no preconceived notions as to the next rate move. As such, I expect Brainerd to be on the same page, and the FX market to continue to tread water at least until Friday’s CPI.

Good luck
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Disconcerted

On Friday the yield curve inverted
With policymakers alerted
That risks have increased
And growth may have ceased
Both prospects have them disconcerted

While the weekend machinations over Brexit have certainly been intense, the big story this morning is the mild inversion of the US yield curve that occurred on Friday. For the first time since 2007, 10-year yields fell below 3-month yields, a signal that the market is anticipating rate cuts by the Fed in order to shore up weakening growth. In fact, according to the futures market, there is now a ~60% probability of a Fed rate CUT by the end of the year, with a 20% probability of two rate cuts! Following this train of thought, US equity markets had their worst performance in months on Friday, and overnight, Asian markets sold off sharply. However, early this morning, German Ifo data printed at a better than expected 99.6 level, which has helped stop the European equity decline in its tracks. Nonetheless, there is a decided undercurrent of concern over the future of the global economy, and risk positions are being pared back around the world.

This is being seen most clearly in government bond markets where, for example, both Australian and New Zealand 10-year yields have traded to historic low levels, with both now well below 2.0%. Japanese 10-year yields have fallen to -0.09%, pushing toward the bottom end of the BOJ’s yield curve control levels, and German bunds have also retreated to negative territory, currently trading at a yield of -0.01%. I have to admit that while my forecasts for 2019 included lower yields based on a weakening growth outlook, I did not expect these levels to materialize in Q1, but rather only by the end of the year. This price activity is an indication of two things; first that longstanding positions are being unwound as investors reassess the global growth situation; and second, that markets can move awfully fast.

Other indicators have also shown a decided move toward risk aversion with gold rallying nearly 3% in the past two weeks, while the dollar, despite declining interest rates, has rebounded sharply from its post-FOMC lows. As I have consistently maintained, while the Fed surprised one and all by turning so dovish last week, there is little possibility that the Fed will be dovish while other central banks continue their efforts at policy normalization. Certainly, while the odd smaller country may still be considering tighter monetary policy (Norway, Hungary or the Czech Republic), no major central bank can possibly consider tightening policy amid slowing global growth and a complete lack of inflationary pressure. And as I constantly maintain, FX is a relative game, where policy on both sides must be considered. In the current environment, the US not only has the highest rates, thus the most attractive investment landscape, but also retains its haven status in times of trouble. Dollar bears have a long road to hoe before seeing substantial weakness in the buck.

The PM is under the gun
While MP’s, her deal, still do shun
It’s Parliament’s turn
To try to discern
What people in England want done

Meanwhile, back in Merry Olde England, the Brexit situation has absolutely no more clarity than it did last week, in fact it may have less. While politicians on all sides of the argument claim they do not want a hard Brexit, there has been precious little movement in the direction of a solution. And remember, the law still states that the UK will leave the EU this Friday. Yes, the EU has offered a two-week extension, but that is not yet the law in the UK and must be approved in a bill. But in the end, is two weeks sufficient to change minds when two plus years has not been able to do so?

There are stories that a deal is being worked out where Parliament supports the deal and PM May resigns, although she has no obvious successor at this point. And while there is talk of either a second referendum or canceling Article 50, the first would require a significant delay, one that would go well past the EU elections due in late May, and that is a problem, while the second would require a complete backtracking of what the current government has been promising for the past two plus years, not the type of thing that endears politicians to their constituents. As it stands now, it appears that this week Parliament will debate a series of open bills that will try to build some support for a path forward, but even this idea is fraught as party whips may well seek to prevent MP’s from voting their conscience and try to maintain a party line. In other words, it is still a gigantic mess. The one thing that continues to be a very real risk, whether it is this Friday or April 12, is the reality of a hard Brexit. In my estimation, all markets are underpricing that probability, and there is a very real risk that the pound could fall much lower. Hedgers, while option prices are somewhat rich, I would contend they offer a great deal of value at this time. Please consider them.

So, looking at the FX market this morning, we see the dollar little changed overall, but some of the key currencies weaker, notably the euro (-0.2% and the pound (-0.3%). Earlier in the session, but were weaker still, but the release of the German Ifo data helped them as well as European equities.

As to data this week, there is a decent amount coming, as well as a lot of Fedspeak.

Tuesday Housing Starts 1.215M
  Building Permits 1.3M
  Case-Shiller Home Prices 4.0%
  Consumer Confidence 132.0
Wednesday Trade Balance -$57.0B
  Current Account -$130B
Thursday Initial Claims 225K
  Q4 GDP 1.8% (last est 2.6%)
Friday Personal Income 0.3%
  Personal Spending 0.3%
  PCE 0.0% (1.4% Y/Y)
  Core PCE 0.2% (1.9% Y/Y)
  Chicago PMI 61.0
  Michigan Sentiment 97.8
  New Home Sales 620K

On top of all this, we hear from ten different Fed speakers, several of them speaking more than once. This started last night when Chicago Fed President Charles Evans was speaking at an event in HK and said that policy is in a good place and the Fed is watching the data carefully. In other words, if further weakness shows up, they will definitely consider easing, while if the current malaise is short-lived, and growth rebounds, look for talk of another rate hike. At this time, it is abundantly clear that the market is turning quite pessimistic, pricing in rate cuts. But it does appear the Fed is not predisposed in either direction for now.

In the end, the global growth story remains the biggest question out there, and as that develops, so will go the dollar, and all markets with it.

Good luck
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Most Are Afraid

Since pundits have often asserted
A yield curve that’s truly inverted
Will lead to recession
The recent compression
Of rates has investors alerted

Meanwhile the concerns over trade
Have not really started to fade
Twixt trade and those yields
Investors need shields
Explaining why most are afraid

It got ugly in the equity markets yesterday, with significant declines in the US followed by weakness overnight in Asia and continuing into today’s European session. With US markets closed today in observance of a day of mourning for ex-president George Herbert Walker Bush, the news cycle has the potential to increase recent volatility. Driving the market activity were two key stories, ongoing uncertainty over the US-China trade situation and, more importantly, further flattening of the US yield curve toward inversion.

At this point, unless you have been hiding under a rock for the past year (although given market activity, that may not have been a bad idea!) you are aware of the relationship between the shape of the US yield curve and the potential for a recession in the US. Every recession since 1975 has been preceded by an inverted yield curve (one where short-term rates are higher than long-term ones). In each of those cases, the driving force raising short-term rates was the Fed, which is no different than today’s situation. What is different is both the level of yields, on both a nominal and real basis, and the size of the Fed’s balance sheet.

From 1963 up to the Financial Crisis, the average of nominal 10-year Treasury yields had been 7.11%. Since the crisis, that number has fallen to 2.62%! Of course that was driven by the Fed’s policy actions of ZIRP and QE, the second of which was explicitly designed to drive longer-term rates lower. Clearly they were successful on that score. However, ten years on from the crisis, rates remain exceptionally low on a historical basis, despite the fact that the economy has been expanding since the middle of 2009. The reasons for this are twofold; first the Fed had maintained ZIRP for an exceptionally long time, and while they have been raising rates since December 2015, the pace at which they have done so has been extremely slow by historical standards. Secondly, although the Fed has begun to reduce the size of their balance sheet, it remains significantly larger, relative to the size of the economy, than it was prior to the crisis. This means that there is less supply of bonds available for other investors, and so prices continue to be artificially high.

This combination of the Fed’s rate hikes, as slow as they have been, and their ownership of a significant portion of available Treasuries has resulted in a much flatter yield curve. Adding to this mixture is the fact that the economy’s performance is now beginning to show signs of slowing down. This has been evident in the recent weakness in both the housing market and the auto sector. Meanwhile, falling equity prices have encouraged more demand for the safety of Treasuries. Put it all together and you have a recipe for a yield curve inversion, which will simply help fulfill the prophesy of an inverted yield curve leading to recession.

The other pressure point in markets has been the ongoing trade drama between the US and China. The weekend’s G20 news was quickly embraced by investors everywhere in the hope that further tariffs had been avoided and the current ones might be reduced or removed. However, China’s interpretation of the weekend discussions and those of President Trump appear to be somewhat different, and now there is concern that the delay in tariff increases may not result in their eventual removal.

Recapping the two stories, fears over a resumption of the trade war have helped undermine views of future economic growth. This has led investors to seek safety in longer dated Treasury securities helping to flatten the US yield curve. That signal is seen as a harbinger of future recession, which has led investors to sell equities, further increasing demand for Treasuries. It is easy to see how this cycle can get out of hand, and may well lead to much weaker equity prices, lower US yields and slower US growth.

That trifecta would be a cogent reason for the dollar to suffer. But remember, the FX market is a relative one, not an absolute one. And if the US is seeing declining growth, you can be certain that the rest of the world is suffering from the same affliction. In fact, the data from Europe this morning showed that Eurozone Services PMI fell to 52.7, its lowest level since September 2016 and further evidence that the Eurozone economy is quickly slowing. While Italy has garnered the headlines, and appears set to enter yet another recession, the data from Germany has also been soft, which bodes ill for the future. If the slowdown in the Eurozone economy continues its recent trend, it will be that much harder for Signor Draghi to begin tightening policy. So once again, despite the fact that the Fed may be slowing down, signs are pointing to the fact that the ECB will be in the same boat. In that case, the euro is unlikely to be seen as terribly attractive, and the dollar still has potential to rise, despite the recent US softness.

The point is that although the long-term structural issues remain quite concerning in the US, the short-term cyclical factors continue to favor the dollar over its G10 and EMG counterparts. We will need to see wholesale changes within the policy mixes around the world for this to change.

With markets closed today, there is no US data to be released, and I expect a subdued session overall. However, nothing has changed my medium term view of dollar strength.

Good luck
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