A New Paradigm

In Germany for the first time
In months, there’s a new paradigm
The pundits are cheering
A rebound that’s nearing
As data, released, was sublime

Perhaps sublime overstates the case a bit, but there is no doubt that this morning’s German ZEW data was substantially better than forecast, with the Expectations index rising to 10.7, its highest level since March 2018. This follows what seems to be some stabilization in the German manufacturing economy, which while still under significant pressure, may well have stopped declining. It is these little things that add up to create a narrative change from; Germany is in recession (which arguably was correct, albeit not technically so) to Germany has stabilized and is recovering on the back of solid domestic demand growth. On the one hand, this is good news for the global growth story, as Germany remains the fourth largest economy in the world, and if it is shrinking that bodes ill for the rest of the world. However, for all those who are desperate for German fiscal stimulus, this is actually a terrible number. If the German economy is recovering naturally, it beggars belief that they will spend any more money than currently planned.

It is important to remember that the Eurozone fiscal stimulus argument is predicated on two things: the fact that monetary policy is now impotent to help stimulate growth throughout the Eurozone; and the belief that if the German government spends more money domestically, it will magically flow through to those nations that really need help, like Italy, Portugal and Greece. Alas for poor Madame Lagarde, this morning’s data has likely lowered the probability of German fiscal stimulus even more than it was before. The euro, however, seems to like the data, edging higher by 0.15% this morning and working its way back to the levels seen just before the US payroll report turned the short-term crowd dollar bullish. There was other Eurozone data released, but none of it (French and Italian IP) was really that interesting, printing within a tick of forecasts. On the euro front, at this point all eyes are on the ECB to see what Lagarde tells us on Thursday. Remember, the last thing she wants is to come across as hawkish, in any manner, because the ECB really doesn’t need the added pressure of a strong euro weighing on already subpar inflation data.

With two days remaining before the UK election, the polls are still pointing to a strong Tory victory and a PM Boris Johnson commanding a majority of Parliament. At this point, the latest polls show the Tories with 44%, Labour with 32% and the LibDems with just 12%. The pound is higher by 0.2% on the back of this activity, despite a mildly disappointing GDP reading of 0.0% (exp 0.1%). A quick look back at recent GBP movement shows that since the election was called on October 30, the pound has rallied 1.8%. While that is a solid move, it isn’t even the largest mover during that period (NZD is higher by 2.45% since then). In fact, the pound really gained ground several weeks earlier after Boris and Irish PM Leo Varadkar had a lunch where they seemed to work out the final issues for Brexit. Prior to that, the pound had been hovering in the 1.22-1.24 area, but gained sharply in the run up to the previous Brexit deadline.

I guess the question is; just how much higher the pound can go if the polls are correct and Boris wins with a Tory majority. There are two opposing views, with some analysts calling for another solid leg higher, up toward 1.40, as the rest of the market shorts get squeezed out and euphoria for UK GDP growth starts to rebound. The other side of that argument is that the shorts have already been squeezed, hence the move from 1.22 to 1.32 in the past two months, and that though finalization of Brexit will be a positive, there are still numerous issues to address domestically that will prevent a sharp rebound in the UK economy. As I’m sure you are all aware, I fall into the second camp, but there is certainly at least a 25% probability that a larger move is in the cards. The one thing that seems clear, though, is that market implied volatility will fall sharply past the election if the Tories win as uncertainty over Brexit will recede quickly.

Turning south of the border, it seems that the USMCA is finally making its way through Congress and will be enacted shortly. The peso has been the quiet beneficiary of this news over the past week as it has rallied 2% in the past week in a very steady fashion, although so far, this morning, it is little changed. One other thing of note regarding the Mexican peso has been the move in the forward curve over the past three weeks. For example, since November 19, 1-month MXN forwards have fallen from 1030 to this morning’s 683. In the 1-year, the decline has been from 10875 to this morning’s 10075. The largest culprit here appears to be the very large long futures position, (>150K contracts) that need to be rolled over by the end of the week, but there is also a significant maturity of Mexican government bonds that will require MXN purchases. At any rate, added to the USMCA news, we have a confluence of events driving both spot and forward peso rates higher. It is not clear how much longer this will continue, so for balance sheet hedgers with short dated exposures, this is probably a great opportunity to reduce hedging costs.

Beyond these stories, there is far less of interest in the market. This morning’s US data consists of Nonfarm productivity (exp -0.1%) and Unit Labor Costs (3.4%) neither of which is likely to move the needle. This is especially so ahead of tomorrow’s FOMC meeting and Thursday’s ECB meeting and UK election. Equity markets are pointing lower this morning, but that feels more like profit taking than a change of heart, as bonds are little changed alongside oil and gold. In other words, look for more choppy markets with no direction ahead of tomorrow’s CPI data and FOMC meeting.

Good luck
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Talks Remain Tough

In Brussels they’re starting to say
A soft Brexit’s soon on the way
Though talks remain tough
There could be enough
To reach an agreement today!

Nothing has changed with regard to which stories are market drivers, although on the equity front we now get to add Q3 earnings to the mix. But as far as FX is concerned, Brexit and trade still dominate the discussion. Regarding Brexit, the rumblings from Brussels have been far more positive this morning, with the EU’s chief negotiator, Michel Barnier, explaining that a deal was still possible before the EU Summit on Thursday, but difficult. Apparently, the UK has submitted detailed plans of how they would like to address the Irish border situation, and there is serious consideration although negotiations continue. From Parliament, the word is that the votes will be there to pass any deal agreed by PM Johnson, as the Tories and Brexiteers recognize that Boris was a Brexiteer from the get-go. The Summit begins in two days, and I continue to expect that a deal, ‘in principal’ will be agreed beforehand. It should be no surprise that the pound has rallied on the news, after giving up some of Friday’s gains during the European session yesterday. This morning, Sterling is higher by 0.4%, although since we closed Friday, it is actually lower by 0.2%. Nonetheless, I continue to see scope for significant advancement here upon the news that deal has been reached.

As to the trade story, Friday also proved to be something of a false dawn as the Chinese backed away from the idea that a deal has been struck and are seeking continued discussions. This morning, however, there seems to be a bit more upbeat tone, even with the Chinese, as it is clear that talks will continue over the next few weeks at both mid-level and high-level (Mnuchin, Lighthizer and Liu He) conference calls. The Chinese have also figured out that they need to import a LOT if pork and that is something of which the US possesses a great deal. Overnight, Chinese data showed PPI falling 1.2%, meaning factories continue to lose pricing power, but CPI rose 3.0%, above expectations and starting to put pressure on the government. As part of that CPI rise, pork prices rose 69%! African swine fever is clearly taking its toll on the Chinese swine herd. This morning, the Chinese offered to remove tariffs on $50 billion of agricultural products if the US would remove a similar amount. While no decision has been made, I expect that there will be agreement on this subject as for President Trump, the demographics of the beneficiaries of this action would be his biggest supporters. Despite broad dollar strength since Friday, we continue to see the renminbi (+0.2% since Friday) perform well, a testimony to the PBOC’s efforts to prevent the currency from weakening, but also in response, I think, to the idea that there is positive movement on the trade front.

Away from those stories, we continue to see weak Eurozone growth data, with the German ZEW Survey falling to -22.8, slightly better than expected but still miles below its longer term average of +12.8. On top of that, a survey of 53 economists by Bloomberg has forecast that German GDP will shrink 0.1% in Q3, defining a technical recession in the country, and weighing further on the entire Eurozone. As I have repeatedly pointed out, the EU cannot afford a hard Brexit and are highly incented to reach an agreement this week. The euro, which had been holding its own of late has given up 0.2% this morning and a bit more since Friday and is back at the 1.1000 level, although that is in the upper half of performers in the G10 space. The biggest loser is NZD, which is down 1.1% since Friday after the RBNZ bid for bonds, which traders read as a form of QE, and which is tracking Aussie lower after remarks from the RBA indicate that further easing is on the way.

The other big loser this morning is the Norwegian krone, which has fallen 0.8% since Friday following oil prices’ downward trajectory. The latter is due to a combination of concerns over slowing global growth reducing demand for oil, while inventories continue to rise.

In the EMG space, INR is today’s largest mover, sliding 0.75% after CPI data was released at a higher than expected 3.99% in September. The rupee had been a beneficiary of inward investment based on the idea that quiescent inflation would allow further RBI rate cuts and enhanced growth and equity market performance. However, if inflation has bottomed, it seems that investors are likely to be a little more circumspect. Overnight there was clear selling of Indian bonds by international investors leading to the currency’s decline. However, beyond that movement, the EMG bloc had more losers than gainers, but none with a significant move or story.

On the data front this week, we see a bunch of middle tier data with the highlight arguably Retail Sales.

Wednesday Retail Sales 0.3%
  -ex autos 0.2%
  Business Inventories 0.2%
  Fed’s Beige Book  
Thursday Initial Claims 215K
  Housing Starts 1320K
  Building Permits 1350K
  Philly Fed 8.0
  IP -0.2%
  Capacity Utilization 77.7%
Friday Leading Indicators 0.1%

In addition to the data, we hear from a total of ten Fed speakers this week, ranging from the uber-dove James Bullard to the uber-hawk Esther George and every spot along the spectrum in between. Overall, the Fed message has been that they feel the economy is in a ‘good’ place, but they won’t hesitate to ease further if the data turns downward. Of course, their message was also that buying $60 billion / month of T-bills to help ease reserve conditions was in no way more QE. That is a much tougher circle to square.

Looking ahead, the market remains headline driven so care needs to be taken. There is no clear risk view this morning with both equity futures and Treasuries higher, and the dollar is mixed, again clouding any view. My expectation is that the market will likely tread water ahead of the next piece of news. And my money remains on that being a positive Brexit story.

Good luck
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Doublespeak

The sitting Prime Minister, May
Heard terrible news yesterday
Her plan to promote
A Brexit deal vote
Was halted much to her dismay

This forces her, later this week
A longer extension to seek
But still the EU
Seems unlikely to
Do more than add new doublespeak

In yet another twist to the Brexit saga, the Speaker of the House of Commons, John Bercow, refused to allow another vote on PM May’s deal this week. He explained that Parliamentary rules since 1604 have existed to prevent a second vote on a bill that has already been rejected unless there have been substantial changes to the bill. In this case there were no changes and PM May was simply trying to force approval based on the idea that the clock was running out of time. The pound reacted to the news yesterday by quickly dropping 0.5%, although it has since recouped 0.2% this morning.

This has put the PM in a difficult spot as she prepares to travel to the EU council meeting in Brussels later this week. Given that there is still no clarity on how the UK wants to handle things, or at least how Parliament wants to handle things, she will need to seek an extension in order to avoid a no-deal Brexit. However, the comments from several EU members, notably Germany and France, have indicated they need some sense of direction as to what the UK wants before they will agree to that extension. Remember, too, it requires a unanimous vote by the other 27 members of the EU to grant any extension. At this stage, the market is virtually certain an extension will be granted, at least based on the fact that the pound remains little changed on the day and has been able to maintain its modest gains this year. And it is probably a fair bet that an extension will be granted. But the real question is what the UK will do with the time. As of now, there is no clarity on that at all. Unless the EU is willing to change the deal, which seems unlikely, then we are probably heading for either a new general election or a new Brexit referendum, or both. Neither of these will add certainty, although the predominant view is that a new referendum will result in a decision to stay. Do not, however, ignore the risk that through Parliamentary incompetence, next week the UK exits without a deal. That risk remains very real.

One side note on the UK is that employment data released this morning continues to beat all estimates. Wages continue to rise (+3.4%) and the Unemployment Rate fell further to 3.9%. Despite a slowing economy overall, that has been one consistent positive. It has been data like this that has helped the pound maintain those gains this year.

Elsewhere the global growth story continues to suffer overall, as both China and the Eurozone continue to lag. While there was no new data from China, we did see the German ZEW survey (-3.6 up from -13.4) and the Eurozone version as well (-2.5 up from -16.6). However, at the same time, the Bundesbank just reduced their forecast for German GDP in 2019 to 0.6%, although they see a rebound to 1.7% in 2020. My point is that though things may have stopped deteriorating rapidly, they have not yet started to show a significant rebound. And it is this dearth of economic strength that will continue to prevent the ECB from tightening policy at all for quite a while to come.

A quick glance Down Under shows that optimism in the lucky country is starting to wane. Three-year Australian government bonds have seen their yield fall to 1.495%, just below the overnight rate and inverting the front of the curve there. This calls into question the RBA’s insistence that the next move will be an eventual rate hike. Rather, the market is now pricing in almost two full rate cuts this year as Australia continues to suffer from the slowing growth in China, and the world overall. While the FX impact today has been muted, just a -0.1% decline, Aussie continues to lag vs. other currencies against a dollar that has been on its back foot lately.

Speaking of the dollar, tomorrow, of course, we hear from the Fed, with a new set of economic projections and a new Dot Plot. Since there is no chance they move rates, I continue to expect the market to be focused on the balance sheet discussion. This discussion is not merely about the size of the balance sheet, and when they stop shrinking it, but also the composition and general tenor of the assets they hold. Remember, prior to the financial crisis and the utilization of QE, the Fed generally owned just short-term T-bills and maybe T-notes out to three years. But as part of their monetary policy experiment, they extended the maturities of their holdings with the average maturity now nine years. This compares to the six-year average maturity of the entire government bond issuance. The longer this average tenor, the more monetary ease they are providing to the market, so the question they need to answer is do they want to maintain that ease now or try to shorten the current maturity, so they have the opportunity to use that policy in a time of greater need. While this remains up in the air right now, whatever decision is made it will give a strong clue into the Fed’s view of the current situation and just how strongly the economy is actually performing.

This morning’s Factory Orders data (exp 0.3%) is unlikely to have a market impact of any sort. Equity markets have been muted with US futures pointing to essentially an unchanged opening. Yesterday saw limited price action, with both the dollar and equities barely changed. My sense is today will shape up the same way. Tomorrow, however, will be a different story, of that you can be sure.

Good luck
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Now In Disarray

The saga of Minister May
Improved not one whit yesterday
When Boris resigned
Pound Sterling declined
And her party’s now in disarray

The news from the UK continues to dominate market headlines as less than twenty-four hours after the resignation of the Brexit Minister David Davis, Boris Johnson, a Brexit hardliner and Foreign Minister also resigned from PM May’s cabinet. While PM May replaced both men quickly, the problem is one of appearances in that she seems to be losing control over her government. The market’s immediate reaction was to sell the pound (it fell 0.7% yesterday after the news and has maintained those losses) as concerns over a leadership challenge and potentially a new election were brought to the fore. However, since then, it seems things have quieted down a bit and there is even talk that this could be a Sterling positive as it may result in a softer Brexit with less economic impact. In the meantime, this morning’s data showed that GDP has been rebounding from Q1’s flat reading, with the monthly May reading rising 0.3% and although IP data was soft (-0.4% in May), Construction was strong (+1.6%) and it appears that Governor Carney will still have enough ammunition to justify a rate increase next month. The risk to that outlook is if a leadership challenge emerges in Parliament and PM May is deposed. In that event, market participants may take a dimmer view of the near future depending on who replaces her.

Away from the British Isles, however, there is less excitement in the G10 economies. The big US news remains political with President Trump naming Brett Kavanaugh to replace retiring Supreme Court Justice Anthony Kennedy. However, on the economic front, there has been precious little news or commentary. In fact, until Thursday’s CPI reading, I expect the US story to be benign unless something surprising happens in the Treasury auctions beginning today, where the US is raising $69 billion via 3yr, 10yr and 30yr auctions.

From Germany we saw the ZEW surveys disappoint with the Sentiment Index falling to -24.7, its lowest print since December 2011 during the European bond crisis. This has encouraged a reversal in the euro, which is down 0.3% this morning after a week of gains. As well, the other, admittedly minor, Eurozone data also pointed to modest Eurozone weakness, thus giving the overall impression that the recent stabilization on the continent may be giving way to another bout of weakness. However, we will need to see more important data weaken to confirm that outcome. Certainly, Signor Draghi is convinced that the worst is behind them, but he has always been an optimist.

In the emerging markets, Turkey has once again stolen the headlines as President Erdogan named his son-in-law as Minister of Finance and Economics, thus following through on his threat promise to take firmer control over monetary policy. In the cabinet reshuffle he also removed the last vestiges of central banking experience so I would look for inflation in Turkey to start to really take off soon, and the currency to fall sharply. And that is despite the fact that it fell 3% yesterday after the announcement. In fact, I would look for more moves of that nature and a print above 5.00 in the not too distant future.

But other than that, while the dollar is stronger this morning, it is not running away. The broad theme today seems to be modest profit taking by traders who had been running short dollar positions, and so a bit of further strength would be no surprise. On the data front, the NFIB Small Business Optimism Index was released earlier at 107.2, stronger than expected and still showing that small businesses remain confident in the economic situation for now. The JOLTs jobs report comes at 10:00 and should simply confirm that the employment situation in the US remains robust. My gut tells me that modest further dollar strength is on tap for today, but really, barring a political bombshell, I expect that things will be very quiet overall. It is the middle of summer after all.

Good luck
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