Emerging Markets, US Yields, Yellen and the ECB
Currencies and asset prices in the EM world have responded strongly and favorably during the past ten days to dovish Fed signals, sharply declining UST yields, and a string of predominantly helpful data releases out of the US and China. The ECB president, Mario Draghi, will have an opportunity to put an end to the party at his press briefing tomorrow, but we do not think he will. If anything, he may be slightly inclined to help halt the euro rally by conveying a dovish message, though we think he is more likely to be neutral. With uncannily poor timing we warned on these pages a week ago (12 July) of possible negative consequences for EM investors of the Fed’s and the ECB’s pending tightening of their balance sheet policies; but a few hours later those concerns were moved to the sidelines by the Fed Chair, Janet Yellen, as she offered Congress and the market new and soothing commentary on the recent low US inflation numbers. Her wording persuaded the broad investor community (and us) that she and her FOMC colleagues feel only halfheartedly committed to their plans for monetary policy tightening.

EM investors responded with enthusiasm. Yellen’s testimony set off a fall in yields on US Treasuries, depreciation of the dollar against most other currencies, and a bounce in the dollar price for EM assets across most of the world. Yesterday’s decision by Republicans in the US Senate to abandon their health care reform plans has further fueled the down move in US yields and the dollar. We still think investors will eventually switch their focus back towards concerns about the ECB’s and the Fed’s pending balance sheet reduction, but this month’s muted inflation data, Yellen’s soothing choice of words, the dwindling chances of US tax reform, and ECB President Draghi’s likely reluctance to push up bund yields (and the euro) at his press briefing tomorrow will probably ensure that investor concerns about potential eventual global monetary policy tightening stay on the sidelines for at least another couple of weeks, as the market waits for the release of further US inflation data that may (or may not) upset the apple cart.

In Yellen’s testimony on 12 July she used the word “partly” to describe the contribution to low US inflation that reflects one-off declines in certain price categories. Four weeks earlier she had used to word “significantly” in the same context. Though the distinction between the two words is subtle, the change of wording is likely to reflect a wish on the part of Yellen to send a signal to the market. In the prepared text for her Congressional testimony, Yellen used text that she had previously published. Text from her last FOMC press briefing was copied wordby-word, except for the replacement of “significantly” by “partly”. The switch of words suggests an increase in her doubt about the likelihood that inflation will really bounce back. US Treasuries rallied strongly in response to the word-switch.

A few days earlier, a batch of US labor market data had conveyed a picture of still-muted wage growth alongside still-strong employment growth. On Friday 7 July, when the data were released, UST yields initially rose by a couple of basis points as investors responded with greater force to the strength of the employment figures than to the muted nature of the wage numbers. However, yields began to drop slowly the following Monday and continued to do so Tuesday as investors swung their focus in the direction of the soft wage data. Thus, bond investors were already primed to question Yellen’s confidence in the prospect of an inflation bounce when she initiated her testimony to Congress. Once she delivered her dovish linguistic innovation (the switch from “significantly” to “partly”), UST yields dropped in earnest. By the end of Wednesday (12 July) ten-year yields were 7 bps lower than they had been by the end of the preceding Friday (7 July).

The sell-off in 10yr Bunds took a pause yesterday, as some flight to safety on the back of the missile test conducted by North Korea and dovish comments by ECB Executive Board member Peter Praet underpinned demand. The volume of the Bund future, however, was almost 50% below its 10-day moving average thanks to the closure of US markets. Moreover, yields on 30yr German paper continued their ascend. Meanwhile, semi-core and peripheral bonds managed to squeeze out some further tightening verus Bunds, with OLOs and Bonos bucking the trend though – which makes sense given their tight levels relative to comparables. Interestingly, we find 8-10yr Spain currently trading at the tighest level versus OLOs of the past two years. With US markets open again, the main focus today is on the release of the FOMC minutes, which should offer clues as to whether the intended changes to the balance sheet reinvestment policy are indeed forthcoming “relatively soon”. Interestingly, we find the fed funds strip between the Nov-17 and Jan-19 contract having re-steepened more than 10bp over the past two weeks, suggesting more and more market players are embracing the view that the Fed delays their next rate hike until December and announces the start date of the reinvestment policy changes at the September meeting.

ECB QE data. Net asset purchases in June amounted to €62.4bn. PSPP purchases accounted for €51.6bn (82.7%). Interestingly, purchases remained skewed towards France and Italy, whereas German purchases were roughly in line with the Bundesbank’s capital key in the ECB for the third month running. Furthermore, the weighted average maturity of German purchases jumped from 3.99 years in May to 5.33, the highest reading since January (we doubt the monthly WAM estimate was meaningfully influenced by the reinvestment of maturing holdings). This sheds further light on the strong tightening seen in Schatz ASW spreads last month EGB supply. Germany will launch a new 5yr OBL today. With the markets recently reassesing the ECB policy outlook, the 5yr segment has cheapened more than 10bp on the fly versus the 2s and 10s since the end of May, and more than 12bp on ASW. This should ensure today’s auction won’t fail. Also note that the OBL 10/22 traded at an attractive roll of 9bp in the grey market yesterday – and that 4-5yr OBLs trade at a concession versus the interpolated DBR curve.


Energy • API weekly US crude oil inventory data: the API data shows that US crude oil inventory have dropped 5.8MMbbls over the last week with gasoline inventory also declining 5.7MMbbls. EIA will be publishing official data today after one day delay on account of the Independence Day holiday. EIA’s confirmation of similar withdrawals could support the crude oil prices. • US Strategic Petroleum Reserve sales: US crude oil SPR dropped by 13MMbbls over the past four months to take the total SPR at a 12 year low of 682MMbbls as on 30 June 2017. The US Congress has approved the sales this year to fund the SPR maintenances. Further, the Trump administration plans to sell 270MMbbls of SPR over the next decade (to fund the country’s debt reduction) as rising output lowers the requirement to maintain large reserve.

Metals • Gold silver ratio at the lowest in a year: Gold to silver price ratio increased to 76.4 currently, the levels last seen in April 2016. Amid the uncertainties around the Brexit, Middle East tensions and North Korea missile tests, investors have been favouring safe haven gold over the silver. • Large inflow of copper into LME warehouses: nearly 40kt of copper was rushed into the LME warehouses on 5 July, its sharpest one day inflow since March 2017. Previously, a massive load-in of 30kt was reported on 3 July as well. With these stocks inflow, LME copper inventory has increased to a one month high of 316kt on 5 July 2017 putting some pressure on LME copper spot prices.

Agriculture • Renewable fuel quota in the US: The Trump administration has proposed to keep the conventional renewable fuel quota at the maximum permissible limit of 15bn gallons in 2018 supporting the corn demand and prices. Refiners have been protesting against the high biofuel targets citing ‘blend wall’. • USDA crop progress report: the weekly crop progress report from USDA shows that 68% of US corn crop was in good or excellent condition for the week ended 2 July 2017, higher than 67% a week before but much lower than the 75% a year ago. Meanwhile, only 48% of winter wheat and 37% of spring wheat are in good and excellent condition compared to 62% and 72% a year ago. Below average crop conditions are likely to keep supporting grain prices in the US.

Some DM central banks potentially undergoing a regime shift – trying to avoid mistakes of the previous cycle when funding costs undershooting nominal return expectations for too long led to a leveraged-funded boom and capital misallocation, eventually unleashing a substantial deflationary shock – stand in contrast to falling energy prices in terms of market implications. Fed minutes confirmed anticipated hawkishness, leaving it only a question of time before the Fed starts its balance sheet reducing operations. The ECB will release its minutes today. More important will be ECB’s Weidmann’s speech on the future of the EUR.
Simultaneously, markets have to digest oversupply issues mainly affecting energy markets. Here, two big issues seem to stand out. First, OPEC’s inability to stay compliant with previously agreed production cuts and second, the US turning into an energy exporter following its shale energy revolution. Our US economist estimates business investment into US oil and gas drilling structures will increase by 80% in Q2and 25% in Q3,not only supporting US economic growth via its implementation, but also adding to the supply of energy into global markets. The FT is running an article today suggesting that LNG supply could increase by about 50% from 2015 to 2020. The US will turn into a leading LNG supplier. Australia has also now built up infrastructure to become a big LNG exporter. Our stance of selling currencies of traditional oil suppliers such as NOK and COP remains unchanged.
Declining energy costs have helped dampen inflation expectations and yesterday’s pause of US yields breaking higher despite increasing prospects of the Fed adding to future net bond supply should be attributed to oil prices showing their biggest decline since 25th May. The 5% oil price decline on 25th May set the starting point for a four-week decline, seeing Brent losing around 17%.
The exhibit illustrates the crucial position in which markets are currently progressing. We compare the 10-year US real yield with 10-year US breakeven. For risk markets to flourish, a combination of falling real rates and rising inflation expectations bodes well, explaining the strong equity performance witnessed in 2012/13. The reverse picture emerged in 2015, pushing share markets into two significant downward corrections in August 2015 and January 2016. The problem is that real rates have diverged from falling inflation expectations as they did in 2015. In this sense, falling energy prices are not risk supportive if not compensated by other reflationary forces. Yesterday, we mentioned rallying soft commodity prices. Today, we like to put our emphasis on growth data where we hope the upcoming June ISM non-manufacturing PMI and NFP report may allow the gap between US real rates and inflation expectations to narrow somewhat.

This analysis suggests that the risk outlook has turned more data sensitive. The Fed’s potential change of its reaction function – now increasingly emphasising buoyant financial conditions – and its readiness to look through current weak inflation data have created this new data sensitivity. The Q2 earnings reporting season starting tomorrow should help tip the balance in favour of risk appetite for now. We stay USDJPY bullish and use a near term setback to last Friday’s bullish 112.00 break point as a buying opportunity. The 10y JGB yield trading up to the unofficial 10bp upper ceiling due to a weak open market operation should not strengthen the JPY. There is no appetite within the BoJ for moving the signposts of its yield curve management policy yet. The MoF weekly security flow data showed foreign investors shying away from JPY money market investment, suggesting the USDJPY cross-currency basis should stop tightening, thus no longer reducing Japan-based investors’ hedging costs. Japanese investors reducing their FX hedge ratio should strengthen USDJPY.

GBP has corrected some of its recent gains in light of weak UK postelection PMI readings. Remember, post-Brexit UK soft indicators crashed for a couple of months before turning back up again. Anyhow, our GBP optimism finds its foundation in what we call ‘Brexit economics’ and the BoE reconsidering GBP weakness and its impact on the economy. So far, GBP weakness has been unable to lift net exports, but ithas undermined real disposable income via rising import prices. In short, GBP weakness has undermined living standards and with inflation above the BoE’s 2% target and its own staff projections, GBP stabilisation should now be on the BoE’s agenda. Talking up rate expectations is a sufficient tool to reach this target. With regard to the GBP outlook, we should not underestimate the growing influence of Chancellor Hammond within the Cabinet. There is a new openness to listen to businesses to reduce Brexit-related supply and market access restrictions, which should work in favour of the market which is still GBP short positioned. We hold our GBPUSD 1.32target.

Energy • ICE Brent speculative position: Similar to WTI data, positioning data released for ICE Brent yesterday showed that speculators reduced their net long by 24,366 lots, leaving them with a net long of 283,157 lots. Since the end of May, speculators have reduced their net long in Brent by 66,723 lots. • API US inventory data: Later today, the API is scheduled to release its US inventory report. Expect volatility in prices if the number is significantly different from the 1.2MMbbl drawdown the market is expecting the EIA report to show on Wednesday.

Metals • Indonesian nickel smelters suspend operations: According to Bloomberg, thirteen nickel smelters in the country, including some that are still under construction, have suspended operations, given the fall seen in nickel prices. According to the Indonesian Processing and Refining Industry Association, prices have fallen below the cost of production, which is estimated at US$9,000- 10,000/t. The smelters have a combined capacity of 750,000t pa of nickel pig iron. • Silver ETF holdings: Having seen quite the recovery over May, ETF holdings in silver have started to decline at a fairly rapid pace. Total holdings currently stand at 664moz, compared to 671moz seen at the end of May. Expectations of a US Fed rate hike (which materialised last week) have weighed on the precious metals complex.

Agriculture • US spring wheat rating: Data released by the USDA shows that just 41% of the US spring wheat crop is rated good-to-excellent, which is down from 45% last week. It looks even worse when compared to the same time last year, when 76% of the crop was rated good-to-excellent. • Indonesian sugar output: According to the Indonesian government, the country expects domestic sugar production this season to reach 2.5mt, up from 2.2mt last season. Improved weather has helped the crop this season. Meanwhile, for next season, the country is targeting 2.7-2.8mt. Indonesia is aiming to move towards sugar self-sufficiency, with an increase in acreage and a number of new mills expected to start up in the coming years.

USD has potential to rally further, helped by hawkish Fed commentary, rising US bond yields and, last but not least, investors adjusting their super-bearish USD book. The Fed’s Dudley said he is confident that the economic expansion has a long way to go and that a strong labour market will eventually trigger a rebound in inflation. Precious metals have turned lower, with a potential of developing a ‘double top’ formation, pushed lower by the recent rise in US real rates. Importantly, rising US real rates did not prevent risk appetite from staying supported, which we attribute to the new availability of capital.

There are two new sources of capital and liquidity which will keep risk assets supported for now. First, US banks now running solid balance sheets seem to benefit from potential deregulation imposed by the US Treasury. In order to enact its ambitious fiscal plans, the US administration needs the economy to accelerate from here urgently. Only with growth getting closer to 3% will its current budget plans have a chance of being viewed as credible by markets, in our view. The upcoming mid-term election in November 2018 adds to this urgency. Hence, the US administration has significant interest in boosting the economy with the help of better capital availability provided by the US financial sector.

USDJPY has reached levels near 111.80, trying to reenter its previous upward channel. The importance of last Friday’s BoJ statement for the valuation of JPY has not yet been fully priced in by markets. The BoJ suggesting that it stood by its JPY80trn QE target has not only dashed hopes that the central bank was in the middle of ‘stealth tapering’, it has also underlined that compared to the size of its current effective QE operation of JPY60trn, it seems ready to increase its Rinban operations by 25% should upward pressure on BoJ yields become undesirably strong. The BoJ’s intention is to keep real rates low, allowing local asset prices to stay supported and JPY to weaken.

We expect the CBT to end the tightening cycle and remain on hold this month with inflation peaking, relief in domestic political concerns and the conducive external backdrop. Equally, the bank is likely to refrain from early easing. This should be TRY supportive as the lira retains its very high risk adjusted carry. TURKGBs look attractive from a carry perspective, but one should not expect a YTD-like strong performance as the CBT is at no hurry to cut rates.

• The CBT is to keep the current tight liquidity stance for a while, until the recovery in the inflation outlook becomes apparent.
• Ongoing geopolitical issues (which could create pressure in market prices) as well as still elevated inflation levels will likely force the CBT to be cautious and refrain from early easing.
• We think any easing would be via gradual increase in TRY liquidity, while the policy rate, the upper/lower bounds of the interest corridor and late liquidity window rate will likely remain unchanged until the year end.

FX: In the current carry-friendly environment, TRY continues to stand out for numerous reasons: (a) the CBT regaining inflation-targeting credibility by keeping interest rates high despite CPI likely reaching its peak and the appreciating TRY; (b) TRY offers extremely attractive risk adjusted carry compared to its high yielding EM peers (Fig 5) due to the CBT’s tight liquidity stance and high average funding costs; (c) the still very attractive medium-term valuation, with USD/TRY currently being overvalued by c.24%. The expected CBT decision on Thursday to keep interest rates unchanged and leave the current liquidity stance tight (now and for a foreseeable future) should underpin the lira’s attractiveness. In the relative value space, TRY seems to be the most attractive among the CEEMEA higher yields as RUB decoupled from the oil price and seems too rich while ZAR’s highly unpredictable domestic politics warrants a larger risk premium and caution vs TRY. We expect USD/TRY to break through the 3.5000 level, though the bulk of future returns from long lira positions should come from the carry factor, rather than spot appreciation.

Domestic Debt and Rates: Following a c.150bp rally in long-end bond yields from the peak observed at the beginning of this year, we do not expect further strong performance. The 10-year TURKGB yield should not meaningfully break below the 10% level given the tight CBT policy stance and what we see as a low probability of rate cuts in coming months. Yet, given its high nominal yield and the likely increase in real yields once Turkish CPI starts moving lower more meaningfully (by the end of this year or the beginning of the next – Fig 6), TURKGBs look attractive from a carry perspective. Long dated bond yields should hover around current levels in coming weeks. For USD-TRY cross currency swap rates, we also expect limited room for a decline from here, given the tight CBT liquidity stance and expected only modest TRY spot appreciation.

In the June MPC meeting on 15 June, we expect the Central Bank of Turkey (CBT) to remain mute and keep all relevant rates unchanged. Since the beginning of this year, the CBT has increasingly used unorthodox policy tools and in the last two meetings, the bank was more hawkish than expected with more-than-expected hikes on the late liquidity window rate. The bank has pulled the effective cost of funding significantly up, by c.370bp since end-2016, to close to 12.0%. During the tightening process, the late liquidity window (LLW) rate, a facility to cover emergency needs of the banks, has been aggressively utilized, while the bank has also introduced a new tool by opening an FX-deposits-against-TRY-deposits market, a swap facility with 1-week maturity. Utilisation of the tool has reduced volatility in excess TRY liquidity in offshore markets and helped achieve stabilisation in the TRY. This month, we do not expect a further tightening move, given that inflation has already peaked in April.
Following significant deterioration in recent months with the lagged spillovers of TRY depreciation and volatility in food prices, inflation showed modest improvement in May from its high levels in April (the highest since the GFC). Core inflation (excluding all food & beverages, energy, alcoholic drinks & tobacco, gold) recorded a 1.33% change, below the average of May changes. This is another sign of weakening following a moderation in the strong upward pressure last month. As a result, annual inflation in this indicator inched down to 9.38% from 9.42% a month ago. However, core figures stay elevated, despite the fading FX pass-through. We thus think the bank has likely reached the end of the tightening cycle and won’t embark on further tightening unless the currently supportive global backdrop changes significantly. Recent TRY strength (due in part to the supportive global backdrop and improving political climate after the referendum) works to the CBT’s advantage, with increasing downside risks to the inflation outlook.
On the flipside, the bank should refrain from early easing and keep its current tight liquidity stance in place for a while, until the recovery in the inflation outlook becomes apparent. Economic activity continues to strengthen, thanks to fiscal easing, given stimulus measures such as VAT cuts in some consumer durables and social security premium cuts and significant lending acceleration. Credit growth (13-week MA, FXadjusted and annualised) has converged to 25% on the back of contributions from the Guarantee Fund. Recently released indicators hint at some further acceleration in 2Q17 economic activity, with higher PMI in tandem with rising CUR.


GDP expanded by 5.0% YoY in 1Q17, much higher than the market consensus at 3.5%. The rebound was driven by private consumption while net trade had a significantly positive contribution with improving export performance. The data show continuation of the recovery that started in 4Q16 at a strong pace. Economic activity was higher than expected in 1Q with 5.0% YoY growth while market expectations, according to a Bloomberg Survey were at c.3.5% with a range between 0.8% and +4.8% vs our call at 3.6%. Accordingly, following a contraction in 3Q16 for the first time since the global crisis, growth has maintained an improving trend, pulling annual GDP growth to 3.0% in 1Q17 from 2.9% in 2016. In seasonal and calendar adjusted terms (SA), GDP expanded 1.4% QoQ, down from 3.4% QoQ a quarter ago, though showing that the recovery has remained in place. 12-month cumulative adjusted GDP growth accelerated to 1.1% from 0.9% on a sequential basis.

Looking at the expenditure breakdown, we see that private consumption was again the main contributor to growth at 5.1% YoY in the first quarter of the year. This shows the improvement in consumer sentiment in recent months with stabilisation in the currency and the impact of stimulus measures such as VAT cuts in some consumer durables and social security premium cuts as well as easing macro-prudential measures, ie, extending the maximum maturity of consumer loans, arrangements in credit card installments, etc. Fixed investment gained further strength despite the political uncertainty ahead of the referendum and recent CBT tightening with 2.2% YoY growth. This is attributable to significant lending acceleration as credit growth (13-week MA, FX-adjusted and annualised) has converged to 25% on the back of contributions from the Guarantee Fund. Public consumption was up by 9.4% YoY with the introduction of stimulus packages and with increased public spending, providing a stronger contribution to growth vs 4Q. We think this will likely reverse in the second half of the year. Also, exports were up by 10.6% due to the strong economic growth in the EU and recovery in trade with Russia while imports recorded a mere 0.8% increase with the result that net trade provided the first positive contribution to the headline since 2015. Finally, inventory depletion shaved a significant 2.3ppt from GDP growth, supporting the view that production should improve in the coming period. All in all, the improvement was relatively broad-based in 1Q17 showing a further rebound after the robust performance in 4Q16 following a significantly weak 3Q16 with implications of the failed coup attempt in July on household and corporate sector behaviour.

Among the sectors, manufacturing stood out with a 1.1ppt contribution with a second strong reading after the drop in 3Q16, while construction was another driver with a 1.6ppt (including real estate activities) addition to the headline. Overall, after economic growth rose back into positive territory in the last quarter of 2016 following political tensions and a shock to the tourism sector, we saw across-the-board strength with further recovery in private consumption and net exports. For 2017, risks seem to be on the upside given the acceleration in activity in 2Q17 and low base effect of 3Q16. Recently released indicators hint at some further acceleration in 2Q17 economic activity, with higher PMI in tandem with rising CUR. Improvement in sectoral and consumer confidence after the referendum should also contribute to the recovery.

UK consumer price inflation is getting closer to 3%, but slower growth and political uncertainty mean there is little chance of an interest rate rise. The pound’s collapse since last June’s EU referendum has seen import prices rise across the board, but it has been most felt in food and fuel costs. This has seen headline CPI rise to 2.7% YoY and we look for it to push higher again today. This is primarily due to higher utility bills (gas and electricity) with providers having announced significant price hikes in response to wholesale price moves. There are also tens of thousands of households impacted by fixed term deals coming to an end this month. These people will find themselves put automatically on higher price tariffs.

However, there is going to be some offset from a temporary drop in motor fuel prices (they have risen again in early June), but with an increasing number of retailers facing higher import costs as their currency hedges come to an end we suspect headline inflation will rise to 2.8% before hitting 3% in 4Q17. Tomorrow’s labour report is likely to show wages remain little changed so the squeeze on spending power looks set to intensify. Already, there are worrying signs for consumer spending with this week’s retail sales report likely to post a heavy decline after a bizarrely strong outcome last month. Indeed, Visa, the payment card provider, reported that according to its own internal data consumer spending is now falling when adjusted for inflation. The pain is likely to get worse before it gets better.

The outcome of the election is not helpful for the growth story either. The uncertainty that this generates is prompting a steep fall in business confidence. The Institute of Directors found that 57% of their members were either “quite” or “very” pessimistic about the UK economy over the coming year versus just 20% who described themselves as optimistic. Given the lack of positive news flow on the domestic economy and the political uncertainty the UK faces it is not surprising that financial markets are pricing in a less than 10% chance on an interest rate rise this year, with the probability of a rate rise by the end of 2018 put at just 33%. Given the lack of domestic price pressures (as highlighted by subdued wage growth) we don’t expect an interest rate hike before the official deadline for Brexit talks to conclude in 2019.

USD sentiment hit a bearish extreme as investors disagreed with the Fed’s projected rate hike path, buthas started rebounding since last Friday. Yesterday’s sharp CAD appreciation on the back of BoC Deputy Governor Wilkins saying the central bank was looking at the possibility of raising interest rates as the economic recovery picks up indicated that there is a substantial risk of the USD rallying should the Fed underline its current rate projections. We call the DXY 2% higher from here in the next six weeks. Japan’s FinMin Aso suggesting that he can see the USD rallying on higher US interest rates is a view we subscribe to. Higher US rates will increase Japan-based fund managers’ USD hedging costs, which should push USDJPY higher as they reduce their hedge ratios. USDJPY closing at 110.40 or higher would signal that a corrective bottom has been traded.

Rates pessimists cite the recent decline of global surprise indices spreading from the US into other economies including EM. However, most of the recent data moderation has been spotted among soft indicators while most hard data have remained solid. Most labour markets continue to tighten at a rapid pace and it seems that it is now the shortage of skilled labour which is hampering hiring. In the US, the spread between job openings and the rise of employment has become wider, suggesting that a period of higher wage growth may be imminent. It has primarily been the recent moderate wage growth slowing in the US from 2.8%Y to 2.5%Y which has pushed 10-year inflation expectations (measured by breakevens) from 2.08% to 1.78% within the past six months.


Energy
• US oil rig count: The number of active US oil rigs increased by 8 over the last week, taking the total number to 741 rigs. The rig count has increased consistently since mid-January 2017, with producers bringing back 219 rigs since then. The growth in the number of active rigs has supported production, which has increased by 548Mbbls/d since the start of the year.
• Oil speculative position: The latest Commitment of Traders Report shows that speculators increased their net long position in WTI crude oil by 15,037 lots over the last reporting week, leaving them with a net long of 221,140 lots. However, given the pressure on prices since Tuesday, it is expected that the speculative position will show a large reduction in this week’s release.
Metals
• Chinese iron ore inventory: Latest data from Steelhome shows that Chinese iron ore port inventory stands at a record 140mt, up 26mt since the start of this year, and up 40mt YoY. We expect that the scale of Chinese inventories should keep prices under pressure.
• Chinese steel output: Metal Bulletin reports that Chinese crude steel output over the last 11 days of May averaged 1.7639mt, compared to a daily average of 1.8050mt seen over mid-May. It appears that production has started to respond to lower domestic steel prices, which have been under pressure since early March.
Agriculture
• WASDE report: The USDA released its latest WASDE report on Friday. While the market was expecting the USDA to lower US ending stocks for corn and soybeans, the department kept corn ending stocks unchanged. For US soybeans, the crush estimate was lowered for the current season, which saw the estimate of ending stocks for this season and next grow by 15m bushels to 450m bushels.
• Global coffee market: Brazilian coffee trader Comexim expects that the global coffee market will see a deficit of 4.2m bags over the 2017/18 season, compared to a deficit of 1.7m bags in 2016/17. The market has largely expected a deficit for the 2017/18 season, particularly because Brazil is in the lower-yielding year of the biennial cycle

Treasury Secretary Mnuchin said that the US government has “backup plans” for funding itself if Congress doesn’t raise the debt limit before lawmakers leave for their August recess as hoped. When the US Treasury used accounting methods to bridge shortfalls ahead of the increase of the 2015 debt ceiling, US front-end rates fell to zero, but this happened within an environment of increasing global deflation concerns and China facing risks of substantial outflows threatening financial stability. Nowadays, global growth conditions are supportive as 2015 global economic headwinds have turned into powerful tailwinds for the US. The Treasury using accounting flexibility suggests it will issue less, which may ease US financial conditions further. There is no need for the Fed to reconsider the pace of its anticipated tightening path, it seems.

Ahead of Wednesday’s FOMC meeting, US financial conditions continue to improve, supported by the US House Republicans passing the vote to revamp the Dodd-Frank Act and repeal the Volcker Rule which restricted banks from making speculative investments with their own capital. This suggests freer investment in riskier assets as well as lower US funding costs. Hence, we pay little attention to the 1.8% decline of the NASDAQ on Friday, considering the resilience of the broader S&P 500 and limited spillover into Asian equity markets. A 25bp Fed Funds rate hike is 95% priced in, suggesting that all eyes will be on the statement in respect of the Fed’s judgement of the future economic outlook, and on the FOMC providing updates on their Policy Normalization Principles and Plans, including a set of gradually increasing caps, or limits, on the dollar amounts of Treasury and agency securities that would be allowed to run off each month, and only the amounts of securities repayments that exceeded the caps would be reinvested each month.

USD: Role of Fed hikes reduced to providing a buffer for the $, not a driver When the FOMC meet this week (Wed), there’s no doubt that the case for a rate hike will be less compelling than it was back in March. Economic data, especially short-term inflation dynamics, have been unnervingly soft and one could argue that this should keep a data-dependent Fed sidelined until things pick-up. Most FOMC members, however, have been quick out of the blocks to dismiss this soft patch as nothing more than a transitory phase. Still to us, this week’s move looks like an opportunistic rate hike if anything, making use of the fairly benign market conditions to take another step away from the zero-lower bound. Not everyone in the FOMC may agree, so watch out for dissenters (Kashkari, possibly Brainard). As for the economic projections, well there’s an outside chance that the growth and inflation profile could be tinkered lower – the extent to which will be telling of just how transitory some members see the current slowdown. We see downside risks to the Fed’s dot projections as well, although it’s more likely that we’ll see a more positive skew rather than any wholesale changes to the median dots. We think the Fed have been somewhat clever in constructing a dot plot that serves to fit in either a world of Trump ‘reflation’ or the status quo of secular ‘lowflation’. A hike this week means that we’ll move one step closer towards the start of the Fed’s balance sheet reduction. We’re likely to see the normalisation principles updated, though overall we don’t expect to see any surprises that could lift the $.

EUR: Quiet EZ week allows focus to shift to central bank events elsewhere In the EZ, we expect a relatively calm week following the June ECB meeting; the German ZEW index (Tue) should pick up. EUR/$ neutral around 1.12 this week.

GBP: Short-term political woes could see GBP/USD decline towards 1.25 The dust is beginning to settle following another UK election rollercoaster. Still, there remain many domestic political – as well as Brexit policy – unknowns that will continue to hangover the pound over the coming weeks: Domestic political risk premium: Theresa May has unequivocally stated her intention to stay on as Prime Minister and while there may be some underlying unrest within the Conservative Party, it seems that a leadership contest at this stage remains highly unlikely – especially as it would see another election that could risk handing the keys to Downing Street over to Jeremy Corbyn. On that note, the Labour leader hasn’t given up on forming a minority government and putting forward an alternative Queen’s speech – but again this seems unlikely. Still, we note that any confidence and supply arrangement between the Tories and DUP would be a less stable form of government than the 2010 coalition. It would risk slowing down the legislative process on key policy areas – not least the Budget and Brexit. Political uncertainty remains a headwind for GBP. ‘Hard’ Brexit risk premium: Brexit negotiations are set to begin shortly and the UK’s position remains up in the air. Calls for a ‘softer’ Brexit seem pre-mature, especially as Labour have signalled their intent to leave the single market. What we do see, however, is an economically rational Brexit – with the dial shifting towards obtaining a deal that is in best interests of the UK’s long-run economic prospects. This would be a net positive for a undervalued GBP.

EM-dedicated fund flows (up to June 7) amounted to US$2.3bn of inflows, an increase of US$500m from the week before. Hard currency funds saw nearly two-thirds of the inflows at US$1.8bn (1% AUM).Local currency funds also saw US$600m of inflows. This brings YTD inflows to US$22bn in hard currency and US$12bn in local currency. Inflows into ETFs stood at 40% of the total, up from 30% YTD. The majority of the ETF inflow is concentrated in one hard currency ETF, showing investors’ appetite for low-cost, passive investment.

China headline PPI slowed more than expected: May headline PPI came in at 5.5%Y,a tenth lower than consensus expectations, reflecting weak commodity prices. However, non-commodity PPI and core CPI in May did hold steady relative to April levels. Yesterday’s FX reserve numbers showed an increase of ~US$3bn in reserves after adjusting for valuation effects, marking the fourth consecutive month of reserve growth. While USD/CNY could move higher in the medium term, we believe that recent CNY appreciation versus USD is a tactical adjustment reflecting USD weakness, and we’ve advocated a tactically bullish stance on RMB.

Slower growth and weakening revenue have weighed on fiscal performance. The weak growth outlook also forced the government to increase nominal spending, with a consequent jump in the annual deficit to its highest since the beginning of 2010. The government measures are to expire by year-end, with likely improvement in budget metrics next year, though currently increasing the Treasury’s borrowing requirement.

According to the Ministry of Finance, the budget deficit will be c.TRY61.1bn at end- 2017 (translating into 2% of GDP, vs 1.9% already as of April, on a 12M rolling basis), implying that stimulus measures like VAT cuts on certain consumer durables, deferral of social security premiums for new hirings, etc, will not be extended. Given that most of these measures are temporary in nature, we are likely to see an improvement in fiscal performance next year, while early elections, ruled out by the government so far, remains a key risk. The debt-to-GDP ratio, on the other hand, is envisaged at c.30%, still comparing favourably with other emerging markets.

TurkStat is due to release 1Q17 GDP data next week. We expect a continuation of the recovery that started in the last quarter of 2016. Recently released indicators hint at some further acceleration in 2Q17 economic activity, with higher PMI in tandem with rising CUR. Improvement in sectoral and consumer confidence after the referendum should also contribute to the recovery.
Following the significant deterioration in recent months, with the lagged spill-overs from TRY depreciation and volatility in food prices, inflation showed a modest improvement in May, from the peak realised in April. However, we think that May inflation will not make any significant impact on CBT behaviour. The central bank is likely to refrain from early easing and keep the current tight liquidity stance for a while, until recovery in the inflation outlook becomes apparent. Apart from the CBT’s liquidity tightness, the continued supportive global environment and a REER close to the lowest level realised since the 2001 financial crisis are likely to support TRY in the near term. Significant external financing needs are likely to remain a source of weakness in the longer term.

Elevated inflation and the CBT’s consequent policy tightening have kept the yield curve inverted in recent months, while an improving domestic climate after the referendum has accelerated debt inflows since mid-April, though foreign ownership of domestic debt remained low. Following a c.150bp rally in the long end from the peaks realised at the beginning of this year, we do not expect further strong performance.

USDJPY has rebounded, but still needs to overcome the 110.20/40 resistance zone to stabilise medium-term prospects from a technical perspective. Fundamentally, chances of a USDJPY rebound have improved. James Comey’s statement released yesterday was non-controversial and today’s hearing is unlikely to go beyond what has been stated yesterday. This morning’s Q1 GDP release showing nominal GDP shrinking by 0.3%Q and the deflator declining by 0.8%Y suggests that Japan may need continued monetary accommodation support. BoJ’s Kuroda seems to be in a similar position as ECB’s Draghi in being pressed by hawkish politicians to define its exit strategy from monetary stimulus. In light of the disappointing Q1 GDP report, the BoJ is thinking how to re-calibrate its communications to acknowledge that it is thinking about how to handle a future exit from monetary stimulus, without giving the impression that this is on the agenda anytime soon.

MoF flow data. The release of April’s MoF security flow data revealing a JPY4.2trn repatriation from foreign bond markets including the US and Europe is making headlines, but is water under the bridge. It is ‘yesterday’s story’ related to French election uncertainties, fading the Trump trade, Japanese lifers’ fiscal year end window dressing, and the Japanese banking sector dealing with an expected adjustment in the regulatory regime. The MoF’s weekly security flow data covering the month of May showed sizeable foreign bond buying interest. It was only last week when Japan-based accounts were selling foreign bonds again. The more interesting part of the MoFreport reveals that foreign flows into Japan’s money market funds has sharply reversed, suggesting that the ‘monetization’ of the USDJPY basis may have slowed, nd that Japan’s USD hedging costs may not fall much further from here.

The failure to secure political stability – and the outcome of a hung parliament – was always going to be the pound’s nightmare scenario. When Theresa May called this election, markets were viewing things through the rosiest of lenses – with hopes that political uncertainty would decrease substantially under a more stable Conservative government. That narrative has been all but dashed. With the two-year Article 50 clock ticking, the passage of time is GBP negative; a working government is needed as soon as possible to avoid a further drop in the pound. The most likely path looks to be a Conservative-led coalition with the Democratic Unionist Party (DUP); while it may not be straightforward given noise over Theresa May possibly standing down, GBP could enjoy a small relief rally on any political clarity. The worst outcome for GBP now is any prolonged political uncertainty and difficulties in forming a working government over the coming days; here we would expect GBP to trade with a 3-4% political risk premium, with GBP/USD falling back to 1.24 and EUR/GBP moving up towards 0.90.

The FT reports that Labour and Conservative party strategists predict a comfortable 50-100 seats majority for the Tories. If confirmed, markets may see an initial relief rally. Nonetheless, over recent weeks, GBP has turned from a ‘buy the dip’ into a ‘sell the rally’ currency. We cite a handful of reasons.First,valuation is no longer as much in favour of sterling as compared to November when we expressed our out-of-consensus bullish GBP call. Second, GBP weakness has failed to provide a positive contribution to net exports. Third, EMU’s negotiation stance has hardened. Instead of considering making concessions to the UK, the EU has started focusing on deeper political and economic integration.Fourth, PM May has been criticised of weakness during what the FT has suggested has been “widely seen as a misfiring campaign’after the apparent reversal of part of the social care policy.Finally, the UK’s national balance sheethas weakened over recent months as households reduced savings, bringing forward consumption, while the real estate sector has started slowing as indicated by today’s release of the May RICS house price index slowing from 22% to 17%.

The Monetary Policy Committee (Copom) cut the Selic rate by 100 basis points (bps), from 11.25% p.a. to 10.25% p.a., at its May 31 meeting. The decision was in line with our forecast and that of the vast majority of market participants (43 out of 47 institutions, according to Bloomberg). The communiqué released after the meeting signaled moderate reduction in the pace of the current easing cycle at July’s meeting. The committee’s view is that greater uncertainty regarding the speed of the approval of reforms has deteriorated the balance of risks for inflation. The committee ascribes a higher probability to scenarios in which reforms are postponed and is uncertain of how inflation would evolve in those cases. The document also emphasized that the reduction in pace is still conditional on the dynamics of economic activity, inflation expectations, and the committee’s own understanding of the extent of the current easing cycle. We share the view that the latest political developments have increased uncertainty regarding the approval of reforms.

At least for the next few months, members of Congress will probably not be inclined to approve any significant bills, especially those that require close coordination, such as social security reform. The most likely scenario is that, if approved, the social security reform will be further diluted, therefore with a milder impact on fiscal accounts. As we have already argued in several of our publications, a strong social security reform is required in order to stabilize primary expenditures and, consequently, to comply with the cap on primary expenditures. The more uncertain scenario regarding the approval of reforms in Congress and the recognition by Copom members that the probability of negative scenarios has increased lead us to revise our base-case scenario for the path of the Selic rate in the coming months. We now expect a smaller rate cut in the Selic rate at the Copom’s next two meetings on July 26 and September 6, from 100bps to 75bps. If our forecast materializes, the Selic rate will decline from the current 10.25% p.a. to 8.75% p.a. in September.

The Copom unanimously decided to reduce the Selic rate by one percentage point, to 10.25 percent per year, without bias. The following observations provide an update of the Copom’s baseline scenario: The set of indicators of economic activity released since the last Copom meeting remains consistent with stabilization of the Brazilian economy in the short run and a gradual recovery during the course of the year. If sustained over a long period, high levels of uncertainty regarding the evolution of reforms and adjustments in the economy can have detrimental effects on economic activity; Stronger global economic activity has so far mitigated the effects on the Brazilian economy of possible changes of economic policy in central economies; Inflation developments remain favorable.

Disinflation is widespread and includes IPCA components that are most sensitive to the business cycle and monetary policy. It is necessary to monitor possible impacts of higher uncertainty on the prospective path of inflation; Inflation expectations for 2017 collected by the Focus survey fell to around 4.0%. Expectations for 2018 are around 4.4%, and expectations for 2019 and longer horizons are around 4.25%; and The Copom’s inflation projections for 2017 and 2018 in the scenario with interest rate and exchange rate paths extracted from the Focus survey are around 4.0% and 4.6%, respectively. This scenario assumes a path for the policy interest rate that ends 2017 at 8.5% and remains at that level until the end of 2018. The Committee emphasizes that its conditional inflation forecasts currently involve a higher level of uncertainty. The Committee views the heightened uncertainty regarding the speed of the process of reforms and adjustments in the Brazilian economy as the main risk factor. This arises from both a higher probability of scenarios that may hinder this process, and the difficulty in assessing the effects of these scenarios on the determinants of inflation. Taking into account the baseline scenario, the balance of risks, and the wide array of available information, the Copom unanimously decided to reduce the Selic rate by one percentage point, to 10.25 percent per year, without bias.

The Committee judges that convergence of inflation to the 4.5% target over the relevant horizon for the conduct of monetary policy, which includes 2017 and, to a greater extent, 2018, is compatible with the monetary easing process. The Copom emphasizes that the extension of the monetary easing cycle will depend, among other factors, on estimates of the structural interest rate of the Brazilian economy. The Committee judges that the recent increase in the uncertainty regarding the evolution of reforms and adjustments in the economy hampers a more timely reduction of estimates of the structural interest rate, and makes them more uncertain. The Committee will continue to reassess these estimates over time. In light of the basic scenario and current balance of risks, the Copom judges that a moderate reduction of the pace of monetary easing relative to the pace adopted today is likely to be appropriate at its next meeting. Naturally, the pace of monetary easing will continue to depend on the evolution of economic activity, the balance of risks, possible reassessments of the extension of the cycle, and on inflation forecasts and expectations.

As USD sentiment hits the lowest level since May 2011 (only 5% of traders are bullish), we are now seeing the flows-related impact on the treasury market. Yesterday saw a very weak 1 year US government T-bill auction, where the bid to cover ratio, at 2.84, was the lowest since 2009. USDJPY may have rallied yesterday in response to longer end yields rising but we feel that for the USD to rally more broadly, you need to have the supporting capital inflows to the US. Lack of demand at a bond auction may naturally suggest less global USD asset demand. Recently, foreign investor participation in 10y bond auctions has fallen to 16% relative to a high of 28% in April. We see the USD weakening vs the EUR and tactically further vs NZD.

Political stability and increasing voices from core Eurozone countries to move towards a fiscal union have driven the EUR higher. The improved sentiment and growth outlook supports equity inflows. Helped further by Schauble and Merkel saying the EUR is too low for Germany, foreigners have been buying Eurozone equities on a currency unhedged basis (USD7bn since March via ETFs), in contrast with only a fraction with the FX hedge (USD0.9bn). In 2014, when inflows were with a currency hedge, stronger risk appetite drove EURUSD lower (the negative correlation). Today, stronger risk appetite should drive EURUSD higher (the positive correlation). We are already starting to see the EUR moving in line with positive economic data surprises (see Exhibit). Stronger growth means a stronger EUR.

But what about EUR bond flows? EURUSD is trading much higher than where the German-US 10y spread would suggest. Since August 2016, the correlation between the bond and FX market was close and using that relationship, the EUR should be trading close towards 1.10 (vs 1.1170 today). . The difference, we think, can be attributed to the equity inflows. Bond inflows may have not picked up as significantly due to the uncertainty that ECB tapering may bring for that market. We believe we need to see much higher yields before the equity inflow turns into a more sustained bond inflow. As of the last update of the balance of payments in March, Eurozone investors were still buying more foreign bonds than foreign investors were buying of theirs. Japan’s weekly security flow data is released overnight, where weakness in USDJPY would suggest Japanese had slowed bond purchases last week, but we don’t expect that to last.

As equity volatility has come down to close to its lows (VIX at 10.72),even China’s sovereign rating being downgraded by Moody’s to A1 from Aa3hasn’t dented risk appetite in the Asian market. China was put on negative watch in March 2016, therefore it is the timing of today’s announcement thathas come as a surprise. Moody’s cited an expectation that financial strength will erode somewhat over the coming years as debt increases and potential growth slows. AUDUSD has weakened 0.5% overnight, suggesting the technical uptrend is complete. We keep our bearish AUD bias driven more by domestic factors, such as the housing market. Construction activity fell by 0.7% in 1Q, leading to a 1Q GDP tracking estimate of -0.2% QoQ.

The market prices an 81% probability of a Fed rate hike in June, supported further by the Fed’s Harker saying that a June hike “is a distinct possibility”. The FOMC minutes will be watched to provide clues on the path for rates and how the committee views that tightening measure along with balance sheet reduction. Market expectations for the OPEC meeting tomorrow are for a 9-month extension to the production cut. Today US crude inventory data will be watched for NOK and CAD investors. The US budget proposed yesterday to sell 270 million barrels of oil from the Strategic Petroleum Reserve over the next decade.

10Y bond spreads have overall widened in the last one week (1W). Central America and LatAm have widened the most, while Asia is the only region to tighten in the last 1W. All the credit rating buckets have widened over the last 1W, with BB rated credits underperforming the most.

10s30s spread curves steepened by 1bp in the last 1W to currently stand at 64bp. On an absolute basis, COL is the steepest curve, while PHI is the flattest. On a 6m z-score basis SOAF and ARG are the steepest curves, while BRA is the flattest.
The CDS-bond basis decreased by 2bp in the last 1W to currently trade at positive 11bp. This leaves the basis close to the 6m average of 10bp. On a 6m z-score basis BRA has the most positive basis, while SOAF, PHI and INDO have the most negative.

As the markets recover from last week’s jolt triggered by allegations by Washington Post and New York Times that President Trump urged director Comey to end investigations into General Michael Flynn, who was forced to resign from the post of National Security Advisor based on a memo allegedly written by James Comey and read out to the reporters of New York Times by an anonymous source, the hike probabilities have started to strengthen but are still a bit far from pricing two more hikes.

The probability of the next hike to be in June increased from 65 percent last week to 79 percent as of latest. However, the market is pricing just 43 percent chance of the third hike in December. Some of the policymakers have also recently toned down their rhetoric towards the rate hike path. St. Louis Fed President James Bullard has recently commented that expected rate hike path is too aggressive. He also raised doubts about the June hike possibility. While Mr. Bullard is not a voting member of this year’s FOMC, his comments might be resonating the views of other policymakers too.

The ruling ANC has for many years called for radical transformation, of society and the economy, to attain “shared prosperity, social justice and human solidarity”. Yet it is still not clear what radical policies and tactics will be employed. Its nine Discussion Documents, prepared for its National Policy Conference starting on 30 June, do not in general reveal much that is radical, in our assessment. Radical interventions may well be formulated at the Policy Conference in July and adopted at the Elective Conference in December 2017, but for now we highlight the following themes:

The Discussion Documents in general reveal: first, honest self-reflection on the recent failings of the party and the need for renewal to arrest its “declining fortunes”; second, a continued reference to the National Development Plan, as the guiding long-term plan; third, statements on fiscal and monetary policy that investors will find reassuring, in our view; fourth, acknowledgements of where policy and tactics have not worked and which need to be reformed; fifth, a continued devotion to the utilization of state-owned enterprises as channels for economic development; and sixth, a desire to transform the other three pillars of the state – the legislature, the judiciary and the media. A final general observation is that the documents, as they currently stand, allow for wide interpretation of what radical transformation would look like and how it would be achieved. Herein lies the uncertainty for investors.

Of 108 key selected extracts – statements, proposals or tactics ? from the nine Discussion Documents, we consider: (a) 70 (in isolation) as positive for growth, productivity and investment; (b) 30 as neutral, either because we have uncertainty about intentions or they have little direct financial market impact; and (c) 8 as negative. Within the list of 70 ‘positive’ statements, proposals and tactics, we think that 32 have elements over which investors have doubts, be they about the ANC’s commitment, implementation, funding or unintended consequences of policies. Within the list of 30 ‘neutral’ statements, proposals and tactics, we think that 19 have elements over which investors have uncertainties. Within the list of 8 ‘negative’ statements, proposals and tactics, all will be of concern to investors.

There is much in the ANC documents that is worthy of debate and serious analysis. We are however concerned that this will not happen at the ANC’s Policy Conference, which could be used by factions to strengthen positions for the party’s leadership battle. Policy positions could end up being mere proxies for factions, according to former Deputy Finance Minister Jonas, who recently also said that populism could hijack the policy discussions.


US Interest Rates and the Fed
The Federal Reserve left monetary policy unchanged yesterday in what was a unanimous decision. The accompanying statement saw few meaningful changes to the one issued following the March announcement. The Fed still expects inflation to “stabilise around 2% over the medium term” while growth risks “appear roughly balanced”. There were slight nuances given that 1Q GDP was disappointing and the PCE deflator has softened recently, but the Fed suspect’s these developments will be “transitory”. In terms of the direction of policy the Fed reiterated that they believe economic conditions will “evolve in a manner that will warrant gradual increases in the federal funds rate”. Their last forecast update, published in March, showed that at that point in time the median Fed member’s expectation for the Fed funds rate was 1.4% for end-2017, 2.1% for 2018 before rising to 3% by end-2019. In terms of the outlook for policy we continue to favour just one 25bp hike this year rather than the two to three currently pencilled into the Fed’s FOMC member forecasts and the 40bp of tightening priced in by the OIS curve. The recent data flow has been somewhat softer than hoped, be it business surveys, GDP, employment growth or inflation. There is also a lack of clarity on the scale and timing of any fiscal stimulus brought about through President Donald Trump’s tax and spending plans. Consequently, there is scope for market disappointment that could lead the Fed to reappraise the situation. The statement also repeated that the Fed will maintain its “existing policy of reinvesting principal payments from its holdings” of debt securities and of “rolling over maturing Treasury securities at auction”. We will have to wait for the minutes to this meeting to see the actual discussion around this. Last time officials suggested that we could hear something about lowering the reinvestment rate this year. Such action would reduce demand from the biggest buyer and likely lead to higher longer dated bond yields and a steeper yield curve. However, given our more cautious prediction for Federal Reserve rate hikes we see scope for this policy change to slip into early 2018 – note the line that the wind down in the balance sheet won’t start “until normalization of the level of the federal funds rate is well under way”.


European Interest Rates
The outcome of the first round the French presidential election will likely dominate global yield behavior over the coming two weeks. Whether the impact will be limited to that period or last longer will depend on the outcome. In our view, the risk of surprise is higher in the first round, given how closely bunched together candidates’ poll numbers are (Macron 23%, Le Pen 22%, Fillon 20%, Melenchon 19%). It appears likely that the candidates’ final poll readings could end up within the margin of error ahead of the election, making it hard for markets to price out this risk ahead of actual results. The main reason, of course, is that both Le Pen and far-left candidate Melenchon are staunchly anti-EU, and a victory by either would be highly disruptive for both France and Europe more broadly. Alleviating some of the tight polling in the first round is the fact that the second round polls show a comfortable margin for either mainstream candidate (Macron or Fillon) in a head-to-head matchup with Le Pen. Even here, however, there are some risks, as there’s more of a mixed result versus Melenchon. The real risk to markets then, appears to be Melenchon making it to the second round. We discuss how interest rates markets may react to the various outcomes in the first round below. The first, and more likely scenario in our European economists view, is that Le Pen and Macron will be the top two finishers in the first round. In this case, polls indicate that Macron is expected to win fairly easily in the second round, having consistently led by about a 20 point margin—markets would view this outcome as fairly benign. We had estimated previously that there was about 25bp of “redenomination risk” premium in Bunds.

Since then, more of this negative premium has been priced into German sovereign debt, and we now estimate there’s about 35bp. Some of this is likely to be unwound immediately following this outcome in the first round, though not the entire 35bp as the second round polls are still over two weeks away. In terms of peripheral spreads, this would mean compression, given that they are currently close to their widest levels seen in the past few years. Some caveats are in order; in the event that Le Pen wins with a much larger margin than current polls show, the selloff in bunds may be rather muted, given that a surprisingly large margin could reveal some polling issues.


Global FX, DXY strength, China and AUD
The DXY is expected to gain further from here, with the overnight FOMC statement helping to restore USD optimism. Our probability of the Fed hiking rates on 14th June has risen to 80%+ after the Fed called the slowing in growth during the first quarter as ‘likely to be transitory’ and that the fundamentals for consumer spending ‘remained solid.’
Today will see US releases on trade, initial jobless claims and factory orders. Initial jobless claims may have been distorted by the Easter holidays; hence we will not pay too much attention to a potential rise in claims. Weak productivity data is a reflection of the past and the natural consequence of the rising labour/capital ratio witnessed in the US over the past years. Factory orders have improved substantially over recent months, seeing orders ex transportation now gaining 7.5%Y, representing its best expansion for more than 5 years. March trade data should be looked at in terms of activity, with rising imports and exports pushing the USD higher. US trade is now in a better position compared to previous occasions when the US was aiming for higher growth rates. Previously, better US demand acted as a magnet for imports, driving the trade deficit swiftly higher. Nowadays, the increasing output of the US energy sector reduces energy imports and likewise increases energy exports, helping to keep the trade deficit stable for longer.

USDJPY has reached 112.89 overnight and will now need to overcome the 112.90/113.10 resistance to open upside potential to 116.50. Our bearish JPY call requires markets to stay confident on the global reflation outlook. The Fed expressed this confidence yesterday, but commodity prices have come off sharply over recent days, suggesting USDJPY may see some corrective activity before overcoming the 113.10 resistance. Over the next few days, AUD may be the better short instead. China related commodities have come under selling pressure with iron ore and coal futures now approaching their mid-April lows. China’s PMI releases including today’s services sector PMI have disappointed. Its equity markethas underperformed while its bond yields have risen, indicating that China’s financial conditions have tightened. The mini tightening cycle designed to reduce the pace of leverage build-up seems to now be impacting China’s economy. The PBoC has injected RMB 140bn (USD 20.3bn) on Wednesday, representing the largest single-day addition since 19th January, but their refraining from rolling over maturing medium-term lending facility loans caused the seven-day repo rate to rise 80bp to 4.5%. Back-end RMB yields have continued to rise, representing bad news for the AUD.

Rising RMB yields may undermine the AUD from various sides, especially if the yield increase is not covered by better Chinese economic data. First, the discrepancy between the evolution of China’s economic growth rate and yield does not only signal tighter financial conditions, it also highlights the risk of the economy deleveraging, suggesting it will lose further growth momentum. Secondly, globally rising bond yields increase the funding costs of Australia’s wholesale dependent banking sector.


The JPY, US Yield Curve, Asian FX and Global Bonds
The JPY is set to weaken further from here. Importantly, US Congressional leaders reached a tentative deal on government spending to end Sep, averting a shutdown, suggesting the US Treasury will increase its cash balance somewhat. The sharp decline of the Treasury’s cash level starting in February has unleashed additional cash, pushing US front end rates lower, and adding to the trend of the 3m USDJPY cross-currency basis tightening from -91bp in November to -22bp in March. Now the reverse should be expected with higher US bond yields and prospects of the upcoming US tax reform not only increasing US demand for capital, but also the potential repatriation of part of the USD 1.2-1.4trn of US corporates’ foreign earnings held in cash and marketable securities reducing the availability of offshore USDs. EURJPY has reached its highest level since 14th March.

US Treasury Secretary Mnuchin underlined the government’s 3% GDP target which he hopes could be reached through revamping the tax system, regulatory overhaul and improving trade agreements. Interestingly, he pointed out that the difference between 2% or 3% GDP growth could make up USD2trn of additional tax revenues, providing further indication of the US administration aiming for a tax reform which initially may be funded via higher deficits. His hint of using the very long end of the US yield curve for funding added to the steepening of US yield curve. Transportation Secretary Elaine Chao said the Trump administration’s sweeping infrastructure proposal will be unveiled ‘fairly shortly’. Wednesday’s vote on the Obamacare Repeal Act – if successful – could spark further optimism around the administration regaining its ability to push through reform. It may be this optimism pushing US share prices higher, volatility lower and yield differentials and the USD higher against low yielding currencies.

It seems the US administration’s future economic and fiscal plans overrule macroeconomics for now. US and global data have all been coming in weak with the Australian and the Indonesian PMI being the exception. Despite a string of mostly disappointing PMIs from Asia, the procyclical currencies in the region are the outperformers globally so far this week: TWD, NZD, MYR, KRW and AUD. The US equity market no longer takes the lead from the economic surprise indicator which has fallen to its lowest level since October 2016. It seems that declining global headwinds and prospects of an increasing pace of reform in the US have persuaded US investors to stay long risk.

Interestingly,global bond yields rallied overnight with better risk appetite and rebounding industrial raw material prices helping. Barely noticed has been the stabilisation of the CRB Rind index and copper futures challenging its three months downtrend. Apparently, commodity markets have looked beyond China using the stabilisation of its capital account to rebalance the domestic side of its economy away from its old commodity-intensive areas such as property. According to the Chinese Economic Daily, the sale of commercial property in Beijing slipped to 84 units compared to 807 units this time last year,. Sales volume in first- and second-tier cities fell to the lowest level

Predictably, the announcement of the US tax reform lacked funding details and hence has come under immediate criticism. For instance, the Committee for a Responsible Federal Budget released a rough analysis saying the plan could cost USD3-7trn over the next decade, potentially “harming economic growth instead of boosting it.” Markets reversed early gains. We stay firmly within the reflation camp and view USDJPY setbacks to 111.00 as a buying opportunity. Today’s US durable goods release may confirm that US capex is on the rise, pushing rate and yield differentials wider in support of USDJPY. Today’s ECB press conference may see a cautious Draghi relative to expectations fearing an early tightening signal may push BTP spreads wider. EURUSD should stay offered below 1.0970 with the risk of closing Monday’s opening gap down to 1.0870.
Although Chinese equity markets recouped most of their early morning losses, the divergence in their performance relative to DM equity markets witnessed since November has caught our eye. We are bearish on low yielding commodity currencies and run aggressive AUD short positions. There are many reasons suggesting AUD weakness, reaching from too low AUD-supportive interest rate and yield differentials to fund Australia’s 60% of GDP foreign liability position, to an overvalued property market running the risk of unleashing deflationary pressures once prices come off the highs. However, our best reason for running AUD shorts is that Australia has builtup capacity to deliver into the ‘old’ China, an economy expanding via commodity intensive sectors such as investment and property. An evolutionary China rebalancing its economy away from investment and property will leave Australia’s commodity overcapacity exposed.

It may be debatable whether the equity performance gap between the US and China will widen further from here or whether China’s equity markets will catch up with the better US performance. What is true is that the recent decline in China’s stock prices came along with peaking margin debt. Higher RMB funding costs may have triggered leveraged share investors to take some chips out of the market, leading to the diverging China – US equity trend. The connectivity into the FX market comes via the RMB TWI weakness and may have contributed to the increase in RMB yields. While a lower RMB TWI helps China utilise its capacity and hence is good for its growth outlook, there is a risk within the highly leveraged economy that rising debt funding costs more than undermine the positive impact coming from the FX side. The relative weakness of China’s equity market may be a symptom of this development and this morning’s disappointing release of China’s March corporate profits did nothelp China’s equity markets either (the gain for industrial profits was 7.7% lower than in the January-February period, but it was 12.7% higher than the gain in March 2016). The message seems clear: China should concentrate on bringing its funding costs lower, shifting its focus away from RMB TWI weakness. Since the RMB is quasi-pegged to the USD, this shift of China’s policy focus will work in support of the USD.

AUD, with its significant trade exposure to China, should weaken most should China reduce its resistance to the USD rising allowing the RMB TWI to rebound. China may need capital inflows into the bond market to reduce capital funding costs. Since RMB hedging tools are not as developed as in G4 currencies and hence less efficient to use, currency stability is an essential tool convincing non-RMB-based investors to allocate funds into China. Consequently, the rising USD will put AUDUSD under selling pressure. This move may be leveraged by redirected capital flows from G4 into China, pushing G4 bond yields higher. Australia’s banking sector has reduced its wholesale funding dependence over the course of the past decade, but still has one of the most wholesale funding-dependent banking sectors within G10. Hence rising G4 rates and yields mechanically increase local AUD funding costs without the RBA increasing its rates. This is why we are sceptical of Australia maintaining its real estate strength at times of globally rising funding costs.

The best case scenario for markets would clearly be the elimination of the two “extreme” candidates: if Macron and Fillon manage to top French voters’ preferences on the 23rd, we anticipate a risk on move from financial markets. The worst outcome for risk assets would be a second round featuring Le Pen and Melenchon. Although we would expect markets to be volatile for some time, such an outcome wouldn’t equate to the end of the world (yet), as it is unlikely that an extremist candidate, even if appointed President, would be able to do much harm without a parliamentary majority.
Historically, France always had two strong candidates, coming from the two main parties. This time round, there is a significant chance that none of them will be represented in the second round. Indeed, this election has faced a series of twists:

? Initial favorite candidate, Francois Fillon (center-right), has lost more than ten points in the polls, partly because of his family’s allegedly fictitious employment issues. Although only third in most polls, Fillon can count on a solid base of center-right voters to keep alive the possibility of being in the second round.
? Macron (center) has managed to emerge as a credible candidate and is now ahead in all polls – with a remaining fragility, though: his voters’ loyalty is seen as lower than than of Fillon or Le Pen’s.
? Marine Le Pen’s campaign hasn’t seen any momentum so far. Starting from a very high position, she has slowly been trending down over the past two months – still, she should still manage to access the second round. She doesn’t seem able to attract new voters, though.
? Finally, Melenchon (far-left)’s support has surged in the past few days pushing him up to the fourth position in the presidential race with a score very close to Fillon’s one. Meaning he could still make it to the final round.
If anything, as soon as the risk of “Frexit” comes into view, we believe the issue for markets will not be France leaving the euro, but the euro leaving France. The most likely reaction to such an episode of financial stress would be a political response in the opposite direction, we believe. If Le Pen and Macron move on, they expect a likely unwind of some of the “redenomination risk” premium embedded in bunds and compression in peripheral spreads. Melenchon in the second round, on the other hand, would present a risk to markets given his favorable second round polling against Fillon and Le Pen. In a favourable outcome EURUSD may move quickly towards their 1.10 3 month forecast. An adverse scenario may see a drop towards recent lows below 1.04.

Historically, exit polls provide a first estimate of results at 8pm local time. However, conclusive results could be available a little later as it could be hard to get a precise estimate of the two winners early, if results are very close. Note that although French media are not allowed to publish any results before 8:00 pm on Sunday, it is possible, as happened in the past, that medias in other countries will. Participation rates at 12pm and 5pm are also worth watching: we believe a high participation rate could be negative for Le Pen (and to a lesser extent for Fillon) – and potentially positive for Macron or Melenchon – and viceversa, providing an early indication on the direction things might take.

Through the early-2017, Canada’s economy continued to bolster; however, the sources of the accelerating growth of the nation are proving slightly different from the ones expected a few months ago, noted Scotiabank in a research report. In the hand-off from last year, the rising affordability concerns were expected to be a drag on housing and auto sales, while record consumer indebtedness and increasing interest rates would possibly hurt consumption growth.

These mild drags were expected to be countered by strengthening investment, rising non-energy exports, and follow-through on public infrastructure plans. However, housing, auto sales and consumption growth have not decelerated, whereas business capital spending and non-energy exports have not accelerated. Also, public-infrastructure spending is delayed, stated Scotiabank.

The main growth drivers of Canada’s economy continue to be the same and imbalanced. According to Scotiabank, the Canadian economy is expected to expand 2.3 percent this year, whereas it is likely to grow 2 percent next year. The sources of Canada’s GDP growth are projected to start shifting and diversifying in the year ahead, lowering the economy’s dependence on housing and consumption and increasing the contribution of exports and investment to growth, added Scotiabank.

The Central Bank of Russia is expected to continue the series of the key rate cut. There is a 100 percent possibility for the CBR to continue cutting its key interest rate, noted Nordea Bank in a research report. Inflation in the country is at the lowest levels since the post-Soviet period. Furthermore, the inflation expectations are trending lower.

In the meantime, the Russian economic growth figures are not positively surpassing expectations at present. Growth in retail sales continues to be negative, while capital construction fell 5.4 percent in the first quarter of 2017. Also, investment activity growth continues to be symbolic. Thus, certain stimulus is required and it can be achieved through easing of the monetary policy.

Firms in Russia do not mention the interest rates as the top thing as the hindrance for business development. Meanwhile, money market rates have already begun pricing in a rate cut.

There are some factors that might prevent the Russian central bank from aggressive rate cuts. There is uncertainty regarding the OPEC/OPEC+ agreement for the second half of this year. If the agreement is not prolonged, oil prices might decline and inflation might accelerate in tandem resulting in depreciation of the RUB. Meanwhile, high consumption growth can also pose as a threat to the inflation. Additional aggressive rate cuts would stand out against the central bank’s cautious rhetoric and earlier take steps, stated Nordea Bank.

The euro area economy has indicated signs of a considerable acceleration following a 0.4 percent quarter-on-quarter growth in the fourth quarter of last year. Recently, all business surveys have continuously surprised on the upside, indicating towards GDP growth accelerating closer to 2.5 percent year-on-year, a rise from 1.7 percent year-on-year recorded at the end of 2016. This is stronger than the possible growth estimated at about 1.1 percent year-on-year, suggesting that the euro area output gap might be closing at a much rapid rate as compared to projected earlier, noted Scotiabank in a research report.

Throughout the euro area, Germany is expected to be an economic outperformer, owing to the firming global demand. The latest IFO surveys have come to their highest levels since 2011 when the German GDP growth was growing by over 4 percent year-on-year. But there are also signs that the euro area recovery is widening throughout its member states. The PMIs are rising in Italy and France in spite of the negative effect of increased political uncertainty, stated Scotiabank.

Moreover, increased supportive financial conditions continue to strengthen the euro area economic recovery, with interest rates staying at low levels along with continuing stimulus provided by the ECB. The subdued euro is also giving a boost, with the nominal effective exchange rate trending at its lowest level in nearly 15 years and helping local competitiveness. Hence, credit growth has bolstered, rising to 2.3 percent year-on-year in February, the most robust since 2009 and over double the growth pace witnessed a year ago. Overall, these developments bolster the view that the euro area economic recovery is becoming more sustainable, stated Scotiabank.

“The risk to the Eurozone growth outlook has now shifted to the upside, with both the EU Commission and the ECB revising their real GDP growth forecasts for this year and next year up closer to 2.0% y/y”, added Scotiabank.

The Leading Economic Index for the U.S. rose again in the month of March, rising 0.4 percent. This is the seventh straight rise. Of the total components, six of them contributed to the topline figure, whereas two segments contributed negatively, noted Wells Fargo in a research report.

The labor market component contributed negatively to the index. It had been contributing positively in recent time. Initial jobless claims and manufacturing hours negatively contributed 0.09 percentage points and 0.13 percentage points respectively from the topline figure.

Optimistic consumer expectations contributed 0.12 percentage points to the index, the largest contribution since December 2004. The interest rate spread contributed 0.19 percentage points. This was the largest contributor to the index in March. Meanwhile, ISM new orders and the housing permits components also contributed to the segment, adding 0.19 and 0.11 percentage points respectively. The Leading Economic Index’s upward trend continues to signal moderate economic growth in 2017, stated Wells Fargo.

The German bunds gained Friday, following a lower reading of the country’s manufacturing and composite PMI.

The yield on the benchmark 10-year bond, which moves inversely to its price, fell nearly 1 basis point to 0.24 percent, the long-term 30-year bond yields also slipped around 1 basis point to 0.95 percent and the yield on short-term 2-year bond plunged 1-1/2 basis points to -0.80 percent by 08:40 GMT.

The Markit Flash Germany Composite Output Index registered 56.3 in April, down from March’s near 6-year high of 57.1. This signaled the first easing in growth of private sector business activity since the start of the year, but still the second-fastest rate of expansion in over three years.

Further, the ongoing strength of business conditions in manufacturing, in particular, was reflected in the headline Markit Flash Germany Manufacturing PMI coming in little-changed from March’s 71-month high of 58.3, at 58.2.


Since Monday, April 10, positioning has shifted. Within G10, the largest shorts are still in USD and GBP; the largest long is now in EUR. EUR positioning moves further into long territory: All components except IMM showed an increase in EUR positioning. Global macro funds and Japanese retail accounts were big buyers, moving from neutral to long. Japanese retail accounts are now small net long EURJPY for the first time since November. Sentiment also turned less bearish, helped by a fall in USD bullish sentiment after Trump’s comments that the USD was getting too strong.

Non-commercial IMM accounts were the only ones who sold EUR, but their net short EUR positioning remains near the smallest since May 2014. The French election this Sunday will be the main driver for EUR; see our expectations for EURUSD under different scenarios here. JPY positioning remains neutral: Investors’ JPY positioning was mixed. Among Japanese investors, retail accounts were JPY sellers but Toshin accounts were buyers. Among global investors, global macro funds were sellers, but non-commercial IMM accounts were large buyers, and sentiment turned bullish, with the percentage of bullish JPY traders rising by nearly 20% on the week. We remain bullish on USDJPY strategically.

GBP short positioning unchanged: GBP was the second most sold currency among non-commercial IMM accounts, bringing these accounts’ short GBP positioning back near the historical high. Global macro funds were also large sellers. On the other hand, Japanese retail accounts doubled their long GBP positions last week, and sentiment became less bearish. This short positioning is likely to contribute to GBP strength on any positive news, as shown by the GBP rally today after the announcement of early elections. We still like EURGBP shorts on positioning differentials and the potential for GBP to develop a safe haven status should markets get worried about Eurozone political risks.


The first trading day after the long Easter weekend saw a lot of volatility in EGB markets, helped by the call for snap elections in the UK. Interestingly, despite the risk-off mood in equities and widening in iTraxx credit indices, peripheral EGB spreads managed to tighten. What is more, the 10yr OAT/Bund spread eventually closed little changed at 73p, although 5yr spread widened by 2bp. Thanks to the afternoon rally in US Treasuries, the 10yr Bund yield closed 3bp lower at 0.15%, hitting the low end of the year-to-date range. With four French presidential candidates clustered around 20% in the polls for the first round on Sunday and the backdrop of heightened geopolitical uncertainty, we expect core bond yields to hold at current depressed levels in coming days.

ECB QE data. In the first full week of buying subject to the new monthly target of €60bn total APP purchases amounted to €15bn, which suggests a moderate frontloading ahead of the Easter weekend. The PSSP accounted for €12.5bn, or 83% of the total. This share is within previous ranges, if not slightly lower, with the average since July 2016 at 85%.

EGB supply. Today Germany will re-open the off-the-run DBR 2.5 7/44 line for €1bn. The bond is trading exceptionally rich on ASW by historical standards (i.e. -38bp). However, it is also trading rich in repo (i.e. -0.85% s/n yesterday), suggesting a short base among dealers, and looks cheap on the curve, with the DBR 42/44/46 micro-fly at its highest level on record. This should ensure that the auction won’t fail. For comparison: the previous tap in February saw a real bid/cover of just 0.7 and a retention rate of 41.7% Elsewhere, KfW is expected to launch a new 5yr EUR benchmark today. Interpolating between the KFW 0 6/21 and 7/22 lines would pitch fair value on the secondary curve in the MS -39/-38bp area. Belgium yesterday announced that the bonds that will be tapped on April 24 are going to be the OLO 10/23 and 6/27 lines.


Energy
• Iran supports extension of the ‘cut’ deal: Bijan Zanganeh, Iran’s petroleum minister, has been quoted as saying that Iran would support an extension to the deal. Several other countries, including Saudi Arabia, Venezuela and Oman have already lent support to the extension, raising the probability of the OPEC/NOPEC deal staying intact until the end of the year.
• US crude inventory seen falling: A Bloomberg survey sees US crude oil inventory having fallen 1.4MMbbls WoW to 532MMbbls for the week ended 14 April 2017. In terms of products, gasoline and distillate inventory could drop by 2MMbbls and 1MMbbls, respectively, with refinery utilisation improving marginally by 0.2% to 91.2%. Drawdown in oil and products inventories is likely to help the current rally in oil prices continue.
Metals
• Australia Met coal supplies returning: The Goonyella coal rail system in Queensland could reopen as early as 26 April, vs the initial expectation of around 8 May, though with lower capacity and speed restrictions. With this, all four of Aurizon’s rail systems in Central Queensland will be operational, increasing Met coal exports from Australia and easing the supply shortage in key importing markets, including China and India, from next month onwards.
• Wage talks at Collahuasi: To allow more time for negotiations and avoid a stand-off (as seen at the Escondida mine earlier this year), management and labour unions at Collahuasi, Chile’s second-largest mine, have started wage negotiations early; the current contract expires in October 2017.
Agriculture
• Brazil sugar production: Conab, the Brazilian crop agency, expects the country’s sugar production to be flat at 38.7m tonnes for the 2017/18 season, which starts 1 April 2017. Sugar cane processing in the country could drop 1.5% YoY to 648m tonnes; however, high cane availability in the sugar industry (47.1%, vs 45.9% in 2016/17) is likely to keep sugar production flat.
• Dry weather in Latam supporting harvesting: After severe rains and floods over the past few weeks, the weather is getting drier in Latin America, supporting the soybean and corn harvests in Argentina and Brazil.


Political risk remains a key driver for FX markets, with a mix of predictable and unpredictable drivers. While the upcoming French presidential election and the weekend’s Turkish referendum have featured on calendars for some months, risks such as those associated with US foreign policy or South African politics have not. The latest “out of the blue” event is Theresa May’s decision to call for a UK general election on June 8. The move has been well received by GBP, based on the thesis that the Conservatives are likely to win by a landslide and have a clear mandate to push through Brexit negotiations without too much inconvenient domestic opposition. Remember that the next parliament would run through to summer 2022, giving plenty of time to negotiate and implement Brexit outcomes. Assuming an easy Conservative win with a large majority is indeed the election outcome, which is not unreasonable based on the latest polls, presumably this would also allow PM May more degrees of freedom to negotiate a softer form of Brexit than the market currently feels is achievable. After all, a large majority won directly by PM May would leave her much less vulnerable to rebellions from hawkish factions than she is today, given she currently has only a slim and inherited majority now.

One factor that helped the market price a form of “hard Brexit” in Q4 2016 was PM May’s 2 Oct 2016 speech to the Conservative Party autumn conference, where she suggested a firm commitment to contentious policy aims such withdrawing the UK from the European Court of Justice and seeking full control over UK immigration policy – policies seen as totally at odds with core EU principles and single market membership. In this context, it’s worth noting that May had claimed till yesterday that she did not believe a new election was in the national interest, but now “reluctantly” has changed her mind.

The same PM May was also a “remain” supporter who presumably only “reluctantly” is driving Brexit through having triggered Article 50 last month, at least based on her original position. As such, there is also room presumably for PM May to again “reluctantly” decide that the pledges she made last autumn are no longer in the national interest if they would lead to a disruptive form of Brexit. Simply having to price in higher odds of this series of events going forward are GBP positive in our view, even beyond the possibility of stable government being more likely. Finally, it’s worth noting that the June election could also pose a tricky test for the Scottish National Party. After all, it will be hard for the SNP to better its 2015 general election showing when it took nearly every Scottish seat in the UK parliament. Anything that falls short of that in June would allow PM May to attack the legitimacy of new moves towards a fresh Scottish independence referendum as SNP leaders have pushed for, again helping GBP on the margin.
The steady outperformance of EM currencies since the US election suggests that markets have been very willing to discount expectations that the US administration will deliver on the protectionist promises made during the campaign. We have ourselves participated in this trend, as per our long Mexican peso position.

The US administration’s aggressive stance on trade has also been a reason behind our ongoing bearish stance on the Canadian dollar. Last week the Bank of Canada made a significant shift in a less dovish direction, moving the projected date at which the output gap will close from mid-2018 to earlier in the year.

For Asia FX, slowing global industrial growth momentum is likely to become a key theme. We judge this global IP momentum to already be slowing from about 5% 3m/3m to closer to trend growth of about 3%. Although this would be a modest slowing in IP momentum by historical standards, it nonetheless seems to be having a historically standard negative effect on risk appetite. Core yields have fallen, core equities have begun to struggle and our technical analysts argue for further downside.

After the U.S. Vice President Mike pence visited the demilitarized zones between the South and North Korea and warned that the United States’ strategic patience with North Korea is over and sent a message to North Korea to not to test the resolve of President Trump, Russia has issued a warning to the United States against unilateral action in the region. Vice President Pence said, “In the past two weeks, the world witnessed the strength and resolve of our new president in actions taken in Syria and Afghanistan……North Korea would do well not to test his resolve or the strength of the armed forces of the United States.”

Speaking at a news conference, the Russian foreign minister Sergei Lavrov said that this is a very risky path. He added, “We do not accept the reckless nuclear missile actions of Pyongyang that breach UN resolutions, but that does not mean that you can break international law………I hope that there will not be any unilateral actions like the one we saw recently in Syria.” Russia has also warned the United States against further unilateral actions on Syria.

China is reportedly working with the United States to resolve the issue with North Korea. However, the North Korean regime has so far remained defiant. It test fired a ballistic missile to commemorate the 105th birthday of the country’s founder Kim Il-Sung but the test failed as the missile detonated immediately after launch.

The independent centrist candidate Emmanuel Macron is still the favorite candidate to become the next French President. Odds of his presidency still hovers above 50 percent, far higher than any of his rivals, however, the odds have declined from 67 percent just three weeks ago to 52 percent as of now. While nobody can predict with certainty on who might win on May 7th, one thing is certain that the French are looking for changes and they are looking for it so hard that for the first time main political parties are not at all expected to make it to the round two of the election that will be on May 7th. The incumbent President is so unpopular in France that his approval rating at one point declined to just 4 percent and that legacy would continue to hurt his socialist party for years to come. That is probably is the main reason for his not running for re-election.

Shadow of his disastrous legacy is one of the reasons why the odds are declining for Macron. Many lawmakers of the socialist party are openly supporting Emmanuel Macron against his closest opponent Marine Le Pen. President Hollande has openly declared that it his duty to make sure that Le Pen doesn’t’ win the Presidency. The former Prime Minister under Hollande government of the Socialist Party Manuel Valls has openly declared his support for Mr. Macron instead of his own party’s candidate Benoît Hamon.

Mr. Macron is increasingly being seen as an extension of the establishment and the current socialist government and that is not a good portrayal on an anti-establishment year.

The German 10-year bund yields hit its lowest since December 30 last year on Tuesday as investors poured into safe-haven assets ahead of the Eurozone’s final reading of the consumer price inflation (CPI) for the month of March, scheduled to be released on April 19.

The yield on the benchmark 10-year bond, which moves inversely to its price, slumped nearly 2 basis points to 0.17 percent, the long-term 30-year bond yields plunged 1-1/2 basis points to 0.91 percent and the yield on short-term 2-year bond also traded nearly 1-1/2 basis points lower at -0.86 percent by 08:30 GMT.

The Eurozone flash CPI inflation reading declined to 1.5 percent for March, from 2.0 percent in February. This was significantly below market expectations of a 1.8 percent increase and the lowest reading for three months.

The core inflation reading also declined to 0.7 percent from 0.9 percent previously and was below expectations of a smaller decline to 0.8 percent. The core rate was 1.0 percent for March 2016, illustrating that overall inflationary pressure has been subdued.

Defying demand for a general election for months, the UK Prime Minister has finally decided to hold a snap general election on June 8th in order to receive a mandate from the people of the United Kingdom to take the country through the two-year Brexit process. She surprised many politicians as well as the market with her announcement from the Downing Street. The decision reportedly came after consultations with senior figures and advisors within the party. The recent state of the opposition Labor Party which is fighting internal battles and revolts against the leadership of Jeremy Corbyn might have also influenced the decision. The recent opinion polls show that Theresa May’s conservative party is as much as 21 percent ahead of the main opposition, so holding an election now would likely provide Ms. May with a stronger majority in the parliament.

In addition to that, a win by Ms. May would also end the criticism that she has not contested her post; instead, it was given to her as the former Prime Minister David Cameron resigned after the referendum. This surely adds to the political uncertainties in Europe.

The pound initially suffered a shock selloff on the news but recovered and now trading stronger for the day at 1.264 against the dollar.

The opposition Labour party leader Jeremy Corbyn has welcomed the decision.

The following are some of the highlights from last week’s release of the central bank’s monetary policy minutes from the 30 March meeting. The majority of the board members noted that the “preventive” monetary policy adjustments since late 2015 have generated an “appropriate stance” to face the shocks that the central bank has been facing. One board member said that possible interest rate increases abroad would not necessarily have to be matched with a greater monetary restriction in Mexico, in the absence of additional adverse shocks that could affect inflation in Mexico. Two board members, however, countered this. One of them said that “it is probable that new increases in Mexico’s overnight rate may be needed in coming months” to ensure the convergence of inflation to the target. Another board member said that there cannot be much flexibility for the central bank of Mexico to deviate from monetary policy decisions taken by the US Federal Reserve and, therefore, the central bank of Mexico should at least keep the current short-term interest rate differential with the US. The majority of the board members agreed that the balance of risks to inflation did not worsen further, but noted that risks to inflation are still to the upside (higher inflation), mainly due to the number of inflation shocks in recent months. The majority of the board members also noted that conditions in the labor market have been tightening “in an important way.” Some of them think that the output gap is at zero and one of them said that there are indicators that reflect risks of possible generalized pressures on prices. Another board member noted that he is not too concerned about wage-related pressures on prices given that the economy is slowing down and that recent pressures on wages have not been excessive. The majority of the board members acknowledged the risk of an abrupt reversal in investor sentiment, due to economic policies in the US, geopolitical problems and/or the strengthening of nationalist policies particularly in Europe.

Energy • US crude oil inventories: Yesterday’s EIA report showed that US crude oil inventories fell by 2.17MMbbls over the week, the first significant decline seen this year. However Cushing, Oklahoma crude inventories increased by 276Mbbls, taking total Cushing inventories to a record 69.4MMbbls. • Chinese oil imports: Latest data from China showed that crude oil imports over March totalled 38.95m tonnes, which is a new record for monthly imports. Crude oil inflows for the month were 19% higher YoY, and 23% higher MoM. Stronger imports have come about as a result of declining domestic production.

Metals • China iron ore imports: Preliminary Chinese customs data shows that China imported 95.56m tonnes of iron ore over the month of March, which is 11% higher YoY, and 14.5% higher MoM. Iron ore inventory at Chinese ports remains at elevated levels, and we expect import demand to slow moving forward as a result. • Chinese aluminium exports: China exported 410,000 tonnes of unwrought aluminium and aluminium products over the month of March according to preliminary customs data. This is significantly higher than the 260,000 tonnes exported over February, but still 2% lower YoY. The stronger price environment should support higher Chinese output, leading to an increase in the country’s exportable surplus.

Agriculture • Malaysia cocoa grinding: Latest data from the Malaysian Cocoa Board shows that cocoa grindings over 1Q17 totalled 54,384 tonnes, a 15.7% increase YoY. However the grinding numbers were almost 5% lower than the 57,029 tonnes that was processed in the previous quarter. Although this decline is seasonal, and the grinding numbers are still fairly constructive for demand. • Chinese soybean imports: China imported a total of 6.33m tonnes of soybeans over March 2017, 4% higher YoY, and 14% higher MoM. Total Chinese soybean imports over 1Q17 totalled 19.5m tonnes, 20% higher YoY. However with Chinese crush margins now negative, we should see a slowdown in imports moving forward.

EUR: French elections likely to cap EUR/USD upside around 1.07 level Naturally one would have expected EUR/USD to have rallied substantially in the face of President Trump’s $ jawboning and rising geopolitical tensions. But gains have been harder to come by recently, with the pair struggling to push above the 1.0670/80 area. It is likely that EZ political risks are playing a role, with investors wary of chasing EUR upside in the run-up to the French presidential elections. A EUR/USD move above 1.0700 looks unlikely and could be met with spec sellers.

Verbal intervention does require the backing of fundamentals to develop a lasting impact on markets. Unlike previous occasions of talking USD down, President Trump has linked his dollar overvaluation comments to the US interest rate outlook. His suggestion thathe likes low interest rates (also said in May last year)has now put the debate on the appointment of potentially dovish Fed Chair, representing a fundamental shift compared to his election campaign when he criticised the Fed for running interest rates at a too low level. A reappointment of Janet Yellen seems to no longer be categorically ruled out. Alternatively, Trump could opt for a non-conventional appointment such as from the business world, declaring implicitly that the US still had a wide output gap by saying that the economy had a higher growth potential than currently calculated and therefore could afford lower rates for longer. Yesterday’s comments have opened a new playing field and markets will have to digest its implications.

Two countries, one interest: The good news of President Trump comments was that China will not be called a ‘currency manipulator’ when the Treasury releases its currency report this month. CNY has strengthened by 0.3% to 6.8745 this morning, reaching its highest level since March 31. However, RMB has weakened in TWI terms. In respect of USD, China and the US administration have the same interest. A weaker USD has the potential to boost competitiveness for both countries – directly in the case of the US and indirectly in the case of China, where a weaker USD allows China to depreciate RMB againstnon-USD currencies such as EUR, JPY and KRW just to name the heavyweights of China’s currency basket.

Commodities to undermine AUD: Australian labour market data for March were very strong on the headline, with job growth at 60.9k (20k expected) and all in the full-time sector (75k). In addition, China’s March trade balance, seeing exports growing at 16.4%, by far outpacing the 3.4% consensus expectation, while its imports expanded at 20.3%, is in line with our constructive view on the state of the global economy. However, the CRB Rind index has rolled over and iron ore prices have lost another 1.4% overnight, coming in addition to yesterday’s 2.3% decline. China’s commodity import seasonality may play in here, but China trying to curb housing sector investment and shift growth from the old, commodity consuming part of the Chinese economy towards its service sector may play in too. Anyhow, falling prices for China-related commodities have two effects. First, they should weaken AUD, in which we hold short positions, and second, they may allow international bond markets to keep rallying for somewhat longer, keeping USD selling pressure intact for now.

Does payrolls matter for the USD today? The FOMC minutes gave the market a lot of information on how the Fed is thinking about reducing monetary accommodation. In 2018 the focus will be on balance sheet reduction. The market took this as a signal that the focus in 2017 will be to use the pure interest rate tool to tighten. The market prices 38bp of hikes by the end of this year and a cumulative 70bp by the end of 2018. The strong ADP print on Wednesday has already pushed expectations higher for today’s headline NFP (MS: 195k), therefore it is the wage data that matters for the USD. Average hourly earnings above the 2.7% market expectations would drive the USD higher on the day, particularly vs the JPY. The US 10y breakeven rate has come down from the Jan high of 2.07% to 1.95% today.

Short EURGBP. The best way to play for a dovish ECB in the next 3 months is to sell EURGBP. The pair is developing strong bearish technical signals, which continue to hold as long as EURGBP stays below the 0.8610 level. Draghi and other ECB members yesterday tried to send a message that there has been a recovery in the economy, monetary policy is working but inflation needs to be sustainably close to 2% for us to consider changing policy. Emphasis was also on the sequencing of the removal of accommodative policy, should they reach their targets. We don’t think the ECB will raise rates before starting to taper asset purchases. The ECB minutes said they discussed removing the phrase “rates will remain at present or lower levels”, but that has stayed, possibly to give the ECB as much flexibility as possible, should political events cause market volatility. On the GBP side, a survey released overnight highlights some labour market tightness appearing. The Recruitment and Employment Confederation showed that companies are finding it difficult to fill jobs in London and the South, particularly in the temporary sector where staff availability fell at the fastest rate since January 2016.

SNB still intervening. After the Czech National Bank removed their EURCZK currency floor yesterday, focus will naturally turn to the Swiss. Without having a formal floor any more, we don’t think the SNB are near stopping their currency interventions since they currently have the flexibility to intervene if and whenever they like. Inflation data have been improving, with the latest headline print now at 0.6%Y, the highest since 2010. The latest core inflation print is now above zero (0.1%) but has not yet recovered to levels seen in late 2015 (0.4%). The domestic economy is still dealing with the impact of a strong currency and, more importantly, the slowdown in Chinese demand for luxury goods. For now we think the SNB will continue to intervene in the largest volumes around major risk events, with the next ones being the first and second round of the French election. Recently the SNB have been more explicit than ever before about their management of the FX reserves portfolio. Interestingly they are justifying holding a large equity position (20% of portfolio) by saying they need to do this because of the strong exchange rate. We expect EURCHF to stay stable for now.