Wednesday’s meeting: ignore at your peril
This week’s FOMC meeting may not be the non-event that many in the market are seemingly viewing it. While the long-awaited announcement of the Fed’s balance sheet unwind will be the main event, there will be keen interest in the new official forecasts. These may be used to reinforce the message that, while there is little need for aggressive interest rate hikes, the market remains too complacent on the prospect of higher interest rates.

Don’t rule out a dots downgrade
With just one hike priced in by the end of 2018, the market’s view on interest rates is still worlds apart from the Fed’s June projections, which pencilled in 100bp of rate hikes over the next 18 months.
Some market scepticism is understandable. The Fed has signalled higher interest rates on numerous occasions over the past couple of years, only to then subsequently not follow through with them. But also with several measures of inflation well below 2%, there is a sense that there is little need for tighter policy.

This latter point, in particular, may see some officials becoming less aggressive on their expectations for the path of interest rates. As such, we would not be surprised to see the dot diagram move closer to our forecast of three rate hikes rather than the four previously indicated.

What could seal the deal for a December hike
While there may be some added caution on the dots, the encouraging economic outlook means the core message from the Fed is still that the market remains too complacent on rate hikes. The economy grew 3% in the second quarter, and there will probably only be a marginal slowdown in the third (despite some soft retail sales numbers) given the prospect of a significant inventory rebuild. We don’t see any long-term economic disruption from Hurricanes Harvey and Irma. In fact, in the medium term, they are likely to boost growth due to rebuilding efforts and households and businesses replacing lost equipment and belongings.
We also note inflation could rebound more quickly than the market anticipates. Headline CPI is back to 1.9% and with gasoline prices having spiked, dollar weakness is pushing up import costs, and there are tentative signs that wages are again on the rise given the tight labour market.

We therefore suspect the Fed will keep its positive, longer-term forecasts unchanged and we currently look for a December rate rise followed by two more 25bp hikes next year.

Politics, not data, the main risk to a December hike
The recent hurricanes saw President Trump push and get a three-month extension of the debt ceiling. While this is positive as this allowed relief funding to be released for affected areas but it now means the 13th December FOMC meeting will coincide with a new debt ceiling deadline.

Given the divisive nature of politics in Washington right now, we are somewhat nervous that there could be major market worries about a government shutdown, the furloughing of workers and the potential talk of debt default, although this would be highly unlikely to happen.

The result is that the Fed could conceivably choose to wait until early next year given the potential for a pickup in market volatility – although that is not our base case.

Don’t rule out impact on yields once normalisation begins
In a bid to avoid taper tantrum 2.0, the Fed has for many months made it clear that it wishes to ‘normalise’ (or shrink) it’s USD 4.5 trillion balance sheet. We already know this will be done by a very slow tapering of the reinvestment of maturing assets.
Now we know most of the details, the formal announcement of an October start to the balance sheet unwind should be taken in the market’s stride.

The Federal Reserve decision will be the key scheduled event of the week for the US and should result in a formal announcement of the balance sheet reduction strategy. We have known the structure for a couple of months, which is a very gradual tapering of the reinvestment of maturing assets. The bond market has taken this in its stride so far and we do not expect any major volatility due to this announcement. However, the Fed releases new economic forecasts and there will be significant interest in its expectations for the path of the Fed fund’s target rate. Currently the Fed is anticipating four 25bp rate hikes by the end of 2018, whereas the market is only pricing in one such move. We would not be surprised to see the median forecast to show that the Fed now feels three hikes is the most likely scenario, reflecting the more subdued inflationary environment than anticipated and some near-term uncertainty on growth, as a result of the recent hurricanes. For the UK, we will be focusing on BoE speakers. It appears that the BoE is trying to prepare the market for a potential rate hike in November; so, any direct hints from Mark Carney is clearly likely to heighten such expectations and offer further support to sterling. It will be another calm week in Germany, with all political parties preparing for Election Day. No poll results will be released in the last few days in the run up to the election. It currently looks as if the race for No.3 will be the most important aspect of the election on 24 September.

Momentum trades are in vogue. This week will be about whether a dovish FOMC reinforces the USD bear trend, while the BoE-fuelled GBP rally faces a pivotal test from PM May’s keynote Brexit speech.

Theme of the week: Will a dovish Fed reinforce the USD bear trend?

The Sep FOMC meeting will be the main event of the week (Wed), with investors looking to see if there is any change in policy bias in light of the recent negative developments in the US economy. We think this may be one of the more difficult meetings and press conferences for Chair Yellen to navigate, not least because of the growing dichotomy within the FOMC over the appropriate near-term policy approach. Our base case is for the doves to prevail, with a lower conviction over the pace and extent of future policy tightening visible in the Fed’s dot plot. While the median 2017 dot is still set to tentatively pencil in a Dec rate hike, we expect to see more members calling for a pause for the remainder of the year; anything more than five would suggest that hopes of a Dec hike stand on a fragile footing. More telling of a dovish shift would be if the 2018 dot also moves lower; here we require five or more members to downgrade their views over future policy hikes, a scenario that cannot be ruled out given the softer US inflation dynamics. What is highly likely is that we’ll see the 2019 and longer-run dots moving lower – with Fed officials acknowledging that a 2% handle for the terminal Fed funds rate is more realistic in the prevailing US economic environment.
While we do not expect US yields or the USD to move much on what would be a well-telegraphed balance sheet announcement this week, there is a slight risk of the Fed delaying the start of this process. This would be indicative of the Fed’s more pessimistic view of the US economy and we would expect this tail risk scenario to be outright USD negative – more so through the sentiment channel, rather than any major move lower in US yields.

Majors: Dovish Fed to trump cautious ECB & BoE
While a dovish FOMC could reinforce the USD bear trend, ECB officials will look to keep their QE taper cards close to their chest this week. The BoE-fuelled GBP rally faces a big test from PM May’s keynote Brexit speech in Florence on Friday.

EUR: Dovish Fed confirmation could see a 1.20 handle again
• The September FOMC meeting is the main focus this week (Wednesday) and we will be looking to see how Chair Yellen manages the two emerging camps within the committee – that is those members looking for a continuation of the current normalisation cycle and those looking for an extended (or even permanent) pause in hikes until there is greater confidence in the US inflation outlook. We note that it’s typically hard for the dollar to rally post-FOMC meetings and this time may not be any different; any hawkish Fed cries could again fall on deaf ears given the lack of convincing economic evidence to point to. Moreover, we do not expect to see US yields or the USD moving much on what would be a well-telegraphed balance sheet announcement this week – especially as offsetting this will be a downshift in the distribution of Fed dots and signs of less conviction from the committee over the pace and extent of future monetary tightening.

• While Fed officials will also follow up the meeting with their own views (Williams, George and Kaplan all on Friday), the focus in the European calendar will be on ECB talk – including two speeches by President Draghi (Thursday and Friday). We would expect much of the same script as the September ECB meeting, with Mr. Draghi likely to keep his QE taper cards close to his chest. Our economists also expect no change in the final release of EZ CPI data (Monday).


European Government Bonds; QE purchases and supply
The risk-off move in EGBs on the back of yet another North Korean nuclear test was fairly shallow, suggesting markets have gotten used to North Korea’s sabre rattling – or are increasingly convinced that a military response from the US is unlikely. Indeed, while 10yr Bund yields edged 1.5bp lower and 5yr German paper outperformed 0.5bp on the 2/5/10yr fly yesterday, core EGB curves actually steepened (admittedly, in part due to the large amount of long-end supply due to hit markets this week), with the 30yr Buxl ASW tightening 1bp. What is more, long-end peripheral spreads over Bunds also managed to tighten, by some 2-4bp. That being said, flows were light yesterday due to the closure of US markets, meaning the impact may have been delayed somewhat.

ECB QE purchases: During the summer lull net QE purchases slowed to €50b in August, versus the stated monthly target €60bn, ECB data released yesterday revealed. Net PSPP purchases accounted for slightly more than 85% of the total, in line with previous months. While net purchases allocated to Germany were back in line with the ECB’s capital key split, purchases in French and Italian paper continued to overshoot their implicit targets more substantially. Calculating the maturity of monthly purchases based on the weighted average maturity (WAM) of portfolio holdings is becoming increasingly distorted by redemptions. In Germany, where redemptions should still play a minor role, the calculated WAM of last month’s purchases increased slightly to 5.8yrs from 5.18yrs.

EGB & SSA supply: Today Austria will re-open 10yr and 20yr lines for a combined €1.4bn (including retention). The RAGB 4/27, at almost -20bp on ASW, offers a 9bp pickup in z-spread versus the NETHER 7/27 and is trading at a small concession again vs the ESM 3/27 line. The RAGB 3/37 was trading exceptionally rich on ASW in early August, but has since been on a cheapening trend, to now trade in the -15bp area. Elsewhere, KfW is likely to come to the market to issue a new 10yr benchmark, a KfW 9/27. We find 10yr KfW sector trading cheap versus NEDWBK and EU. Looking at mid z spread levels, switches from the latter might even offer a pick-up (or minor give up, respectively) when looking at the KFW 2/27 versus EU 9/26 or EU 11/27 for instance. Elsewhere, Spain’s ICO has mandated banks for a new € benchmark 4/22.

Despite tension in the Korean peninsula, global asset markets continue to perform well. The S&P 500 is quietly edging up to its highs of the year and forward looking measures of volatility, e.g. the CBOE’s VVIX, are declining to levels last seen in early August. Unless there is fresh news from Korea, today’s events look set to extend this benign run. There is no US data of note, but the Fed speakers (Brainard at 1330CET and Kashkari at 1830CET) are certainly on the dovish end of the Fed spectrum. As an aside today, we see the news that Norges Bank is proposing to cut its EM bond investments (currently 12%) from the nation’s fixed income portfolio. The rationale is that diversification in fixed income is not delivering the same benefits as the diversification in equity investments. The market may choose to ignore this news today, but Norway’s government pension fund has been one of the most forward-looking Sovereign Wealth Funds over recent years and the news looks certain to prompt a debate. DXY to drift to 92.00, since it is heavily weighted to safe havens of EUR & JPY.

ECB will struggle to generate a lasting correction in the buoyant EUR. For today, EUR/USD may well trade inside a 1.1850-1.1950 range. Elsewhere, Swiss 2Q17 GDP disappointed and with what should be a low CPI figure released later (0.4% YoY) should serve as a reminder that the SNB will ‘out-dove’ the ECB. Korean-triggered weakness in EUR/CHF looks a buying opportunity in the 1.1300/1350 area.

Noise-levels regarding Brexit remain elevated and look set to extend further. Brexiteers are once again pushing for a Hard Brexit (no deal with EU) and there is now focus on a potential speech from PM May on Sep 21, where we doubt she takes a harder line. PMI services is the focus today, but we doubt GBP finds much solace from the data over coming months. EUR/GBP looks steady nr 0.92.
The trade weighted index for the CNY (CFETs) yesterday rose to the highest level since mid-June 2016, briefly coming out of an ~3% trading range ithas been in for that whole period. USDCNH has now caught up with the weakness in the DXY index seen since the start of the year. What will be important is whether the basket stays lastingly above the historical range. We remain long CNH, supported further by China’s Financial News suggestingFX reserves should be kept steady to stabilize market expectations and that “Regulators should continue to guide market expectations and prepare for yuan appreciation”


FX Outlook: USD headwinds, debt ceiling, Bannon, Jackson Hole
The departure of President Trump’s chief strategist Steve Bannon from the White House last week has been flagged by media as an apparent victory for market-friendly “globalist” figures such as NEC Director Gary Cohn as well as traditionalist security figures such as National Security Advisor McMaster. The former concept so far has its best evidence in the form of the Cohn’s feared resignation not transpiring. The latter idea is best represented by Monday night’s speech by President Trump outlining recharged and indefinite US troop commitments to Afghanistan, a move that “alt-right” media has been quick to label a betrayal of Trump’s base.

While signs of Republican civil war may be welcomed by the political left in the US, which is more focused on the bigger and older Civil War, it is not helping investor sentiment as arguably it suppresses the energy available for a new Trump rally. The post-Bannon departure rally in stocks has been somewhat tepid so far, and notable investors have been on the wire signaling that they continue to de-risk as a function of disharmony in Washington DC. Markets are caught between optimism raised by the likes of Cohn and Treasury Secretary Mnuchin that tangible progress can be made this year towards delivering a tax cut and other pro-growth measures, and the reality that delivery on pro market policies has been weak so far, with the debt ceiling issue still unresolved and likely to hit a crescendo in about 5-6 weeks from now.

Nonetheless, from an FX market perspective, if these developments are sufficient to give rise to hope that at least there is some chance that the White House will be stable, unified and pro-market enough to deliver results, we would expect a lower volatility environment characterized by a subdued VIX Index. This would back our decision last week to keep key forecasts such as USDJPY unchanged for now despite the noise of recent weeks, and to look for a more stable (though not materially stronger) USD after the generalized losses of recent weeks. The key risks to our view are as follows:

1. more unexpected domestic incidents along the lines of the Charlottesville theme that illicit controversial messaging from President Trump and raise doubts about how tenable the support base from his current cabinet and other senior Republicans can be going forward,
2. a clear sign that the debt ceiling issue may not be easily resolved (which would be a large shock given that Senate majority leader McConnell said this week there is “zero chance” Congress does not raise the debt limit),
3. dovish statements by Fed chair Yellen or other senior Fed officials that cast further doubt on whether more rate hikes can materialize in 2017, or limit the market’s scope to see a sustained hiking cycle next year and beyond. As far as the third point above goes, the market is heavily focused on Friday’s speech by Yellen scheduled for 10:00 a.m. EST at the Jackson Hole symposium.

Given that the latest Fed minutes pointed to an emerging debate about the validity of more traditional Phillips Curve approaches in today’s global economy amid a backdrop of seemingly persistent low inflation, the market will be keen to see if Yellen can provide more color on whether this debate is material enough to require a repricing of US rates expectations. We note, though, that markets need to be careful about the risk of other Fed speakers speaking to the media around the same time and creating noise, as happened in 2016 when Fed vice chair Fischer made comments soon after Yellen to the media that were deemed more hawkish. Given the low level of US rates going into Jackson Hole, it would likely take a consistent and relatively direct set of statements from Fed officials highlighting issues such as low productivity, low inflation and a weakened Phillips Curve to lead to a break of key supports (e.g., 2.12% in 10-year Treasury rates) and lead the greenback lower across the board.


Global Rates, 5-30 Spread Widening, Jackson Hole
BTP/Bund spreads experienced increased widening pressure yesterday, with investors appearing to unwind some of their summer carry trade positions. 5-30 spreads over Bunds widened by c.7bp, while the concession versus Bonos was c.3-4bp. The upcoming weeks and months hold quite some headwinds for BTPs: the resumption of supply pressure, with BTP auctions slated for Wednesday next week, an ECB QE taper decision pending this autumn and the general elections looming early next year. That this is not yet a classic flight to safety episode is underscored by the fact that 10yr Bund yields were unchanged at 0.40%. Moreover, semi-core spreads were little changed, even though 10s30s in OLOs and OATs steepened by more than 1bp. Meanwhile, equity markets (outside of the FTSE MIB) seemed more preoccupied with regaining some of the lost ground over the past weeks.

Ahead of the Jackson Hole symposium kicking off tomorrow, ECB Draghi’s opening speech at the Lindau Nobel laureates meeting on economic sciences today will be followed closely. But it would be an unusual choice of venue and timing to provide new policy guidance. Elsewhere, flash Eurozone PMI data should confirm the ongoing recovery across the currency bloc. EGB & SSA supply. Today Germany will tap the 10yr benchmark DBR 8/27 for €3bn. Absolute 10yr yields are relatively low given that levels around 0.60% were seen a little more than a month ago.

The recent richening of 10yr Bunds is also evident in the 5/10/30yr fly valuation, which is back near the levels prevailing before Draghi’s Sintra speech. The auction may nonetheless be supported by its timing, with the carry trade unwind seemingly having started. Moreover, repo specialness (c. 25bp in s/n yesterday) remains a strong selling point of the 10yr Bund. In SSA space UNEDIC has mandated banks for a tap of the 4/32, thus following in the footsteps of NWB bank and Rentenbank yesterday. The former priced a €600mn 30yr social bond NEDWBK 1/48 at MS+19 versus an initial guidance of MS +22. The latter launched the 8yr RENTEN 8/25 at MS -23 coming from an initial guidance of MS -21. We are also still waiting for an RfP from the EFSF ahead of next week’s auction slot.


Global FX, CNY Strength, NZD and GBP weakness to come
There will be no UK data releases today, but there are other reasons why GBP is expected to break lower. Next to the CHF, JPY, USD and NZD, we identified GBP as one of our preferred shorts in July,arguing that the combination of the BoE staying on the sidelines and inflation comfortably exceeding its 2% target will keep 10-year real yields near -2% for now. GBPUSD’s crucial support is at 1.2810, which we expect will break today. Sure, media reports of Brexit Secretary Davis proposing to soften the UK’s Brexit stance on the ECJ today is a positive factor, but this move does reveal a deep split within the government, leading to additional speculation concerning the political future of PM Theresa May. PM May has previously argued that leaving the jurisdiction of the ECJ would be essential to complete Brexit. It appears this position may no longer command a majority within the government.
The political tail risk in the UK seems to be rising ahead of the early October Tory party conference. The worst case outcome could lead towards new elections. This scenario would receive more support should the next few weeks see the successful launch of centre ground party ‘The Democrats’, leading to possible defections of centrist Labour and Tory MPs, which could lead the informal partnership of the Tories with the Northern Irish DUP to lose its majority within the Commons. Meanwhile, the Recruitment and Employment Confederation said an index of economic conditions has fallen to the lowest this year, with a greater proportion of survey respondents saying things are getting worse. It seems that the lack of clarity in respect of the UK’s post-Brexit position may start hitting investment plans. However, signs of declining investment are not only spotted within businesses. Take the prime London housing market as another indicator. Here, GBP weakness is no longer inspiring foreign buyers to come into the market. Brexit appears to be putting the UK economy into a relatively weaker position when comparing within G10. Moreover, the UK’s current account revision to 5.2% of GDP for 2015 suggests that foreign funding dependence may be a bigger issue than previously assumed. Obviously, the UK has entered Brexit at a time of relative weakness and vulnerability. We like GBP shorts even against an otherwise weak USD. EURGBP long is the best GBP bearish trade.

Despite our bullish risk attitude, we have turned NZD bearish arguing that New Zealand’s overleveraged economy is now rolling over. Overnight, the government trimmed economic growth and budget surplus forecasts a month before the country’s general election on 23 September. The appearance of populism could put the anti-immigration party ‘New Zealand First’ into a kingmaker’s position, suggesting its programme ‘to promote and protect the customs, traditions and values of all New Zealanders’ may be influencing government policies. Similar to the UK’s Brexit, New Zealand First’s influence on the government does not bode well for economic growth potential. Given the higher degree of NZD overvaluation, we expect the NZD to come under sustained selling pressure. NZDUSD should soon break the neckline (0.7225) of a ‘head& shoulder’ formation, targeting 0.7130 initially.

Despite the USD regaining some ground ahead of today’s speech by Draghi and Friday’s Jackson Hole Symposium, USDCNY has remained under selling pressure. The 3-year RMB-denominated sovereign bond auction drew good demand, following last auction attracting the strongest bidding on records going back to 2005. We expect the RMB to remain bid as China tries to attract foreign funds into the country via its Stock and Bond Connect programmes. Domestic liquidity conditions are tight, manifested by banks’aggregate excess reserve ratio falling to only 1%. The low reserve ratio could cause unwelcome volatility. There are choices for the PBoC. Either it helps the central bank’s foreign exchange purchase position to increase sharply, or the PBoC may have to inject a large amount of liquidity. We think the PBoC may opt for the first option and recent data suggests that it is on the right track. Overseas investors increased their China onshore bond holdings by RMB 62bn ($9.3 bn) in the second quarter after a reduction of RMB22bn in the first three months of this year.


Flight to safety prevails courtesy of Mr Trump. US President Trump’s North Korea comments unleased a flight to safety bid in EGB markets yesterday, with 10yr Bunds rallying and peripheral spreads widening sharply. Price action was very much futures driven, though, with flows in cash space, reportedly, still subdued (ie, in holiday mode).

The 10yr bund yield temporary rebounded somewhat after the news that the 5yr OBL tap was technically uncovered but eventually closed almost 5bp lower. The auction of US 10-year notes – that took place after the European close – also felt the pinch, causing Treasuries to pare some of the earlier gains – while pointing to slightly higher Bund yields this opening.
The damage to semi-core and peripheral spreads (of respectively 1bp and 3-5bp in the 10yr area) would likely have been more pronounced if not for the soothing words from US Secretary of State Rex Tillerson on the ‘threat’ from North Korea. Interestingly, the widening of core govie ASW spreads, particularly in the 2-5yr area, has rendered SSAs more attractive again versus govie peers (see for example KfW 1/21 versus DBR 1/21).

urther out the cure, we also find the z-spread concession at which 20yr KfW trades versus Bunds drifting towards year-to-date highs again (Figure 1). With little data of significance due for release in the Eurozone, European bond markets will probably continue to take their cue from the US in the remainder of this week, with today’s auction of 30yr Treasuries and tomorrow’s US CPI reading – which could well surprise on the upside – standing out. EGB supply dries up.

Activity in the primary EGB market has come to a full standstill. There are no auctions scheduled for the next two weeks – the next planned re-opening is that of the 10yr Bund on August 23. Towards the end of this month we also expect Finland to launch a new 10yr benchmark via syndication. Note that the DSTA yesterday reaffirmed that the launch of the new 7-year DSL via DDA will take place in September or October.


Key UK data and the government’s Brexit position
While markets are in the midst of summer holiday mode, the combination of key UK data releases, as well Brexit and geopolitical headlines, may present some near-term turbulence for GBP markets. On the data front, there are three key reports to note next week:

CPI report (Tue 15th Aug): After coming in surprisingly softer last month – and denting August Bank of England rate hike expectations – our economists expect annual headline inflation to pick up to 2.7% as GBP weakness continues to feed through into higher food prices. Utility price hikes are also beginning to take effect. Equally, core inflation could rebound to as high as 2.6%. While this is likely to raise some eyebrows among the MPC hawks, we would caution that part of this increase is also due to the transitory effects of a weaker currency. Given that domestically generated inflation overall is likely to remain muted for some time, we suspect any subsequent move higher in short-term UK rates and GBP – as a result of greater BoE tightening sentiment – may prove short-lived.

Labour market report (Wed 16th Aug): Those looking to wage growth as evidence for rising underlying price pressures are unlikely to find much support in the latest jobs report. We expect average hourly earnings growth to remain unchanged at 2% in June – and stay pretty much anchored at this level for the rest of 2017. This may not come as too much of a surprise to markets given that it would be in line with the BoE’s latest forecasts outlined in the August Inflation Report. The bigger question, however, is whether wage inflation can pick up to 3% in 2018 as the Bank estimates; such a sharp uplift in earnings growth is unlikely in our eyes given greater signs of slack in the labour market.

Retail sales report (Thu 17th Aug): Our view for a more cautious BoE policy bias would be reinforced by a disappointing July retail sales report. While the second warmest June on record got UK consumers out spending at the start of summer, a range of factors, including waning confidence and less credit-card spending, suggest households are cutting back on non-essentials as the squeeze on real incomes takes effect.

Reports in the media also suggest the UK government is set to release position papers on key Brexit issues in the next few weeks. Of particular economic interest will be the UK’s proposals for replacing the customs union and achieving ‘frictionless trade’ with the EU. We could also receive clarity on the type of transitional deal the UK is willing to seek, notably the length of any transition period and willingness to replicate existing arrangements.

GBP implications: Data to deliver final blow to 2017 BoE rate hike calls
We expect the next round of key UK data releases to be the final nail in the coffin for a 2017 BoE rate hike. The implied probability of a 25bp hike by year-end has already fallen to less than 25% after the BoE’s dovish disappointment. While higher inflation figures may keep lingering hopes alive, the slowing trend in consumer activity, as well as uncertainty over the degree of slack in the labour market, should keep the hawks at bay. Risks are that the front-end of the UK curve continues to flatten and that BoE rate hike expectations get pushed further out into 2018. This could weigh on GBP in the near-term.

On the Brexit front, we continue to believe it is too early for GBP markets to price in any Brexit transitional deal hopes; there are a number of “divorce” stumbling blocks that need to be overcome before any transitional arrangement is signed, sealed and delivered. Diminishing tail risks of a cliff-edge Brexit is certainly easing any major downside GBP pressure but the currency is far from out of the woods when it comes to political event risks. We earmark early October as a key test for GBP markets; both the governing Conservative Party Conference (1-4 Oct) and the final round of opening Brexit talks (Oct 9) will shed light on the stability of the UK political environment, as well as any progress being made when it comes to the UK’s ‘smooth’ exit from the EU.

We think that the central bank will leave the overnight rate unchanged at 7.0% in today’s monetary policy meeting; this is in line with market expectations. We think that the central bank will relay a message of caution regarding the inflation outlook and leave the door open for potential additional interest rate increases. In our view, the bank will acknowledge that real GDP growth was stronger than expected in the second quarter, that inflation has been higher than expected due to rising agricultural prices, and that the tightness in the labor market may be causing nascent wage pressures. At the same time the bank will likely note that medium- and long-term inflation expectations are in-check. The next monetary policy meeting after today’s will take place on 28 September.

Our central scenario is that the central bank will leave the overnight rate unchanged at 7.0% in the remainder of 2017 and first half of 2018. Consumer prices rose 0.38% in July versus June, clearly above our estimate of 0.29% mom and median market expectations of 0.32% mom; in annual terms headline inflation rose to a new multi-year high of 6.4% from 6.3% in June. Core inflation was 0.27% mom, marginally above our estimate of 0.25% mom and in line with median market expectations; annual core inflation rose to 4.9% from 4.8% in June. Our estimate at the 20% level shows that annual inflation held steady at 4.8% for a third consecutive month. July’s inflation upside surprise, relative to our projections, was fueled by agricultural prices, which rose 2.5% mom, given notable price increases in red tomatoes, green tomatoes, and potatoes. In the second half of July agricultural prices rose 2.1%, compared to our estimate of 1.0%. This was the main factor accounting for the gap between our headline inflation estimate and the actual result, as core inflation results for the second half of July, as well as administered prices, were largely in line with our expectations. In the remainder of the year agricultural prices will be key in determining the inflation path.

If prices follow the seasonal pattern of the past five or six years then annual headline inflation will likely remain near 6.5% through year-end. According to our estimates, it will take some clear deflation prints in the agricultural price index in upcoming months for annual headline inflation to move much closer to 6.0% by December. For instance, if agricultural prices rise by just one-fourth of what they have risen on average in the past five years between August and December, annual inflation would still close 2017 at 6.0%. The Ministry of Labor will release today nominal wage figures for July. As a reference, nominal wage increases for the next twelve months averaged 5.2% in June, up from 4.7% in May and from 4.0% in April. This was the highest average increase since late 2009, confirming the view of some members of the central bank’s board that unit labor costs seem to be trending higher. Average wage increases were particularly high among private sector firms at 5.3%, up from 4.5% in June 2016. Wage increases in the public sector averaged 3.5%, down from 3.8% in the same period last year.


New Zealand’s 10-year bond yields rose 2.3bp to 2.83% overnight as the RBNZ signalled it would allow the economy to run hot before starting to reduce monetary accommodation in earnest. Similar to previous Fed communication, it indicated the ‘need for stronger capacity pressure than might otherwise be necessary to generate a given level of inflation’, prompting a fall in real interest rates weakening NZD. The rate projection continued to show the OCR would remain unchanged until mid-2019, in contrast to market pricing for the first hike by around August next year. RBNZ’s Wheeler and Mc Dermott have tried to be as explicit as possible that they don’t like the NZD trading as strong as today. Firstly their NZD forecast is lower than today. Secondly, they referred to the traffic light system of deciding when to intervene in FX markets, as an indication they are thinking about it. Finally McDermott stated specifically that the NZ dollar needs to adjust down. Long positioning in the NZD is at risk. Anyhow, the uncertain outcome of the upcoming General Election, signs of its housing market slowing down from overvalued levels and the upcoming leadership transition within the RBNZ should keep the NZD on the back foot, which should be best expressed by long AUDNZD.

The RMB is trading at the strongest level since mid-March, based on the CFETS basket. High real yields, a stable currency and a resilient economy seem to be transforming China into a local safe haven destination with continued tensions in Korea working as an additional catalyst for RMB strength. RMB strength has FX implications going beyond directly impacted currency pairs. The 10-year US – China yield differential has reached 141bp,not far off the 149bp reached in June. This not only keeps domestic funds within China, thus reducing the capital outflow risk; it may also attract foreign capital too. China’s FX reserves have started to rise again. Rising FX reserves suggest that there is an excess of hard currency to be recycled back into DM bond markets, keeping bond yields lower than otherwise suggested. In addition, some of the reserves may be reallocated away from USD, keeping the USD internationally offered. The second Exhibit shows the relationship between the DXY and USDCNH, suggesting China’s RMB push higher should especially keep EURUSD supported as the EUR acts as the alternative reserve currency to the USD.

Yesterday, we warned about risk turning tactically offered as investors de-risk their portfolios in light of the increasing Korea-related tail risk. Price action confirms that this move is about position squaring and not about the reassessment of the global economic outlook. Corrective activity occurred in places where positioning is extreme, while other market segments with low positioning have not joined the risk downside correction. Concretely, industrial metal prices continued to rally which looks even more impressive in the context of China’s recent tightening of its monetary conditions. The industrial metals rally supports the view of a strongly expanding global economy subsequently leading to reflation. Consequently, we view the current risk setback as providing a buying opportunity.

We expect risk-premia (rp) to start building up in MXN as soon as 2018 begins. Some preventive hedging might already
be taking place as the vol curve has steepened while the forward vol structure shows higher skew and kurtosis. We see additional room for rp to increase in the months to come.

We argue that leadingup to next year’s elections, MXN’s behavior might more closely resemble that of GBP ahead of the Brexit referendum than its own before the US presidential election. We expect the market to start actively trading politics as soon as we enter 1Q18.

We do expect USDMXN to trend down for the rest of the year before MXN depreciates as soon as we enter 2018. We believe that risk-premia will increase in MXN spot during the firsthalf of 2018 because of 1) The enhanced momentumof antiestablishment parties during the local elections,2) The uncertainty regarding the potential economic policies that could be implemented after the
elections,3) The tightness of the race and 4) A higher subjective margin of error due to whathappened in Brexit and the US election.

The vol market seems to be already pricing some of this. The volatility curve has steepened in the last few months while 6M6M risk reversals and kurtosis show increased premia. We interpret this as precautionary hedging activity that might continue increasing in the months to come.

It is still very unclear what the end game will be for MXN due to the political risk that it may face next year. We think MXN outperformance could come to an end as soon as we begin 2018 due to the fact that risk-premia needs to increase to accommodate the uncertainty related to the possibility of less orthodox economic policy in the years to come.

The result of today’s No Confidence ballot in the South African parliament was 177 votes in favour of the motion, some 24 votes short of the number required to end Jacob Zuma’s eight-year term as South Africa’s President. Understandably the Rand has given back yesterday’s gains – seen when the Speaker announced the ballot would be secret – and perhaps encouraging thoughts of defections from some of the ANC’s 249 members of the 400 seat parliament.
The failure of the No Confidence motion (assuming no more such motions are forthcoming) would leave Zuma in office as President until May 2019. The political focus will then shift to the 54th ANC Congress taking place 16-20 December – where a new leader of the ANC, and Zuma’s likely successor as President, will be chosen.
Here, the two front-runners are: (i) Cyril Ramaphosa, the current Deputy President and Zuma critic, seen as a market-friendly outcome and (ii) Nkosazana Dlamini-Zuma, Jacob’s former wife and favoured by the current President as a continuity candidate.

While we think USD/ZAR should be trading near 12.00 based on long-term fair value and the currently benign external conditions, we suspect Zuma’s survival today will maintain a political risk premium in the ZAR. This was most manifest when Zuma fired his respected Finance Minister, Pravin Gordhan, in March, prompting ratings agency downgrades on governance concerns.
Here we remain concerned that South Africa’s local currency debt remains one notch above junk at the key ratings agencies of Moody’s and S&P. A shift to junk status for the local currency ratings from both agencies would take South African government bonds out of key international benchmarks such as the WGBI and Barclays Global Aggregate, prompting ZAR outflows as much as 2.5% of GDP (around US$8bn), according to the IMF.
We therefore suspect that as long as the market and ratings agencies have governance concerns, and the prospect of the ANC leadership (and Presidency) being handed to his ex-wife remains a possible outcome, USD/ZAR is more likely to trade in a 13.00/13.50 range rather than heading down to fair value closer to 12.00.

Will the U.S. Blow Up the Iran Nuclear Deal?: QuickTake Q&A
2017-08-02 15:36:26.689 GMT

By Ladane Nasseri and Golnar Motevalli
(Bloomberg) — The Iran nuclear deal, struck in 2015 after
countless late nights and serial missed deadlines, is running
into trouble just six months into Donald Trump’s presidency.
Trump signed legislation Aug. 2 broadening sanctions against
Iran. And he has indicated he’s unlikely to again certify Iran’s
compliance with the nuclear agreement, as required under U.S.
law every 90 days, arguing its missile program and foreign
policy are an affront to the spirit of the pact. The pressure
has put Tehran in a bind: It sees the American actions as an
infringement of the agreement, and factions that have
consistently rejected it are pushing for a more aggressive
Iranian riposte. Delivering one would risk allowing the U.S. to
blame Iran for any subsequent collapse of the accord.

1. Will the U.S. blow up the deal?

As a candidate, Trump variously promised to scrap or
renegotiate the Iran deal. Last week, he seemed to be veering
toward attempting the latter, with an official saying the
administration wanted to work with allies to build a case that
the agreement has serious flaws. The Associated Press reported
that the U.S. wants to push for more inspections of Iranian
military sites that it deems suspicious, an inflammatory move.
European nations — along with Iran — have so far ruled out
reopening the hard-won text. With five other sovereign
signatories to the agreement with Iran, a unilateral American
exit wouldn’t necessarily spell the end. But it would deal a
heavy blow and damage further Iranian hopes of securing the
funding it needs to rebuild its economy.

2. How do others see the accord?

Three European signatories — France, Germany and the U.K.
— remain committed to the agreement, and European Union foreign
policy chief Federica Mogherini is scheduled to attend the Aug.
5 inauguration of Iranian President Hassan Rouhani for a second
term, in a clear show of support for the moderate cleric who has
championed diplomacy. Ali Vaez, an Iran analyst at International
Crisis Group, said the backing offers Iran a chance to protect
the accord but such a strategy would depend on the appetite in
Paris, Berlin, Brussels and London for a transatlantic
confrontation. Iranian Foreign Minister Mohammad Javad Zarif
will push the message that the U.S. is “rocking the boat” — and
risking European business interests in the Islamic Republic —
at a time when international monitors agree that Iran is
adhering to commitments to curb its nuclear program, said Ariane
Tabatabai, an Iran expert at Georgetown University.

3. Are there other friends out there?

Iran has deepened economic and military ties with the two
other powers that signed the pact, Russia and China, both veto-
wielding members of the United Nations Security Council. That
allows Iran to signal to the U.S. that “we are everywhere you
have an interest in,” said Tabatabai. But neither country can
unlock the financing Iran requires, nor are they likely to
persuade Trump to back off.

4. Is Iran likely to respond militarily?

Parliament has already approved the outlines of a bill that
would increase funding for the country’s missile program —
which Iran considers essential for its defense — and the
Revolutionary Guards, the premier security force. Under Trump,
the U.S. has expanded sanctions on both. More flashpoints are
likely. Iran said July 27 it had successfully tested a rocket
for sending satellites into space, a move immediately denounced
as provocative by the U.S. for its use of long-distance
technology. With Iranian and American forces in proximity in
Syria and Iraq, as well as the waters of the Persian Gulf, Iran
could look to “raise the cost” in the region for the U.S., said
Vaez. However that’s very risky, he said, and the nuclear deal
could end up as “collateral damage.” Unintended clashes are a
possibility. The U.S. 5th Fleet and Iran’s Guards gave
contesting accounts of a July 28 incident in which American
helicopters shot warning flares.

5. Can Iran appeal to the law?

Iran argues that the U.S. is contravening the nuclear deal
by taking steps that undermine the normalization of trade with
the Islamic Republic. Just like any other signatory to the
agreement — known formally as the Joint Comprehensive Plan of
Action — Iran can take a complaint over non-compliance to a
Joint Commission, which has representation from all parties. The
commission would have 35 days to resolve the dispute, including
possible referral to the seven nations’ foreign ministers.
Action through an international judicial agency would be
difficult, said Will Breeze, a partner at London-based
international law firm Herbert Smith Freehills. The U.S. is
targeting issues, such as Iran’s missile development, that
aren’t covered by the nuclear deal. “These are just U.S.-driven
sanctions and it’s a sovereign right,” he said. “Many might not
like the extra-territorial nature of U.S. sanctions, but they
can’t do anything about it.”

6. Might Iran expand its nuclear activity?

Countering what Iran sees as U.S. bad behavior with some of
its own would likely bring retribution. Accelerating its nuclear
work beyond what’s allowed under the accord could invite U.S. or
Israeli strikes on its facilities, said Vaez at Crisis Group. It
would also put the supportive Europeans “between a rock and a
hard place,” he said. In an interview in late July, Zarif said
that as long as the deal was functioning, the Islamic Republic
would not give Trump a “gift” by leaving it. Iranian leaders see
Trump as the “unreasonable” party and want to portray themselves
as the “grown-ups in the room,” according to Amir Handjani, a
senior fellow at the Atlantic Council. Iran’s unlikely to walk
away unless the Trump administration does something that
fundamentally changes the equation, he said.

7. How could that happen?

The U.S. could unilaterally trigger a process to reinstate
broad United Nations sanctions. The Security Council would then
have 30 days to pass a resolution to continue sanctions relief
and halt the deal’s so-called “snap-back” mechanism. A failure
to do so, Iran has asserted, would leave it with no option but
to stop abiding by the accord.

The Reference Shelf

* A guide to the Iran nuclear deal by the Belfer Center
* Bloomberg News has published a QuickTake on Iran’s nuclear
program, including a map of its major atomic facilities.
* Federation of American Scientists overview of the
effectiveness of applying sanctions on Iranian nuclear
facilities.
* A Bloomberg story on Middle East battles where Iranian and
U.S. forces operate in close proximity.

To contact the reporters on this story:
Ladane Nasseri in Dubai at lnasseri@bloomberg.net;
Golnar Motevalli in Tehran at gmotevalli@bloomberg.net
To contact the editors responsible for this story:
Alaa Shahine at asalha@bloomberg.net
Mark Williams, Lisa Beyer

Poland: Preliminary estimate of the June balance of payments data and the final details of the July CPI inflation data will be released on Friday (11 August). According to the preliminary estimate of the Central Statistical Office, headline inflation picked up to 1.7% yoy in July from 1.5% yoy in June. In our view, the increase in headline inflation was driven by higher food price inflation, which means that core inflation should remain unchanged in July.

Hungary: First, budget data for the calendar-year to July will be published today at 10:00 a.m. London time by the Ministry of National Economy. In June, the deficit widened sharply, taking the cumulative fiscal-year deficit to HUF911bn, from HUF213bn at the end of May and compared to HUF402bn in the period January-June 2016. As a percentage of GDP, the cumulative deficit in 1H 2017 was an estimated 2.6%, compared to 1.2% in the same period in 2016 and 2.5% in 1H 2015. Second, external trade data for June will be released tomorrow at 8:00 a.m. London time by the Central Statistical Office. In May, the trade account recorded a surplus of EUR959mn, which was 29% higher than in May 2016. On a three-month moving average basis the surplus in May was 4.7% higher than in the same period in 2016. Import growth in May, on a three-month moving average euro basis, outpaced export growth for a fifth consecutive month.

Third, consumer price data for July will also be published tomorrow at 8:00 a.m. London time by the Central Statistical Office. We expect that headline inflation increased to 2.1% yoy from 1.9% yoy in June. The Central Statistical Office’s core inflation measure increased to 2.4% yoy, a three-year high. Our estimate of the runrate of core inflation surged to 3.6% yoy in June. The National Bank said of its measures of core inflation for June that they “remained stable, in line with expectations”. The average of the Bank’s three core inflation measures was 1.9% in June, compared to a low of 1.4% in August 2017.

Russia: Headline inflation fell to 3.9% yoy in July, below the central bank’s 4.0% inflation target. According to Rosstat, headline inflation fell to 3.9% yoy in July after a sharp increase to 4.4% yoy in June on the back of higher prices for fruits and vegetables. The outcome was a surprise for the market that expected headline inflation at 4.3% yoy (according to a Bloomberg survey), but actually it was consistent with weekly inflation data (on our estimates, weekly headline inflation fell to 4.0% yoy as of 31 July). July inflation report confirmed the recent developments, especially those with regards to food prices that started rolling back aggressively in July.

This drop in headline inflation was mainly driven by food price inflation that slowed to 3.8% yoy in July after a spike to 4.8% yoy in June. Durable goods inflation fell to 3.7% yoy in July (from 4.0% yoy previously), while services inflation was at 4.1% yoy in July, unchanged from the previous month. Official core inflation fell from 3.5% yoy in June to 3.3% yoy in July, its lowest level on record. Our measure of core inflation (net of all food and energy prices) picked up to 2.3% yoy in July from 2.2% yoy previously. Our estimate of the run-rate of core inflation picked up to 2.2% in July from 1.8% in June, while the run-rate of official core inflation picked up to 2.6% from 2.2% in June. Run-rate of headline CPI inflation picked up to 5.2% in July from 4.1% in June. The increase in the run-rate of official core and headline inflation was due to the impact of higher prices on some food categories. If there are no further disruptions to the harvest, we believe headline inflation will be 3.8%-3.9% yoy in August.

We think that concerns over inflation were not the main reason behind the CBR’s decision on 28 July to keep the policy rate unchanged at 9.00%. In our view, the main argument for keeping the policy rate on hold was the risk related to higher rouble volatility in an environment with increased geopolitical risks. If the impact of the new US sanctions on the rouble turns out to be mild, the CBR will catch up with its easing cycle and cut the policy rate by 50bps to 8.50% in September, in our view.

South Africa: The noteworthy event this week is the National Assembly’s vote on a motion of no confidence in President Zuma tomorrow. Our key thoughts are: First, we do not think the motion will succeed, even if the Speaker decides that the vote should be held in secret. Second, some ANC MPs look likely to vote in favour of the motion, but not enough to make up the shortfall of 50 votes required for the 201 majority. Third, though there may be more MPs that agree with the motion, they likely believe that the leadership crisis is best resolved at the party’s Elective Conference in December, when 4,500 voting delegates will gather. Fourth, if the parliamentary motion were to succeed, then the President and his entire cabinet would have to resign. The speaker of the National Assembly, Baleka Mbete, would then become acting President, while the National Assembly debates and appoints a new President. Fifth, such a scenario, where the motion succeeds, raises a variety of risks for the ANC and the country. The risk of a split in the ANC would increase in our view. Governance of the country could be further weakened.

On Friday (11 August), Moody’s will deliver its second formal review of the sovereign for this year. We don’t think that the agency will make any changes to its ratings or outlook. It looks likely to wait until year-end, by which time the outlook for fiscal policy under Minister Gigaba will be clearer, with the Medium Term Budget Policy Statement published on 25 October. Furthermore, there may also be greater clarity on the direction that the ANC leadership contest is taking. Moody’s has another scheduled review on 24 November.


• A solid US jobs report has dented any immediate prospect of EUR/USD hitting 1.20 and we think a little more downside could be seen this week. Driving this should be firmer US price data (PPI Thu, CPI Fri), where PMI indices are starting to warn of a slight uptick in US pricing power. • Some modest uptick in US rates (and quite a negative patttern on the weekly candle chart), warns that EUR/USD could make a run to 1.1650/80. Yet what should be good German IP data should keep the downside limited.

• $/JPY remains key vehicle to play both: (i) Trump’s political travails and (ii) the US growth/rates story. On the former, it’s hard to know when the bad news will hit, but on latter, this week should prove +ve for the USD. The US rates curve is very flat & higher US prices should steepen the curve. • In Japan this week, we’ll see surveys on activity (Mon & Tue), June trade & regular portfolio data. We’re still of the opinion that Japanese residents should be accelerating foreign bond purchases around now.

• The combo of a dovish BoE disappointment and a slightly rejuvenated USD has seen GBP/USD fall back to 1.30; we see near-term risks of a move below here as the BoE’s patient policy approach could see GBP take on more of a funding currency role in a diverging monetary policy environment. • Expect GBP to remain sensitive to UK data outcomes as markets continue to reassess 2017 BoE rate hike odds; Jun industrial production and trade (Fri) to note this week, with both important for any 2Q UK GDP revisions.

• The Aug RBA meeting noted greater concern over the recent AUD rise (albeit USD related), though the central bank’s slightly more optimistic projections have limited any meaningful fallout below 0.80. • We think a neutral RBA policy bias will remain in place and see limited scope for AUD rates moving higher. Focus will be on speeches by the RBA’s Kent (Tue) and Lowe (Fri) for clarity on the inflation outlook, while the data docket sees the latest consumer and business confidence indicators.

• A small miss in both Canadian job gains and the Ivey PMI has added to the fading CAD optimism. We see scope for a bigger USD/CAD correction higher as markets have got ahead of themselves in pricing an extensive BoC hiking cycle. Lower short-term CAD rates would fuel a move back to 1.27-1.28. • The domestic calendar in the week ahead is sparse, with only housing data to note. CAD vulnerable to noise around the OPEC meeting (Mon-Tue) – but oil stuck in the $45-$55/bbl range won’t be a big catalyst for the pair.


GBP shorts are recommended as the UK economy shows increasing signs of losing growth momentum as households adjust spending to their weaker balance sheets, investment stays weak due to Brexit related uncertainties and real rates stay one of the lowest within the G10 with 10-year inflation adjusted returns at minus 1.799%. GBPUSD may see a marginal new cycle high but levels near 1.33remain a sell.

This morning GBP markets wake up to a set of mixed news. GBP positive is that, according to the Telegraph, the government may be willing to pay an exit fee of EUR40bln. However, this is not entirely new news as the UK government turned towards a more constructive Brexit negotiation approach under the leadership of Chancellor Hammond indicating that it is willing to honour its obligations, hoping that it can negotiate a multi-year transition when leaving the EU. This allowed markets to re-price prospects of a March 2019 cliff edge, pushing GBP temporarily higher. The more constructive UK negotiation approach is in the price. Moreover, Brexit MPs have accused Brexit negotiators of using the summer quiet period to press through the ‘Brexit bill’ which could become the early start of fresh Tory rebellion (Telegraph).

Credit card transaction data suggest a sharp slowdown in UK consumer spending as households try to consolidate their currently high level of non-secured debt. Weaker household spending may allow the BoE to look through the CPI reaching 3% in October, suggesting the window for the BoE taking out last August’s ‘insurance’ rate cut is closing rapidly. Former chancellor Lord Darling has warned in the Sunday Times that “small rate rise could kill spending”, after a “decade of rock-bottom interest rates has left consumers vulnerable to a ‘shock’ from even a marginal increase in borrowing costs” … “with knock-on effects for the broader economy”. The best outcome for the UK is its main trading partners maintaining its high economic growth rates providing net trade support. Within this scenario the UK should find enough willing investors to fund its twin deficits. A more difficult scenario would spring into place should global growth slow down and reduce cross border funding flows. In this case, the UK’s credit risk would have to adjust upwardly pushing its real rates up not because of economic growth, but to attract sufficient international capital to fund its current account deficit.

A dose of additional uncertainty has been injected by comments by Nick Timothy, the ex-adviser to PM May, suggesting that the position of PM May concerning Brexit has not changed. In September, PM May will have to clarify her official position concerning the subject. Currently, markets hope Chancellor Hammond represents the government’s (now moderated) position. Should May’s September speech (date not announced) move the clocks back to what investors would interpret as a hard Brexit then GBP would weaken significantly.

The Goldilocks scenario is staying with us as China surprises by its growth resilience. Since June, steel rebar has increased by 45% due to China-related demand dragging other industrial metal prices higher too. China’s July trade date will be released tomorrow and is likely to show a strong performance. Even oil, dealing with oversupply and inventories, has broken above significant chart levels. Today and tomorrow an OPEC/Non-OPEC meeting will be commencing in Abu Dhabi. US corporate earnings surprises plus July labour market data showing strong activity and only moderately better wage data should push financial conditions further up from here. China agreeing to sanctions against North Korea by supporting a related UN resolution is a positive.


European Fixed Income
The sell-off in Bunds after Mario Draghi’s speech in Sintra felt like a distant memory this week, as 10yr yields dropped back well below 0.50%, the top end of the range that prevailed in the first half of this year. The catalyst of yesterday’s downtick was the less hawkish tone from the BoE, with the news on the Russia probe in the US further supporting the bullish momentum.
This didn’t prevent 10yr BTP/Bund spreads from hitting fresh year-to-date date lows this week, suggesting carry trades remain in favour. We also saw Bono/Bund spreads holding near their post-QE lows, despite the growing clash between the Spanish central and Catalan government on the latter’s desire to hold a referendum on independence on October 1.

We still believe that peripheral spreads, Italian ones in particular, are vulnerable to the upcoming ECB QE taper. Indeed, our fair value estimate for 10yr Bono/Bund spreads, which is based off relative growth and fiscal differences amongst others, suggests that the tightening impact of QE is still around 50bp at the moment. While we do not think this will fully disappear after the taper announcement, much will depend on how long the tapering will take. In our view the ECB will be keen to avoid a scenario where investors immediately extrapolate the end of the net asset purchases. To credibly signal that QE could be extended further, however, taking into account the scarcity of eligible debt, the ECB would likely have to tweak the modalities of the PSPP, e.g. increase the issue share limit for non-CAC bonds. All in all, the summer calm in peripheral bond markets may well persist until Draghi’s speech at the August 24-26 the Jackson Hole Summit, which takes place two weeks before the September ECB meeting.


Global FX: USD weakness, EUR strength and GBP hike bets.
USD: Hoping for some payrolls lovin’… or least signs of wage inflation. Betterwage growth data in today’s US jobs report may not change the market’s cautious outlook on the Fed. However, it could prove to be a saving grace for a beleaguered $ in need of some love from the US data. With the US 10-year yield at 2.2%, we would expect confirmation of a 0.3% MoM average hourly earnings print to see rates moving higher. It will be interesting to see if a steepening bias helps the USD to recouple with interest rate differentials, in particular those crosses where the decoupling has been notable.

EUR: Ain’t no stopping us now…Though we continue to view this as a near-term overshoot. Saying that, sentiment towards the euro has changed so much in recent months that it may not take much to break the psychological 1.20 level (even if bund yields are stable); the run-up to President’s Draghi Jackson Hole speech (end-Aug), rising QE taper speculation ahead of the ECB meetings in Sep and Oct and risks of a sustained slowing of the US economy are potential catalysts. The spillovers from the EUR rally are clear; we expect European FX (both within the G10 and EM space) to benefit vis-à-vis their USD-bloc peers.

GBP: £ vulnerable again as BoE said it best, when they said nothing at all In keeping with our Game of Thrones preview, the takeaway for markets from the Aug BoE meeting was “brace yourselves, winter is coming”. Admittedly, this statement is a light-hearted embellishment of the more tame reality. But relative to what markets had been expecting, the 6-2 MPC split vote – with no new rate hike dissenters – can be seen as a dovish disappointment, with some hoping for greater hawkish gestures from the Bank this week. The slightly more cautious growth projections, the dichotomy of MPC views and a lack of coherent policy bias mean the bar for a 2017 policy move still remains pretty high; we continue to see a credible BoE rate hike debate being more of a 2018 story. Although the immediate fallout for GBP has been contained, the BoE’s patient policy approach does now mean that GBP will be bucketed into those currencies at risk of being sold in the current theme of monetary policy divergence.

Higher core CPI in Turkey should prolong the CBT’s hawkishness, helping the curve to flatten. Wereceive5yr USD/TRY swap and seethe window to receive the front end postponed to year-end. Our analysis also shows that positioning in TURKGBs is not concerning.
With lower headline inflation but much higher core inflation, our economist expects the CBT to stay on the hawkish side and keep the blended funding rate close to the late liquidity window until year-end. This should prolong the CBT’s hawkishness, helping the curve to flatten. We receive 5yr USD/TRY swap and see the window to receive the front end postponed to year-end. TURKGBs have received US$5.8 billion of inflows YTD. We estimate that US$3.8 billion comes from GBI-EM investors covering their UW positions. Non-ETF and ETF investors could have bought US$1 billion and US$370 million each on the back of strong inflows. This leaves US$745 million of inflows from other investors, which is around 0.6% of the overall TURKGBs market. Using the same methodology, we estimate that non GBI investors have bought around 6% of the SAGBs market this year. Such a comparison suggests that positioning in TURKGBs is not concerning.

Despite the CNB hiking rates yesterday, we do not see much value in being short EUR/CZK and think the risk/reward is unattractive at current levels. However, we do see potential for some gradual CZK gains, given that the CNB appeared more comfortable with currency strength than previously.

In our view, ZAR should underperform and so we continue to recommend short positions. Our expectation for a further 50bp of rate cuts over the coming quarters along with a weak economic position and political uncertainty should continue to weigh on the rand. Moreover, with volatility in core bond markets and uncertainty about G3central bank monetary policy as they become more hawkish, ZAR will likely become increasingly vulnerable. Our pivot to a CNH/ZAR position reduces funding costs at the same time as offering attractive risk/reward. Fundamentally, we think CNH is strong, supported by domestic investment and still strong global trade. What’s more, China’s economic growth rate has been accelerating over recent quarters, with a tight monetary policy environment, and a substantial reduction in capital outflows. We target 2.10 in CNH/ZAR with a stop at 1.93.

A Reuters report indicated that the PBOC may consider widening the USD/CNY trading band to 3% around the daily fixing from 2% currently. While such a reform would be in line with China’s long-term market liberalisation goals, in the near term, CNY spot continues to track the RMB fixing closely amid tighter capital controls this year. China has widened the trading band gradually from 0.5% in 2007 to 1% in 2012 and then to 2% in March 2014. Interestingly,2007 and 2012 were both years of the Party Congress, where the band widening occurred before the Congress meeting. While such a reform would reinforce policy-makers’ focus on financial market liberalisation and increasing confidence in RMB, the market reaction, we think, would depend on the underlying economic fundamentals and USD. The previous two band widenings did see CNY spot weakening to the top of the trading band. However, we argue that China’s fundamentals and expectations on RMB have improved since 2012and 2014, when growth was on a weakening trend and RMB fixings were on a depreciation bias into the two band widenings.

EM-dedicated fund flows over the past week (up to August 2) totalled US$1.92bn of inflows,up from US$1.60bn in the previous week. This is in line with decent one-week returns for both hard currency (0.6%) and local currency (0.4%). Overall EM funds saw net inflows of US$1.48bn to non-ETFs, while ETFs managed inflows of US$454m. Inflows to hard currency funds increased to US$1.37bn (0.73% of AUM), of which ETFs saw inflows of only US$200m,as opposed to non-ETFs, which received inflows of US$1.17bn in the last week. Local currency funds saw inflows of US$612m (0.36% of AUM) in the last week, an increase of 50% over the previous week. Inflows to ETFs decreased marginally to US$254m, while non-ETFs saw inflows of more than four times (US$367m) the previous week. Split by geographical focus, global mandates saw inflows of US$407m while country or regional mandates saw net inflows of US$214m after two consecutive weeks of outflows. Lastly, blend currency funds saw outflows of US$55m (-0.10% of AUM) in the last week. Overall net inflow momentum to EM debt-dedicated funds has now lasted for 27 weeks and amounts to total inflows of US$44.2bn (or US$47.4bn YTD), making it the strongest sustained period of inflows out of the five inflow surges since the taper tantrum.


European Bonds and Global Bond Indices
While European equities received uplift from encouraging Eurozone GDP data, a risk-off mood took hold across Eurozone bond markets, especially after weak US auto sales data send US Treasury yields sharply lower. Core curves bull flattened and the recently launched 10yr Bund benchmark, which will be re-opened today (see below), closed 3bp lower at 0.49%, marking the low end of the range it has traded over the short course of its life thus far.

EGB peripheral spreads saw an initial widening yesterday led by 5-10yr SPGBs – on Thursday Spain will tap the 5yr, 9yr and 25yr segment. Into the market close especially longer dated spreads were able to reverse the widening. In the end, only 3-7yr SPGB and PGB/Bund spreads stood wider – the latter by c. 3bp, although these hit fresh one-and-ahalf year lows yesterday. 10yr and longer BTP/Bund spreads were around 2bp tighter. In terms of today’s dataflow, the main focus is on the US ADP report, which is expected to hint at a solid payrolls report due on Friday, albeit it will be the hourly earnings growth figures that will shape the market’s reaction (here the consensus is for a pick-up in the MoM rate to 0.3%). EGB supply.
Today Germany will tap DBR 8/27 for €3bn. Outright yields don’t look that unattractive, as 0.49% still marks the upper end of the 0.15-0.50% range for 10yr German yields that prevailed in the run-up to Draghi’s Sintra speech on June 27. Moreover, the 10yr Bund also looks relatively appealing on a cross-markets basis, with DSL/Bund and OAT/Bund spreads at around their tightest levels in 12 months. The repo specialness of the DBR 8/27 (-1.32% s/n yesterday), also compared to other 10yr core paper, is another reason why we would expect the auction to get done at reasonable levels.

Elsewhere, Austria announced taps of the RAGBs 2/47 and 10/23 (€1.1bn in total) for its 8 August reserve date. The last time it did not make use of the reserve date was in 2014. Also note that Ireland’s NTMA yesterday cancelled another €500mio of the IRISH 2045 floater, held by the Central Bank of Ireland (CBI). These holdings are also relevant for the issuer limit of 33% for the PSPP, and as such the cancellation frees up room for the Irish central bank to conduct more PSPP purchases. Ireland is among the jurisdictions where the Eurosystem PSPP purchases undershoot the target implied by the capital key.

Energy • US crude oil inventories: API data released yesterday showed that US crude oil inventories surprisingly increased by 1.78MMbbls over the week. If today’s EIA numbers are similar to this, we could see some further downward pressure on prices, with the market expecting the release to show a stock drawdown of c. 3.1MMbbls. • OPEC production: Latest estimates from Bloomberg show that OPEC oil output increased by 210Mbbls/d over July to total 32.66MMbbls/d. The increase, once again, predominantly comes from Libya, where output grew by 180Mbbls/d to 1.02MMbbls/d. Both Saudi Arabia and the UAE increased output by 30Mbbls/d over the month.

Metals • Brazilian iron ore exports: Latest data released from the Brazilian Ministry of Development, Industry and Foreign Trade shows that iron ore exports over July totalled 31.31mt, up 3.5% YoY. Cumulative exports for the first seven months of the year total 215.3mt, up 3.7% YoY. Stronger supply from Brazil is a result of the ramping up of the S11D iron ore mine in the country. • Further Indonesian nickel ore exports: The Indonesian government has issued two more miners in the country with export recommendations for low-grade nickel ore. PT Trimegah Bangun Persada received an export recommendation of c.1.5mt, while PT Gane Permai Santosa received an export recommendation of c.500kt. This takes total export allowances issued so far this year to c.7mt.

Agriculture • Brazilian corn exports: Brazil’s Secretariat of Foreign Commerce reported that Brazilian corn exports totalled c.2.32mt in July, compared to c.1.05mt in the same month last year. Meanwhile, soybean exports for the month totalled c.6.96mt, up Hamza Khan 20% YoY.


Global Yields, Asian Currencies, USD weakness vs JPY weakness
Yesterday saw one of the rare occasions when European 10- year real yield fell faster than nominal yields. Data wise, there was little to explain this move as data globally have stayed strong. US Senator Lindsey Graham not ruling out the US going to war with North Korea had little impact on Asian currencies and, with investors happy to buy risk-related higher yielding assets, we instead attribute current market behaviour to strong liquidity conditions and Secretary of State Tillerson’s more conciliatory tone towards North Korea. US banks deploying their balance sheets to reach for higher yields, plus the US Treasury reducing its cash balance ahead of reaching the debt ceiling in September, have pumped additional funds into the system, keeping risk assets supported. After a meeting with Minority Leader Schumer and Treasury Sec Mnuchin, Senate Majority Leader McConnell said there will be a vote on the debt ceiling ‘next month or so’ suggesting that the US should ‘never ever’ default on its debt. USD cross-currency basis spread arbitrage seems to be working again, converting onshore USDs into offshore USD liquidity, which we view as an important condition for keeping the risk rally alive.

The US auto cycle seems running tired with yesterday’s car sales data (moderately) disappointing again. Consequently, the Dow Jones transportation index – a bellwether of the equity market – has fallen 6.4% from its June top. However, a similar signal emerged in March and did not prevent the equity market from continuing to work higher. This is because European and US equity markets continue to be supported by strong earnings releases. Yesterday’s sharp 3.5% fall in oil prices tells a similar story. API inventories released overnight showed a surprise 1.8m barrel rise in US crude inventories, and OPEC output was reported to have risen in July, according to Bloomberg and Reuters surveys. The commodity market seems split between those commodities facing inventory and overcapacities (such as energy) and other industrial raw materials (such as copper and iron ore) where recent growth in demand have led to higher prices. For risk markets to turn lower we need inflation to pick up, which we only expect late this year going into 2018. Yesterday’s core PCE release coming in at 1.5%Y is consistent with the risk rally extending further from here.

With real DM yields falling rapidly, narrowing interest rate differentials, one would expect the JPY to continue its recent rally. Instead, the JPY has weakened overnight with EURJPY trying to break above its 200-week MAV. EURJPY is one of the currency pairs most sensitive to trends, rarely spending too much time within a corrective pattern. Over the past 10 years EURJPY has crossed its 200-week MAV only three times; all occasions were followed by significant moves. Important to the future path of the JPY will be the policy stance of the BoJ. Some market participants view the JPY as the next EUR with respect to the BoJ changing its stance in light of economic recovery. We disagree with this view. Overnight it was the BoJ’s Funo suggesting the BoJ must maintain its aggressive monetary easing stance to achieve stable 2% inflation, which would create room for lowering real borrowing costs when the economy slumps. USDJPY has formed a tradable bottom and is expected to rally from here.


Global FX, US Inflation Expectations, Real Yields and EMFX
US inflation indicators coming in on the soft side of market expectations suggest risk appetite should stay solid. This morning saw raw material prices breaking higher once again despite the release of slightly weaker Chinese PMIs (July non-manufacturing PMI declined to 54.5 from 54.9, manufacturing PMI fell to 51.4 from 51.7), continuing the bullish trend which started in June, with iron ore prices 38% higher. Asian materials producers have rallied overnight. Some indicators suggest that market participants are not relentlessly bullish: NASDAQ has weakened over the past several days; weekly Fed data suggest primary dealers increased their bill holdings to their highest level since 2014;and foreign investors reduced their holdings in the Korean stock market at the fastest pace since August 2015. It is this ‘wall of worries’ which should keep the bull trend intact. In order to reverse our bullish interpretation, we need to see higher US inflation rates, the Fed signaling a significant increase in its pace of withdrawing monetary accommodation, or US real rates rising with the help of stronger data releases, notably higher capital expenditures. These seem unlikely without a calmer US political environment.

Conditions for a risk reassessment are not yet in place. US real rates have declined over the course of the past week, eeping the USD on the back foot and allowing for a higher valuation of risky assets. It seems that overseas Treasury demand has contributed to keeping US nominal and real yields lower, supporting our thesis of viewing the current macro landscape through the lens of the 2004-2006 cycle. During this period it was US nominal funding costs staying below the anticipated nominal return of investment which led to a leverage boom. Consequently, foreign central bank holdings of US debt at the Fed have jumped to USD3.33tn, the most since 2015. The portion of the Treasury market held by foreign investors is climbing in 2017 after dropping last year.

Reserve managers increasing their foreign asset holdings suggests to us that there is too much hard currency in circulation, which we view as a late cycle effect of DM central banks increasing the size of their balance sheets via QE operations. Initially, QE increased onshore liquidity with DM central banks expanding their balance sheets, but funds remained largely onshore. This created an environment of USD shortage abroad, reflected in the widening of the cross currency basis. It is the new strength of the financial sector now driving offshore USD liquidity conditions. Banks and other investors are arbitraging onshore – offshore spreads, in turn reducing the offshore USD scarcity. The rise in offshore USDs increases reserves. Official institutions invest these reserves into US Treasuries, pushing US bond yields down, reducing the relative attractiveness of USD holdings for private funds, in turn boosting EM inflows and pushing EM FX reserves even higher.

However, the relative decline of US nominal and real yields can only partly explain USD weakness witnessed since the start of the year. Indeed, the USD trades at a politically derived discount as investors have priced out the probability of reforms increasing the growth potential of the US economy. Worse, reform uncertainty has held back investment, suggesting the return of a reliable policy approach could have a significant effect in pushing the US economy towards better growth.

Energy • WTI speculative long: Over the last reporting week, speculators increased their net long position in WTI crude oil by 23,013 lots, to leave them with a net long of 238,501 lots. This is the largest position speculators have held since the end of April and, given the price action seen since last Tuesday, this position is likely to be larger than what was reported in the latest release. • Another OPEC/non-OPEC meeting: OPEC members, along with a handful of non-OPEC producers, are set to meet in the UAE on 7-8 August, according to reports. The meeting will be to discuss compliance issues around agreed production cuts, and why some countries are falling short.

Metals • Chinese aluminium capacity cuts: Bloomberg reports that Shandong province in China will be even stricter on aluminium smelters during the winter months. Shandong province makes up c.30% of Chinese production and it was mentioned previously that smelters in the top seven producing cities would face capacity closures over the winter months if they did not meet emission standards. However, there are now reports that all cities in Shandong will be targeted. • Base metals push higher: Further positive data from China has pushed the whole base metals complex higher this morning. China released manufacturing PMI data that showed that factory activity in the country continued to expand, although it was slightly lower than what many were anticipating.

Agriculture • EU sugar prices rise: Latest data from the European Commission shows that average white sugar prices in the region climbed to EUR497/t in May 2017, up from EUR495/t the month before and the highest price reported by the EC since October 2014. However, with the lifting of production quotas from 1 October 2017, expect sugar prices in the EU to come under pressure. • Soybean speculative position: Speculators continue to build on their net long position in CBOT soybeans. Over the last reporting week, speculators bought 12,534 lots, to leave them with a net long of 50,885 lots. This is the largest position speculators have held in soybeans since March 2017. The bulk of the buying over the week was short covering, rather than fresh long positions.


Global FX, USD, FED and China
Ahead of tomorrow’s Fed meeting, markets are staying within tight ranges as tactical versus structural forces maintain balance. Tactically, investors fear the Fed emphasizing the gradual but continued tightening path projected by its dots, which, for a market that is heavily underpricing, the Fed could be a major headache. Structurally, excessive liquidity conditions will stay in place even if the Fed delivers according to its projections. The prospect of US financial sector deregulation has added a new source of capital availability, allowing capital costs to diverge significantly from nominal GDP expansion rates not only in the US, but also globally. Indeed, the testimony of Randy Quarles, who has been tapped by President Trump to serve as Vice Chair of Supervision, on Thursday is likely to support this effort and will have the means to do so. Spreads have stayed tight against warnings that credit spreads should widen when approaching a late cycle. The continued tight spread reading suggests either the market does not believe in the late cycle mantra or that investors, blessed with liquidity looking for yield pickups, are willing to ignore late cycle related credit risks. Regardless of driver, the message remains a risk positive one pushing financial conditions towards new highs.

The Fed may lean against a further valuation acceleration of risky assets. Given FX market positioning, there could be a significant short-term USD supportive impulse created by the outcome of the Fed meeting should its communication signal an earlier-than-expected balance sheet normalization or a faster-than-expected rate path. However, the USD is unlikely to return to its previous long-term bull trend. Indeed, the combination of US growth not accelerating meaningfully from its recent 2% path and financial sector deregulation has created a textbook environment for USD weakness. For the USD to rally lastingly, the US has to shift its growth potential closer towards 3%, which would require critical structural reforms. Fed policy changes may impact the USD tactically, but structurally it is the amount of USD made available for international use driving the USD.
Often we hear investors talking about China’s weakening credit impulse dampening demand for commodities via slowing Chinese economic growth. According to China News, the 25-member group of the Politburo stressed that the government would further regulate “financial chaos”, curb the increase of illegal debt raised by local governments, and stabilize the real estate market. The “barbaric” growth of the Public-Private Partnership projects will be controlled through better management of local government debt, the committee suggested. It seems China is heading towards a period of monetary tightness which does not bode well for the credit impulse. North Korea-related tensions have come back onto the agenda too, with the WSJ reporting that China is preparing for tensions with North Korea.

However, CNY swap rates and bond yields have eased since May. Interestingly, despite the PBoC ‘s tightness, China’s economic growth rate has accelerated over recent quarters. Here too the availability of capital plays in. When China faced strong capital outflows in 2015/16 it was its weakening asset base driving domestic monetary conditions tighter. The now-sealed capital account has stabilised domestic capital supply, allowing CNY spreads to tighten, bond yields to come down, and local equities to rally. This morning China’s Security Journal wrote that the liquidity situation is expected to improve further in the near term as the PBoC is showing a clear bias toward maintaining liquidity stability while positive changes in capital flows are providing additional support. All in, China’s liquidity and capital position is not overly tight.


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.