EM and risk outlook stays relatively supported but we see risk aversion alert signs across the board. While investors focus on US politics and especially on today’s vote on the repeal act of Obamacare, other developments should, in our view, not remain unnoticed: a research paper published by two Fed economists and released by the Brookings Institute suggesting US interest rates staying low with the Fed tolerating inflation overshooting targets, the ECB’s targeted LTRO allocations, and the continued fall of iron ore futures. Despite equity markets retracing some of the post-election rally, US monetary conditions have become more accommodative with the falling USD contributing most to this easing. Foreign conditions have turned from providing hefty headwinds as experienced from 2012-16 into tailwinds, helping US reflation gain momentum over time. Accordingly, we prepare for putting on FX trades that benefit from a steeper US yield curve. Short EURSEK and long USDJPY fall into this category. While short EURSEK should work from now, USDJPY’s current downward momentum suggests waiting for 109.50 or for a stabilisation above 112.50 before establishing longs.

US vote: Today markets will wait for the outcome of the vote but FX investors should note that the vote is not scheduled for a specific time. At the moment the vote count may be low so the Republican leaders need the time to gather votes, indicating why no specific time is provided. There is even a risk the vote may be delayed if the leaders feel the vote may not pass.

Watching iron ore. The PBOC-run Financial News newspaper highlighted that the recent rise of RMB money market rates should be put into the context of recent money market operations. China seems to be tightening its monetary conditions to deal with excessive leverage. Importantly, tighter RMB lending conditions have sparked China’s USD denominated loan demand, pushing its USD denominated liabilities up again. Should this loan-related USD inflow into China end up into a higher FX reserves (see chart below) – thus providing an additional signal that offshore USD liquidity conditions are on the rise – EM markets should see further inflows. Meanwhile, China has seen the ratio of mortgage loans to total credit of commercial banks reaching uncomfortably high readings. It has been China’s property and infrastructure investment driving commodity – including iron ore – demand. Authorities are now directing growth away from the property market which suggests that commodity prices may ease. Falling iron ore prices will not bode well for the AUD. Within this context we recommend using the AUD as a funding tool for high yield EM longs and for a long GBP position. GBPAUD has moved away from levels suggested by relative forward curves.

The Australian bonds traded in a tight range Tuesday as investors refrained from any major activity amid a light trading session. Also, the Reserve Bank of Australia’s (RBA) March monetary policy meeting minutes, painted a mixed picture of the economy, adding sluggishness to market sentiments.

The yield on the benchmark 10-year Treasury note, hovered around 2.82 percent, the yield on 15-year note also traded flat at 3.21 percent and the yield on short-term 2-year remained steady at 1.81 percent by 04:20 GMT.

The minutes of the RBA March board meeting continued to paint the picture of an RBA unwilling to move official interest rates anytime soon. The Board highlighted a range of positives, but concerns were also raised. The central bank was notably more upbeat about the global outlook and the flow on effect to higher commodity prices.

Concerns surrounding the outlook for the labor market were apparent, with the RBA noting that “conditions had remained mixed” and that “momentum in the labor market remained difficult to assess”. A further mixed picture on the labor market leaves the RBA between a rock and a hard place.

Lastly, markets will now be focussing on the RBA Deputy Governor Guy Debelle’s speech, scheduled to be held on March 22 for further direction in the debt market.

Growth in Japan is holding up nicely and economic activity has gained momentum since 4Q16 with the pickup in the global capex and manufacturing cycle. Inflation has started to push back above the waterline. But as Governor Kuroda emphasized at a press conference last week, inflation expectations remain stuck, something highlighted by this year’s spring wage negotiation projected to produce only modest wage increases. With price pressures nailed to the floor, the Bank of Japan (BoJ) doesn’t seem to be in a hurry to raise rates.

“With our USD rates forecasts pushed upward, we now expect that the BoJ will taper its asset purchases at a somewhat slower pace than previously and that QE will end in H2 2019, instead of mid-2019. JGB rates unchanged,” said DNB markets in a research note to clients.

There is an ongoing debate whether the BoJ will have to raise its 10-year bond yield cap because of the lack of JGB liquidity. There seems to be still a split of views inside the BoJ on whether the Bank should or should not raise the 10-year yield target when the real interest rates decline further. The longer the BoJ keeps the 10-year yield target unchanged, the more rapidly it will have to adjust the target later.

Analysts expect the BoJ to maintain the current 10-year yield target through year-end, but if it sees greater yen weakness, it would adjust the target in 2H17. BoJ will have to strengthen communication strategy with forward guidance on its yield curve control (YCC) policy to manage market expectations. It would probably provide the conditions under which the BoJ would raise the 10-year yield target.

“While we expect the BoJ to introduce forward guidance on its yield curve control (YCC) policy relatively soon, we think it would do so in July at the earliest, when the BoJ reviews its economic outlook and discusses its monetary policy stance in the Outlook Report. If it may take time to build a consensus among the board members on this issue, delaying its introduction until October,” said J.P. Morgan in a report.

USD/JPY trades below 100-day moving average. The pair is tracking DXY lower, amid holiday-thinned markets (Japan closed for Vernal Equinox Day) and lack of fresh fundamental drivers. Technical studies are bearish, RSI and stochs are biased lower and MACD has shown a bearish crossover on signal line. 112 levels in sight, violation there could see test of 111.60 and then 111 levels.

The Japanese government bonds traded narrowly mixed Tuesday as investors await to watch the Bank of Japan’s (BoJ) 2-day monetary policy meeting, scheduled to be held on March 15-16, announcing its decision on Thursday.

The benchmark 10-year bond yield, which moves inversely to its price, hovered around 0.09 percent, the long-term 30-year bond yields also traded flat at 0.87 percent and the yield on the short-term 2-year note remained steady at -0.25 percent by 06:00 GMT.

The BoJ is expected to keep monetary policy steady on Thursday and stress that inflation is nowhere near levels that justify talk of withdrawing massive stimulus, as weak consumer spending casts a cloud over an otherwise healthy pick-up in the economy.

Further, at the two-day rate review that ends on Thursday, the central bank is expected to maintain its short-term interest rate target at minus 0.1 percent and a pledge to guide the 10-year government bond yield around zero percent via aggressive asset purchases. Analysts also expect the BoJ to keep intact a loose pledge to maintain the pace of its annual increase in Japanese government bond (JGBs), which is JPY80 trillion (USD696.62 billion).

The German bunds jumped at the start of the week on Monday as investors remain keen to watch the European Central Bank (ECB) Governor Mario Draghi’s speech, scheduled for later in the day. Also, the 30-year auction, scheduled to be held on March 15 will remain crucial in determining the teh future direction of the bond market.

Besides, markets shall remain hooked to assess the speeches by other ECB members Sabine Lautenschlaeger, Vitor Constancio and Peter Praet later through the day.

The yield on the benchmark 10-year bond, which moves inversely to its price, slumped nearly 4 basis points to 0.45 percent, the long-term 30-year bond yields plunged over 4 basis points to 1.22 percent and the yield on short-term 2-year bond traded 1-1/2 basis points lower at -0.82 percent by 08:30 GMT.

The ECB kept all policy measures unchanged at last week’s meeting, which was in line with market expectations. However, Governor Mario Draghi had a hawkish tone during the Q&A session as he said the Governing Council discussed whether to remove the ‘lower levels’ from the forward guidance on policy rates.

Further, on the very short-end, German yield curve, Draghi said the ECB was monitoring distortions. The market reacted by sending German government bond yields higher by around 5bp beyond the 10Y point.

Lastly, investors will be closely eyeing February consumer price inflation, due to be released on March 16 for detailed direction in the debt market.

The Australian bonds rebounded on the first trading day of the week as investors remain glued to watch the February employment report, scheduled to be released on March 15. Further, the 10-year bond yields have formed a ‘bullish gravestone doji’ pattern after two consecutive sessions of selling activity in the last week.

The yield on the benchmark 10-year Treasury note, which moves inversely to its price, plunged 3-1/2 basis points to 2.95 percent, the yield on 15-year note also dived 3-1/2 basis points to 3.34 percent and the yield on short-term 2-year traded 1-1/2 basis points lower at 1.91 percent by 04:40 GMT.

Australia’s unemployment rate unexpectedly fell in January, despite a plunge in full-time jobs, underscoring the mixed picture of the country’s labor market. The unemployment rate held below 6 percent partly due to discouraged job-seekers giving up the hunt, underscoring spare capacity in the labor market.

Commodity markets are taking centrestageas oil had its largest one day fall (- 4.5%) in 13 months. Oil net long positions from the CFTC have been overextended since the start of the year, but it was the combination of technicals and ever more inventory builds in the US that gave investors the signal to take profit. Within G10, CAD has been, and should continue to be, more sensitive than NOK because leveraged market positioning is still very long CAD. CADJPY is sitting on its 100DMA, with a move below 84.20 marking a technical break. AUDUSD is about to break below its 100DMA at 0.75,helped by iron ore prices falling 9% from their peak, keeping us bearish on this pair. AUDUSD has bounced off the top end of a trend channel, bringing the bottom end of the channel at 0.7080 into focus. Even with expectations of a neutral Norges Bank next week (or essentially less dovish than last time), we stick with our tactical long USDNOK trade of the week.

Oil inventory data from the EIA showed a rise of 8.2mb to 528.4m, which is the highest in the data series going back to 1982. US producers appear to be ramping up production quickly, helped by stronger margins from high oil prices and relatively low funding costs. According to Reuters, producers in the red-hot Permian Basin in Texas are expected to increase production soon. An observation from our oil desk highlights the extent of the extreme technicals. They say that there hasn’t been a time in the last 30 years when the weekly front end Brent contract has been in such a tight range, trading sideways for three months. The longer that went on for, the more positioning stresses built up, explaining the sharp drop yesterday. The next formal OPEC meeting isn’tuntil May 25.

The DXY is still under performingtherisein positive US data surprises: Yesterday’s bumper ADP jobs estimate of growth of 298k in February beat market consensus of 187k. Our US economist has revised up his NFP expectation from 200k to 250k. Jobless claims hitting a series of record lows all year, combined with one of the warmest Februarys on record, has helped outdoor industries like construction do well. The market now prices a 100% probability of a hike in rates by the Fed next week, and so any USD strength needs to be driven by expectations of a faster pace of rate hikes in 2018.

JPY: Investors sensitive to US yields: Weekly security flow data for last week showed Japanese net selling of 1.13trn of foreign bonds. There will likely be some volatile data in the run-up to fiscal year-end (March 31) but we think there should be more focus put onto country reallocations for Japanese investors, with a potential to shift into higher-yielding assets. Yesterday the Nikkei reported that the Japanese Financial Services Agency will start to audit regional banks who have large exposures in foreign debt. In particular, concerns have been raised about losses made on US Treasuries. The benefits of USD rising versus JPY as US Treasuries sell off are not there if the bank is holding the foreign asset with an FX hedge. This story needs to be watched to see if changing governance may push Japanese banking sector investments locally instead of abroad. Thinking about that flow, it may actually still be bearish for JPY if it puts downward pressure on JGB yields or increases local lending. If the BoJ’s central bank liquidity turns into ‘high-powered liquidity’ as the banks lend more to businesses, this would help local inflation and thus weaken JPY. Selling EURGBP over the ECB: Today’s market focus will be on the ECB press conference and specifically how much more confident Draghi is about the recovery in inflation. Should the market, against our economist’s expectations, perceive today to be a hawkish outcome, then we think that EUR will trade in two stages. Initially EUR should rally as bond yields rise (with our limit being at 1.08). However, the bond yield rise may be disproportionate across the region, causing spreads to widen. The spread widening is not a good sign for the monetary union as it will highlight further the divergence in economic data performance. EUR should fall as markets realise this and EUR becomes inversely correlated with peripheral spreads. On the UK side, Nicola Sturgeon has suggested to the BBC that a second independence referendum in autumn 2018 would make sense but still stresses thatno final decision has been made. This story adds to our bullish GBP view since it may bring Theresa May’s approach to the Brexit negotiations away from the ‘hard Brexit’ and towards the middle to accommodate Scottish views. We think that Brexit risks are largely in the price and still like selling EURGBP, with a stop at 0.88.

The Japanese government bonds traded flat Wednesday as investors digested the upswing in the country’s fourth-quarter gross domestic product (GDP).

The benchmark 10-year bond yield, which moves inversely to its price, hovered around 0.07 percent, while the long-term 30-year bond yields jumped 3 basis points to 0.87 percent while the yield on the short-term 2-year note traded flat at -0.28 percent by 06:40 GMT.

Japan’s GDP gained 0.3 percent on quarter in the fourth quarter of 2016, the Cabinet Office said in Wednesday’s final revision, missing forecasts 0.4 percent and was up from last month’s preliminary reading of 0.2 percent. GDP gained 0.3 percent in Q3.

On a yearly basis, GDP was revised up to 1.2 percent from 1.0 percent, although that also missed forecasts for 1.5 percent. GDP gained 1.4 percent in the three months prior. Nominal GDP was bumped up to 0.4 percent on quarter from 0.3 percent in the third quarter. That missed forecasts for 0.5 percent but was up from 0.2 percent in the three months prior.

The Australian bonds continued to slump Wednesday as investors cashed in profits after the Reserve Bank of Australia (RBA) remained on hold at the latest monetary policy meeting held yesterday, hinting at no further policy easing in the near-term.

The yield on the benchmark 10-year Treasury note, which moves inversely to its price, jumped nearly 5 basis points to 2.87 percent, the yield on 15-year note also climbed nearly 5 basis points to 3.28 percent while the yield on short-term 1-year traded 1 basis point lower at 1.61 percent by 05:00 GMT.

The RBA has left the official cash rate on hold for a sixth straight meeting on signs the economy is strengthening and business investment has picked up. The decision to maintain rates at current levels comes as the labor market, inflation and wages growth continue to stutter at the same time that growth has recovered, housing prices continue to surge and business and consumer confidence hover around multi-year highs.

Further, the central bank expects the economy to grow around 3 percent annually over the next several years on steady consumption growth and expanding resource exports.

The Australian bonds gained modestly at the start of the trading week Monday ahead of the Reserve Bank of Australia’s (RBA) monetary policy decision, scheduled to be held on March 7. However, investors have largely shrugged off the upbeat reading of the country’s retail sales during the month of January.

The yield on the benchmark 10-year Treasury note, which moves inversely to its price, slipped nearly 1 basis point to 2.81 percent, the yield on 15-year note also fell nearly 1-1/2 basis points to 3.23 percent while the yield on short-term 2-year traded nearly 1/2 basis point lower at 1.84 percent by 03:50 GMT.

Australia’s nominal retail sales rose by 0.4 percent m/m in January, in line with market expectations and a recovery from soft results in November and December. In annual terms, retail sales were up 3.1 percent y/y in January.

However, in trend terms, retail sales slowed to 0.2 percent m/m in January (from 0.3 percent m/m in both November and December) but remained steady at 3.2 percent y/y.

“There is little sign of this dynamic changing anytime soon, in our view. Thus, while we think the RBA is most likely on hold we see the prospects of a rate cut in the next 12 months as much greater than those of a rate hike,” ANZ Research commented in its latest research report.

The Japanese government bonds traded narrowly mixed Monday as investors wait to watch the super-long 30-year auction, scheduled to be held on Tuesday. Also, the fourth-quarter gross domestic product (GDP), due to be released on March 7 at 23:50GMT, is closely eyed by market participants as well.

The benchmark 10-year bond yield, which moves inversely to its price, rose 1/2 basis point to 0.08 percent, while the long-term 30-year bond yields fell nearly 1 basis point to 0.84 percent while the yield on the short-term 2-year note traded 1/2 basis point lower at -0.28 percent by 05:30 GMT.

Japan’s economy is likely to have grown faster in the fourth quarter than initially reported, as companies ramped up investment in plant and manufacturing equipment, a latest Reuters poll showed. GDP growth for the October-December quarter is expected to be upwardly revised to an annualized 1.6 percent from a preliminary 1.0 percent, according to the median estimate of 20 economists.

Separate data from the finance ministry is expected to show Japan’s current account surplus in January narrowed to 239.0 billion yen (USD2.09 billion) from JPY1.1 trillion in the previous month due to a slowdown in exports, Reuters reported.

Commodities, Oil Rig Count, Copper Mine Strike

WTI speculative positioning: It has been another week where speculators have increased their net long in WTI. Over the reporting week, speculators increased their position by 23,299 lots, to leave them with a net long of 413,637 lots. This is yet another fresh record net long held by speculators. This large net long continues to see positioning risk grow.

US oil rig count: Over the week, the US oil rig count passed 600 for the first time since early October 2015. The rig count has increased by 77 since the start of 2017 and by an impressive 286 since the lows of late May 2016. At current prices, we would expect the rig count to continue trending higher.

Escondida copper mine strike: According to Bloomberg, striking workers at the Escondida copper mine will be able to hold out for more than two months. The main trade union for mine workers says that they have a contingency fund to cover strike costs, while they have also secured further funding from a credit union if needed.

Brazilian aluminium import quota: The Brazilian government has lowered the quota for duty-free primary aluminium imports. The government has reduced the quota from 240,000 tonnes to 173,000 tonnes. Reports suggest the quota was reduced as a result of poor domestic demand.

Wheat spec positioning: Over the last reporting week, specs reduced their net short in CBOT wheat by 12,662 lots, to leave them with a net short of 27,385 lots. This is the smallest net short position that specs have held since November 2015. 

EU sugar exports: The European Commission is set to vote this week on whether the second tranche of out-of-quota sugar exports is to be approved. Given a tight EU balance, the EC has held off from allowing these exports. Export licences are usually awarded in January.

South Africa Inflation and Central Bank Outlook

Consumer price inflation in December was a higher-than-expected 6.8% yoy. Our expectation had been 6.5%, the same as the median consensus estimate. In November that rate was 6.6%. The average for 4Q 2016 was 6.6%; the highest of the year. Core inflation in December also jumped, to 5.9% from 5.7%, according to data published yesterday by Statistics South Africa. Numerous components of CPI were higher than our estimates, in particular:

? ‘Food and non-alcoholic beverage’ prices (15.4% of CPI) were up 0.8% mom; and

? ‘Housing and utilities’ prices (24.5% of CPI) were up 1.0% mom; Some core inflation items also surprised on the upside:

? ‘Alcoholic beverages and tobacco’ prices (5.4% of CPI);

? ‘Household contents and equipment’ prices (4.8% of CPI;

? ‘Recreation and culture’ prices (4.1% of CPI); and

? ‘Restaurant and hotels’ prices (3.5% of CPI).

The profile of the jump in inflation in December would support a continued cautious approach to monetary policy, in our view. Inflation looks likely to remain elevated for some time still, before the benefits of the recent decline in domestic agricultural prices begin to filter through. We still expect that inflation will decline through the year, but a sustainable return within the inflation target range of 3%-6% is only likely towards the end of 2017, according to our estimates.

Our estimates for CPI inflation assume a USDZAR rate of 15.25 at the end of 2017, and a Brent oil price of $60/bbl. by year-end (. We think that the Reserve Bank’s monetary policy committee will hold the repo policy interest rate at 7.00% throughout 2017. Retail trade data published yesterday showed that sales in November were up a very strong 3.5% mom, in seasonally adjusted and constant price terms. We will comment more fully on the domestic trade sector after the publication today of some additional data.

Hungary Central Bank

Speaking yesterday, National Bank Deputy Governor Marton Nagly said: “We are in an easing cycle; the word tightening doesn’t even arise in our thoughts.” He also said that the country faces less of a risk of a jump in inflation than regional peers, according to the Bloomberg report. Nagly said that the Bank remains ready to use unconventional tools to ease monetary conditions if needed and that the MC would decide in March whether the three-month cap on deposits with the Bank was still sufficient. The MC next meets on Tuesday (24 January)

Global Rates Mild reflation, Wild Politicisation, US Yields and Outlook

In a ‘post truth’, ‘fake news’ world, economic forecasters are troubled. After the political shocks of last year, the financial markets are banking on ‘peak populism’ this year. But the promise of mild reflation from the new Trump Administration in the US could easily be upended if his strong arm tactics backfire. And while polls in the Eurozone suggest that mainstream political parties will prevail in forthcoming elections, the question is at what price. The markets have taken on trust that incoming President Trump will deliver on his progrowth agenda. But the combination of fiscal reflation and deregulation will take time to deliver. Meanwhile, growth will face headwinds from the uplift in bond yields and the potential for Trump’s hawkish Cabinet to deliver on his hawkish rhetoric on trade. The US economy has regained the momentum it has lacked since 4Q15 with a strong 3Q16 GDP figure. We expect this to continue, with investment playing a stronger role than it has for years. But inflation is picking up too – providing the Federal Reserve with a headache in terms of further rate hikes, or instead shrinking its bloated balance sheet later this year. Any mid-year dip in bond yields will likely give way to rises later in 2017.

 For the Eurozone promising economic signals are overshadowed by the potential for fresh political shocks. Markets are drawing comfort from polls that suggest that it will be much tougher for populists to take power in the Netherlands, France, Italy or Germany. However, even if the mainstream prevails, it may only do so by leaning towards populist themes and backing off on closer integration. The UK economy shrugged off the ‘Brexit’ vote in 2016, benefiting from the inadvertent easing delivered by a big fall in sterling. But 2017 is looking more challenging. With Article 50 set to be triggered in the next three months, worries about the prospects of a deal may see businesses choosing to sit on their hands. At the same time, household spending power will be squeezed by rising inflation, leading to a marked slowdown in growth. This is likely to become the BoE’s main concern rather than inflation. In Japan the Bank of Japan (BOJ) is enjoying success in resisting the global upturn in bond yields, which has had the additional benefit of pushing the Japanese yen lower by around 9% on a trade-weighted basis, and the US dollar above the JPY120 barrier. With that stimulus in hand, the Japanese government is likely to hold off until the second half of the year before considering a further fiscal impulse.

The US dollar has largely held onto its late 2016 rally. We expect further gains through 1Q17 as the market further adjusts to the prospect of looser fiscal/tighter monetary policy in the US. EUR/USD could be dragged close to parity during this period, but our year-end forecast of 1.12 is above consensus. This is based on the view that a Trump Administration will not want the dollar to strengthen too much and that an undervalued EUR can recover. Japan aside, global bond yields are being led higher by the US. Firming economic data, a re-evaluation of economic growth post-Trump and a more aggressive Fed have driven up inflation expectations and real yields. Both aspects could rise further in our base view, with the major downside risks being failure of Trump to deliver growth promises, and political disruption stemming from Europe.

2017 could be transformational for the US. Questions about the aggressiveness or otherwise of trade policy will hopefully be answered. And uncertainty about the degree of any fiscal easing will also likely dissipate. Against this backdrop, the Fed will be trying to balance its cautious tightening, against growth and inflation that may be substantially stronger than its own forecasts. 2016 ended with market optimism about expansionary fiscal policy from an incoming Trump administration. The macro backdrop also ended on a more supportive note. After a soft-patch lasting three quarters, the final 3Q16 GDP growth estimate was an impressive 3.5%. This will make very little difference to the full year figure, finishing the year on a strong note is a very good way to ensure healthy figures for 2017.

We are forecasting growth for the US of 2.8% this year – substantially in excess of the 2.2% forecast shown in January by the Bloomberg consensus. Still absent, however, is a clear recovery in investment. Business investment recorded another negative score in 3Q16. But optimism is growing for a tax amnesty for America’s multinational firms and their $2tr-plus of retained overseas earnings. We expect this policy to be made contingent on some demonstration of increased domestic investment spending. The prospect of lower corporate tax rates could provide a further lift. In contrast, structures investment has shown a big improvement – a trend we think will continue. The rise in oil prices in recent months, helped by OPEC’s announced production caps, is lifting an already-rising rig-count, and with it structures investment. We retain some caution with respect to the scale of fiscal expansion that President-elect Trump will announce in February in his “President’s budget”. The timeline for such expansion is not a rapid one, and much of the benefit from whatever Congress actually decides to adopt will likely not emerge until late 2017 or early 2018. However, if that extends the growth spell from 2017 to 2018 (albeit at a rate closer to 3% than the 4-5% Trump suggested during the election campaign), whilst not generating too much alarm in terms of inflation or debt expansion, that would not be a bad thing. Longer dated bond yields will likely rise, but we think increases will be limited, and potentially suffer a mid-year pull back from higher levels as impatience over the delivery of fiscal stimulus plays with market nerves.

The outlook for trade, which is potentially far more threatening to US growth, remains concerning. Trump’s senior trade appointments include Wilbur Ross (Commerce Secretary), Peter Navarro (Head of White house National Trade Council), Robert Lighthizer (tipped for Head of US Trade Representative Office) and Dan DiMicco (transition team trade advisor). With a trade team that is heavy in terms of China critics, this is the big downside risk to both US and global growth prospects. Our base case is that this will be more of a war of words than a full blown trade war. Trump has already seemingly managed to influence Ford’s investment decisions to Michigan instead of Mexico through Tweets alone. And whilst aggressive rhetoric may weigh on the USD, that may not worry the incoming administration if it helps support US manufacturing.

The Fed threw a forecasting grenade into the mix at the end of 2016, signalling that it saw scope for three rate hikes in 2017. Like markets and the bulk of economic forecasters, we have our doubts. But while most forecasters can fall back on moderate growth forecasts as an excuse for Fed inaction, we think that the Fed will hike again in 1Q17 and potentially 2Q or 3Q17, before switching its attention to its balance sheet. The Fed has said repeatedly that it would not change its re-investment policy until the rate ‘normalisation’ process was well underway. “Well underway” probably equates with a Fed funds range of 1.0-1.25% – just two hikes away. In effect, this will remove from the bond market a substantial “buyer” each month, pushing up yields. In the meantime, we see evidence that the Fed is adjusting its holding of assets from longer to shorter dated assets, in a sort of “reverse twist” operation that is consistent with a steeper yield curve. If this becomes the Fed’s preoccupation in late 2017, there will be little need for additional tightening by conventional rate hikes, and we envisage a pause in rate movements in late 2017 and early 2018 whilst the market gets used to the new environment.


Commodities: OPEC and Oil, Metals, Agriculture
• Iraq & OPEC: The Iraqis now say that they will be willing to cut output as part of the larger OPEC deal. The Prime Minister wants to see OPEC cut output by 900,000 bbls/d, from the current 33.6MMbbls/d. Previously Iraq was insisting to be exempt from any cuts, and their apparent change in attitude does increase the likelihood of an OPEC agreement. • US inventory data: There was little in the way of surprises from EIA inventory data released yesterday. US crude oil inventories declined by 1.25MMbbls (similar to the API numbers), while US gasoline stocks increased by 2.3MMbbls.
Metals • US Midwest aluminium strength: Premiums for US Midwest aluminium have moved higher this week, with tightness in the spot market. Regional producers are apparently sold out for the month of December. As a result the premium over the week has strengthened to 7.70-8.25c/lb from 7.50-7.75c/lb, the strongest levels seen since May this year. • Silver weakness: ETF holdings of silver have declined to their lowest level since August 2016, with total known holdings standing at 661.28m oz, down from a record high of 676.15m oz back at the end of October. A further reduction in holdings will put further pressure on silver, which is already down over 12% since early November.
Agriculture • Sugar deficit narrows: Green Pool Commodity Specialists have revised their 2016/17 global sugar deficit estimate from 5.8m tonnes to 5.3m tonnes. The driver behind this change has been weaker demand, and this has been a result of the stronger prices that we have seen in the sugar market this year. • Indonesian palm oil: The Chairman of the Indonesian Palm Oil Association expects palm oil output in the country this year to decline by 10% to 30.9m tonnes, the fall is a result of the impacts from El Nino. However moving into 2017, expectations are that there will be a recovery in production.


Emerging Markets, Mexico, Turkey and South Africa

Long USD positioning remains relatively muted, as our positioning tracker indicates. As such we expect pullbacks in the USD to be reasonably shallow. Nonetheless, we believe that high yield EM currencies will post decent total returns in the near term as real yields in the US are starting to stabilize and commodity prices continue to rally. Typically EM currencies do fine during periods when real UST yields are stable, even as nominal yields move up. BRL is our top high yield pick.  

We maintain our bullish stance on Brazilian assets despite the latest negative headlines on Brazil. Focus has turned to concerns over the 2017 growth picture.  Tomorrow’s IPCA release could also support the trade if it continues to decline, opening the way for an aggressive cutting cycle. We are also watching headlines regarding uncertainty surrounding Temer’s cabinet, as domestic politics remain the greatest risk to our otherwise constructive view on the country, and in particular our long BRL/COP position. Today’s current account data will provide information on the external health of the economy.

The Turkish PM has stated that he believes the CBT will take measures on the TRY’s volatility, which has raised expectations of a 25bp hike at this Thursday’s central bank meeting. The impact of declining TRY deposit rates will mitigate the impact, and with the authorities doing little to change the dominant view in the market that they would prefer to have lower TRY interest rates over the medium term, we doubt the impact of a small rate hike on TRY will be meaningful. Latest data on FX deposit trends suggest that even as the currency depreciates, there is a reluctance of local deposit holders to shift back into TRY, from foreign currency. So far in November, the value of deposits in foreign currency has stayed broadly flat in USD terms.

South Africa continues to take measures that reduce the likelihood of a ratings downgrade and support market sentiment. Following labour market reform measures yesterday, the government has announced plans to delay building nuclear power plants, which will lower the market’s concern about potential contingent liability risks that the projects entailed. This should support ZAR in the near term, though we believe that the base case for the market is already that South Africa will avoid a ratings downgrade. Moody’s announces its ratings decision on November 25th,and S&P is on December 2nd.


USD and EM Flows, Bond Liquidation, VIX Correlation

The USD has remained in demand with high yielding currencies feeling most of the pressure yesterday. Judging the durability of this move we may have to differentiate between a portfolio and a macro effect. The portfolio effect is driven by the evolution of nominal financial return differentials. In short, rising US bond yields now trading within its 10-year sector back to levels last seen in January has reduced the relative attractiveness of higher yielding EM holdings. Our EM flow indicator show that there have been at least $2 billion in outflows from EM bonds and equities over the past week, with 85% of that in the 2 days following the election.

Liquidation pressures: Within the post-Lehman word seeing central banks doing most of the heavy lifting to support growth in struggling economies, investors have increased the effective duration within the US bond market from 6 towards near 8 years. Long duration bond portfolios now face capital risk as bond yields rise and bond prices fall. This liquidation pressure meets a secondary market with banks now holding less inventory due to tightened regulation, suggesting that there is less of a buffer function, explaining why bond yields have increased abruptly. There are worries we may see a repeat of the 2013 market when the taper tantrum pushed US 10-year government bond yields from 1.6% to 3%. Hence it seems understandable that investors are shifting portfolios from EM high yield into US equity markets. Investors speculating about the elected President’s ‘putting America first’ and its implications on global trade additionally justify this portfolio shift. A side effect of this outcome is another inverse correlation break.

The US VIX breaks lower while EM high yield weakens. This is new. Other correlation breaks seen since September include the USD now moving in line with industrial commodity prices, US inflation expectations no longer trading down as the USD rises, the US core PCE no longer reacting to falling import prices from China and a rising USD no longer flattening the US yield curve. Trading similarities have emerged with the year 1999 when output gaps diverged in a similar fashion compared to nowadays. Some DM areas including the US seem to be closing their output gaps while other regions in the world are widening. Hence any cost increase registered globally has a bigger impact on those economies where the output gap has apparently closed. This is why the USD has strengthened. Abating global headwinds. Note the global Manufacturing PMI has sharply improved over recent months, and is now at 52. Today, China released its October electricity consumption rising 4.8% Ytd YoY accelerating from 4.5% reported in September and Malaysia’s Q3 GDP came in at a faster 4.3% (consensus estimate: 4.0%). Hence, the anticipated US policy shift falls into fertile soil. Unlike last year when the Fed prepared for a December rate hike, external headwinds have eased. Due to global output differentials better global data have enhanced the position of the USD as an investment currency. The Dow rose 1.2%, to 18807.88, surpassing its previous closing record of 18636.05hit Aug. 15. The index is up more than 5% this week with pro-cyclicals like bio tech and financials leading the advance.

 Market language. Markets have undergone a fundamental change of trading. Not so long ago it was all about yield enhancement pushing funds into high dividend yielding equities, consistent with the rally seen within high yielding EM. Now it is all about growth with investors pulling out of traditional yield enhancement plays including high yielding EM, shifting into growth stories. This ‘portfolio effect’ may have further to go, but we acknowledge too that US real yields have remained low as the increase of nominal US yields has been mostly driven by rising inflation expectations. Should the new US government concentrate on supporting US nominal GDP growth and not raise trade issues then the EM high yield sell should be limited. The chart below shows that the bearish Latam FX move is not justified when using the 10-year US yield as the guide. Should we trade Latam long? No is the answer. AxJ FX shorts offer better opportunities. To turn bearish on Latam we would need to see the new US government ‘playing the anti-globalisation card’ or US real rates rising from here. Both are not expected near term outcomes.



The FED and Global Bond Markets, European Supply

The Fed clearly telegraphed they remain on track to hike rates in December, but failed to give any definitive signal in the statement. Indeed, they refrained from repeating the “appropriate to hike at the next meeting” language from the meeting prior to the December 2015 rate hike. Nonetheless, the market-implied probability of a December hike, at 78%, is now much higher than at the same time last year (i.e. 50%). So long as next week’s election outcome does not trigger market turmoil and/or the data do not take a dramatic turn for the worse, the December meeting indeed looks to be “the one”. UST 2yr yields closed 1.5bp lower at 0.82%, while the Fed funds futures curve (FF1– FF12) flattened to slightly below 30bp – suggesting investors expect at most two hikes from the Fed over the next 12 months. Interestingly, the 2/5/10yr fly valuation continues to reflect a scepticism amongst investors on whether the Fed will pull even this off.

EGB supply. Today France will reopen the FRTRs 11/26 and 5/36 (€7-8bn). The 10yr yield spread versus Bunds has widened to c. 32bp, thus just short of the previous peak in early October. Going into the auctions OATs have started to perform versus OLOs in the past few days, suggesting part of the earlier underperformance was owed to pre-auction concessions. The FRTR 11/26 yields 6.5bp more than the BGB 6/26 (1.8bp in z-spreads). Note that the 10yr benchmark in particular has been trading very special in repo lately.

Spain will reopen the 5yr SPGB 7/21, 10yr SPGB 10/26 and 15yr SPGB 7/30 (€2.5- 3.5bn) alongside the 10yr linker SPGBEI 11/24 (€0.5-1bn). The end to the political deadlock has benefitted SPGBs over the past weeks, but 10yr spreads versus Bunds have run into resistance at around 105bp. A new government is one thing, but passing a budget with a minority government is another. Furthermore, Catalan independence ambitions could move back into focus again, where unilateral action by the Catalan regional government around mid-2017 cannot be excluded. On balance, we think SPGBs look relatively rich by now, not only versus BTPs. Elsewhere, Ireland will tap the IRISH 5/30 (€0.75bn), which could well be the last auction for the year. Issuance to date has reached €7.6bn already and will move to the upper half of the NTMA’s envisaged €6- 10bn target range after today.


Global Fixed Income Flows and Price Action

Inflows to emerging market and investment grade corporate funds continue to contrast with outflows from developed markets government bonds. We also note inflows to inflation funds, which added to duration shortening gels with recent price action. Flows to high yield have been balanced of late, as high yield continues to lag the inflow process seen into emerging markets. We are still in a phase of risk on, but there is evidence that it is beginning to wane.

Inflows to emerging markets remain, although at a slower pace in more recent weeks. Hard currency continues to see the best of the inflows, and in proportional terms blend funds have seen more inflows than local currency funds (which are also seeing inflows). We note downsizing in allocations to Brazil and Mexico versus an upsizing in allocations to Russia and S Africa, while Turkey is now stable in terms of allocations post downgrade.

Inflows to high yield have been less impressive than seen into emerging markets. In the past quarter AUM in high yield is up 1.3% (mostly into USD) compared with a 5.2% increase in emerging markets (mostly into hard currency). W Europe high yield continues to struggle relative to USD high yield flows, which in fact is contrary to a burst in W Europe high yield inflows prior to the post-summer risk-on period.

Inflows to developed market (DM) corporate funds continue to contrast with steady outflows from DM government funds, a theme that has persisted through the past few months. We note a decent build in buying in inflation linked funds, both US and European. Money market funds have also been re-building AUM following prior outflows. We also note a theme of outflows from Eurozone centres versus inflows to select non-Eurozone centres, and these include both the US and UK.



10 Yr Bunds, Gilts and EFSF re opening pushing European Yields Higher

10yr Bund yields closed at the highest level in four months yesterday (i.e. 0.09%), and broke above the upper end of the -0.10%-0.05% trading range we identified for the coming weeks. Still, with the steepening pressure in EUR swap 10s30s remaining contained, we doubt whether the sell-off has further legs. Indeed, part of the sell-off seems Gilts-driven and due to a one-off reassessment of the UK monetary policy outlook in the wake of hawkish comments by Mark Carney (i.e. “there are limits to the MPC’s willingness to look through a temporary inflation overshoot”). Moreover, the wave of (SSA) issuance hitting the market yesterday, including a €2bn 10yr re-opening by the EFSF, surely also weighed heavily on Bunds. Note that the €1bn 24yr deal printed by Slovenia at MS +90 implied a 5-7bp concession to secondary market levels, though some would argue that it is the new bond that is fairly priced. Stronger-than-expected US macro data accounted for the remaining share of upward yield pressure. Here we need to see whether the upbeat picture painted by the preliminary PMIs will be confirmed in next week’s ISM surveys. All in all, we continue to believe that risk events including the US elections and Italy’s referendum plus speculation about an extension of ECB QE in December will keep a lid on any further sell-off pressures. Interestingly, Reuters reported yesterday that the ECB will almost certainly keep buying bonds beyond March next year and that changes to the capital key, issuer limit and depo rate floor for PSPP purchases were all under consideration. We stick to our view that a combination of increasing the issuer and ISIN limit for non-CAC bonds and relaxing the depo rate floor will be preferred over abandoning the capital key or more exotic options like buying senior bank bonds (although an expansion to bank loans would make a better choice). Tomorrow’s EGB supply. The Italian Tesoro will reopen the BTP 0.35 11/21 (€2.25- 2.75bn) and the BTP 1.25 12/26 (€2-2.5bn). It will also launch a new floater CCTeu 2/24 (€2.75-3.25bn)