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.

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

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

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

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

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

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

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

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

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

The Japanese government bonds remained flat Wednesday 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 rose by 1/2 basis points to -0.25 percent by 05:10 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 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).

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.


Commodities, US Oil rig count, Copper strikes

US rig count: Baker Hughes data shows that the US oil rig count increased by 6 over the week, taking the total number of active rigs to 597. Since the start of the year, the number of rigs has increased by 72, while from the lows in May 2016 the number has increased by 281. 

WTI speculative position: Over the last reporting week, speculators increased their net long position in WTI by 30,951 lots to leave them with a record net long of 390,338 lots. This sizeable position does continue to pose a risk to the market, although with the right catalyst. 

Escondida strike: Having failed to meet last week, BHP and unions at Escondida copper mine are scheduled to meet today, in the hope of moving closer towards an agreement. Workers at the copper mine have been on strike since the 9th February, which has continued to offer support to the copper market. 

Philippine mine closures: There is still plenty of uncertainty around the closure and suspension of mines in the Philippines. The president will now be reviewing the environmental secretary’s decision, while miners continue to fight the order. The Philippines in the largest nickel supplier in the world. 

Indian sugar production: Cumulative sugar production in India since the beginning of the season to mid-February totalled 14.7m tonnes according to Indian Sugar Mills Association. This is a 15% decrease YoY, and with a number of mills already shut for the season, production will be significantly lower YoY. We continue to believe that India will need to import around 2m tonnes of sugar for domestic needs this year. 

Corn spec position: Speculators continue to build their long position in the corn market, with their net long increasing by 56,527 lots to leave them with a net long of 85,360 lots. This is the longest speculators have been since July 2016, and expectations of reduced US acreage next season has been positive for sentiment. However this is some distance off still, and with good crops expected from South America this season, we would expect the upside in corn to be limited. 

Monthly Global EM Outlook, Trump Policies and Inflation

From the current starting point, the near-term inflation outlook is generally unthreatening in most markets that have a large weight in the international benchmark indices for EM local currency debt.

Inflation has risen in some EM countries during the past half year in response to currency depreciation and increases in global oil prices; but the CPI impact of exchange rate weakness has in most cases diminished and the oil price effect is probably about to peak. Beyond the group of EM countries that now have large weights in the EM debt indices, it is notable that core inflation is on the rise in China.

 The current level of core inflation (2.2% year-on-year) is not seriously disconcerting but if it continues to creep upwards then it will eventually become a constraint on China’s monetary policy. This represents a risk for the entire EM/commodities complex, but it is more likely to be a risk for the second half of 2017 than a focal point in the next few months. More imminently, the main risk of abrupt policy rate increases in the EM universe comes from the US in the form of the possibility of a surprisingly large batch of Fed rate hikes during the remainder of the year and/or a border adjustment tax. Either of these shocks could force a swathe of EM central banks to choose between raising their policy rates substantially or having to live with undesirably steep currency depreciation.

Given the current predominantly unthreatening EM inflation trends and residual labor market capacity slack in many countries, a large share of the EM central banks – especially in Asia – look set to be able to leave their own policy interest rates unchanged if the Fed keeps raising rates at a gentle pace and if the US border adjustment tax fades away.

An important source of inflation volatility in the EM world in recent years has EM currency depreciation (in nominal trade-weighted terms) that has led to increases in prices not only for imports, but also for those domestically produced goods that compete against foreignproduced items either in the domestic market or the export market. However, this problem dissipated in most of the EM world during the course of 2016, and only a few of the large EM countries – Mexico and Turkey to be precise – are seeing this problem unfold right now

Two other large EM countries – Brazil and Russia – are in the opposite camp. Inflation has fallen sharply in both countries in the past year. This reflects in part a swing from large-scale currency depreciation in late 2015 and early 2016 to equally forceful currency appreciation during the past 12 months. Deep recession, widening output gaps, and cautious monetary policy in both countries have also helped contain inflation. The view of our Brazil-based economists is that recent currency appreciation will continue to help drive down the country’s inflation in the present year whereas the main drivers of last year’s fall in inflation were a large decline in the pace of adjustment in government controlled prices (in part reflecting currency dynamics and a big change in global oil price inflation), the depth of the recession and, related to this, weakened wage pressure in the labor market.

To be sure, the behavior of EM currencies, inflation and policy rates would be highly likely to become much messier if the Fed were to accelerate the pace of its rate hikes substantially beyond what is currently priced into the US rates curve, perhaps in response to stronger wage data or aggressive future plans for unfunded US tax cuts. There is also, in our view, a very real risk to EM investors associated with the plan of Republican members of US Congress for border adjustment taxation (BAT), or from the possible imposition by the US of other types of import taxation. As we have argued multiple times on these pages, the BAT and import tariffs are likely to be highly dollarsupportive. If Trump’s decides to support either, and if he secures congressional approval, dollar-based holders of EM local-currency-denominated assets are likely to take a hit.

It might seem inviting to think that the BAT would help curb inflation in the EM world, because it would be likely to drive down the dollar price that EM-based importers pay for goods from the US (as US exporters would be entitled to a new subsidy) while also driving down the dollar price that EM-based exporters would obtain from sales to the US (because their sales would be subject to taxation at the US border). But the inflation “benefit” would be eroded by EM currency depreciation against the dollar. EM currency depreciation would most likely be sufficient to drive the local-currency prices for EM countries’ exports and imports (in trade with the US) almost all the way back to their pre-BAT levels.


Global FX Stories, USD, EUR, JPY and PLN

USD: Focus turns back to the domestic drivers The lack of focus on the currency manipulation rhetoric’s during the Trump-Abe meeting on Friday (note JPY was one of the currencies mentioned recently by the US administration as being unfairly kept weak) should allow USD to re-focus back on its domestic drivers. Bar the expectations of the details about the ‘phenomenal’ Trump tax plan, markets will be closely watching Chair Yellen’s testimony to the House (Tue) and Jan CPI and Jan retail sales (both Wed). With market pricing rather benign 30% probability of Fed March rate hike and much cleaner long speculative USD positioning, the bar is not very high for USD to record more gains this week, particularity vs low yielders such as EUR and JPY.

EUR: EUR/USD to move towards the 1.0500 level Very calm week on the EZ data front suggests that EUR crosses will be driven (a) news/data from elsewhere (b) potential additional increase EZ political risk. On the latter, EZ political risk premium pricing in EUR remains still very benign, allowing for more downside to EUR. We look for EUR/USD to move towards the 1.0500 level this week.

JPY: Scope for USD/JPY to resume its upside Japan Q4 GDP modestly disappointed the consensus expectations (0.2%QoQ vs 0.3% expected). Yet with the little scope for material shift in the BoJ policy stance in coming months, the driver of USD/JPY remains the USD side of the equation. Following the non-negligible adjustment in USD/JPY lower since the beginning of the year, the potential for higher UST yields and cleaner USD/JPY speculative positioning (ie, the speculative community is currently net short USD/JPY) point to USD/JPY re-testing the 115.00 level this week.

PLN: Boost from Jan CPI to provide a good entry point to short PLN Our economist look for an above censuses Polish Jan CPI (1.8%yoY vs 1.7%). While this may provide a boost to PLN, the zloty gains are likely to be short lived given the already stretched EUR/PLN levels. Equally, we don’t expect the Friday’s PiS leader Kaczynski’s confirmation on a dilution of CHF bill (see Snap) to lead to persistent PLN gains due to: (a) with PLN no longer pricing a domestic political risk premium (on short term basis), the Friday’s good news should not lead to material re-pricing of PLN risk premium; (b) the EZ politics and negative spill over into CEE FX should kick in as we approach Dutch and French elections. We retain negative PLN view and stay long EUR/PLN.



  • Specs reduce WTI net long: Having held a record net long of 379,927 lots previously, speculators over the last week reduced their long by 20,540 lots to leave them with a net long of 359,387 lots. A further build in US crude inventories, along with US production creeping higher could see further liquidation by specs. Although OPEC and non-OPEC production cuts are a counterbalance to this. 
  • US oil rig count: According to Baker Hughes data, it has been another week where US producers have added to the rig count, rigs increased by 8 over the week to total 591. This is the highest number of active rigs since October 2015. 


  • Indonesia copper output: Copper miner Freeport-McMoRan has suspended production of copper concentrate at its Grasberg mine in Indonesia. The miner has not been able to export since 12th January 2017, and needs to apply for an export permit. As a result of not exporting, storage is full. 
  • Chinese iron ore imports: Strong Chinese imports continue to support iron ore prices, which traded to the highest levels seen since 2014 last week. However robust imports have seen inventories in the country build to record levels. As of the end of last week total iron ore port inventories in China totalled almost 127m tonnes, up from around 80m tonnes in September 2015. 


  • Russian sugar output: Over the 2016/17 season, Russian sugar production is expected to reach a record 6.1m tonnes, which has seen the country become a more important exporter. Expectations moving forward is for production to grow further. The head of Ros Agro says output could reach 6.3m tonnes in the upcoming 2017/18 season. 
  • Ivory Coast cocoa exports: According to reports, local cocoa exporters in the Ivory Coast are unable to fulfil about 350,000 tonnes of contracted exports. These local exporters have come under pressure with falling cocoa prices, defaulting on these contracts would see the industry regulator in the country having to re-auction this cocoa for export. However someone will have to bear the loss, given that the cocoa will have to be re-auctioned at lower prices. 

USD Strength trying to recover, ECB committed to low real rates, Japan bond buying and AUD outlook

Conditions for the USD rally have improved with three events becoming topical. First, ECB’s Praet and the BoE have made it clear that Europe is not aiming for early rate hikes and are comfortable with seeing real rates dropping further from here. Secondly, Japan’s money market operations have underlined its commitment to control the JGB yield curve, which we view as a step towards Japan’s commercial banking sector regaining profitability and thus creating conditions for a faster money multiplier growth. Within an environment of DM reflation, the side effect of this policy is JPY weakness working via widening rate and yield differentials. Thirdly, China tightened its monetary policy by 10bps overnight, reported slower January manufacturing activity, but fixed the RMB weaker compared to market expectations. USDCNY came off a moderate 0.2% while USDCNH rallied this morning by 0.24%.

 The next hurdle for the USD to overcome is the Fed. Wednesday’s interest rate statement left the impression it may be operating behind the curve by acknowledging that inflation ‘will’ reach 2%, but refusing to send a signal to turn March into a ‘live meeting’. Today’s release of the US labour market report is only important in respect of impacting the FOMC’s mind set. Concretely, a strong labour market report helping the Fed by sending hawkish signals will be USD supportive. However, should the Fed stay dovish then a strong US labour market report may only steepen the US curve, but do little to support the USD. Fed chairwoman Janet Yellen’s testimony on 14 February will be a key risk event. In between, today the Fed’s voter Evans will speak on the economy and monetary policy.

The BoE has upped its growth forecast, has kept its inflation forecast little changed and has maintained its neutral policy bias leading to sharp GBP losses. The BoE left the impression of possibly underestimating inflation risks and by doing so it may be able to run accommodative monetary conditions for longer. While the National Institute of Economic Research sees inflation reaching 4% by the end of this year, the BoE has found additional labour market slack allowing it to project wage growth staying muted. The BoE sees inflation averaging 2.7% this year and 2.6% in 2018, little changed from its November projections. Its long-term economic projections are based on the assumption of rates rising early 2019, differing significantly from current market pricing, and suggesting rates going up by 25bp by August 2018.

ECB’s Praet as presented an equally dovish message suggesting that the recent upward trend in inflation was due to temporary factors including energy and food prices and the ECB would continue to “look through” factors contributing to the underlying trend.” With the Maastricht contract framework becoming less effective and EMU remaining fragmented in fiscal and regulatory terms (lack of fiscal and banking union) the ECB has to conduct policy according to the needs of its weakest link (see here for more). Italy seems to fall into this category. EMU’s equity markets and volatility curves have steepened recently. While some of this steepening may be related to upcoming general elections in Holland and France, the recent widening of EMU sovereign bonds spreads has added to concerns. EURUSD is a sell at current levels with a stop at 1.0840 and a target 0.9700. The risk to this trade is Italian data turning better, but given the continued weak credit creation by Italian banks we regard this risk as minor.

Some investors link bullish AUD strategy into a global reflation framework. Associating reflation with rising commodity prices may provide support to this idea. However, reflation and commodity prices are unlikely to stay linked for long should our view prove correct that part of DM is developing into a cost push inflation environment comparable to the 70s. The 70s did see precious metal strength while other raw materials stayed lacklustre. Opposite, the deflationary past 15 years were accompanied by periods of excessive raw material strength. So far, the CRB Rind has kept on rising, but with China tightening its policies while its manufacturing sector is weakening (Jan Caixin PMI eases to 51.0 from 51.9) it may not take too long from here to see commodity prices topping out.


USD divergence from bond yields, US savings, JPY curve

Accordingly, the current divergence of USD from US bond yields should not stay for long. It will be the steepening of the US yield curve reducing the relative attractiveness of taking advantage of the wide USD-JPY cross currency base. Otherwise, real yield differentials should be watched closely. It is the 10-year real yield differential and not the front end that matters here. The 10-year real yield differential leads USDJPY while 2-year real yield differentials and USDJPY follow a random pattern. With DM reflation gaining momentum and the BoJ keeping the JGB curve controlled, the real yield differential should soon pointhigher again, taking USDJPY with it. Moreover, the 40-year JGB has reached 1%, which may be too high for the yield curvecontrolling BoJ. Rinban operations emphasising long-end JGB purchases may be the next event to push USDJPY up.

Since the summer, the US savings ratio has declined from 6.2% to 5.5%,and with the government considering tax cuts and public sector spending programmes, US aggregate savings are set to decline. This is important should the economy enter self-sustaining growth with private investment picking up. Private investment increases capital demand which, in the context of lower aggregate US savings, must lead to a higher yield unless a higher USD and related capital inflows do not moderate this effect. We emphasise that the US has the choice between higher bond yields and a higher USD. The vacuum of US economic data this week gets filled today with a flurry of reports on jobless claims,new home sales, the trade balance, wholesale inventories, leading indicators and the services sector. Another set of better US data releases should work via higher yields into support for USD.

Global FX: USD bouncing higher, USDJPY, Yellen and closing output gap, CAD losing ground.

Yesterday USDJPY developed, with the help of Janet Yellen,a key reversal day testing a new low (1.1257) during the Asian session and closing the New York session (1.1465) above the previous day’s high (1.1428).Further gains are in store as Yellen’s remark suggests the Fed standing reading to hike rates at a faster pace than currently priced into the rate forward curve. It is the differentiation between an output-gap closed economy (The Fed’s Beige book data was positive yesterday) receiving a fiscal stimulus compared a situation of an output-gap running economy receiving a stimulus. In the latter case the size and the implementation pace of the package is of greater importance compared to the first case.

An output closing economy should see capex improving. Capital expenditure suggests higher capital demand which, within an environment of constant domestic savings, must lead either towards a higher USD driven by capital inflows or higher bond yields. Receiving a fiscal stimulus when there is an output gap suggests the fiscal stimulus may contribute to closing the output gap, but there is no guarantee that the stimulus leads to higher capex. For instance, in the case where the stimulus is inadequate size-wise or its implementation turns out to be too slow; then markets will see a bigger disappointment with the USD and bond yields falling back sharply.

Making this differentiation between an output gap closing economy and an economy offering output gaps is essential for trading within our current framework. Yesterday’s hawkish comments from Yellen and Kaplan address the fact that the US has closed its output gap suggesting rates should be moved towards turning policy neutral. This level is currently estimated at 3% suggesting that the current US monetary policy set-up is highly accommodative. Seeing real Fed funds rate falling below -1.0% as inflation has rebounded at a quicker pace than the Fed hiking rates adds weight to this view. Seeing the US equity market rallying in reaction to hawkish Fed commentary underlines the pro cyclical market set-up. The difference from last year could not be more pronounced. Fed Q4 2015hawkishness flattened yield curves, pushed inflation expectations off the cliff, undermined EM currencies and finally led to a sharp equity market decline. Yesterday saw US long end break evens rising (December CPI did beat market expectations), the yield curves staying steep and the equity market turning early losses into moderate closing gains with financials leading the pack.

The BoC leaving the door towards a further rate cut wide open fits well with our output-gap differential driven framework. Policy divergence coming on the back of inflation divergence should weaken most currencies against the USD. The CAD will be not an exception as a cut in the policy interest rate, currently at 0.50%, “remains on the table” should major downside risks to the economy emerge. Those downside risks could largely stem from the trade-related policies of the incoming U.S.administration. Designated Commerce Secretary Ross said the Trump administration will turn quickly to deal with trade relations with Mexico and Canada in the context of NAFTA.

2017 Start, Trump, G10 and Emerging Markets

2017 so far has been characterized by a relative lack of new direction in G10 markets. Indeed the action has largely been in the EM space, with some familiar players from last year such as CNH, TRY and MXN again dominating the headlines. From our perspective, one reason for this is the relatively benign outlook now priced in for changes in monetary policy. In the G3 space, the Fed is priced to hike twice in 2017, at roughly 6-monthly intervals. But both the ECB and BoJ are expected to take 2017 off entirely, with core inflation low enough to allow rates to stay suppressed and QE programs to continue despite a much brighter economic outlook and the disappearance of key disinflationary forces. The BoE is also widely expected to stand pat given Brexit macro risks, while the RBA and BoC are also priced to do either nothing or in Canada’s case only grudgingly follow the Fed’s rate hike path. The market appears to be saying that, bar a sudden and unexpected surge in inflation expectations, there is little reason for major central banks to do anything other than cruise along in autopilot along a largely pre-set course for now. It is no surprise in this context that, with the exception of Brexit-plagued GBP, most G10 FX vols are down so far in 2017. Nonetheless, today could see a change if the proposed press conference by presidentelect Trump leads to statements that upset the apple cart. In our view, there are three scenarios to consider from an FX perspective:

1. If Trump sticks to selling a positive economic story characterized by promises of tax reform, de-regulation and infrastructure spending, the USD should feel comfortable maintaining an overall upward trajectory given that US rates would likely move higher again in this scenario. Our current 3m forecast profile (EURUSD 1.03, USDJPY 122) is in line with this as our central case. Indeed, with markets only pricing in a 20-25% chance of another Fed hike in March, we see some upside USD risk if these odds rise in the weeks ahead, assuming US equities stay bid and fiscal expansion plans become more transparent.

2. If Trump focuses more on themes like Nafta withdrawal and especially labelling China a currency manipulator, the market may finally start to price in some possibility of a negative growth shock at a global level, which in our view would be best expressed in G10 space by buying safe havens like CHF and especially JPY. It is notable that JPY implied volatility remains lofty despite the overall pressure on G10 vols, with risk reversals still bid for JPY calls, suggesting that the market already owns some insurance against such an outcome. This suggests that a Trump press conference viewed as entirely benign would ease tensions and provide for a fresh reason for the market to buy USDJPY again after recent profit-taking. Indeed till now we have argued that the best places to trade specific Trump risks to global trade are in the currencies that most reflect likely losers, i.e. to be short MXN (3m forecast : USDMXN 23.00) and CNH (3m forecast: USDCNH 7.07). Although the carry costs are high and have risen still more on balance, the Trump message has been nuanced enough so far to warrant this approach.

3. The true wild card the Trump press conference could generate would be comment attacking overall USD strength. We see this as a very low delta outcome at this stage – recent events suggest more time is likely to be spent discussing actresses and TV shows than discussing the currency specifically – but it should not be ignored altogether. If this does emerge we can imagine it generating significant resistance to further USD strength, at least in G10 space, given current market positioning. A comparison would be with the March 2015 FOMC that saw the “dots” lowered partly as a function of USD strength, which helped to draw a line in the sand for EURUSD around 1.05 until December 2016. With the market more focused on long USDJPY as its most effective G10 USD-bullish expression, we would expect this pair to have the most significant retracement under this scenario, perhaps as far as the 110 level.

Assuming Trump addresses matters that can have relevance to the FX market at all, we would ascribe a 20% probability of just scenario 1 happening, a 10% probability of just scenario 2, a 65% probability of some fusion of 1 and 2 and a 5% probability of scenario 3 being the dominant message. In EM, we note that last week’s CNH funding squeeze has run its course for now, with implied CNH rates materially lower in the past few days. This has allowed spot USDCNH to move higher again, even as longer-term forward outrights are not much changed from last week’s levels. We acknowledge that onshore liquidity has also tightened somewhat of late, but the bottom line is that there is little evidence as yet that policymakers are willing to tighten the screws enough to change the underlying psychology in favour of acquiring overseas assets in a rising dollar world. As such we retain a view that buying longer-term USDCNH tenors makes sense, for example the 5m outright around 7.05. Meanwhile in Mexico, higher MXN funding costs combined with Banxico intervention are likely only to stall MXN losses as opposed to actually changing the downward trajectory. We discuss both these currencies in depth in this week’s FX Compass. As for the Turkish lira, we remain bearish against forwards even from current levels and are unconvinced that either the central bank or the government have the willingness or ability to support the lira. We revise our 3-month forecast to 4.00 and our 12-month target from 4.10 (from 3.65 and 3.85 previously). If extremely shallow liquidity, poor investor confidence and repeated disappointments from the central bank are becoming a new reality for the lira, there may be no clear upper bound on where USDTRY may be heading. Indeed yesterday’s attempts by the central bank to tighten TRY liquidity remind us of several similar attempts over 2016, where small measures did not prove to be sufficient substitutes for hikes. In the current environment markets may be disappointed with anything less than 100bp on 24th January – especially with the political environment becoming more awkward for the central bank to act in an aggressive manner as April’s referendum approaches. To make matters worse, a potential downgrade from Fitch to junk on January 27th is unlikely to help sentiment, even if it is the third major rating agency to do so.

China Economics – PPI jumps further in December

  • China’s PPI accelerated to 5.5% in December, against its previous reading of 3.3% and Bloomberg consensus of 4.5%. CPI inflation moderated to 2.1% from 2.3% previously.
  • The improved PPI is supportive of corporates’ cash flow and profitability. The PBoC may be able to pay more attention to financial risk management issues. Room for the PBoC to guide up the level and volatility of interbank rates is getting larger.
  • Current CPI inflation is still below the government’s upper bound. This offers room to keep overall credit and monetary growth at a steady rate for the time being.
  • In our previous note, we expected the PPI to overtake 5%. Based on the latest information, we believe the PPI is likely to increase further towards 6.5% in the coming months. The key risk to China’s inflation dynamic is an increase of consumer inflation expectations. This also offers motivation for the PBoC to introduce tightening elements for its policy setting.

China tightened its checks on personal forex purchase

The SAFE introduced new administrative requirement for personal foreign currency purchase in China. Specifically, an extra form filling process is now required to declare the purpose of the foreign currency purchase. There is no change to the annual 50k USD FX purchase quota.

? We expect strict implementation of the new requirement and strong reinforcement by the SAFE and all of the commercial banks.

? Combined with the tightening rules on corporate’s ODI, we expect these measures to help ease some of the pressures on China’s FX reserves.

? However, with monetary policy still too loose and Chinese asset diversification rate still low, capital outflows are likely to continue. We maintain our forecasts for USDCNY to rise to 7.33 over the year ahead.

Tightening checks on personal FX purchase procedure The SAFE introduced new administrative requirement for personal foreign currency purchase in China. Specifically, an extra form filling process is now required to declare the purpose of the foreign currency purchase. There is no change to the annual 50k USD FX purchase quota.

In addition to the extra form filling requirement, the PBoC has also tightened the regulation on all of the bank transactions broadly in an announcement made earlier. Some of the elements effectively tightened the FX transaction too. For example, financial institutions have to report to the Center of anti-money laundering for “onshore transactions between individual account to other accounts if the amount is above US$100k equivalent per transaction or per day”. The reporting threshold is set at US$10k for cross border transactions.

May help ease pressures on FX reserves in the short term This follows a series of measures towards corporates’ outward. Combined with recent NDRC’s pledge to attract more foreign investment, we think the message is clear that the top authority in Beijing is paying substantial attention to FX reserves and CNY dynamic. However, the key risk is that participants may be able to find other loopholes if there is underlying need. Recent experience in other areas, e.g., shadow banking, suggests that players tend to find new channels fast, too. Over the longer term, the fact that Chinese households still have little relative allocation to overseas assets would be one of the key factors for more overseas allocation, and an increase of income per capita tends to suggest more demand for global services, too. On the other hand, successful reforms in the domestic economy, if they take place, will help China to attract more FX inflow.

USD Strength, China and Yuan Weakness, AUDUSD

Despite being with the consensus we underline our bullish USD view, but unlike November/December when the USD rise was mainly driven via low yielding currencies seeing USDJPY gaining 15% within seven weeks, we put our bearish focus towards Asia and Australia. The dominance of USD strength prevented the AUD from benefiting from rising commodity prices and the associated terms of trade improvement. Going into December, the AUD started to underperform other currencies, which we have partly exploited running AUD shorts against the CAD and the NZD.

First, improving terms of trade may not necessarily lead to better investment spending should Australian companies regard higher commodity prices as only a temporary development. Indeed, mining investment plans have not picked up as much as terms of trade have. During the 2009/2012commodity boom, Australia’s mining sector had built up overcapacities putting the return of equity during the following commodity slump under additional downward pressure. Nowadays, mining companies seem to be more careful, improving corporate cash positions instead of engaging in new investment activities. Hence, better commodity prices fail to develop growth supportive second round effects.

Secondly, there are two major risks for the global growth outlook and both of these risks will not bode well for Australia. Global trade growth has stalled since 2013, which may be linked to trade growth reaching its natural limitations as global imports and exports reach 60% of global GDP. This observation is already a negative for overcapacity-running and manufacturing oriented economies, of which most are located in Asia. Should the incoming US administration provide new trade hurdles it will hit trade surplus countries most. Note, China’s State Information Centre suggested a one-off devaluation of the yuan exchange rate should be considered to maintain the currency’s stability at a balanced level. These comments from the State information Centre may have to be seen within the context of the current trade discussion in the US.

The other risk is related to the underlying strength of the Chinese economy. Unlike January 2016 when most of the markets’ risk-focus was on China, investors are looking in other directions when trying to locate potentially upcoming market risk events. This morning’s release of a strong Caixin report (51.9 in December from November’s 50.9) showing growth momentum in China’s manufacturing sector in December posted the strongest monthly upturn since January 2013and seems to justify the view of China growth risks as not significant. Indeed, over the past year the Chinese economy performed better compared to downbeat expectations, supported by loose fiscal and monetary policies.

China’s monetary policy may from now on act less as a growth support. Instead, currency outflow pressures and ambitious house price valuations suggests a tighter PBOC policy approach, thus leaving, within an environment of lacklustre private sector investment activities, fiscal policy as the only game in town supporting the Chinese economy. Meanwhile, markets will carefully examine if the State Administration’s measures, effective from 1st January 2017,have the desired impact to reduce RMB outflow pressures. These measures include citizens not using the USD50k per person quota for purchases of property, securities, life insurance or investment-type insurance.

Last year, the AUD often appeared on top of many selling recommendation lists. Not so this year, where we feel markets may not recognize the entire AUD downside potential. For starters, AUD-USD sovereign yield differential is at historic lows. Hence, the AUD qualifies less as a ‘yielding currency’, bearing in mind that Australia’s net foreign liability position has further deteriorated. Its banking sector has reduced its whole sale funding exposures since the financial crisis, but within an international comparison its banks still feel the impact of rising USD funding costs more than most other G10 banking sectors. An interesting read is provided by the most recent BIS release examining the international impact of changing funding costs of the USD, EUR and the JPY. Countries with high foreign funding needs should be most exposed within an environment of rising international funding costs. Add to this mix global trade and Chinese growth risks and the outcome should be a much lower AUD.

USD Shortage Across Markets, A Dovish Rate Hike by the FED, RMB Offshore Rates and BOJ Bond Buying

Signs of an USD shortage are rising putting our emphasis towards Australia’s wholesale funding-dependent banking sector now experiencing tighter funding conditions. AUDUSD has tested levels near its 200- day MAV with the help of rallying commodity prices. The November consumer climate has eased towards its weakest level since April following earlier reported real estate weakness. AUDUSD should break lower and we are positioned via short AUDNZD. We remain GBPUSD bullish ahead of today’s Carney speech (which is not on monetary policy).For the first time in five years UK PPI is expanding at a more rapid pace than the CPI, helping GBP in the short-term.  

Today, the Fed should aim for what we call a ‘dovish rate hike’ putting rates up by 25bps but signaling that there is no rush to hike rates further from here. The still relatively weak investment cycle suggests monetary policy will stay accommodative for longer, leaving markets with a mixture of liquidity, inflation and growth helping pro-cyclical equities such like financials to outperform. So far, the equity market rally has focused on DM leaving most EM markets behind.

RMB offshore interest rates have sharply risen this morning as authorities absorb liquidity to stabilise the RMB. The overnight CNH Hibor rose another 2.7% to 7.3% today, rebounding after a dip on Tuesday and taking the overnight rate to its highest level since last Monday’s 12.4%. Meanwhile, suggestions claiming China’s authorities may return back towards a fully managed FX system have become louder. Sheng Songcheng, ex-head of the PBoC’s statistics department and now a PBoC advisor, warned that the RMB could face greater depreciation pressure at the beginning of next year as the annual foreign exchange quota of USD50k reopens for individuals in January. He warned a weaker RMB could undermine financial stability and eat further into China’s USD3.1trn currency reserves. Currency reserves have declined by USD900bln in less than two years.

Interestingly, by restricting capital outflows international USD liquidity seems to have tightened as Chinese companies will be forced further into the offshore debt market to fund their more than USD200bln in acquisitions announced this year. China’s USD denominated debt sales – in the past targeting Chinese investors aiming to diversify into USDs – seem to no longer have access to this group of investors as China’s authorities tighten capital account related regulations. Consequently, Chinese companies may have to look for alternative funds to absorb USD liquidity from Asia’s offshore USD markets, pushing yields for these funds higher. Over recent months USD denominated claims against China’s corporate sector have increased again to USD619bn in 2Q, suggesting two things. First, funding tightness leaving the USD market as a quasi ‘ lender of last resort’ and secondly increasing the vulnerability of corporates again should the USD continue to rise.

There are increasing signs of a USD shortage in offshore markets. One expression of this tightness is the widening of the cross currency basis most emphasised in the case of USDJPY. USD front end funding costs have become increasingly expensive which. within the current constellation of widening bond yield differentials, Japan’s markets offering virtually no yield and Japan’s insurance companies runninghigh FX hedging ratios, could spark a rapid USD rally going into the next year. This is why a dovish Fed today may provide opportunity to pile into cheap USDs.

Tightening offshore USD liquidity increases FX hedging costs, but with the BoJ managing its yield curve, JPY based investors have little other choice looking for yield outside. However, with FX hedges becoming increasingly expensive they may have to seek foreign yields on a currency unhedged basis. Existinghedges, often with a maturity between 3 – 6 months, were established at cheaper costs, but when these hedges are due for prolongation it may no longer make sense to continue to run these hedges. Expiring hedges lead to more currency demand and a weaker JPY. Typical for those situations is seeingFX moving unrelated to the release of economic news.

Predictably, the BoJhas increased the scale of its longer-end Japanese government bond buying operations this morningnot only to cope with the recent rapid rise in longer-end bond yields but also to ease market concern over possible volatile moves in future, an official at the BoJ’s Financial Markets Department told MNI. The amount of JGB buying with a remaining life of 10 to 25 years was raised to JPY200bln from the previous amount of JPY190bln while bond buying with a remaining life of longer than 25 years was increased to JPY120bln from JPY110bln.


China 7 Day Repo and Monetary Policy

The PBOC has tightened monetary policy recently by raising the level of the 7- day repo rate and increasing its volatility. These steps seem to be aimed at controlling asset inflation in housing in general and particularly that funded by small and medium-sized banks. We think it is too early to rule out the PBOC needing to tighten policy further. Some progress in slowing activity has occurred, but house prices are still rising and banks may find ways to work around the tightening so far. Crucially, we see these measures as aimed at containing specific risk factors – housing and SME bank lending – and believe they are not aimed at a more general slowing in credit and economic growth. We think the government remains committed to keeping GDP growth at 6.7-6.8% in 2017 and we estimate this will require broad credit growth to remain at least 13%. A key market implication is that monetary policy should prove incompatible with the recent effort to hold the CNY stable vs. its basket. We continue to expect the CNY to fall about 1% vs. the basket over the next several months and about 4-5% over the next year. Given our USD-G10 forecasts, this leads us to expect USDCNY to rise to 7.01 and 7.33 in 3 and 12 months respectively.

USD Index Momentum, the FED meeting, GBPUSD and China

Finally, conditions for a USD downward correction are in place. DM bond yields have moderated overnight, as nominal yield spreads have turned less USD-supportive, oil prices and other industrial raw material prices have come off their highs and importantly the better data releases coming out of China have failed to push bond yields higher. Technical and market sentiment indicators such as the increasing skew of option put prices being higher than calls for US Treasuries (see Exhibit) suggest USD falling from here. Higher yielding EM currencies are best positioned to rally, while the anticipated USD correction should find little traction against low-yielding currencies such as JPY and EUR. USDJPY should drift to 114 and only if it breaks this level does it have the chance of seeing 112. Anyhow, this pre-Christmas USD setback should lay the foundation for a stronger USD advance going into January.

GBP should resume its rebound as there are increasing signs within the British government of it avoiding the cliff edge. Yesterday, it was Chancellor Philip Hammond suggesting that there was an emerging view among “thoughtful politicians” that Britain might need more than the two-year period stipulated under the EU’s Article 50 divorce process to finesse its departure.

Today the Fed will start its two-day meeting. A 25bp rate hike is priced in. Some bond-bearish market participants suggest that the Fed may shift its dot plot towards higher levels, reacting to the Presidents-elect’s expansionary fiscal plans and increasing signs that the US economy may have closed its output gap. More likely appears to be that the Fed executes what we call ‘a lazy rate hike’, signaling a rate pause after today’s likely rate hike. First, the incoming government plans are not yet concrete. While lowering taxes may be easy to implement, expenditure increases are more difficult to find majorities for on Capitol Hill. Second, the Fed wants to see investment spending picking up. So far, investment has been weak and, with the US economy increasingly replacing capital with labour productivity, it has declined. At the same time, the ratio between labour and capital has become increasingly sub-optimal. Third, there is an increasing number Fed participants believing in the beneficial effects of a steeper yield curve. After years of pushing long-term bond yields lower, officials start to understand the importance of capital availability relative to the cost of capital. A commercial banking sector seeing its profitability supported by a steeper yield curve may increase its now more profitable lending activities, which would work in favour of the money multiplier.

Ahead of tomorrow’s Fed announcement, investors may reduce USD long positions while recognising that there is an asymmetric risk looming. A USD long-positioned community may find little appetite adding to longs within pre-Christmas markets even if the Fed – against our expectations – turns out hawkish. Moreover, Brent has scaled back from our technical target (57.60) on news that China has increased its output from a seven-year low. Former Fed Chair Bernanke has argued in his blog that 40% of the 2014/15 oil price decline had been driven by global demand moderation, suggesting that oil prices should rebound as global demand normalises. The ‘problem’ is that oil supply is now greater than at any time of the post-WWII period, increasingly driven by market oriented companies, with profit margins and access to capital determining the pace of capacity increases. Seeing the oil price moderating from here may allow bond markets to recover globally, delivering a weaker USD as a side-effect.

China saw November industrial production climbing 6.2%Y, compared with a median estimate of 6.1%Y. Retail sales rose by 10.8%Y, which was the biggest gain since December,and fixed asset investment increased by 8.3% YTD. These data points seem to support the global reflation story, but caution is warranted. Capacity utilisation rates have reached lower levels compared to 2008/09. The rising activity has come with the support of a strongly expansionary fiscal policy, rising by 12.2%Y in November and 10.2% YTD. The Chinese Academy of Fiscal Sciences has warned local authorities that the debt-moderating impact of debt swaps has not reduced medium-term fiscal risks. It appears that China’s current economic rebound has been fiscally driven. Private sector investment has stayed weak.

Turkey Update on Economic Measures Taken

Prime Minister Yildirim announced yesterday various measures to support economic activity. The most noteworthy of these measures is that the government will support bank lending up to TRY250bn to exporters and SMEs through government guarantees. This measure basically aims to encourage the banking sector to overcome its low confidence in some counterparties following the failed coup attempt in July, and is similar to a scheme that the government used during the 2008-2009 global crisis.

Although the NPL ratio is about 3.5% in the banking sector, the government will set aside 7% of this amount, i.e. TRY17.5bn (about 0.7% of GDP over 3-4 years), in the budget as a contingency in case these guarantees need to be exercised. The maximum burden on the budget will be around TRY4-4.5bn (0.2% of GDP) per year, according to Deputy Prime Minister Simsek who clarified the scheme during Yildirim’s press conference. and will not require any changes in next year’s budget given the existing reserves.

The announced measures did not include possible issuance of dollar-linked bonds by the Treasury that was mentioned by some local sources earlier this week. Industrial output growth momentum moved into positive territory in October after a sharp fall in 3Q following the coup attempt in mid-July. According to data released by the Statistics Office yesterday, seasonally and workday adjusted industrial output was up 3.7% mom in October, broadly in line with the Bloomberg consensus forecast of 4.0% mom. (We do not forecast this variable due to its volatile nature.) On 3m/3m basis, industrial output growth momentum moved into positive territory in October for the first time since May; it was 2,0% compared to -2.9% in September and -0.6% in June. The increase in industrial output growth momentum in October was broad-based, but the momentum in domestic-demand-oriented sub-sectors was stronger than that in export-oriented sub-sectors, on our rough classification.

This suggests that the incentives announced by the government in late September to stimulate household spending and the increase in consumer loan growth momentum since September impacted industrial output favorably in October. Whether this was sustained through November, given the rapid depreciation of the lira and its consequent potential negative impact on sentiment across the country during that month, remains to be seen. However, the October data give support to our view that there is a cyclical recovery in economic activity in 4Q following the adverse developments of 3Q.

Commodities, Energy, Metals and Agriculture
Energy • US crude inventories: API are said to have reported that US crude oil inventories fell by 2.21MMbbls over the last week. The EIA are scheduled to release inventory data today, which the market is expecting will show a decline of 1.5MMbbls. • Chinese coal mine closures: Henan province in China has said to have shut down 100 coal mines over 2016, with a combined capacity of 23.9mtpa. This has seen the province exceed its 2016 target of shutting 22.2mtpa of capacity.
Metals • Record copper spec position: Unsurprising given the strength seen in copper prices recently, speculators have increased their net long in LME copper to a record 78,054 lots. Since the start of 4Q16, the speculative position in copper has increased by 35,796 lots. • Chinese iron ore inventory: Iron ore port inventory in China currently stands at almost 111m tonnes according to Steelhome. Inventories at Chinese ports have increased by almost 6% since the start of 4Q16. While stock levels are fairly close to the record 114m tonnes of inventory seen back in 2014.
Agriculture • Brazilian gasoline price increase supports sugar: Brazilian oil company, Petrobras has announced an 8.1% increase in gasoline prices in the country. The increase has been supportive to ethanol prices, and as a result also sugar prices. With the sugar market in deficit, sugar prices need to remain above ethanol prices so that Brazilian sugar mills allocate more cane towards sugar production. • Larger French wheat acreage: French cooperative, Axereal expects that farmers would have increased wheat acreage by up to 5% YoY. This is a result of farmers switching from rapeseed to wheat, given the dry conditions seen over the rapeseed planting period. A larger acreage for the next wheat crop, should see a recovery from this season, which saw a poor harvest.


ECB & QE Expectations

Our base case of a likely two-quarter ECB QE extension with no taper signal should be EUR neutral as it would partly keep concerns about Italy at bay. Under current circumstances, QE tapering may be tricky for EUR if higher EZ yields are offset by a rise in EUR risk premium (due to concerns about Italian banks). But whether it is the higher EZ yields channel or the EUR risk premium channel that dominates, being short PLN and HUF should be the desirable strategy under a QE taper scenario.

We expect the ECB to: (1) extend the QE programme by two more quarters at the current €80bn per month pace; and (2) change the modalities of the programme (options include increasing the issuer and issue limit on nonCAC bonds, dropping the deposit floor limit on purchases under the PSPP programme). Despite the recent emergence of speculation regarding QE tapering (as per a Reuters article last week), we believe this looks less likely at his point following the outcome of the Italian referendum and the market’s focus on the Italian banking sector. EUR reaction under no QE base-case tapering – muted Should the ECB extend the QE programme at the existing pace by two more quarters (our base case) its impact on EUR should be limited as: (1) this outcome is widely expected; and (2) there may be a muted increase in the EZ periphery credit risk premium (though equally no meaningful decline given concern about recapitalisation of Italian banks). EUR reaction under QE taper alternative case scenario – rather tricky Under current circumstances, EUR reaction may be tricky should the ECB opt for tapering this week and be determined by: (1) the scale of German bunds/EZ bond yield increase (EUR positive); and (2) the extent to which higher EZ yields will lead to concerns about peripheral countries, spread widening and EUR risk premium rise (EUR negative). Following the Italian referendum, markets seem to have priced in a glass half full view and further ECB QE support. This is reflected in the muted reaction in BTP spreads and decline in EUR/USD volatility premia (Figure 1). Should the QE taper announcement lead to peripheral spread widening and rise in EZ risk premium (risk of which does not seem to be priced in), there is a risk that this may offset the effect of higher bund yields on EUR.


Global Commodities, Energy, Metals and Agriculture

Energy • Russian oil output: 11.21MMbbls/d was what Russia managed to produce over the month of November, which is slightly below the record 11.23MMbbls/d pumped over October. Russia has said that they will gradually reduce crude output over 1H 2017, as part of non-OPEC cuts, with the Russian energy minister saying that the country will cut output by as much as 300Mbbls/d. • Indian coal production: Coal India output over the month of November totalled 50m tonnes, up 5.3% YoY, however still short of a targeted 53.85m tonnes. This takes cumulative Indian coal output since the start of April 2016 to 323.6m tonnes, compared to 321.4m tonnes at the same stage last year.

Metals • Indian aluminium imports: There are reports that the Indian government will soon impose a minimum import price (MIP) on primary aluminium imports. The Aluminium Association of India has been pushing for the government to impose a MIP of 15% of the LME’s price. • Peru copper output: According to government data, copper production in Peru over the month of October increased 38% YoY to 218,685 tonnes. The increase in output that has been seen in Peru this year has been a result of a ramp up at a couple of mines in the country.

Agriculture • French sugar: CGB, the French sugarbeet growers association has said that post production quotas, sugarbeet area in the county could expand by 20%. Meanwhile for the current season, the association are expecting poorer yields YoY as a result of poor weather conditions over the summer. • EU wheat exports: The EU Commission has lowered its estimate of EU wheat exports for the current 2016/17 season by 1m tonnes to 24m tonnes. The EU has had a poor wheat crop this season, which was largely driven by wet weather over the early summer in France.


Commodities, Energy, Metals and Agriculture

Energy • OPEC agreement: Members of OPEC finally came to an agreement on a production cut, with the group agreeing to cut output by 1.2MMbbls/d to 32.5MMbbls/d starting 1st January 2017. Meanwhile OPEC have an understanding that an additional 600Mbbls/d of cuts will come from some nonOPEC members, including Russia. The decision is positive in the short term, but stronger prices should see US output picking up moving forward. • US inventory data: Receiving little attention yesterday, the EIA released its weekly report, which showed that US crude oil inventory fell by 884Mbbls/d, while market expectations were for an increase. However there were large stock builds in gasoline and distillates over the week.

 Metals • Chinese import quotas on gold: According to reports the Chinese government has restricted licences to domestic banks for gold imports, in an attempt to help stop a weakening in the renminbi. Sustained restrictions in imports could see even further pressure on gold, which fell more than 10% over November. • Norsk Hydro aluminium outlook: Norsk Hydro estimates that primary aluminium demand has grown around 5% over 2016, and expect in 2017, for global demand to grow between 3 and 5%. They are also expecting that the primary aluminium market will be largely balanced over 2017.

Agriculture • Egyptian wheat imports: The General Authority for Supply Commodities (GASC) in Egypt bought 240,000 tonnes of Russian wheat at a tender this week. This takes total GASC purchases since the start of July to 2.58m tonnes, lower than the 2.83m tonnes purchased by the same stage last year. The country has had issues with trade interest in tenders this year, given confusion around its policy regarding ergot in wheat. • Honduras coffee exports: Shipments from Honduras reached 188,7777 bags over the month of November, a significant increase from the 89,960 bags exported at the same time last year. Higher output is the reason behind stronger imports, the local association earlier in the year estimated that 2016/17 production would total 7m bags compared to around 5.4m bags in the 2015/16 season.

Further progress on fiscal reformsgives Brazil moreroom to cut rates:

After having made it through each voting round in the Lower House successfully, the spending cap bill – which aims at limiting increases in government spending to inflation for the next 20 years – was approved in the first instance in the Senate lastnight. The second and final round is expected to take place in December, after which the government intends on unveiling the initial contour of pension reform before year-end. Positive strides in much-needed reforms are welcome, but digging deeper into more socially-sensitive issues such as pensions will likely require a greater and more coordinated effort by the government. This is especially true in an environment where public disillusionment and distrusthave increased on the back of consistently subdued economic growth and substantial political fallout from the Lava Jato investigations. In any case, we believe that the government is committed to austerity measures and will be able to gradually tighten fiscal policy to help mitigate Brazil’s increasing debt burden, lower inflation,and provide the conditions for a recovery in consumer and business sentiment. With regards to monetary policy, we expect the BCB to lower rates by 25bp in its COPOM meeting later today, in line with consensus and market pricing


Low Interest Rates in EU and China, European Policy Response

Real estate overvaluation could become an important currency mover. Yesterday, it was ECB’s Draghi warning about the unwanted side effects of keeping rates low for too long. Ironically, the ECB seems to have no other option to keeping monetary accommodation in place given peripheral bond and bank vulnerability. Hence, macro-prudential measures may have to do the job of cooling down the real estate markets. Draghi suggested that there were eight EMU countries facing misallocation risks into real estate. When bubbles are in the making the effects are reflationary, but when bubbles burst modest reflation can turn into difficult to control deflationary pressures as witnessed during the US sub-prime crisis

Draghi citing mis-allocation risks is another form of admitting that there are strong diverging economic trends working in the Eurozone. The lack of an adequate fiscal response – most optimal via a fiscal transfer from core into peripheral countries – leaves the adjustment burden entirely with the ECB. However,a one-currency fits all approach does not allow for monetary policy specification, i.e tightening monetary conditions in the core while loosening conditions in the peripheral. Instead, the ECB has to apply monetary policy according to the needs of EMU’s weakest links. Asset booms in core EMU countries are the result. Whether macro-prudential measures are sufficient to ease diverging asset prices trends may be doubted given the experience of other countries using macro-prudential policy.

China has addressed its real estate mis-allocation risk by tightening its monetary and easing its fiscal policy. Latest house volume sales numbers showed a significant reduction in activity. According to a survey provided by the China Index Academy, highlighted in today’s Economic Information Daily, sales volume has declined by 21.9%Y.For EMU to avoid misallocation risk within core countries, tighter monetary conditions would be required. However, the absence of a fiscal option – consider limitations provided by the German debt break introduced in 2009 (and then broader EMU by the Fiscal compact in 2012) – the ECB has no other choice than keeping monetary accommodation in place.

The BTP market acts as EMU’s risk barometer. Markets have remained nervous ahead of Italy’s Senate referendum comingup this Sunday. By now the linkages between the Italian banking sector and the BTP are well understood by market participants as was proved yesterday when BTP spread widening did lead to the Italian bank index falling back towards early October lows. Hence, the ECB may keep its security purchase program in place, indirectly providing support for Italian banks. While this policy is directed towards EMU’s weakest links it may be the core countries seeing the best of expansionary economic impact. The core countries closing their output gaps will produce higher inflation rates which in conjunction with lower core bond yields should depress real yields while peripheral real yields may be pushed higher via rising credit risks and resilient deflationary pressures.



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.


EM Outflows, US monetary policy, Japan Earthquake, USDJPY levels

Since the US election day, EM markets have lost USD11bln of international capital as investors moved out of EM equities and bonds. Unsurprisingly, it has been Asia mostly hit by the outflow. A couple of reasons are worth mentioning. First, Asia received two thirds of all EM inflows seen earlier this year as investors piled into AxJ fixed income and then when local risk free rates fell, emphasised equity flows. Second, yield differentials have remained a nominal story so far which is essential for keeping risk appetite supported. As long as US real yields remain muted, investors will see little reason to reduce their valuation of risky assets. Yes, over the past couple of weeks there have been days when US real yields were rising, but this increase seems related to liquidation pressures rather than a fundamentally justified rise of US real yields. DM central bank rhetoric suggests that there is no appetite for higher real rates yet as investment spending has not reached levels to break away from what some call ‘secular stagnation’. US Fed Chair Yellen has suggested that her monetary policy decision making may involve allowing the US economy to run hot. In this environment there would be a pick up of investment spending. This approach requires real yields staying low implicitly, thus implicitly supporting risk appetite for now, keeping our FX trading interest in selling low yielding currencies.

It will be only much later in the cycle when DM central banks see better investment spending suggesting real yields moving higher. That is when the USD rally may change its focus from low yielding towards high yielding currencies. Overnight saw US breakeven yields rallying again supported by sharply higher commodity prices. US real yields may ease back somewhat from here, but due to the BoJ’s yield curve management, Japan’s real yield is now falling sharply. This morning’s JPY reaction to the 7.4 magnitude earthquake near the Fukushima coast line tells it all. After a brief USDJPY dip to 110.27 this currency pair recovered quickly now overcoming channel and cloud resistance stopping bearish moves around 111.00/36. A daily closing price above these levels suggests the rally may extend to its 115.10 February high.

Surprisingly, markets are still long the JPY not only manifested by IMM net commercial JPY long positions, but also BoJ’s large scale survey of the nation’s financial literacy explaining households have a high share of deposit holdings relative to total financial assets. Cash and deposit holdings are an expression of risk aversion. Japan may need a period of negative real yield to push investors into higher yielding assets. The consequently better allocation of capital may improve Japan’s productivity outlook. Now as the globe shows signs of reflation, impressively illustrated by sharply rising commodity prices, the BoJ has a chance to impose negative real yields which should push Japan’s cash holding households into higher yielding foreign and domestic asset holdings including its share market.


A pushback to our JPY bearishness often involves Japan’s 4% current account surplus. Arguments used are two fold. First, JPY weakness increasing the surplus further may trigger the US Treasury to impose trade sanctions. Secondly, the surplus itself creates commercial JPY demand limiting the JPY’s downside potential. Our view suggests that higher commodity prices plus Japan seeing its domestic demand and inflation outlook improving will reduce the current account surplus. A weaker JPY kick starting inflation expectations to rebound is one of the few tools left that Japan can use to improve its domestic demand outlook. In addition, JPY demand derived by the rising CA surplus may be easily outbalanced by JPY selling interest coming from Japan currency managing its substantial JPY331trn foreign asset position.



Japan and monetary policy, German Elections, China and AUD weakness

In Japan we see increasing signs of officials moving closer towards our way of thinking in respect of reviving Japan’s money multiplier which is conditional for ‘Abenomics’ to succeed. This morning the BoJ’s Takako Masai suggested that ‘excessive’ falls in interest rates could undermine the economy, a view we advocated in January when the BoJ rushed into its negative interest rate policy. A too flat yield curve not only runs the risk of leading to an deflationary increase of real yields via inflation expectations falling at a faster pace compared to the potential nominal yield decline, a too flat yield curve also tends to undermine bank profitability. A non-profitable banking sector faces balance sheet pressures making it difficult to turn central bank liquidity into high powered liquidity within the economy. It has been Japan’s banking sector balance sheet retrenchment reducing the amount of effective JPY in the system causing the JPY to rally. It was Japan turning towards yield curve management combined with internationally steeper yield curves allowing yield differentials to turn against the JPY.

This morning it isn’t the release of weak Japanese trade data moving the market. The 10.3% October export decline undershoot expectations (at -8.5%). The 16.5% fall in imports allowed net trade to add 0.5% to GDP. The driver for JPY weakness is found in the JGB yield curve, where the 10y now trades at 0.025%, which is above the BoJ’s 0% target. The BoJ should soon enter the market buying long dated bonds to push yield levels back to desired levels. When the BoJ moved towards yield curve management in September it had two incentives. First, to establish moderate steepness in order to allow commercial banks to shift their short-maturity JGBs (16.5% of total assets)holdings into the back end of the curve. This operation is essential to avoid another unwanted decline of broad money supply growth. Secondly, to create conditions for yield differentials to widen in favour of currencies creating an incentive for private Japanese entities shifting capital abroad and thus weakening the JPY. Last week the BoJ moved towards quasi-unlimited QE prioritizing managing the JGB curve. The BoJ has created an efficient mechanism to weaken the JPY according to its needs.

Japan needs to kick start inflation expectations suggesting to us that there will be front loaded JPY weakness. Next to USDJPY we have recommended JPY crosses such as EURJPY and GBPJPY too. The outcome of the French Republican Party primary seeing the former PM Francois Fillon gathering 44% support followed by 28% for Alain Juppé, leaves the impression that the probabilities of a populist party winning may be in retreat. Fillon stands for a Thatcher-like reform agenda. Should he win next Sunday’s second round bailout too then a significant political risk to Europe’s political agenda may be now be sharply reduced allowing the EUR to rally. EURJPY looks lucrative.

Unsurprisingly, Germany’s Merkel will seek a 4th term when Germany votes in late September next year. The lack of credible alternatives makes her re-election likely especially in the context of Germany’s well performing economy. In October, Germany saw a very strong 8.2% increase in tax revenue. However, FinMin Schaeuble is not ready for fiscal expansion. According to ‘Die Welt’ Schaeuble wrote a letter to the European Commission urging EMU sticks to tight fiscal rules suggesting that EMU’s general consolidation efforts have been insignificant so far.

Zeng Xiangquan,head of the China Institute for Employment Research, estimated the size of China’s labor force dropping further in 2016,at the same pace as in 2015 if not faster, with the total decline in the five- year period 2012-2016 amounting to some 20 million workers. China steers its economy from the labour market side. Hence, a falling labour force reduces the need for China growing fast. We maintain our strategic call for AUD weakness. 



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.



China and Commodities, Oil, GBP early elections talk

We agree with Li Wei, deputy director of Development Research of the State council, saying that the disconnect between finance and the real economy is the main problem for China, citing bubbles in financial and property sectors (MNI). These bubbles are domestically funded suggesting that the likelihood of a sudden investors’ strike leading to an economic shock is minor. Instead, China may be due for a long-term adjustment process revealing long term deflationary pressures. Within this long-term cycle, there will be ups and downs. Recent data have continued coming in strong and after having experienced falling producer prices over the past five years, prices have started to increase again.

Chinese producer prices may surprise given the country’s falling capacity utilisation rates suggesting a higher output gap. The increasing slack suggests domestically generated prices may fall. However, ithas been rising input costs coming on the back of the falling RMB and, even more importantly, rising commodity prices that have pushed domestic factory prices higher. What counts for China’s producer prices are the costs for industrial non-oil raw material prices such as iron ore, copper, aluminium, coking coal,etc. These prices have rallied over the past couple of months.

Interestingly, these prices have de-correlated from the performance of the USD. From 2012until the summer of this year, the USD had an important reverse impact on commodity prices. Now the USD and commodity prices tend to rise simultaneously. Even more importantly the higher USD no longer undermines US inflation expectations. Over the past couple of months US inflation expectations and the USD both moved higher. Investors seem to conclude that the US may close its output gap suggesting higher commodity prices increasing the likelihood of the Fed hiking rates. The better US rate outlook is then expected to drive the USD higher.

The previous ‘model’ saw higher commodity prices in the context of better EM demand indicating a wider US – EM growth differential leading to US capital outflows and hence USD weakness. The US potentially closing its output gap suggesting marginal US investment and hence capital demand increasing may have made the difference. Higher US capital demand combined with the US household sector seeing its savings ratio declining from 6.2% to 5.7% over the course of this year suggests higher US yields unless USD supportive capital inflows compensate for the change within the domestic US capital – demand balance.

Oil prices have come under renewed pressure as investors worry that OPEC’s production limitation agreement may not hold. Indeed, Saudi Arabia could raise oil output again. Adding to the potential oil glut has been US oil rig count increasing from 316 in May to 450 suggesting US oil production (currently 8522 mln bpd, peak: 9644mln bpd In June 2015) rising again. Oil no longer trades in line with other commodity prices which may have some important ramifications for oil currencies. The deterioration of the relative oil price outlook does not bode well for traditional producers which explains our bearish NOK, CAD and COP projection.

In the UK, newspapers speculate Theresa May may call a spring election should the Supreme Court confirm the High Court’s verdict giving the Parliament a bigger say within the Brexit negotiations. Our economists also noted that the probability of early elections have increased. Should the government aim for new elections it could signal a tougher negotiation stance, diminishing chances of a ‘soft Brexit’.For now we remain long GBPJPY.


Global Markets, Brexit and GBP, China PMI
The S&P 500 has fallen 4.2% below its August top, which seems marginal in respect of recent developments in FX markets, seeing in particular JPY and CHF rallying. It seems investors are looking for hedges instead of liquidating yielding asset holdings, and these hedges are executed in places where there is ample liquidity. Here the FX market qualifies. It seems US Presidential election fears are dominating, as illustrated by aspects of currency trading yesterday when the Fed statement confirmed our view that the Fed is heading for a December rate hike.
On a ‘normal’ day, investors may have picked up the Fed talking about rebounding inflation rates and better labour markets. Accordingly, one should not expect a strong US October labour market report due tomorrow to make any difference. In many aspects, the markets seems to be in an opposite mood to the pre-Brexit situation when investors got over-optimistic about the UK voting in favour to stay in the EU, clearing the way for a big disappointment when it became clear that this optimism was unjustified. Nowadays investors seemingly try to ‘avoid the Brexit mistake’ and prepare for a market-unfriendly outcome. There are two conclusions to draw from this observation. First, USD selling may continue into election day unless opinion polls, for whatever reason, swing back more into Clinton’s favour. Second, on November 8, markets may be best prepared for a market-unfriendly outcome. Hence, a risk-favourable election result may push USD sharply higher while options markets may converge towards lower volatility levels.
The string of better economic data releases has remained in place, with China’s Caixin October services sector PMI improving from 52.0 to 52.4 and composite PMI gaining at an even better rate from 51.4 to 52.9, reaching its highest level since 2013. Two other observations leave the impression that reflation has remained intact.First, the US yield curve has remained steep, withstanding the risk-off mood in other markets. The US 10-year yield has only declined from 1.85% to 1.80%, which seems marginal in light of current FX market volatility. Second, most industrial commodity prices have remained stable, with the exception of oil, which has broken lower due to concerns about OPEC finding it difficult to comply with its recent production cut agreement. The CRB Rind indexhas reached a new high, now trading at 469, which is 3.6% higher than the September low.
Today at 10am, the UK’s High Court will announce its verdict concerning the parliament’s voting rights in respect of triggering Article 50. The government under Theresa May denies the parliament has this right while the complainants suggest that such a right exists. In the unlikely case of the Court deciding in favour of the complainants, opening the theoretical case for parliament denying Article 50 being activated, we believe that GBP may jump by about 5%, taking it back to the level traded when the markets were pricing in a soft Brexit. In the contrarian case, GBP may ease by about 1%, bringing it back to levels where the hard Brexit fear factor was highest.


China PMI, Bond Yields and the USD, RBA decision

China’s October PMI data surprised on the firm side and,although this strength has come with the support of seemingly unsustainable debt acceleration, ithas produced some inflationary pressures which are now expected to spill over into other economies. The Caixin report showed that input costs accelerated at their fastest pace since September 2011 and output charges rose by the greatest extent since February 2011. Rising input costs may have come via rising commodity prices. Coking coal has rallied 200% while iron ore prices have gained 60%.

 Importantly, China is the biggest global exporter and the US purchases 22% of its total imports from China. Hence, rising inflation pressures in China will likely develop a global impact. The chart below illustrates how US inflation expectations have diverged from the performance of USD, presenting a new feature. This observation is most emphasised in the case of USDCNY. Previously,a rising USDCNY steered US inflation expectations lower, but when USDCNY rallied in October, US 5Y/5Y inflation expectations wenthigher and not lower. The once tight inverse relationship between the two broke. There are two explanations which in both cases should bode bearishly for bonds. First, the US may have closed its output gap (all eyes will on Friday’s wage release with the October NFP report), suggesting that USD-induced reductions of import prices no longer compensate for increasing domestic upward price dynamics. Second, China factory gate prices now rising at a faster pace (as indicated by the Caixin PMI report) are no longer compensated by the higher USDCNY.

Seeing nominal DM bond yields risinghas created an ideal environment for USD to rally against low-yielding currencies such as JPY. Importantly, the current USD rally has not yet found the support of higher US real rates and yields. Most of the recent yield lift-off has been driven by US inflation expectations, providing the current USD rally with an unusual feature, namely risk appetite staying relatively supported. Last year, it was falling risk appetite,asset volatility and its destabilising effect on cross border flows convincing the Fed to ease verbally, ultimately undermining the USD rally. Nowadays matters are very different. With US real rates and the term premium within the US bond market showing little movement, the risk outlook seems to remain supported for longer. Hence, the rising USD does not come with a significant tightening of US financial conditions, providing USD with additional space to rally.

USDJPY has to develop a daily closing price above 105.30 to open scope to 107.20 defined by the 200-day MA. EURJPY finds resistance at 115.65, which on a break opens potential to 119.70. Globally rising inflation rates work against JPY. Remember, it was Japan’s ‘exhausted’ yield curve converting inflation into the main variable determining JPY’s real rate level. The BoJ conducting ‘yield curve management’ suggests higher inflation rates translating one-for-one into lower real JPY rates and yields.

The RBA left rates unchanged and projected the economy to “grow at close to its potential rate, before gradually strengthening. Inflation is expected to pick up gradually over the next two years”. AUD rallied, but in light of anticipated USD strength, we view current levels as providing strategic selling opportunities. Mining sector investment is expected to stay weak, leaving the labour market weak as the construction boom runs out of steam. Real estate is overvalued and while China, as Australia’s most important trading partner, is doing ok for now, we see its current unbalanced growth as unsustainable. Last butnot least, Australia’s inflation remains subdued. Hence, it will not take a lot to turn the RBA around once again, in our view.