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

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

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

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

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

The Reserve Bank of Australia (RBA) will continue to remain on hold at Tuesday’s board meeting where the official cash rate will remain parked at 1.5 percent. Future markets have priced in only a 2 percent chance of a cut and no chance of a rise. The RBA has expressed an unwillingness to lower official interest rates further, given the financial stability risks associated with the housing market and high household debt levels.

The central bank also remains caught between underlying inflation that is below target and reaccelerating house prices. With economic growth under its potential and inflation below the target band, the RBA has left the door to an interest rate cut ajar. There are growing doubts about the ability of labour market growth to boost wages growth and inflation.

Capital city dwelling prices across Australia rose by 1.4 percent for the second consecutive month in March. Growth in house prices has outpaced that of unit prices over the year to March. Nationally house prices rose 13.4 percent, outpacing growth in unit prices of 9.8 percent.

The Australian Prudential Regulation Authority (APRA) has again tightened measures on investor lending, albeit rather lightly. The measures are designed to ensure financial stability and are likely to result in a slowing in investor activity and a moderation in house price growth, over time. If measures from APRA are successful in lowering financial stability risks, in time it could potentially lower the hurdle for an interest rate cut from the RBA.

Building approvals posted a strong increase in February, beating expectations of a decline. House prices were up strongly in March, yet again. Detached housing approvals were up 5.7 percent m/m, reversing two months of falls. The CoreLogic capital city house prices rose 12.9 percent y/y in March compared with 11.7 percent y/y in February. This is the strongest annual price growth since the first half of 2010. Data suggest house price growth has not yet peaked, despite the efforts of the regulators.

“RBA will leave its key rate unchanged tomorrow morning. Rising property prices are worrying the Australian central bankers but are unlikely to cause any measures any time soon,” said Commerzbank in a report.

AUD/USD is extending its three-day losing streak after the Aussie remains dented by worse-than-expected Australian retail sales data. The pair is currently holding strong trendline support at 0.76 levels. Technical indicators support downside, RSI and Stochs are biased lower. Price action has broken below 50-DMA and is on track to test 200-DMA at 0.7551.

Rotation from high yield into emerging markets is in evidence, on HY outflows versus EM inflows. Investment grade space sees a different rotation from government funds into corporate funds, with in particular large chunks of cash going into front end corporate funds of late. At the same time, long end government funds have seen resumed inflows, which should help to cover some duration shorts, leaving aggregate positioning more balanced (bearish).
Seven things learnt from latest flows data
1) There is evidence of rotation out of high yield space into emerging markets, as the latter continue to see steady cash inflows. No evidence of EM re-think as of yet.
2) Emerging markets hard currency funds have been the largest recipient of new money, and local currency funds have seen significantly more inflows than blend funds.
3) Some centres that had seen reduced investor allocations are now seeing a re-build in allocation, with for example Turkey and Mexico now seeing increased allocations
4) High yield inflows in the past couple of months have correlated with the risk-on theme seen in equity markets, and the recent pull back in equities is consistent with the maintenance of that generic correlation.
5) Valuation effects rationalise the recent rotation from high yield into emerging markets, whereas prior W Europe high yield outflows were more reflective of evidence of deceleration of issuance volumes.
6) Rotation from peripheral Eurozone government paper into corporates continues as evidenced from flows. The biggest of the corporate inflows have been into front end funds, which acts as something akin to “a front end haven with a spread”. 7) Government funds continue to see outflows, but there have been some reverse inflows to long end government funds in the past quarter. We read this as evidence of short covering, which should see positioning becoming more balanced ahead.

EM staying in strong demand. Despite easing commodity prices (Dalian iron ore futures sliding 6% to an 11-week low, rebar futures off by 4%, oil turning lower despite OPEC recommending extension of oil output cut, Baker Hughes US rig count rising to 652showing the 10th successive gain), EM currencies should remain in demand. Friday did see Colombia cutting rates by 25bp to 7%, with easing inflation rates providing monetary easing potential and China reported Jan-Feb industrial profits surging 31.5%Y due to faster growth in prices of coal, steel and crude. The spread between DM and EM inflation has fallen to its lowest level in 20 years, catapulting EM real rates higher. It is the EM supportive real rate differential keeping EM currencies supported despite currently falling commodity prices. In addition, declining foreign funding needs have reduced EM’s vulnerability should international funding costs rise. However, US long end bond yields have come off, pushed lower by investors scaling back on hopes of an early and aggressive US tax reform increasing US capital demand. Adding to the US yield downside pressure has been the sharp decline of USD funding costs signaled by USDJPY 3m cross currency basis tightening by 68bp from its November highs. Declining USD hedging costs have increased the attractiveness of investing into currency-hedged USD-denominated bond holdings for foreign investors, adding to the yield downward pressure.

The EUR/PLN currency pair is expected to gradually edge higher towards a level of 4.35 in the coming quarter, following the National Bank of Poland’s relaxed monetary policy stance. The zloty appreciated in recent months, even outperforming peers such as the Hungarian forint, despite notable adverse political developments, Commerzbank reported.

Among recent developments, there was the awkward situation recently surrounding the PiS government’s opposition to the re-nomination of Donald Tusk for European Council President, and deterioration of EU relations as a result, when even allies, Hungary and the UK, voted against Poland.

Secondly, the Constitutional Tribunal probe is ongoing and could re-escalate at any time; this week, European Commission Vice-President Frans Timmermans remarked that the Polish government’s response to EC recommendations has been unacceptable — it could easily have triggered the use of the so-called Article 7 sanctions (which could strip Poland of its EU vote).

But, despite calls on him to activate this clause, Timmermans is resisting because of other political re-occupations in EU. Finally, the PO opposition has called for a vote of no confidence in the PiS cabinet and PM Beata Szydlo which will be held around April 5-7. Ruling PiS will be able to win the vote in the Parliament, no problem, but this is not to gloss over the fact that PiS’ approval ratings are no longer rising.

In fact, polls express greater public confidence in PO’s ability for foreign policy. All said, the zloty has remained unaffected, which probably reflects some kind of market ‘fatigue’ after constant debate and discussions of Polish political risks over the previous year, which ultimately led to nothing significant, the report added.

The CBR meets to set interest rates today. Our team in Moscow look for a ‘dovish hold’ today as do a majority of participants, although there are a few analysts looking for a 25bp or even a 50bp cut. The arguments for a cut are that CPI is falling slightly quicker than expectations and the CBR has started to sound a little more dovish. This year we do see 150bp of rate cuts, taking the policy rate to 8.50%, but see the 50bp per quarter cuts starting in 2Q. Given recent strong flows into EM debt product, we doubt a surprise cut would impact the RUB too severely and 10 year OFZs might have a chance to break under 8%. Equally an on hold outcome is unlikely to alter market expectations much. Expect RUB to stay relatively supported, especially with large tax deadlines due early next week. We tend to favour a USD/RUB move to 56.50/57.00 short term.

The consensus expects the ECB to allocate EUR110bn via its target LTRO after allocating EUR62.2bln at its last operation. Given that this is the last TLTRO allocation, demand could be heavy and should the allocation exceed the EUR110 expectation,excess EUR liquidity will be parked at the front end of the EUR curve pushing rates lower, which at the margin is a EUR negative. However, for developing a more pronounced bearish impact on the EUR the liquidity boostneeds to impact the 2-year EUR swap. A decline of the German Schatz yield is not sufficient for driving the EUR lower. ECB’s Nouy (8am) and Lautenschlaeger (3pm) will speak today.

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

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

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

UK’s manufacturing output rose by 1.2 percent in the last quarter of 2016. Boost to competitiveness from sterling’s depreciation last year was probably a key driver of this upturn. The underlying trend is clearly upward, as is indicated by the 1.9 percent rise in Q4 production when compared to the same quarter a year ago, says Lloyds Bank.

Official data for the month of January showed a small fall in output in January and the February purchasing managers’ survey showed a modest decline in the level of the headline index from the previous month. Analysts at Lloyds Bank opine that the declines are probably just temporary retreats after outsized gains in previous months.

“With orders as measured by both the PMI and CBI surveys strong enough to point to further output gains over the next few months, the sector still seems on course for further expansion,” said Lloyds Bank in a report.

Fall in manufacturing investment, however, raises concerns about the sustenance of upside in the longer term. UK manufacturing investment probably fell by more than 4 percent last year, its weakest performance since 2009. The start of the Brexit negotiations will likely create more uncertainty which could hamper investments going forward. Continued sluggish investment growth may add to concerns about the UK’s modest productivity performance, adds Lloyds Bank.

As expected, the US Federal Reserve hiked interest rate by 25 basis points in its March meeting. However, aside from the rate hike, there were no major changes in the FOMC forecast or statement, except for few minor tweaks. With March meeting gone, there are now seven upcoming meetings this year and the Fed has forecasted hikes in two of them. Let’s look at the market pricing of the hikes, (note, all calculations are based on data as of 16th March)

May 3rd meeting: Market is attaching 94 percent probability that rates will be at 0.75-1.00 percent, and 6 percent probability that rates will be at 1.00-1.25 percent.
June 14th Meeting: Market is attaching 46 percent probability that rates will be at 0.75-1.00 percent, 51 percent probability that rates will be at 1.00-1.25 percent, and 3 percent probability that rates will be at 1.25-1.50 percent.
July 26th meeting: Market is attaching 38 percent probability that rates will be at 0.75-1.00 percent, 50 percent probability that rates will be at 1.00-1.25 percent, 11 percent probability that rates will be at 1.25-1.50 percent, and 1 percent probability that rates will be at 1.50-1.75 percent.
September 20th meeting: Market is attaching 21 percent probability that rates will be at 0.75-1.00 percent, 45 percent probability that rates will be at 1.00-1.25 percent, 28 percent probability that rates will be at 1.25-1.50 percent, 5.5 percent probability that rates will be at 1.50-1.75 percent, and 0.5 percent probability that rates will be at 1.75-2.00 percent.
November 1st meeting: Market is attaching 20 percent probability that rates will be at 0.75-1.00 percent, 43 percent probability that rates will be at 1.00-1.25 percent, 29 percent probability that rates will be at 1.25-1.50 percent, 7 percent probability that rates will be at 1.50-1.75 percent, and 1 percent probability that rates will be at 1.75-2.00 percent.
December 13th meeting: Market is attaching 10 percent probability that rates will be at 0.75-1.00 percent, 32 percent probability that rates will be at 1.00-1.25 percent, 36 percent probability that rates will be at 1.25-1.50 percent, 18 percent probability that rates will be at 1.50-1.75 percent, 3.5 percent probability that rates will be at 1.75-2.00 percent, and 0.5 percent probability that rates will be at 2.00-2.25 percent.
The probability is suggesting,

There hasn’t been much of a change after the FOMC. The market is still pricing a hike in June and a hike in December. It is still not clear why the market is predicting two hikes in H1 and just one in H2. This is probably because the market is pricing the Fed would keep additional room for easing.
We suspect that if the price of oil tumbles further, so would be the hike odds.

The New Zealand bonds remained weak at the time of closing Friday, tracking softness in the U.S. counterparts amid a quiet trading session that witnessed data of little economic significance. Also, investors will remain focused on the GlobalDairyTrade (GDT) price auction, scheduled to be held on March 21.

The yield on the benchmark 10-year bond, which moves inversely to its price rose 1 basis point to 3.29 percent at the time of closing, the yield on 7-year note jumped nearly 1-1/2 basis points to 2.86 percent while the yield on short-term 2-year note also dived 1 basis point higher at 2.13 percent.

New Zealand’s economy expanded 0.4 percent q/q over the final three months of 2016. That was below consensus expectations and the softest quarterly growth experienced since Q2 2015. Q3 growth was also revised lower to 0.8 percent q/q (from 1.1 percent previously reported). As such, annual growth eased to 2.7 percent y/y.

New Zealand’s Dairy prices fell 6.3 percent in the latest GDT price auction, following a 3.2 percent decline a fortnight ago. Within this, powder prices performed poorly, with whole milk powder prices falling 12.4 percent to USD2,794/MT, and skim milk powder prices falling 15.5 percent. Meanwhile, AMF continues to be well-supported at high levels, edging down only 0.8 percent.

New Zealand’s current account deficit narrowed as expected in Q4, leading to the smallest annual deficit (2.7 percent of the gross domestic product) since September 2014. Looking forward, there seem to be risks skewed towards modestly larger deficits on the back of higher global interest rates and a slow closure of the domestic credit-deposit growth gap, but this is not a cause for alarm.

The unadjusted current account deficit narrowed to USD2.3 billion in Q4 (from USD5.0 billion), broadly in line with consensus expectations. In annual terms, the deficit narrowed to 2.7 percent of GDP, which is the smallest deficit since September 2014 and well below its historical average of 3.7 percent.

In seasonally adjusted terms, the current account deficit also narrowed (by slightly more than we expected), printing at USD1.6 billion, down USD0.4 billion from Q3, driven by a further increase in the services surplus to an all-time high of USD1.2bn on increased international tourist spending, offset by a mildly larger goods deficit. The income deficit also narrowed by around USD0.4 billion to USD2.0 billion as income from New Zealand’s offshore investments increased in the quarter.

Further, net external debt of deposit-taking institutions rose a touch in the quarter to just over USD105 billion. However, that was offset by reduced external borrowing from the central government and ‘other’ sectors, meaning that the county’s total net external debt position actually fell to USD143.5 billion or 55.0 percent of GDP, the lowest since 2003.

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).

WTI dropped more than 9 percent last week as investors fear increased production in the United States and non-compliance within OPEC with the agreed production deal. WTI is currently trading at $48.7 per barrel and Brent at $51.9 per barrel.

Key factors at play in crude oil market –

February report shows that OPEC still remains in full compliance with the deal as a group but many members are yet to adhere to the agreed levels. Iran’s production crossed the agreed level in February but the country is still in compliance based on average monthly production.
Saudi Arabia could be bypassing the OPEC deal by increasing exports of refined products.
US production rose from 8.428 million barrels in last July to 9.09 million barrels per day last week. This is the highest level of production since last year. Payrolls are once again rising in the oil and gas sector according to ADP job numbers.
Some OPEC members are calling for no continuation of the deal when it expires in June.
Backwardation in the oil market extends further, currently at $1.05 per barrel.
API reported a draw 0.531 million barrels of crude oil.
Today’s inventory report from US Energy Information Administration (EIA) will be released at 14:30 GMT. Trade idea –

We expect the WTI to extend gains towards $59 per barrel, and then towards $67 per barrel. However, a decline towards $46 per barrel in the short term can’t be ruled out. We don’t suspect the oil price to break below $42 stop loss area for the long call.

A rate hike from the US Federal Reserve’s Federal Open Market Committee (FOMC) today is almost a certainty. The policymakers would conclude their two days of meeting today and announce the decision at 18:00 GMT, followed by a press conference by the Fed Chair Janet Yellen. As of data available for March 14th, the participants in the financial markets are pricing with 91 percent probability that there will be a 25 basis points rate hike. The market is pricing the next hike to be in June and the third hike to be in December.

We have prepared an FOMC dashboard that segregates members in three distinct groups, Hawks, Doves, and unknowns based on their remarks and commentaries made in public forums, focusing on the March interest rate decision. That dashboard is also suggesting that there will be a hike today. We have found that except for Minneapolis Fed President Neel Kashkari, all the other members are hawkish heading to the rate decision. We also couldn’t confirm the views of Daniel Tarullo, who has recently resigned and this is his last rate decision meeting.

The US dollar index is currently trading at 101.38, down 0.25 percent for the day. The dollar has been struggling to head to higher highs despite a full market pricing (almost) of a hike in March and three this year. So, the dollar index might see selloffs after the interest rate decision if the inflation and interest rate outlooks are not substantially upgraded beyond what was shared in the December projections. In addition to that, the major focus is on the Dutch election this week, for which the results would start appearing after the FOMC meeting.

The Australian bonds traded modestly higher Wednesday as investors poured into safe-haven assets ahead of the February employment report, scheduled to be released on March 16. Also, the Federal Open Market Committee’s (FOMC) monetary policy meeting, scheduled for later in the day will provide further guidance to financial markets.

The yield on the benchmark 10-year Treasury note, which moves inversely to its price, fell 1/2 basis point to 2.93 percent, the yield on 15-year note dived nearly 1 basis point to 3.32 percent and the yield on short-term 2-year also traded 1 basis point lower at 1.89 percent by 03:20 GMT.

Australia’s February business conditions retraced some of the previous month’s gains, but remain at levels consistent with solid growth. Confidence also eased back slightly. Business confidence also edged down in February, alongside a further deterioration in the Federal Government’s standing in public opinion polling.

“We expect the February jobs report, out later this week, to show a solid rise in employment, but over the longer term a sharper downtrend in the unemployment rate is likely necessary for a sustained boost to households’ perceptions of their finances,” ANZ Research commented in its latest research report.

Eurozone industrial production growth increased less than expected in January, data from the European Union statistics office Eurostat showed on Tuesday. Industrial production in the 19-member single currency bloc rose by 0.9 percent month-over-month in January and by 0.6 percent year-on-year.

Industrial production data missed expectations in a Reuters poll for an average monthly rise of 1.3 percent and a 0.9 percent increase year-on-year. Higher investment in machinery was partially offset by a drop in the production of consumer goods.

Data for December which initially showed industrial production fell by 1.6 percent on the month, were revised higher to now show a 1.2 percent drop. On a yearly basis, output went up by 2.5 percent in December, more than the 2.0 rise previously estimated.

Non-durable goods output slipped 2.6 percent in January after 1.4 percent gain in December, marking the first decline in three months. Growth in durable consumer goods production also eased to 1.5 percent from 4.3 percent in the previous month.

Capital goods production dropped 0.8 percent following 0.5 percent growth in December. The intermediate goods output slowed to 0.8 percent from 3.6 percent in the previous month. Energy production growth slowed only slightly to 6.9 percent from 7 percent.

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).

Latest data released yesterday show that the upward march of inflation that continued early last year is still gathering pace in Europe. Spain released its consumer price inflation report yesterday and it showed that consumer prices in February rose at the fastest pace since 2012. In February, Prices were up by 3 percent from a year ago and on a monthly basis it is up by 0.3 percent from January. Two major contributors were transport prices that rose by 8.2 percent and housing prices which rose by 5.9 percent. Furniture and household good is the only sector that took a dip of 0.4 percent compared to the year-ago level. Spanish inflation came in line with that of the entire Eurozone, where the price rose by 2 percent, highest level in four years and above the target of the European Central Bank (ECB).

Data from Poland points that the return of inflation is not just a Eurozone development it’s pan-European and global as well. Inflation in Poland rose by 2.2 percent in February, which is again the fastest pace in four years.

However, one should pay an ear to the European Central Bank (ECB) President Draghi’s comments that the central bank is not worried about inflation as it is being largely driven by an increase in the prices of commodities. Lately, the prices of commodities, especially energy and industrials have taken a hit and it is likely to get reflected in the numbers going ahead. We at FxWirePro expect the European Central Bank (ECB) to continue its easing as declared and throughout the year.

The euro is currently trading at 1.063 against the dollar.

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

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

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

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

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

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

With January meeting gone, there are eight more Fed meetings scheduled ahead for this year and according to the December projection, the Fed is expected to hike rates by 25 basis points in three of them. The financial market has recently started pricing three rate hikes for the year. Let’s look at the market pricing of the hikes, (note, all calculations are based on data as of 10th March)

March 15th meeting: Market is attaching 11 percent probability that rates will remain at 0.5-0.75 percent, and 89 percent probability that rates will be at 0.75-1.00 percent
May 3rd meeting: Market is attaching 10.5 percent probability that rates will remain at 0.5-0.75 percent, 82 percent probability that rates will be at 0.75-1.00 percent, and 7.5 percent probability that rates will be at 1.00-1.25 percent.
June 14th Meeting: Market is attaching 5 percent probability that rates will remain at 0.50-0.75 percent, 42 percent probability that rates will be at 0.75-1.00 percent, 49 percent probability that rates will be at 1.00-1.25 percent, and 4 percent probability that rates will be at 1.25-1.50 percent.
July 26th meeting: Market is attaching 4 percent probability that rates will remain at 0.50-0.75 percent, 35 percent probability that rates will be at 0.75-1.00 percent, 47 percent probability that rates will be at 1.00-1.25 percent, 13 percent probability that rates will be at 1.25-1.50 percent, and 1 percent probability that rates will be at 1.50-1.75 percent.
September 20th meeting: Market is attaching 2 percent probability that rates will remain at 0.50-0.75 percent, 23 percent probability that rates will be at 0.75-1.00 percent, 43 percent probability that rates will be at 1.00-1.25 percent, 26 percent probability that rates will be at 1.25-1.50 percent, 5.5 percent probability that rates will be at 1.50-1.75 percent, and 0.5 percent probability that rates will be at 1.75-2.00 percent.
November 1st meeting: Market is attaching 2 percent probability that rates will remain at 0.50-0.75 percent, 21 percent probability that rates will be at 0.75-1.00 percent, 40 percent probability that rates will be at 1.00-1.25 percent, 28 percent probability that rates will be at 1.25-1.50 percent, 8 percent probability that rates will be at 1.50-1.75 percent, and 1 percent probability that rates will be at 1.75-2.00 percent.
December 13th meeting: Market is attaching 1percent probability that rates will remain at 0.50-0.75 percent, 9 percent probability that rates will be at 0.75-1.00 percent, 28 percent probability that rates will be at 1.00-1.25 percent, 36 percent probability that rates will be at 1.25-1.50 percent, 20 percent probability that rates will be at 1.50-1.75 percent, 5 percent probability that rates will be at 1.75-2.00 percent, and 1 percent probability that rates will be at 2.00-2.25 percent.
The probability is suggesting,

1st hike of the year in March and the second hike in June. The third one is being priced in December.

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

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

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

UK industrial output slows less than expected in January, but manufacturing and construction activity both shrank more than expected. Data released by the Office for National Statistics showed Friday UK industrial production decreased 0.4 percent in January compared to a 0.9 percent rise in December.

This was the first decrease since October 2016 and was less than expected fall of 0.5 percent. On a yearly basis, growth in industrial output eased to 3.2 percent in January, in line with expectations, and compared to 4.3 percent in December.

Both manufacturing and construction activities shrank more than expected in January. Factory output was down 0.9 percent in the opening month of 2017 against expectations of a 0.4 percent decline, while construction sector output dropped 0.4 percent compared to forecasts of a 0.2 percent fall, according to the Office for National Statistics.

The figures follow a strong end to 2016, and markets were anticipating a pullback. However, there is little evidence of a dramatic slowdown as Brexit talks loom, with the falling pound continuing to underpin exports.

“The data suggest the Bank of England will adopt an increasingly dovish view in coming months, with rhetoric highlighting the downside risks to the economy posed by rising inflation and heightened political uncertainty,” said Chris Williamson, Chief Business Economist, IHS Markit

The German 10-year government bund yields climbed to 5-week high on the last trading day of the week ahead of the Eurogroup Summit scheduled to be held later in the day. Also, a hawkish stance by the European Central Bank (ECB) in its monetary policy meeting held yesterday, drove prices lower.

The yield on the benchmark 10-year bond, which moves inversely to its price, jumped 2-1/2 basis points to 0.44 percent, the long-term 30-year bond yields surged 3 basis points to 1.26 percent and the yield on short-term 2-year bond traded 2 basis points higher at -0.84 percent by 08:10 GMT.

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

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

Lastly, investors will be closely eyeing the trade balance, due late today for detailed direction in the debt market.

Energy • US oil stockpile and production: EIA weekly data shows US oil inventory increased 8.2MMbbls over the week ended 3 March 2017 marking nine consecutive weeks of inventory build-up. The US oil stockpile has gained c.50MMbbls since the start of the year raising some doubts over the effectiveness of OPEC cuts. Crude oil production in the US also increased to a one year high of 9.1MMbbls/d. • China coal output restrictions: China doesn’t intend to reintroduce the mining curbs on coal as long as prices stays within the ‘reasonable range’. Last year, China has introduced certain measures including reducing the operating days for coal mines from 330 days to 276 days pushing coal prices higher. However, these measures were removed this winter as heating demand for coal increased. Reintroduction of these curbs would have tightened market balance significantly.

Metals • Fed rate hike expectations: Bloomberg data shows that the market is factoring in a 100% probability of a Fed rate hike of c.0.25% (to 0.75-1.00% range) at the upcoming 14-15 March meeting. Rising bond yields lower the appetite for nonyielding assets including safe haven gold. • Indonesia nickel ore exports to resume: Indonesia’s top nickel producer, PT Aneka Tambang, could resume low-grade nickel ore exports soon easing the supply tightness in the Chinese market. Indonesia would be restarting nickel ore exports after nearly three years of gap and would offset the supply disruption from Philippines on environmental concerns.

Agriculture • Rubber output drops: Association of Natural Rubber Producing Countries (ANRPC) data shows global natural rubber output dropped 2.2% YoY to 1.71m tonnes over the first two months of 2017; demand has increased 3.3% YoY over the same time period tightening the physical market balance. However, ANRPC estimates the supplies to improve in key growing areas over the March-May 2017 with full year production likely to increase 4.2% YoY to 11.2m tonnes • Vietnam coffee exports: coffee exports from Vietnam increased 4.3% MoM (23% YoY) to 146.4k tonnes in February 2017. YTD exports are still down 2.6% YoY at 286.6k tonnes.

Prime Minister Theresa May’s Brexit bill suffered a second defeat at the House of Lords after the lawmakers rejected last week an amendment with regard to the rights of the people of the European Union who are staying in the United Kingdom. Yesterday, by an overwhelming majority, 366 to 268, the lawmakers voted in favor of an amendment which gives the parliamentarians in the United Kingdom, the final say over the Brexit deal, which is expected to be reached over next two years after the Article 50 is triggered before March 31st this year.

The amendment was introduced by the Labor Party of the UK but the government had argued that it would be a threat to national interest. However, that didn’t prevent the amendment from securing a bipartisan victory. While Ms. May had verbally promised a vote to the parliament in her Brexit speech, the amendment binds her to make good on that promise.

The Brexit bill will now return to the House of Commons with the amendment forcing May to have a vote on her Brexit deal and another guaranteeing the rights of EU citizens. The government is working hard to pass the bill and trigger the Article 50 divorce clause by March 31st or the exit would become more difficult after that date. From April 1st, a country looking to exit the EU would need the support of 14 members of the 27 members group.

The Japanese government bonds skid Thursday on the back of falling U.S. Treasuries, after comments by the Federal Reserve Chair Janet Yellen raised chances of an interest rate hike at the monetary policy meeting scheduled to be held on March 14-15. Also, weak investor demand at the 5-year auction held Wednesday weighed on bond prices, pushing the yields to multi-month highs.

The benchmark 10-year bond yield, which moves inversely to its price, rose 1-1/2 basis points to 0.09 percent, while the long-term 30-year bond yields hovered around 0.86 percent while the yield on the short-term 2-year note jumped 2-1/2 basis points to -0.26 percent by 06:30 GMT.

Recent comments from the Federal Reserve Chair Janet Yellen, specifying that a March rate hike is definitely on the cards, if the economy holds momentum, added to the rise in market expectations and investors have quite already priced in for a rate hike this month. This further, led to a surge in bond yields, pushing prices to record lows.

The auction attracted weak investor demand as the five-year bonds remained expensive. Further, the bid-to-cover ratio, a gauge of demand, at Thursday’s JPY2.4 trillion (USD20.97 billion) 5-year auction slipped to 2.86 from 4.26 at the previous sale in February.

Minneapolis Fed President, who is a voting member in this year’s FOMC stand out among the policymakers who have been calling for faster rate hikes in 2017. Some of the well-known doves of FOMC shifted their camps in recent weeks but during an interview with the Reuters, Mr. Kashkari indicated that he would maintain his dovish outlook with regard to interest rates.

Mr. Kashkari believes that the US labor market has more room to run and he remains cautiously optimistic of the recent trend where in the past 18 months, more workers have returned to the workforce. He said that while wages are rising and hope that the trend would continue, he believes it has yet not reached alarming levels. He said that the Fed aims to let the economy run as fast as it can as long as the inflation is low.

With regard to fiscal policies, Mr. Kashkari said that he hasn’t factored them in his forecasts yet due to lack of clarity.

These comments from Mr. Kashkari doesn’t change our FOMC dashboard for March meeting, which as of now looks like below,

Doves – Neel Kashkari.

Hawks – Janet Yellen, Charles Evans, Patrick Harker, Stanley Fischer, William Dudley, Lael Brainard, and Robert Kaplan

Unknown – Jerome Powell

Pls. note that one of the dovish members, Daniel Tarrullo has resigned and the position is yet to be filled.

This may seem a little surreal. US treasury secretary under the Trump administration, Wilber Ross is talking of steps to stabilize the US dollar/ Mexican peso exchange rate. Speaking on CNBC today, Mr. Ross suggested that the US administration would think of ways to work with their Mexican counterparts to stabilize the exchange rate. The dollar/peso exchange rate has been very volatile since the Republican candidate Donald Trump got elected as the president of the United States. Mr. Trump had been severely critical of Mexico during his election campaign and the US border with its neighbor. Mr. Trump has vowed to renegotiate the North Atlantic Free Trade Agreement (NAFTA), calling it a disaster for the United States. Mr. Trump has vowed that he will make Mexico pay for his proposed border wall.

While Mr. Ross said that the administration needs to think of mechanisms for a stable exchange rate, the Mexican central bank governor said that the country is not considering a swap line from the US Federal Reserve.

Peso is enjoying the biggest single-day gain since January as the news surfaced. The Mexican peso is currently trading at 19.56 per dollar, up 2.4 percent so far today.

Retail sales across the eurozone fell for a third straight month in January missing market expectations of a rise. Data released by Eurostat on Friday showed retail sales in the 19 countries sharing the euro fell by 0.1 percent m/m in January. Data disappointed market expectations of a 0.4 percent increase on the month.

Year-on-year, the volume of retail sales grew 1.2 percent in January, also below the 1.6 percent rise forecasted. Data suggested lower consumer appetite for spending possibly caused by higher consumer prices.

A 0.2 percent drop in purchases of non-food products was seen as the main drag on monthly retail sales reading. Sales of food, drinks and tobacco were also down 0.1 percent. Car fuel sale was an exception which rose by 0.8 percent in the month.

The unexpected drop in retail sales was in contrast to broader signs that the eurozone economy has strengthened over recent months. A survey of purchasing managers at manufacturers and service providers also released Friday pointed to a pickup in private sector activity, with the composite Purchasing Managers Index hit its highest level in 70 months.

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

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

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

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

Cable could see range break-out Stronger US rates and a stronger dollar have pushed Cable down to recent lows at 1.2350. Further dollar strength, plus Brexit news could push Cable to 1.2250. Here the UK’s upper House of Lords could tonight win an amendment on the rights of EU nationals, sending the Brexit bill back to the lower house for further debate. This could delay plans for Article 50 being triggered March 9th .

Trump’s plans for fair trade sound like a border tax adjustment President Trump’s address to Congress contained much of what we have come to expect: i) tax cuts for businesses and the middle class ii) $1trn worth of infrastructure spending (financed by public and private partnership) and iii) fairer trade. Last year’s near US$800bn US trade deficit is very much in focus and Trump’s remarks last night regarding unfair international tax structures point to growing acceptance of Paul Ryan’s border tax adjustment (BTA) plan. Beyond the touted benefits of encouraging onshoring and discouraging corporate tax inversions, the BTA is also ear-marked to generate US$100bn of increased tax revenue – which seems essential to pay for corporate tax cuts elsewhere. There is much literature on why a 20% border tax adjustment necessitates a 25% rally in the dollar. The magnitude of the impact will be disputed, but the direction of travel should be pretty clear and keep the dollar supported into key Trump speeches (talk of tax details being released March 13th). The dollar is also being supported by the now 78% probability of Fed March hike – after Fed insider Dudley said the case for a rate hike had become ‘a lot more compelling’. A strong ISM and the Fed’s preferred measure of inflation, headline PCE, pushing to 2.0% today both point to further dollar strength. DXY to 102.05/10.

Most notable hawk in the European Central Bank’s (ECB) governing council and the chief of German central bank Jens Weidmann maintained his sharp criticism of the ECB’s monetary policy as usual; however, he was ready to provide the assurance that the central bank would not end the quantitative easing program all of a sudden. In December last year, the European Central Bank (ECB) unveiled a fresh new package of stimulus which includes buying of debt below the ECB deposit rate which is currently at -0.4 percent, and additional bond purchases of €540 billion until December this year.

However, the recent sharp rise in both actual inflation and inflation expectations has led to the speculation that the ECB might end its stimulus by rolling back on its December commitments. Many in the market feared that such a move could disrupt the bond markets in the Eurozone and could lead to sharp rise in the interest rates. While Mr. Weidmann’s comments would ease some of those concerns, it is quite clear that the ECB is unlikely to dive further into easing and the very next action would be in the opposite but the question that remains is – how fast?

The FED and USD, European Bonds

Whether markets were on an “unmotivated sugar high” (as Larry Summers put it) or were in some fiscal honeymoon period, there is no doubt that reflation trades are now crying out “Show me the money!” And just like in the iconic scene from Jerry Maguire, investors will need more than just a faint whisper from President Trump at his speech to Congress this week (Tue 9pm ET) to be convinced that fiscal promises (and the money) will be delivered. The best case scenario is that a detailed tax plan is unveiled, although we’re not holding our breath – especially after Treasury Secretary Mnuchin said that the President will only be “touching” on tax policy in his Congress Speech. This is unlikely to inspire much $ upside.

On the flip side, we’ve got what could be a hawkish Fed story unfolding; all eyes will be on the PCE inflation data (Wed), which should show the Fed’s preferred inflation measure at the 2% target. This will undoubtedly get Fed hawks excited over the prospects of a March rate hike and with Chair Yellen speaking (Fri), we think there are upside risks to short-term US rates. The $ faces a balancing act between a vague Trump and hawkish Fed, though we remain modestly upbeat.

It’s clear that investors are becoming more unnerved by the upcoming European elections season, with signs of risk aversion creeping into EZ bond markets and greater EUR downside protection being bought in FX markets. But what should we be on the lookout for? Well, the French presidential race is grabbing most of headlines given the less than trivial risks of a ‘shock’ Le Pen win; the next major event here won’t however be until the first televised debate on 20 Mar. Ahead of this, we’ll have the Dutch elections (15 Mar) – which is incidentally also the same day as the March FOMC meeting. This could prove to be a tricky period for EUR, with political risk compounding any widening of US-EZ rates at the short-end of the curve. We look for a combination these factors to drive EUR/$ down to 1.02.

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.


h2>GBPUSD and Scottish Referandum, Trump and the FED

Thin Asian markets allowed GBP to come under selling pressure on a report in ‘The Times’ suggesting that the Scottish government might call a second independence referendum to coincide with the triggering of Article 50 next month. It was only last week when the ‘Independent’ came out with a similar suggestion. This morning’s GBP dip should be viewed as providing a buying opportunity as a hypothetical Scottish referendum would likely only be held after having concluded Brexitnegotiations. In this sense, prospects of a Scottish referendum could potentially have a moderating impact on the negotiation position of the British government which could aim to achieve as much EU market access as possible to encourage Scotland to stay within Britain. Note that latest polls in Scotland do not suggest there would be a clear majority for independence today.

Moreover, the latest by-election results are likely to have consolidated the power of PM May within the Conservative Party but also, according to the Sunday press, may have put the Conservatives in one of the strongest positions they have enjoyed in the last 30-odd years. The Sunday Times suggests that the by-election results which saw weaker results from UKIP and Labour would allow the Conservatives to increase their current 17 seat majority in the Commons if there were early General election held in the UK. The poorer showing of UKIP may have reduced the risk of seeing the Conservatives undermined via the euro-sceptical wing of the political spectrum. This risk now appears lower compared to last autumn. It was the radical speech held at the Conservative Party conference in Birmingham which pushed GBP markedly lower at that time. This speech may have helped to undermine UKIP, but with UKIP now apparently in a less strong position, it could be argued that PM May may now be in a better position to steer upcoming Brexitnegotiations with the aim of keeping Britain closer to Europe than is currently priced into markets. Viewing the current low GBP valuation in comparison with the size of the Brexit related ‘cliff edge’ has been the main reason for our GBP bullishness. We regard GBP cheap relative to the size of the possible cliff edge.

Looking at the other side of the political spectrum, the weaker performance of Labour in the by-elections and the current make-up of the Labour leadership would suggest that the political middle is left to the Conservatives, despite speculation in the Sunday times of a new centrist pro European grouping possibly taking shape. This position for the Conservatives might, in line with this thinking, allow them to take a more pragmatic Brexit stance. Scottish referendum talk, the political debate concerning PM May’s next political move plus the extreme GBP short positions currently held by market participants suggests to us we should remain GBP constructive.

This week will focus on the Fed and US politics. Today the Fed’s Kaplan (a voter) is likely to reiterate his hawkish stance. It will be difficult to make the March 15th meeting a live one for a hike, i.e increasing market probability much beyond the currently priced 28%. In particular, February NFP will only be released 5 days ahead of the Fed and the Feb CPI will be released on the second day of the Fed meeting. Combined with the pre-Fed grace period, that leaves little opportunity for the Fed to increase hike probabilities. Effectively, March is off the agenda, but that does not mean the USD selling off. Thursday’s Beige Book release should illustrate increasing capacity constraints. Fed’s Yellen speaking at the Executives Club of Chicago on Friday may find it difficult to ignore a strong Beige Book read. All this will hit a market which has trimmed leveraged dollar longs for seven straight weeks bringing them down to below their five-year average.

On Tuesday, PM Trump will address the Congress, with markets looking for him to lay outhis budget plans. The New York Times suggests that the new budget will assume a 2.4% GDP growth rate. Treasury Secretary Steven Mnuchin said Trump’s first budget won’t touch entitlement programs such as Social Security or Medicare. It will instead focus on ways to produce long-term economic growth by cutting taxes, thus being bullish for risk appetite and a bullish steepening of the US yield curve. The USD should receive a bid against low yielding currencies, while high yielding EM should remain bid.

European Bonds and Credit

It was quite a rollercoaster ride in Eurozone government bonds yesterday, mainly in semi core EGBs, which was in part related to thinner-than-usual liquidty due to closed US markets. Although opening tighter, semi-core EGBs soon started to underperform Bunds, and after the news that Ms Le Pen had gained some ground on her main election rivals sparked strong selling in the 3-5yr OATs, 10yr OAT/Bund spreads suddenly leapt 4-5bp to exceed 82bp for the first time since August 2012. In this context, the 2yr Schatz yield plunged to a new all time low of -0.85%, helping to push Schatz ASW to 70bp. Meanwhile, the 10yr OAT/OLO spread – one of our favourite measures of the French politcal risk premium – even briefly touched the 30bp level. Later in the afternoon – when French Finance Minister Michel Sapin warned that betting against France would be costly – OAT/OLO spreads re-tightened, although the 3-5yr area struggled to reverse the heavy underperformance  Based on recent performance trends versus Austria and Finland, DSLs still hardly suffer from any political risk discount, even though they trade cheap versus Bunds by historical standards. Against this backdrop, we find 3-5yr BNG and NEDWBK trading at very attractive spreads versus KfW. 10s30s struggled to flatten yesterday, despite the broader risk-off mood, especially after the EFSF announced the intention to launch new 4yr and 39yr lines. When the ESM launched a new 40yr bond back in 2015, the extension in ASW from the existing 30yr line amounted to around 20bp. Applying this to where the EFSF 2047’s are currently trading we would arrive at around MS +68 for the new EFSF 2056 as an indicative pricing. Adding a NIP of abound 10bp (which is slightly more than the one seen in the recent ESM 11/46 deal) to the current 9bp curve extension from the ESM 45’s into the 55’s yields a roughly similar result. Elsewhere, ECB data revealed that PSPP purchases accelerated slightly last week, to €17.2bn from €16.9bn the week before. However, total APP purchases slipped to below €20bn due to slower covered bond purchases. Even so, the ECB remains well on track for another €85bn of asset purchases for this month.

Mexican Central Bank, Inflation and Outlook

According to news reports, central bank governor Agustin Carstens will stay in his current position until the end of November 2017, as opposed to leaving at the end of June. He was set to join the BIS as General Manager on 1 October 2017. At the time of writing, neither the central bank nor the office of Mexico’s President had confirmed this delayed departure. If confirmed, the change in his departure date would give more time for the President to consider submitting an initiative to Congress to change the central bank law to remove the requirement that all members of the board have to be born in Mexico. The main beneficiary of this change would be, in our view, Alejandro Werner, current Director of the Western Hemisphere at the IMF. Results from the latest Citibanamex inflation survey will be released today at about 3:00pm EST. We estimate that headline and core consumer prices rose 0.15% mom and 0.37% mom, respectively, in the first half of February versus the second half of January. If our estimates are accurate, annual headline inflation would stand at 4.5%, down from 4.7% in January, while annual core inflation would be 4.0%, unchanged compared to last month. The government will report consumer price figures for the first half of February on Thursday at 9:00am EST. We expect annual headline inflation to remain above the central bank’s inflation target (3% ± 1p.p) upper limit throughout the year. We estimate that agricultural prices fell by close to 1% in the first half of February, relative to the second half of January, accounting for most of the gap between the headline and core inflation prints. Finally, in a TV interview central bank deputy governor Alejandro Díaz de León said that the central bank’s main job is that inflation expectations remain well-anchored and that price formation in the economy also remains adequate. In his view, the central bank’s interest rate increases are creating a more orderly outlook for inflation. He said that future interest rate increases will be contingent on several items, including relative monetary conditions vis-à-vis the US Federal Reserve, upcoming inflation numbers and the output gap. These are the main factors the central bank has mentioned in its most recent monetary policy statements. On currency interventions he said that the goal has been to foster good liquidity in the market and intervene only in a few instances when liquidity dries up.

USD Strength, European Political Outlook and EURUSD

Low yielding currencies should come under renewed pressure against the USD with the release of the Fed minutes of the 31 Jan/01 Feb and upcoming Fed speeches working in line with better global data releases as the catalyst. Overnight, it has been Fed’s Harker (voter) saying that he won’t take a March hike off the table, pushing US yields higher. Harker will speak again today joined by San Francisco Fed’s Williams (non-voter). However, the US 5-year inflation swap has eased by 22bps from its December highs despite commodity prices moving higher, the USD trading sideways and US data coming in on the strong side. Accordingly, US financial conditions have eased over the course of the past couple of months lending further support to the reflation trade. While US equity valuations have reached high levels, technical factors such like the advance/decline ratio and the continued relative advance of cyclical shares suggests that the risk outlook is likely staying supported for now.

Apart from political uncertainties there are almost no headwinds to the global economy. Global trade seems to be expanding rapidly as confirmed by South Korea’s 26%Y export gain reported for February. Last year, it was global economic headwinds combined with a sharp USD appreciation weakening the US growth and inflation outlook and convincing the Fed to reduce rate hike expectations. None of these headwinds have emerged this year. In contrast, strengthening US financial conditions have turned into a powerful tailwind which could unleash pent-up demand. Creating animal spirits pushing investment activity up will increase US capital demand, which suggests either a higher USD generating move capital imports or US bond yields breaking above the 10-year 2.51% technical resistance. Note it was the Fed’s Harker who talked about increasing signs of pent-up demand within the US economy.

When it comes it political risks all eyes are on Europe where government bond spreads are widening at a significant pace. Yesterday, an Ipsos poll showed Le Pen on 26%, compared with 19% for Macron and 18.5% for former PM Francois Fillon in the first round. That poll appeared to be driving markets but other recent polls have shown a wide range of possible outcomes, adding to market uncertainties. The focus may be on the political left in France, where a potential alliance between two parties could suggest a possible scenario of a left-wing candidate standing against the Front National’s Le Pen in the last round of the Presidential election, an outcome which would not be seen by markets as positive for future EMU reforms.

The market may react to the news that investigators have looked into the use of funds by some Front National candidates. However, if polls remain unaffected and Le Pens’ rating high, then investors may lighten semi and peripheral bond holdings further which should not bode well for the EUR. Ahead of the Netherlands general election due on the 15 March these pressures may even intensify. A good result for Geert Wilders from the Freedom Party could make it difficult for EMU-supportive parties to build a functioning coalition. It was only yesterday that EU’s Dijsselbloem, in respect of the ongoing Greek negotiations, said that creditors will focus on “moving away from austerity and focusing more on deep reforms, which was also a key criterion for the IMF.” Such deep reforms could be more difficult to implement in a potential scenario of increasing influence for European populist political movements.

Against this background we stay EUR negative. Next to political risks we underline the importance of Italian data when judging the EUR. Over the past few years there had been two periods when we saw the Italian economy improving. The first wave came along with the fall of BTP spreads, the second wave came when the EUR declined from 2014 onwards. It seems that Italy does need easier financial conditions to improve its domestic outlook. However, Italy’s financial conditions have recently tightened, not boding well for its economy.

Italy: Risk of imminent snap elections reduced

The PD party will hold a congress after Renzi’s resignation as party leader. Should the PD split, government activity could be possibly negatively affected. The publication of the motivation of the Constitutional Court ruling on the Italicum, the electoral system for the Lower House, was seen as a crucial passage towards the end of the current legislature. As a reminder, the ruling yielded a trimmed-down version of the Italicum, proportional in nature, which the Court itself reckoned already usable. The ruling of the court added that different electoral systems in the two branches of the parliament are acceptable, provided that they do not prevent the formation of “homogeneous parliamentary majorities”. As the electoral law of the Senate is also proportional in nature (with a different entry threshold and no majority bonus), most observers read the qualification of the Court’s motivation as an implicit recognition that a viable, if imperfect, electoral system is in place and ready to be used in case of snap elections. As many key actors on the political scene had been vocally pushing for snap elections, the risk of a vote in June was then seen as increasing. However, developments within the Democratic Party (PD) over the last couple of weeks have mixed up the cards. First came some statements from a couple of ministers, originally in favour of a rush to the polls, who had apparently changed their mind, and started suggesting that a better electoral law should be sought in the Parliament and that the current Gentiloni government should be given some time to complete unfinished work. The second, more powerful, turning factor was the meeting of the steering committee of the PD party, the senior party in the current government alliance, which was held last Monday. The debate, opened by Renzi as the party’s leader, highlighted once more that strong divisions between Renzi and the leftist minority persisted. During the discussion Renzi proposed that a party congress should be called soon and that this should be concluded with a primary election to nominate the new party leadership. The leftist minority refusal to accept Renzi’s candidacy as leader of the party, not to mention the imposition of any short deadline for the congress, opened the door to the possibility of a party split. The issue was tackled again during the assembly of the PD party held yesterday in Rome. Divisions were confirmed as was the scarce willingness to bridge the gap on both sides. Yesterday Renzi formally resigned from his leadership, technically paving the way to the party’s congress, whose timetable will be set tomorrow in the meeting of the steering committee. The risk of a party split now looks very high. In principle, the perspective of a PD congress held over the spring should substantially reduce the risk of a June snap national election. Should a split of the PD party actually materialise, the risk of political instability would likely increase, and PM Gentiloni’s government action could be weakened as a consequence. Not only would it be harder to assign priorities to left-over reforms (the new Gentiloni government is de facto a continuation of Renzi’s government), but chances of reaching an agreement on a parliamentary modification of the electoral law would also be reduced

FX Update- European Politics and the UK

It will be hard for markets to get away from discussing political developments in the Eurozone this year. Friday’s risk off market, driven by what appeared to be shifting probabilities for the French election, is showing just how vulnerable the EURJPY cross has become. The Japanese investor owns 12% of the French OAT market, mostly accumulated in the past 2years. This large asset position is now at risk should volatility in this EUR bond market increase. The Japanese have been net sellers of foreign bonds since the middle of January. While Japanese lifer hedge ratios for EUR assets is generally high (82% in 3Q16), the liquidation pressure and, more importantly, sentiment, will still affect FX markets, we think. The risk of EURJPY falling has increased and so we have chosen to sell as a tactical play for our trade of the week. The next support area is around 119.30.

Markets will watch efforts of the French left combining to bring one of its candidates into the 2nd round. A possible scenario of a 2nd round vote between a hard left and a hard right candidate may increase the chance of the Front National’s Le Pen becoming President. Her agenda to leave the EU and the EUR would require Parliamentary approval and hence represents an unlikely outcome. However,a potential scenario of a hard left or hard right future French President could perhaps reduce Franco-German co-operation which could potentially disrupt EMU for years, leaving the ECB in charge, which might win time by introducing a policy of prolonged period of negative real rates and yields.

The 15 March General Election in the Netherlands could increase jitters further should the outcome point towards increasing populism. Polls over the past week show a tight race, with the PVV party (Geert Wilders) only on a narrow 3-4 point ahead of the VVD party, relative to the 9 point lead seen at the start of the month. Since 8th February,3m implied volatility for EURUSD has diverged from USDCHF, which we think needs to play catch up. The SNB’s sight deposit volumes will be watched again today.

A lot of the anticipated weaker economic data in the UK appears to be in the price for GBP.Friday’s miss on retail sales (0.2%M) showed consumers may have brought forward spending ahead of anticipated price hikes, causing GBP to weaken as markets priced out some probability of a hike by the BoE this year (currently around 3bp). The impact of UK data on GBP goes as far as that. We think that it will be loose global liquidity conditions, increased political uncertainty in the Eurozone, combined with an undervalued GBP which will drive the EURGBP pair lower. The Brexit debate will continue with the FT reporting today on Michel Barnier’s (EU’s Brexit negotiator) proposal that any trade EU-UK talks be denied until progress is made on a EUR60bn exit bill, which could make progress difficult for the UK after they trigger article 50 this quarter. We think however that GBP could be driven higher as global reserve managers start to reallocate into GBP assets.

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.

 

Carry Trade outlook, VIX lower and risk assets higher, Yellen keeps March alive

Selling EUR and JPY vs EM. As the VIX is approaching the lows again, and with iron ore prices bursting 10% higher over recent days, we continue to see risk currencies performing well, particularly vs the EUR. The drivers of risk support are emanating from the DM world, as China’s monetary conditions are tightening. After Yellen only marginally changed market pricing for hikes this year (52bp to 55bp), the sweet spot of low US real yields, with rising growth expectations, remains, helpinghigh yielding EM currencies to outperform. Our own portfolio includes long MXN, TRY and INR. Even Australia’s data is outperforming, with consumer and business confidence rising. Today’s US retail sales data are expected to be strong on the control group measure. While the USD has become less sensitive to US economic surprises, the data point will still add to the long term picture of an economy that is closing its output gap and so could see higher inflation down the line if companies increase capital expenditure.

China is tightening monetary conditions. New CNY loans grew in January (CNY2.03trn) but were lower than market expectations after the Jan 24 10bp rise in the Medium-term LendingFacility (MLF). The gap between M1 and M2growth has also narrowed for a seventh consecutive month to 3.2% last month from 10.1% in December. The result appeared in property sales data which slowed in January after tightening measures and potentially the Chinese New Year holiday. Data from local housing developers shows that average weekly property sales by area in Tier 1 cities in January fell more than 30%Y and more than 10% week over week. Shanghai and Shenzhen fell even more, according to the China Index Academy.

Cash ready to buy risk. The global impact of China’s tightening of monetary standards may not be seen in FX markets straight away as it is masked by still expanding balance sheets at the ECB and BoJ, rising commodity prices helping growth and now a newly developing point, cash ready to be deployed into assets. The FT is reporting on Swiss banks seeing increasing questions from private wealth on where they can invest cash in a rising inflation environment. Surveys among affluent US investors show they held 28% of their portfolios in cash in 2015,up from 25% the year before. Cash holdings in Europe and Asia are much higher at 40% and 37% respectively. The EUR may weaken in this environment as political risks may increase caution in investment into this region. EURGBP is about to break below its 200DMA at 0.8455.

Yellen did little to change our outlook on the USD, so staying positive vs the low yielding G10 and seeing high yield EM outperforming. The market is now pricing 55bp of hikes this year, including 6bp for March. Interestingly, historical G10 currency sensitivity to US front end yields played out exactly with the JPY and NZD under-performing, while GBP stayed flat. There was perhaps a hawkish tilt to the speech, with our economists noting that Yellen didn’t want to send a signal for a March hike by saying they will assess at upcoming “meetings” rather than “meeting”. Reiterating the FOMC’s stance that they will incorporate fiscal policy when details become more evident was a clear sign that the Fed, like the markets, will be waiting for details on Trump’s tax plans expected in coming weeks. Trump’s meetings and interactions with world leaders over recent days appear to be risk supportive as there has been less emphasis on increasing trade tensions. On the politics front, market focus may now turn to the G10 foreign ministers meetings in Bonn on Thursday and Friday. Market is long SEK. On Monday we outlined some scenarios on the details to watch for in today’s Riksbank Monetary Policy Statement (Krona and repo path). Since we think neither of the “hawkish” surprises are likely and that the market appears to be long SEK into the meeting, we worry that there could be a shock in store that would weaken SEK as markets unwind. We are not however saying that the Riksbank isn’t going to be optimistic, just that markets appear to be getting ahead of themselves, with the setup appearing to be very familiar to those who watched the RBNZ recently too. Swedish data may have improved but the fact that the SEK is now at the Riksbank’s year end forecast, the likelihood that enough members propose a rate hike sooner than mid-18 is low. EURSEK should see support around the 9.41 low and resistance around 9.50.