Semi-core and peripheral spreads tightened further last week, with long-end Belgium and Austria standing out positively and 15-30yr BTPS bucking the trend. Given the fairly tight spread levels, especially of 5-10yr semi-core, we see widening risk as the ECB October meeting draws closer.
• Bearish momentum in Bunds has eased somewhat as rhetoric on North Korea has heated up. But with tax reform plans in the US set to take shape and 10yr Bund ASW remaining more than 5bp above our FV estimate, we stick to the view that 10yr Bund yields will breach 0.50% over coming weeks.
• The sharp shift to the right in the German elections suggests a tougher German stance towards Eurozone fiscal integration and in future debt (re)negotiations, implying (at the margin) somewhat wider peripheral spreads.
Rich/cheap analysis
• 2/3yr BTP-SPGB spreads tightened further as the situation in Catalonia escalated, but now look stretched assuming independence won’t happen.
• Long-end E-names continued to perform last week and now look expensive versus core and semi-core EGBs.
• Despite richening in ASW, 20yr NEDWBK cheapened further vs EIB, perhaps due to the tap of the NEDWBK 10/41.
• 7yr EFSF looks attractive vs. NEDWBK as earlier this year at the time of the French elections, probably since investors expect Q4 EFSF issuance (€5.8bn) to target the belly of the curve.
• Scheduled EGB supply of up to €15bn this week, from Germany and Italy (p. 3). Italy will announce the 28 Sep. medium/long term auctions today.
• Belgium will redeem €6.9bn and pay out €2.9bn in coupons.
• EFSF will tap the 0 11/22 line on Tuesday (€1bn). This will complete Q3 funding.
• The DSTA estimated funding needs of €49.6bn in 2018. Based on this we now think DSL issuance will come in below 2017’s nominal total of €31.6bn. Net issuance – even before subtracting PSPP buying flows – will thus be deeply negative. Q4 issuance will comprise a new 7yr (Oct 11) and a 10yr tap (Nov 14).
Events • Multiple ECB/Fed speakers during the week, with ECB’s Draghi speaking today and Fed’s Yellen tomorrow.
• EUR flash CPI (Fri) should not change much, with the risk of a higher headline reading. It is the last month before negative energy base effects kick in.

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

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

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

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

Eurozone factory growth hits six-year high in March as growth accelerates in Germany, Italy and France. IHS Markit’s final manufacturing Purchasing Managers’ Index for the eurozone rose to 56.2 in March, the highest since April 2011, from 55.4 in the previous month. The reading was in line with expectations.

An index measuring output, which feeds into a composite PMI due on Wednesday, rose to a near six-year high of 57.5 from 57.3. The flash estimate was 57.2. A sub-index measuring delivery times fell to 41.9 from 43.9, its lowest reading since May 2011. New orders surged despite prices charged rising faster than in any month since June 2011.

Factories across the euro zone struggled to keep up with demand last month. The survey is also signalling the highest incidence of supplier delivery delays for nearly six years. “These delays send warning signal about rising inflationary pressures, as busy suppliers are often able to hike prices,” said Chris Williamson, chief business economist at IHS Markit.

March saw eurozone manufacturing employment increase for the thirty-first consecutive month. Price pressures remained elevated at the end of the opening quarter. Manufacturers’ purchasing costs rose at a rate close to February’s 69-month high, leading to the steepest increase in factory gate selling prices since June 2011.

“Euro zone manufacturing is clearly enjoying a sweet spell as we move into spring, but it is also suffering growing pains in the form of supply delays and rising costs,” said Chris Williamson, chief business economist at IHS Markit.

The betting market is underestimating the possibility of a Le Pen victory in the upcoming French election. The market is pricing 63-67 percent chance of an Emmanuel Macron presidency, compared to 22-25 percent chance for a Marine Le Pen victory. We think that is largely due to the polling. All the polls are predicting a Le Pen win in the first round on April 23rd and a Macron victory in the second round with a huge margin of 62-38 percent. Then, why do we think that possibility of a Le Pen win is mispriced? Here are some points to note,

In 2012 election, Front National Leader Marine Le Pen was not so much of dazzling political figure compared to the 2016 election and many people associated her with her father’s more extreme politics. Yet, she received almost 18 percent of the votes in the first round and came in third place.
More French are disgusted with establishment politics that they were during 2012 election.
The market is underestimating the commitments of Le Pen voters. While Polls show a Macron win, they also show that 95 percent of Le Pen supporters passionately back her compared to just 2/3rd for Mr. Macron. Le Pen voters are more likely to head to the polls to cast their votes than any other parties. Almost 37 percent of the French people are planning to abstain from this year’s election even if it helps Le Pen.
French people who are backing other candidates that the above two are more reluctant to back Macron or Le Pen in the second round.
According to Pew Research Center’s 2016 polls, 62 percent French have unfavorable views towards the European Union.
All polls indicate terrible performance by established parties like the incumbent President Francois Hollande’s Socialist party, which means that the anti-establishment wind is blowing strong and Mr. Macron is the establishment candidate among the duo.
Madame Le Pen is the only prominent female candidate in this year’s French election and that needs to be counted too.
We, expect the betting market to correct the odds sharply after the first round outcome. If le Pen secures 32-35 percent in the first round, it is more likely to be a Le Pen Presidency than not.

Spanish seasonally-adjusted retail sales remained unchanged in February, data from the National Statistics Institute (INE) showed on Friday. The unchanged reading compared to a revised 0.1 percent drop a month ago.

Data missed expectations for a 0.9 percent rise. January’s 0.1 percent drop which was revised from a previously reported growth of 0.1 percent marked the first time Spanish retail sales shrank after 29 straight months of expansion.

On an unadjusted basis, retail sales fell 3 percent annually, after decreasing 0.2 percent in January. Month-on-month, retail sales increased for the first time in three months. Sales gained 0.2 percent in February, reversing January’s 1.2 percent decrease. Food sales grew 0.3 percent, and non-food sales increased 1.1 percent in February.

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

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

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

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

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

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

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

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

The Westpac-McDermott Miller New Zealand consumer confidence index edged slightly lower in the March quarter. Survey showed that people grew wary about the short-term economic outlook, but extended the nation’s run of optimism to six years.

The Westpac McDermott Miller consumer confidence index fell 1.2 points to 111.9 in the March quarter, but remained above the long-run average of 111.4. The present conditions index decreased 0.2 points to 111.2 and the expected conditions index fell 1.9 points to 112.4.

“March’s slight fall in confidence mainly reflected some anxiety about the upcoming election. It might also reflect concerns around housing affordability or political developments offshore, both of which continued to hit the headlines in recent weeks,” said Westpac Banking Corp senior economist Satish Ranchhod.

The latest economic data showed GDP figures showed that on a per-capita basis, household spending rose by around 2 percent last year which reflected a healthy level of spending confidence. With a growing confidence of consumers in their own household financial security, and a positive outlook for the New Zealand economy we could expect continuing positive consumer sentiment to translate into sustained growth.

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 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.

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

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

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

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

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

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

The New Zealand government bonds jumped Monday at the time of closing, following expectations of a drop in the country’s fourth-quarter gross domestic product (GDP), scheduled to be released on March 15.

The yield on the benchmark 10-year bond, which moves inversely to its price plunged 3-1/2 basis points to 3.39 percent at the time of closing, the yield on 7-year note also slipped nearly 3-1/2 basis points to 2.94 percent while the yield on short-term 5-year note traded 2-1/2 basis points lower at 2.64 percent.

The rate of quarterly GDP growth is expected to soften a touch in Q4, partly related to temporary weather influences. Tight supply (rather than meaningfully softer demand) conditions are dominating. The current account deficit should remain at a historically comfortable level, ANZ research reported.

“We estimate that GDP rose by a modest 0.5 percent in the December quarter, following 1.1 percent growth in September. Construction is again expected to be one of the strongest sectors, with primary production and manufacturing likely to be the most significant drags on growth,” Westpac commented in its recent research publication.

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.

US real yieldsare breaking higher, driven largely by nominal yields and pushing USDJPY through the 115 level. US 10y real yields (59bp)have now retraced 70% of the decline seen in the past 3 months (falling from 71bp to 30bp). Within the G10 the JPY is generally the most sensitive as real yields rise, but recently also the NOK has come up on the scale. The NOK generally moves in line with oil prices, suggesting the recent rise in nominal yields, while inflation expectations stay flat as oil prices have fallen, should keep USDNOK on an upward trend for now. USDJPY is approaching a technical level, where a move through 115.62 should mark a break of the current trading range, with little resistance before 118.60.

USD and Payrolls. Market expectations are for a strongFebruary employment print today following ADP on Wednesday. Using submission to Bloomberg, sent after the ADP, we calculate median expectations to be at 230k. Average hourly earnings will be more important for the USD relative to the headline NFP as this would suggesthigher domestic inflationary pressures. The US saw import prices from China, the source of over 20% of U.S. imports, rise 0.1% in February. According to our economists, that may not seem like much, but it was the first increase in three years. Global and local inflationary pressures could soon make markets reprice Fed rate hike expectations going into 2018 and beyond, which we think would be bullish for the USD.

ECB lookingat EUR REER. Markets perceived the ECB to have been hawkish yesterday,yet we couldn’t find much difference in the commentary relative to December. The sell-off in bunds drove EURUSD higher but we are considering it as an opportunity to sell. Inflation forecasts were pushed higher (as markets expected) with marginal tweaks to growth forecasts. Most importantly for investors looking for signals to the end of the current QE programme, Draghi reiterated several times that their current forecasts are conditional on finishing the current programme and thatunderlying inflation pressures remained subdued. We need to wait for more domestic core inflation prints.For our FX analysis, the most interesting comments were in response to a question about the US administration (Peter Navarro) saying that the EUR is too weak for Germany. After repeating what the US treasury (not classifying Germany as a currency manipulator) and Weidmann (ECB sets monetary policy for Germany) have said before, Draghi went to say, (in a comment that appeared to be offscript,) “By the way, if we look at where the [real] effective exchange rate stands today with respect to historical average, we don’t see especially that the euro is off the historical average. But the [real] effective exchange rate of the dollar is off the historical average. So it means that it’s not the euro which is the culprit for this situation.”

EUR: watching equity flows. EURUSD is currently tracking the 5y yield differential between Germany and the US.Front end rates (such as in the 2y part of the curve) point to a lower EURUSD due to the repo related distortions in the German 2y. We showed earlier this week that looking at forward rate differentials, EURUSD should be trading massively lower and could be experiencing something that we last observed in 2013. Back then it was foreign equity and bond inflows helping the currency. Today, the bond market valuations are much less attractive for a foreigner. Data from the IIFsuggests that global equity allocations to the euro area are low relative to a year ago (partly a result of political worries). We will therefore be watching for the next balance of payments release (22 Mar) to see if equity flows are limiting the downside for the EUR.

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

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

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

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

The 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.

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.

European Bonds and Credit, spread tightening across the board

Yesterday saw some semi-core and peripheral spreads tightening pretty much across the board versus core EGBs, with especially PGBs putting in a strong performance, outperforming 10yr Bunds by more than 10bp. GGBs bucked the tightening trend after ECB’s Stournaras told Greek MPs that the bailout was at a “critical” stage, and that any future PSPP-eligibility of GGBs would be contingent on the completion of the bailout review and a legally binding agreement over specified medium-term debt relief measures (which doesn’t seem imminent to say the least).

A remarkable feature of yesterday’s price action was the further widening of Bund ASW spreads, with the futures-implied 10yr Bund ASW hitting 50bp. It now exceeds our estimate of fair value – which is based off 2s10s, BTP/Bund spreads, 6M Libor-repo spreads and implied volatility – by more than 10bp. ECB weekly data on PSPP showed that purchases slowed marginally to €16.9bn in the week ended 10 February from €17.3bn the week before.

Corporate and covered bond purchases also slowed, but the overall €20.1bn bought across all asset classes still leaves the ECB on track to buy more than €80bn in February. Today’s main event will be Fed Chair Yellen’s testimony to the Senate Banking Panel. If she want’s March to be a live meeting as other Fed officials have suggested it is, she will have to adopt a more hawkish tone beyond the usual reference to data dependency. Currently we calculate a market implied probability of around 17% for March rate hike. Supply. No EGB supply is scheduled for today.

In SSA space KfW has used this opportunity to announce the launch of a new 10yr KfW EUR benchmark. Wide Bund ASWs currently render the agency relatively cheap versus the sovereign. The KfW 3/26 which was launched last year currently trades at a pick-up of 30bp versus the DBR 2/26 – its widest level to date. We think these levels are starting to look attractive for switches into KfW. Not only do our models for the Bund ASW suggest that it is currently much too wide but we also think that the Bundesbank is at the point where it has to increasingly look into the option of sub-depo buying – and also agency- or regional bond alternatives to Bunds.

 US Financial and Monetary Conditions, Yellen, Inflation & Oil, China and RMB

US financial and monetary conditions continue to improve as market indicated real yields remain muted while stocks and other real assets break into higher valuation territory. The S&P 500 has exceeded the 20trn market capitalisation mark on the day when all four major US equity indices reached new historic highs. The advance seems broad-based with cyclicals like financials taking the lead. The stock market trades reflation and, with US markets leading, markets seem to be taking the view that global reflation is centered in the US.

Against this background the Fed’s Yellen will appear before the Senate Banking Committee at 3pm (Ldn) today and the House Financial Services Committee tomorrow. A prepared testimony will be the same both days and will probably be released when the Senate hearing starts but sometimes gets released earlier by the committee. Here Yellen will have to present the Fed’s view which at times has differed from her more dovish attitude. Hence, it is not surprising to see markets walking into these risk events with a relaxed attitude, seeing the Fed hiking only cautiously and not as aggressively as signaled by the median Fed dots. Should Yellen divert from the moderate projection of the interest rate path as currently priced into the market, the USD may rally. This risk is asymmetrically priced leaving us comfortable with our USD long positioning against low yielding currencies EUR and JPY.

Animal spirits are now often mentioned in press reports. The last time the US was experiencing animal spirits goes back to the 90s when James Rubin ran the US Treasury. Then it was the high tech boom driving many asset classes. The stock market started to correlate with retail sales as wealth effects kicked in. We have not yet seen this effect in the US, but with the continued asset rally the likelihood of animal spirits taking over is not insignificant. Last year, it was the shaky international background pushing the USD sharply lower as the Fed eased the markets’ rate expectations via dovish talk. Today even the global environment looks better with EMU economic and political divergence providing the exception.

Inflation and oil. This morning saw China’s PPI growth beating market estimates by a wide margin with rising commodity prices and a strong January base effect providing the main catalysts. US bond yields coming down faster than the Japanese yields may dampen USDJPY, but it does not generally weaken the USD. As long as the reason for lower oil prices is due to higher US oil output the decline of oil may even work in favour of the USD in the long term. Yesterday the US (EIA) reported its oil output increasing by 80k. Oil rigs are on a fast rise as shale companies experience better funding conditions and the ability to sell oil at higher prices.

RMB in focus. According to the WSJ, President Trump’s administration may be considering alternative strategies with regard to currency issues with China. “Under the plan, the commerce secretary would designate the practice of currency manipulation as an unfair subsidy when employed by any country, instead of singling out China, said people briefed on or involved in formulating the policy.” There are two issues coming into our minds. First, the administration hoping China may push USDCNY lower via using its reserves or tightening its own monetary conditions. This strategy comes at relative costs to China and is beneficial for the US. Should this scenario work out then China may switch some of it FX reserves into JPY or EUR even if this comes with potential future FX reserves valuation losses. Secondly, China may turn into an infrastructure investor into the US. Japan seems to already be leaning in this direction. It would help the US in creating jobs while giving China a good investment return for its foreign-held assets. In this scenario the US yield curve would stay steep and the USD strong.

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.

Carry Trades Still Supported, JPY weakness and EURUSD

JPY and EUR funded carry themes stay on top of our recommendation list. The resignation of the Fed’s Tarullo, responsible for bank regulation, will add to speculation that the US banking sector is soon going to be in a position to increase its higher risk assets, which will be seen as market risk friendly. This morning has seen copper prices in China rallying by as much as 5.9%, inspired by disruptions in mines in Indonesia and Chile and strong demand in China. Oil has continued its rally, supported by last week’s IEA report which suggested 90% compliance with the OPEC output cuts agreed. Higher commodity prices will steepen curves within output gap closed economies such as the US adding to USD support against low yielding currencies. In this scenario, EM should stay bid across the board helped by better revenue prospects on the back of higher commodity prices.

TheJPY5_30’s curve has flattened for the 4th day in a row underlining the success of the BoJ’s yield curve management. Today’s release of strong 4Q GDP growth (1%QoQ) provided probably the best outcome for the JPY to weaken further. It was strong enough to keep inflation expectations high enough to keep JPY real yields contained. On the other hand it was weak enough to still keep the BoJ on its yield curve managing approach. The technical position of USDJPY looks bullish leaving markets taking advantage of the benign outcome of the Trump Abe meeting this weekend in Florida. Underlining both countries’ common geo Pacific interests should imply that the US has an interest in a strong and reflating Japan. For Japan to reflate it needs yield curve management leading to JPY weakness, within a globally reflating environment.

The only risk to JPY weakness may come out of Europe where Japan holds significant holdings in semi core sovereign bonds. There is a lot of talk about political risks in the run-up to the 15 March election in the Netherlands, the April/May French Presidential election and the September General vote in Germany. However, economic and credit concerns may be even more important. The hawkish speech by the ECB’s Mersch on Friday does not lead to EUR strength. Instead it revealed EMU’s structural weakness suggesting EURUSD may break the 1.0610 chart point. Should the ECB talk tough and Italy stay economically weak then EMU real rates will be too high for Italy, suggesting the BTP spread will widen out.

In recent days the EUR has become negatively correlated with peripheral spreads. Japanese investors holding semi core bonds may become increasingly concerned seeing core EMU bond curves steepening with peripheral bonds undergoing a bearish credit driven flattening. In comparison to the JPY, the EUR may be the better short. Greek debt worries have come in and out of focus for EUR investors. Greece has a EUR1.8bln payment to the ECB in April and 7bln to creditors in July. Should the IMFstick with its principles (Europe is no longer the main shareholder) then there must be a new package negotiated. Since debt relief is unlikely ahead of the German election, the downside for the EUR is significant for us.

European corporate tax in focus. The rejection of the Swiss corporate tax reform via Sunday’s referendum shows how deeply rooted populism has become, now affecting even rich countries. The CHF should say strong despite concerns of reduced corporate inflow. The main FX takeaway from this story however is its contribution to the Brexit negotiations. There have already been suggestions that the UK could cut corporate tax rates if the EU fails to provide it with an agreement on EU market access, therefore the Swiss tax complications and the uncertainty-induced potential for corporate rates to stay low there could work in the UK’s favour.  EURGBP shorts are making more sense now as a medium term trade, with a move below the 200DMA at 0.845 providing more downside momentum.



European Interest Rates and Equity Divergence, EGB Spreads

Last week we flagged the disconnect between Eurozone equities and EGB spreads versus Germany and suggested that something had to give. Yesterday we finally saw some re-convergence, with equity prices down more than 1% and EGB spreads continuing their dramatic widening trend – helped by growing uncertainty over the Greek bailout review and the role of the IMF. The 10yr BTP/Bono spread breached 70bp, while the 10yr OAT/OLO spread (curve-adjusted) hit a fresh all-time of 12bp. We also saw the FRTR 0 5/22 starting to trade at a concession to the IRISH 0.8 3/22 2023. Interestingly, despite underperforming Bunds, 10yr DSLs richened somewhat further against Austria and Finland, notwithstanding the upcoming launch of a new 10yr DSL and the March parliamentary elections – although a new 10yr (or 30yr) RFGB is also still on the cards. 10yr Bunds initially lost ground during yesterday’s session after a further rise in German inflation (to close to 2%), but yields eventually closed 1.5bp lower at 0.45% on the back of of flight to safety. Today’s Eurozone inflation figure will also rise to a four-year high, but the breakdown of the German figures from yesterday suggest that the core reading will hold below 1%. No government bond auctions are scheduled today. After yesterday’s EGB spread widening, we would argue the time is getting ripe for investors to give consideration again to the safety net of the ECB’s QE programme, which won’t be halted until well into 2018 at the earliest. And after the net purchases stop, there are still the reinvestments as well as the ECB’s OMT, which would be considered for “future cases of ESM or precautionary programmes […] and focus on sovereign bonds with a maturity of 1-3 years”. In any case, the pace of PSPP purchases held up well last week, with €16.9bn bought compared to €18.5bn in the previous week, according to ECB data released yesterday. Overall APP purchases fell from €21.6bn to a still above-average €19.7bn.

Primary balance of the central government in December (Brazilian Treasury)

We forecast a primary deficit of the central government (federal government, social security, and central bank) of BRL71.9 billion in December 2016, compared with a deficit of BRL38.4 billion in November and a deficit of BRL60.7 billion in December 2015. If our forecast materializes, the primary deficit in 2016 would total BRL166.4 billion, or 2.7% of GDP. The greater deficit in December compared to that of previous months would be attributable to, in addition to seasonality, the reduction in the balance of residual payables, with impacts more concentrated in social security and discretionary expenditures. We forecast real contraction in revenues of -14.2% yoy in December 2016 (Figure 1), compared with contraction of -7.1% yoy in November. In rolling 12-month terms, growth in net revenues is expected to have declined, from -2.4% in November to -3.7% in December. December’s tax revenues will likely be influenced largely by a rise in transfers by the federal government to regional entities due to the payment of penalties under the capital repatriation program. We forecast real contraction in expenditures of -5.5% yoy, compared with expansion of 9.7% yoy in November (Figure 2). Such contraction would be explained by the favorable comparison base. In December 2015, there was a payment of BRL55.1 billion for overdue subsidies. In rolling 12-month terms, we expect a reduction in growth in expenditures, from 6.3% in November to 0.1% in December of last year.

Tax revenues growth returned to negative terrain, reaching -1.2% yoy in real terms in December, in line with our expectation. However, the decline was significantly milder than that seen up to September, before revenues having been boosted by the funds from the asset repatriation program in October. Part of this lower year-on-year contraction in December results from the less negative comparison base. As a consequence of today’s figures, tax revenues declined -3.0% in real terms in 2016. The negative dynamics of economic activity, and specifically the deterioration in labor market conditions, led to a strong decline in tax revenues which was widespread among almost all tax lines. The main exception was the increase in revenues from financial entities, most probably driven by higher interest rates and profits. The contraction in tax revenues would have been worse (-6.5% in real terms) without the asset repatriation program in 2016. As a result of the lack of a program capable of generating revenues similar to the 2016 asset repatriation program and the still struggling economic growth, we do not foresee a rebound in tax revenues in 2017.


• North Sea disruption: Production at the Buzzard oilfield in the North Sea has experienced a slight setback with production at the 180Mbbls/d field falling up to 30Mbbls/d. The field is the largest contributor to the Forties crude oil stream. While a minor outage in terms of volume, the market did appear to react to the news.

• US natural gas withdrawals: The EIA’s weekly natural gas report showed that net withdrawals over the week were relatively modest at 119 Bcf, compared to a five year average of 176 Bcf. Warmer than usual weather across much of the US has led to weaker heating demand.


• China gold imports: Chinese gold imports jumped higher over December 2016. Switzerland exported a total of 158 tonnes over the month to China, up from 30.6 tonnes the month before. Meanwhile Hong Kong sold a net 47 tonnes over December, up from 40.6 tonnes in the previous month. Stronger demand ahead of Chinese New Year supports these robust import numbers.

• Samarco mine restart: BHP Billiton and Vale’s Samarco iron ore mine was planned to restart this year, following the bursting of a dam at the mine in 2015. However a local mayor this week refused to approve a plan where the mine would use water from a nearby river. Without this approval the mine will not be able to complete an environmental study before getting approval to restart operations.


• Argentina soybean output: The Buenos Aires Grain Exchange estimate that soybean output for the 2016/17 season will total 53.5m tonnes, down 4.5% YoY. The reduction is on the back of reduced area, while recent flooding also led to some lost acreage.

• Brazil coffee output: Brazilian coffee exporter, Comexim expects that domestic coffee production for the 2017/18 season will fall to 49.4m bags from 54.55m bags the season before. Part of the decline is due to the fact that the season will be the lower yielding year of the biennial cycle. Comexim’s estimate is higher than the 43.7-47.5m bag forecast of CONAB.

Global and European Interest Rates

A risk-on rally pushed 10yr UST yields above 2.50% again and dragged 10yr Bund yields above 0.46% yesterday. The duration heavy supply constituted an additional burden for Bunds, where in particular long-end ASWs felt the weight of the new 30yr ESM and the 30yr DBR tap.

EGB spreads traded mixed yesterday. Semi-core traded on the back foot with Belgium underperforming somewhat versus France. The 10yr OAT/OLO spread had widened to 17bp in the run up to the Green OAT and had started looking stretched. That said, another driver of this spread are the upcoming French elections, where payments to the wife of the Republican presidential candidate Fillon have come under scrutiny by the press. This underscores that much can still happen and a defeat of Front National’s Le Pen is not a done deal. 10yr SPGBs almost completely reversed yesterday’s supply induced widening versus Bunds. BTPs however extended its underperformance after the Italian constitutional court struck down parts of the lower house election law and stated that the new system was immediately applicable.

The court upheld the majority bonus for the party passing the 40% threshold, but declared the run-off vote (if no party manages to pass 40% in the first round) unconstitutional. Note that current polls see no party above 40%. While this could pave the way for re-elections in 2017, President Mattarella has called for a harmonization of the lower house and senate electoral laws before new elections – the latter still being based on a proportional representation. Following the UK Supreme Court ruling the government is set to introduce a Brexit bill to parliament as soon as today.

However, the main focus in the UK will be on the 4Q GDP report. Or economists forecast the report to confirm that despite the Brexit vote in June the UK grew faster than the US, Eurozone and Japan in 2016. EGB supply. Today Italy will tap the BTPei 9/32 (€0.5-1bn) and the CTZ 12/18 (€2- 2.5bn). For Monday Italy announced the issue of a new 10yr BTP 6/27 (€3.5-4bn) alongside taps of the BTP 11/21 (€2.25-2.75bn) and the CCTeu 2/24 (€1.75-2.25bn).

Hungary Central Bank

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

USD safe haven buying, GBPUSD, European Unity and High Yielding Currencies

The USD may replace its reflation related bid with safe haven related demand. This scenario suggests the JPY staying correctively strong for now, gaining on many crosses, while GBP and high yielding currencies may be hit as political and currency related concerns increase. This morning, GBP will be in the centre of currency traders’ attention reacting to weekend press speculation regarding Theresa May’s government laying the foundations for a ‘clean’ Brexit and possibly abandoning what had been perceived as a ‘have your cake and eat it’ strategy, which aimed to keep access to EU’s single market. The possible new strategy leaked by the Sunday press suggests the UK regaining full control over immigration, sovereignty from European Court of Justice decision-making and readiness to exit the customs union. Chancellor Hammond suggested in an interview with German’s ‘Welt’ that the UK may head towards an alternative economic model, threatening to cut UK corporate tax rates should the exit negotiations not show desired results. Note, BoE’s Carney was warning last week that failing negotiations could impose risks to financial stability, but that these risks could be bigger for the EU than for Europe, providing another sign of the UK taking a tough stance.

Northern Ireland heading towards new elections may complicate matters, leading to speculation that Article 50 may not be triggered in late March which could increase economic uncertainty even more. Key EMU states have scheduled elections too: Netherlands, France and Germany. According to the deputy PM the Netherlands will block any EU trade deal with the UK, unless it signs up to tough tax avoidance regulations preventing it from becoming an attractive offshore haven for multinationals and the rich, giving the impression of the UK and the rest of EMU drifting apart.    

European issues seem to release a dose of deflationary pressures. Deflation tends to increase real yields of low yielding currencies, suggesting USDJPY may drift towards our 112.50 target. However, GBPUSD breaking lower will undermine any bid in EURUSD too. This applies even more when following the Carney argument of seeing a failure of UK-EMU negotiations leading to a disproportional increase in inner EMU financial stability risks. Peripheral spreads quietly working higher supports Carney’s view. Meanwhile, Greece could move quickly back into focus should the IMF opt-out require new negotiations with Greece and a new approval by the German Bundestag according to Germany’s Schaeuble. Accordingly, there could be a new programme implying additional fiscal measures and further drastic reforms in Greece. The issue becomes even more complicated when we put the views of the incoming US administration into Europe’s context.

The German tabloid Bild released an exclusive interview with US President elect who predicted other countries following the UK in leaving EMU, calling EMU as servicing the German interest and saying that the UK was smart to leave. In relation to Brexit, Trump said that he could offer the UK a quick and “fair” trade deal. On the global trade front, Trump suggested imposing 35% duty on German cars made in Mexico and exported to U.S. It seems the incoming US government has taken a very different position compared to President Obama’s approach of supporting the idea of a politically unified Europe as much as possible. There could be an early meeting between PM May and Trump trying to help the UK to establish good post EMU trade deals with the US.

High yielding currencies including the AUD could come under selling pressure should the recent round of weaker Chinese economic data releases translate into growth concerns. Car sales and the housing markets have weakened in November/December. This morning, Xiao Lisheng, a researcher with the Chinese Academy of Social Sciences, wrote in the outlook page of the China Securities Journal that “China should stop intervening in the foreign exchange market as soon as possible, conduct a one-off devaluation of the yuan and let the yuan float freely”. The advantages of a one-off RMB depreciation include a competitive gain that would help to utilise China’s substantial output gap and prevent further capital outflows linked to current RMB overvaluation expectations.  

ECB Meeting & Expectations Beyond January

ECB meeting should be one of these very few meetings for which a press conference is dispensable. In fact, it will probably be a meeting for which some ECB officials or ECB watchers might even regret having ended their vacations for. If they had any. After the December decisions, the ECB will in our view stay on autopilot, at least until the summer. 
Solid momentum continues. If anything, the Eurozone economy has gathered momentum towards the end of last year. The European Commission’s economic sentiment indicator climbed to its highest level in almost six years and hard data for November was also positive. Interestingly construction, which lagged the Eurozone recovery for a long while, is finally catching up. 
Headline inflation surged. While the recovery has gathered momentum, headline inflation picked up significantly in December, providing further ammunition for the few ECB hawks. At the same time, however, core inflation in the entire Eurozone remains low (0.9% YoY in December) and has even declined in several countries. So far, the increase in headline inflation is mainly due to fading base effects. 
Still with a dovish base. The minutes of the December meeting indicated that the ECB still has a dovish base. However, there were first signs of a somewhat more optimistic take on the economic outlook, reflected in terms like “a more balanced risk assessment” and a “possible emergence of upside risks to the outlook for growth and inflation”.
No reason to adjust, though. Despite the slightly improved outlook for growth and inflation, only six weeks after the decision to extend QE until the end of 2017 there will be very little appetite for the ECB to adjust the programme again. On the contrary, the December decision has put the ECB on autopilot at least until the summer and until after the Dutch and French elections. This autopilot should also immunise the ECB against short-term volatility in macro data. The fact that there is no need for adjustment is supported by the minutes of the December meeting. Even though the ECB Governing Council was slightly divided on how to extend QE, outright opposition against QE still looks very limited. Formulations like “few members” opposed an extension of QE “in view of their well-known general scepticism” does not really suggest that this opposition is taken extremely seriously. ECB president Draghi will probably point to low core inflation and the need for a sustainable improvement of the inflation outlook when confronted with higher headline inflation during the press conference.
Looking beyond January. There is little to no room for any kind of monetary policy action at next week’s meeting. However, given that headline inflation should continue upwards in coming months, ECB hawks will probably get more vocal with their plea for a faster unwinding of QE. At least when it comes to the argument of deflationary risks, the hawks do have a point. These deflationary risks have definitely disappeared. However, the disappearance of deflationary risks does not automatically mean that inflationary risks are on the rise. In fact, it needs much more than only a couple of energy-driven headline inflation increases to change the minds of the broad majority in the Governing Council. In our view, the ECB will want to see a pick-up in core inflation and political certainty before it would announce a further reduction of the monthly bond purchases. We shouldn’t see such a scenario unfolding before the second half of the year.

Eurozone: Political clouds, Yields and Rates

While the economic momentum is clearly accelerating, the European political outlook continues to be highly uncertain in 2017. A new terrorist attack in December, this time in Berlin, is likely to play into the hands of populist parties, potentially jeopardizing free movement within the European Union. Likewise, it seems realistic to expect that the rise of populism in Europe will push traditional political parties to play a more nationalistic card to secure victory in the upcoming elections. That implies that 2017 is unlikely to see much political and economic coordination on a European level. Besides, Brussels will be completely absorbed by the difficult Brexit negotiations, which is likely to put all other pan-European initiatives on the backburner. For the time being financial markets seem to be taking it in their stride, but that cannot be taken for granted in 2017.

The outcome of the Italian referendum could have been a bombshell, but there wasn’t much of an impact on financial market sentiment. That said, the uncertainty has not disappeared, as once the electoral reform is approved, elections are likely to be called by June. As for the banking troubles, a solution seems to be in the offing, with parliament approving a €20bn fund to prop up banks. A precautionary recapitalization of Monte di Paschi is now all but sure, although it could take until April to put in place a scheme on the back of EC approval. At the same time retail junior bond holders will be compensated after a bail-in, to avoid populist parties capitalizing on the ill-fated small savers. Meanwhile in Greece, the European problem child, the involvement of the IMF in the third bail-out plan remains quite uncertain, while tensions between the Greek government and its creditors flared up in December. Short-term debt relief measures, which had been decided in early December, were withdrawn after a unilateral decision of the Greek government to hand out a pre-Christmas bonus to retirees. We believe that debt relief will be granted after all, but that it will remain a very difficult process.

The Eurozone economy is starting 2017 on a strong footing. December saw an acceleration in manufacturing activity, with the composite purchasing managers index (PMI) hitting its highest level since April 2011. With new orders picking up rapidly (foreign demand has been boosted by a more competitive euro exchange rate), activity is unlikely to slow in the short run. The message is equally positive when one looks at the household sector. As unemployment continues to fall and wages are now slowly picking up, consumer confidence ended the year on a high note, which augurs well for consumption in the first quarter. The pace of the recovery is speeding up, with the €-coin indicator, a monthly estimate of the underlying GDP growth pace, rising to 0.57% in December. Without the potential political uncertainty, GDP growth could hover close to 2% in 2017.

However, in our forecast we incorporate some political turmoil (given the heavy electoral calendar and the rise of populism). In addition 2017 will see fewer working days than 2016, which might also be a small drag on growth. We therefore now have a 1.5% growth projection for 2017, followed by 1.7% in 2018. In December headline inflation increased from 0.6% to 1.1%, while core inflation increased moderately to 0.9% after months of stagnation at 0.8%. We have already suggested that for a few months businesses have been feeling confident enough to increase output prices. However, it will take some time before this translates into higher consumer prices.

On top of that, we don’t believe that the oil price rally has much further to run, meaning that the initial inflation effect will peter out in the course of 2017. Inflation is clearly trending higher, but this is likely to be a very slow process, as witnessed by the painfully slow bottoming out of core inflation. After the decision to lengthen its QE programme until December 2017, the ECB seems to be done easing. But we still believe that there will be a new lengthening of the programme into 2018 to allow for some tapering. Although by mid-2018 the ECB should have stopped adding to its bond holdings, the upward bond yield pressure from a strengthening economy and slowly rising inflation will, to some extent, be capped by the continuing bond purchases.


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

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

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

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

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

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

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

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


Brexit Balance Shifting?
The battle over the Brexit timeline is intensifying. Brexit Secretary David Davis is “not really interested” in a deal that would allow a longer period to manage the Brexit adjustment than the 2 years set by Article 50. Chancellor Philip Hammond responded, “there is, I think, an emerging view… among thoughtful politicians” that some form of transitional deal would “run less risk of disruption”. BoE Governor Carney agrees and PM Theresa May has said she is wary of a “cliff edge”. EU lead negotiator Barnier seems open to the idea of extending talks. This reduces the risk of a “hard” Brexit happening in 2019.

The Bank of England’s move to a “neutral” stance on the path of policy, combined with a sharp rise in inflation and economic resilience, has lifted market expectations for a 2017 rate hike. We are looking for inflation to rise above 3% in 2017, but that’s much lower than when CPI peaked above 5% in 2008/11. The BoE “looked through” price rises then and we suspect it’ll do the same now. UK growth risks are a higher priority. Brexit-related uncertainty is leading to big falls in business surveys regarding investment and hiring plans. Taken together with the squeeze on household incomes, lower corporate and consumer spending poses downside risks to growth next year. That’s why we still think a rate cut is much more likely.

USD Strength, USD Real Yields,  USDJPY and hedging flows, AUDUSD weakness

USDJPY is our biggest buy, with our target of 130 looking less ambitious by the day. EURUSD should break the March-15 1.0463low,heading towards parity. AUDUSD is one of our favoured shorts. With the equity market looking increasingly overstretched as real yields go up, USDKRW is set to break higher.

The Fed has been more hawkish than we thought moving its dot plot higher. Interestingly, markets moved more during the course of Janet Yellen’s press conference compared to the release of the interest rate statement as it took the notion that a dovish central bank President may no longer guarantee a dovish Fed. The yield curve went into an early bearish flattening moving our playbook forward. Abearish flattening of the US yield curve would set the starting signal for US real yields to rise which finally would create increasingly strong headwinds for risky assets. Remember, it is the real yield level driving equity valuations, and with real yields moving higher ‘multiples’ will have to come down. This does not suggest equity markets coming under immediate selling pressure, but risky assets will from now onwards require a stronger earnings support to maintain current price levels

Higher US real yields have provided the USD another shot into the arm with USDJPY breaking once again important resistance levels, suggesting this currency pair will accelerate its pace of appreciation once again. Only a few weeks ago our USDJPY target of 130 looked super ambitious. Now it looks moderate – for the authors, a taste too moderate. There are a few observations underlining USDJPY bullishness. The chart below compares the latest (upgraded) dot pot with the current market pricing for rates. While the spread between market pricing and the median assumptions of Fed participants has narrowed over recent months, the market is still under pricing the Fed which, at a time when the output gap is closing and the US economy is moving towards a fiscally supported growth model, is a substantial risk for markets to bear. This observation receives additional support from Janet Yellen down playing a previous comment suggesting in yesterday’s press conference that she has no appetite to overheat the economy.

While the option market’s skew suggests bond markets heavily betting on bond yields to rise, the 17% rise of USDJPY has come as a surprise for many, expressed by light positioning. This morning’s release of the MoF’s weekly security flow data revealed foreign investors piling into JPY denominated bonds (Y731.0 bln) and money market instruments (Y981.8 bln). Parts of this flow could be related to USD deposit holding banks arbitraging away some of the wide cross currency basis. The evolution of the USDJPY basis swap will provide the answer. If the spread remains wide then the increased foreign participation within Japan’s bond and money market may just be another expression for the market to believe the current USDJPY rally. The Tankan report suggesting that the average USDJPY estimate of exporters for 2H16 is at 103.36 tells us next year they may become increasingly overhedged. The reduction of hedge ratios would support USDJPY.

Rising US real yields will have significant implications for currencies of areas with wholesale-funded banking communities. Australia belongs in this camp and hence we are dismissing today’s strong read of its November unemployment report. Yesterday, AUDUSD failed to overcome its 200-day MAV so is looking vulnerable from a technical perspective. Importantly, higher US yields will increase funding costs globally with areas with wholesalefunded banks importing this new tightness quickly.Local funding costs will increase accordingly, which in the case of Australia’s overvalued real estate market could unleash deflationary forces. We recommend AUD shorts.


G10 FX, USD Strength, EURUSD and Oil Currencies

USD: Higher longer dated UST yields benefiting USD against EM FX The focus of the week is on the Dec FOMC meeting (Wed) which should be neutral / modestly positive for USD. The 25bp rate hike is all but priced in, hence the price action will be largely driven by the new set of FOMC forecasts and Chair Yellen’s press conference. Should the Fed convey the message that it is willing to run the economy hot (with higher growth and inflation projections, yet largely unchanged interest rate forecast), this would likely add to upward pressure on longer dated UST yields and benefit USD particularly against higher yielding currencies, as well as JPY where the BoJ yield curve control allows for a clear policy divergence. US Nov CPI (Fri) should also help the USD as prices are expected to increase to 1.8% YoY. As for today, higher oil price translating into higher UST long-end yields should be USD positive against most of EM FX.

EUR: Consolidation after last week’s large decline We expect EUR to consolidate today following the large decline after the ECB December meeting last week. The news that the Italian Foreign minister Paolo Gentiloni was asked to form a government is modestly EUR positive to the extent to which it shows a commitment to resolve the current political uncertainty without a delay. Yet, the focus still remains on the Italian banking sector particularly after the ECB reportedly rejected Bank Monte Paschi’s request for more time to raise capital. This in turn should prevent any EUR rally at this point.

Oil currencies: Non-OPEC and Saudi production cuts benefiting oil FX The spike in the oil price following (a) the agreement of non-OPEC countries to join OPEC and cut output next year; (b) Saudi Arabia commitment to a larger cut than previously agreed have benefited oil exporting currencies such as NOK, RUB or MXN. For NOK, the another leg in oil price higher all but rules out any easing from NB this week. 

Post ECB, EUR, Scandi FX and CEEMEA

EUR: Draghi achieving the unachievable

Despite reducing the pace of monthly ECB QE asset purchases, Drahgi’s dovish stance and technical adjustments to the QE programme actually weighed on EUR (as short dated German Schatz yields declined). More downside to EUR/USD due to EZ politics and higher UST yielders in coming months. The undervalued SEK is the main beneficiary in the European FX space. More uncertainty to PLN and HUF and scope for more downside to EM high yielders.

The ECB extended its QE programme by three more quarters until end-2017, yet it reduced the pace of purchases from €80bn to €60bn per month. Although EUR/USD initially rallied, it is now 1% lower. This is because: (1) Draghi did whatever it took to downplay the tapering concerns (tapering was apparently not discussed by the Governing Council); (2) ECB keeps in place the option to increase the monthly pace of QE purchases again should it be necessary (ie, if the risk to inflation increases) ; and (3) technical adjustments to the QE programme – decreasing the minimum maturity of bonds being purchased from 2-years to 1-year, scrapping the depo floor limit on these purchases.

Points (1) and (2) imposed a limit on the extent to which longer dated bunds sold off, which in turn limited the upside to the EUR as the longer dated yield differential between the US and Eurozone did not narrow materially. Point (3) has actually put an active downside to the EUR as it has led to a non-negligible decline in short-dated German Schatz yields, a wider US-EZ short dated spread and, hence, lower EUR/USD.

The above dynamics are clearly evident within our EUR/USD short term financial fair value model, which identifies the current EUR/USD levels as fair (Figure 1). In fact, the short-term EUR/USD fair value declined by more than 1% since yesterday due to the decline in short dated EZ yields.

More downside to EUR/USD in coming months

With Draghi being close to 100% successful in avoiding the taper-like EZ bond sell off and in fact generating lower short-dated EZ yields, the EUR/USD upside should be very limited in coming weeks/months. We look for the EUR/USD to move towards the 1.02 level in 1Q17 as: (1) the busy EZ political calendar weighs on the EUR via an increase in EUR risk premium; and (2) there is potential for another leg in UST yields higher in 1Q17.

Today’s ECB decision is favouring SEK, but adding some downside to G10 and EM higher yielders, while rising uncertainty about CEE FX.

SEK – Potential for less dogmatic Riksbank

SEK has been one of the key beneficiaries of today’s ECB announcement as the lower pace of ECB asset purchases suggests that Riksbank should ease its dogmatic approach. While we still expect the Riksbank to extend its own QE programme into 1H17 (by SEK25-30bn in total), there may be a less of a need for a rate cut. Importantly, SEK remains still meaningfully undervalued.

Risks to higher yielding FX and CEE currencies

The ECB reducing the pace of asset purchases should on the margin take some support away from G10 and EM high yielders as: (1) less extra liquidity will be pushed into the system; (2) potential for higher core yields. Hence, the negative knee jerk reaction in AUD and NZD in the G10 FX space.

In the EM, currencies such as TRY, ZAR or MXN are vulnerable. In our view, TRY remains particularly at risk given its high sensitivity to core yields, tricky domestic politics, concerns about the CBT credibility and the very high bar for an emergency rate hike. We continue to favour long RUB/TRY positions given RUB’s lower vulnerability to higher core yields.

In the CEE FX space, steeper bund yield curve and higher longer dated bund yields put PLN and HUF at risk. Moreover, should the lower pace of ECB bond buying increase concerns about the Italian banks recapitalisation process and rise EUR risk premium, PLN and HUF are likely to suffer. Overall, it will be a very tricky 1H17 for the forint and the zloty.

Emerging Markets, MXN, RBI Suprise, Drop in Chinese Reserves

EM currencies could continue to stabilise over the next week ahead of the FOMC meeting, and MXN could bea beneficiary. The latest round of oil block auctions went well, with 80% of deepwater blocks successfully auctioned. USD/MXN could head down to 20. RBI’s surprise hold decision, looking beyond the transitory impact from the currency replacement scheme, shows that INR macro stability remains the focus in India. EUR/PLN is near multi-year highs and we believe PLN is cheap. Our economists expect some dovish commentary from the NBP today, which could provide a better entry point for long PLN. While valuations have played a big rolein the reported drop in China’s FX reserves, capital outflows are continuing and we expect to see more CNY weakness. The USD could stabilise in the near term ahead of next week’s FOMC decision. Long USD positions have been popular and as we approach yearend investors could be more inclined to reduce risk and lock in gains. While a rate hike from the FOMC is fully priced in. In such an environment, EM will likely do well.

Several EM currencies look cheap, including TRY and MXN. However, as we highlighted yesterday, we are not looking to participate in any TRY rebound. MXN, meanwhile, could have a short-term bounce. MXN outperformed yesterday, and we believe in the current environment of a USD moderation, this could continue. Adding further support to MXN are the latest round of oil auctions, which were quite strong, with an 80% success rate in the first set of deep water auctions. This is not to say we are sanguine about the risks that a protectionist US stance poses for MXN, and the potential for spillover to Mexico’s own domestic monetary political picture. The oil auction, while successful, is unlikely to change these risks – it simply removes a potential risk for the currency, rather than adding a strength. However, given valuation, the potential for a USD pause, and the strength of yesterday’s oil auctions, we do believe that the currency could keep stability, and even strengthen a bit more into year end.20 will be a key level for the currency, as it hasn’t traded below here since the elections. For now, we prefer to position in 2s/10s TIIE steepeners in Mexico.

The RBI surprised markets today by keeping rates on hold, against consensus expectations for a 25bp cut, as the committee awaits more clarity on the impact from the government’s currency replacement on growth and inflation. With base effects falling out of inflation starting in December and going into the expected Fed hike in December, the RBI observed caution in maintaining the real rate at 1.25% given its projected inflation rate of 5% by March 2017. 10y IGBs have sold off by ~16-18bps following the policy announcement. With future easing expectations getting priced out and system liquidity also expected to neutralize over the coming weeks we would expect a further correction in bonds. However, the RBI credibly keeping to its real rate framework and maintaining adequate buffer in preparation for the steepening global yield curves implies that macrostability remains a priority over growth. If the growth impact from currency replacement are indeed transient,as our economists expect, we believe a recovery in growth and equity markets would be supportive of the INR.

The slightly larger than expected drop in China’s FX reserves was the biggest monthly decline since Jan 2016, but will to a large extent reflect changes in exchange rate and bond valuations, since the USD rose by about 3.5% versus the majors and US bond yields rose notably. Nonetheless, China continues to experience capital outflows and some FX intervention has occurred, as noted by SAFE. The authorities responded to outflows by imposing new restrictions at the end of November, but we expect continued medium-term depreciation in the CNY. China’s November trade data will be released on December 8,and our economists are more or less in line with consensus with their expectations of – 4.7% and -2.0% export growth, respectively. Trade data from Asia for November has so far been upbeat, with both South Korea and Taiwan posting better than expected export numbers. While positive, we believe that the expected medium term slowdown in China combined with uncertainty over the future of global trade ,as well as domestic constraints on growth, will lead to currency weakness for both KRW and TWD over the medium term.


Russia Outlook – Update

CPI inflation surprised the market to the downside in November. According to Rosstat, CPI inflation fell to 5.8% yoy in November from 6.1% yoy in October. The outcome was in line with our expectation but marginally lower than the Bloomberg consensus forecast (5.9% yoy). Food price inflation was 5.2% yoy in November, down from 5.7% yoy in October. Durable goods inflation slowed to 6.7% yoy from 7.0% yoy in October, while services price inflation fell to 5.3% yoy from 5.4% yoy in October.

Official core inflation (net of fruit and vegetables, but including most other food items) dropped to 6.2% yoy from 6.4% yoy. Our definition of core inflation (net of all food and energy products) also dropped, to 4.9% yoy from 5.3% yoy in October. The runrate of core inflation (on our definition) was 4.3% in November, down from 4.7% in October and the lowest in almost three years. We project headline inflation to drop to 5.6% yoy in December.


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.


US Labor Market Report, Italian Referandum, ECB QE Exit Speculation

Ahead of the October US labour market report we find a short positioned bond market as the US 10y yield is around 5bp away from crossing the June high. The bond put option premium has risen to levels suggesting a short term asymmetric profile. A strong labour market report may not take bond yields and thus the USD much higher, while a weak report could lead to a pronounced setback. However, we think FX investors should differentiate between the trend and the correction. The USD is within a secular uptrend driven by relative return differentials which themselves find their foundation in a global output gap differential. Hence any USD setback should be regarded as welcome to add to USD longs. This applies especially for our main call suggesting a medium term USDJPY target of 130 or higher. Mondays 111.35 USDJPY low should now limit the downside.

After the strong ADP release on Wednesday , risks to the upside with non-farm payrolls today. US data continues to come in on the strong side with yesterday’s ISM hitting a 21-month high of 53.2from an improving orders outlook (53.0) and production (56.0) and strong October construction spending pushing up our Q4 GDP tracker to 1.6% after 1.5%. We would need a very large miss on today’s payrolls figure to lead markets to price out the December Fed hike or even much of the 39bps of hikes priced for 2017.

Our more constructive GBP outlook is paying early dividends as the UK government appears to takes a more realistic position in respect of maintaining access to the common market. Yesterday, Brexit Minister Davis suggested the UK would consider paying for EMU market access. Even if his comments were not a new line from the conservative party (May’s speech at the party conference said an end to contributions was not a red line), the FX markets were more optimistic after a similar line came from EU side. Dutch Finance Minister Dijsselbloem, who is also president of the Eurogroup, suggested that the EU could design a way for the UK to enter the internal market but it would not be as easy or cheap as it is now. GBP longs towards 1.30 offer a good opportunity to weather any short term USD setback.

Italian Referendum. As investors prepare for an interesting week ahead for Eurozone related events, we have put together a few of our thoughts on the potential outcomes.First, the Italian referendum is taking place on Sunday, where polls will close at 10pm GMT. Exit polls are expected and a partial count of the votes. We should have a reliable idea in the early hours of Monday morning (around 3am GMT). We think that FX markets are not too complacent about the referendum. Italy’s complicated politics mean a “No”vote (as expected) doesn’tnecessarily follow through to the 5-star movement coming into power or Italy getting closer to an EU referendum. We expect moderate EUR weakness on a “No”vote but don’t like trading EUR short at these levels.

A Reuters article published yesterday suggesting the ECB is preparing to exit is QE programme should be taken with a pinch of salt. Firstly, the ECB was likely discussing how they may communicate to markets when they plan to exit in order to keep volatility down, with no indication of timing. Secondly, the ECB discussing logistics may be part of a strategy to keep the hawks on the ECB happy, suggesting that QE purchases are not going to last “forever”. Some may also argue that the ECB has very little choice than keeping BTP volatility controlled. Italian banks holding 18 percent of their assets in BTPs are a convincing reason to keep the ECB involved in controlling inner EMU bond spreads. Next weeks’ ECB meeting is likely to be filled with many technical discussions and measures. In this piece we go through the likely EUR impact for each measure in isolation.



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.


ECB, Italian Referandum and Bond Yields

Relief marked yesterday’s session as reports that the ECB stood ready to temporarily step up its purchases of BTPs in the wake of the Italian constitutional referendum. 10yr BTPs tightened by 14bp versus Bunds, outperforming SPGBs by up to 7bp. Note though, that Spain still has auctions scheduled for Thursday while this week’s Italian supply is out of the way. Temporary deviations from the capital key in the country split up of the ECB’s PSPP purchases is not uncommon. Monthly PSPP data shows that the ECB also skewed purchases to the periphery in June this year, when the Brexit vote led to spikes in EGB spreads. We calculate that this additional skew translated into some €0.5bn each for Italy and Spain above their average pace of monthly purchases. The lower weekly purchase figures released on Monday suggests the ECB might have made some room already. More crucially, this reaction function does indicate that the ECB is aware of the important support that QE lends to the periphery. As political uncertainties are unlikely to be resolved with the referendum, we believe that Draghi is unlikely to provide any reason to believe that the ECB is about to reduce its stimulus anytime soon. We stick to the view that an extension of €QE alongside technical adjustments to increase the pool of PSPP eligible assets will be announced at the ECB press conference next week. This should also be supported by yesterday’s German and Spanish inflation data, which do not point to an increase in underlying inflationary pressures in the Eurozone. Yesterday improved risk back drop has helped to push the 10yr Bund yield above 0.20% alongside ASW spreads tightening. The push higher was in part also a spill-over from better than anticipated US data. The next focus here is Friday’s labour market report with today’s ADP release providing a first taste. EGB Supply: Today Germany will tap the OBL 10/21 (€3bn), the penultimate German auction for 2016. The 5yr yield of -0.45% is still above ranges seen before mid-October, but sub depo yields should become PSPP eligible. While ASW levels might seem rich after increasing 10bp in November, the drivers of collateral scarcity remain in place.


Post Trump US Outlook, US Equities, USD Strength

From its February low the broad Russell 2000 equity index has gained 42.3%, outperforming the S&P (+21%) by a wide margin. The outperformance of the inward-looking Russell index suggests investors are assuming that US domestic demand is doing better compared to the demand of America’s trading partners. Relative domestic demand steers rate differentials and exchange rates. Hence, the outperformance of the Russell 2000 is consistent with our call of seeing yield differentials staying wide or widening further from here. The US-German yield differential has reached levels last seen in March 1989 when Europe took longer to recover when dealing with the consequence of the October 1987 equity crash. The DXY rallied 24% from 1897 into June 1989 before falling back again triggered by German unification and the end of the cold war leading ‘peace dividend’ related inflows into the Europe.

Nowadays the situation is diametrically opposite to 1989. Globally, expenditure for military equipment is on the rise, eliminating the ‘peace dividend’. Now, USD denominated investment is not only supported from an economic argument but also from a geo-political angle. Yesterday we saw once again the release of strong economic data supporting our view that the US is closing its output gap quickly. The FOMC minutes showed a similar view on data, supporting a rate hike for December. Remember, strong US October data provide a pre-election snapshot of the economy with economic agents not taking President elect Trump’s neo-Keynesian program into account. Importantly, the November University of Michigan consumer climate not only beat market expectations, but also saw current conditions and expectations rising, adding to evidence that US optimism has survived post-election emotion swings.

The apparently rapidly closing US output gap suggests US demand and supply for capital shifting to the left, creating an environment of higher bond yields unless compensated by USD supportive capital inflows. Our conclusion is that the US has the choice between a higher USD and higher bond yields. US deregulation of its oil and financial sector will increase this trend further. Interestingly, the FHFA (Federal Housing Finance Agency)has raised the maximum loan limits. The housing market as the USD417,000 cap on single-family homes had been in place since 2006 and will be raised by 1.7% to USD 424,100. While this change may look small in nature, it will support the housing market now, on the NAHB index, breaking price levels seen before the financial crisis and pushing more investors out of ‘negative equity’. All this happens when US households operate with multi-decade strong balance sheets and with only a fraction of disposable income required for debt maintenance reaching levels not seen since the mid-70s.

The US economy closing its output gap combined with the planned demand boosting ‘Trump measures’ converts the US from a supplier to a destination of capital. The early days of the incoming US administration will be all about finding funding for planned expenditures, suggesting more capital inflows. Then these funds will be brought to work. At this point it needs to be seen if the US can develop sufficient productivity gains to catapult its economy into a growth potential income. Should it fail in doing so then this neo-Keynesian approach will lead to higher inflation and with the Fed likely to catch up, accelerating its rate hikes, then risk appetite will decline as the US moves closer to recession. However, it may take several quarters for this scenario to play out. Up to then the USD will remain strong.



European Bond Markets, Global Yields and ECB

According to a Reuters report, the ECB is looking into ways to lend out its bond holdings more easily. The market reaction to this report illustrated how much Bund valuations are distorted by collateral scarcity issues already, in particular at the short end which had reached all-time yield lows just before the release. The 2yr yield rose 6bp and lost 4bp versus OIS initially, but also 10yr Bunds temporarily rose by up to 8bp losing 3bp vs OIS. According to the article the discussed changes include reducing the lending fees, accepting new types of collateral and extending the duration of loans. They seem to be targeted more at solving market (il)liquidity- than collateral scarcity-issues directly. In the ideal case this will help mitigate the increased occurrence of “specialness”, but it may not prevent the further richening of general collateral as surplus liquidity increases. Key issues in the way of really tackling collateral scarcity are that lending against cash still remains unlikely as long as QE is ongoing, and furthermore the circumstance that the ECB, which could broaden the acceptance of other collateral against which it lends, only holds a small share of the total purchased assets. The main holder of Bunds is for instance still the Bundesbank which we assume would still only accept other German collateral in exchange. Anything else could be considered as softening of the capital key restriction (in particular if lending volumes are expected to increase). The market reaction was interesting in so far as we would have expected EGB spreads to tighten cet. par. with Bunds more affected also by collateral scarcity. But the bond sell-off was also driven by Gilts (+9bp in 10yr) and better US data. To the extent that this might keep expectations for a QE taper in the market, spread widening especially in Italy and France as observed yesterday appears plausible against the political risk backdrop. While the potential adjustments do not yet address the issue of a shrinking asset pool which the ECB can buy, we think it still has moderate potential to tighten ASW spreads. Much should depend on the additional measures to be decided by the ECB in December. We still believe that an “non-tapered” extension of QE looks likely, along with further adjustments to increase the pool of eligible assets like loosening the depo rate restriction.



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.

European Politics
Two major political news came from the Europe this weekend; German Chancellor Angela Merkel announced that she will be running for chancellorship for the fourth time and former French President Nicolas Sarkozy had to concede defeat and forego his ambition to become President again in a major upset in the first centre right-wing primary, where he came third.

Last Friday, there was an announcement that German Chancellor Merkel would hold a press conference on Sunday, it was well anticipated that she would announce her bid to chancellorship for the fourth time. If she succeeds, she would become the longest serving German chancellor in history. However, this time it is likely to be the toughest in her career, as the German public remains highly dissatisfied with her immigration stance. In the local election in her home turf, her own party, Christian Democratic Union (CDU) lost to the anti-immigration newcomer Alternative for Germany, who secured the second place in that election, next to socialists.

In the French election, which is a lot crowded this year, Nicolas Sarkozy; the former President had to concede defeat in the very first centre-right primary in the French election. However, this is not a major upset, given the fact that Sarkozy’s political campaign was dogged by the scandals of the past. A prosecutor has called for a trial for French President Sarkozy, over illegal overspending during his presidency. But the major upset was the loss of Alain Juppé, who was widely expected to win the election. Instead, François Fillon, who was the Prime Minister under President Sarkozy and promised deep market reforms, came at first place with 44 percent of all votes. Mr. Juppé came second by securing 28 percent of all votes and Mr. Sarkozy got 20.7 percent. Next Sunday, there would be a show off between Mr. Fillon and Mr. Juppé. After losing, Sarkozy endorsed Fillon. With Socialist president François Hollande’s rating at record low, whoever wins among the above two would fight Marine Le Pen, the populist leader, whose winning the presidency could lead to further disintegration of Europe via French exit from the Union.



European Credit and Rates

Equities firmed up across the US and Europe, as a continued rise in the CPI (which came in at 1.6% YoY) yesterday suggests that US inflation is no longer a concern for the December FOMC meeting. Hence, the expectations of an imminent rates hike, which kicked in post Trump elections, keep driving rates higher. Synthetics painted a mixed picture as the Main, Senior and Sub Financials all closed 0.5-4bp in the red, while Crossover was 2bp tighter. Cash spreads kept widening by 2-4bp across the board. In the secondary market, the widening trend continued throughout the day. With no improvement in market sentiment post-elections, and with the struggle to digest the ample supply of the last days, mid and long maturities in both corporate and FIG space are under selling pressure. Peripherals especially took a hit. Utilities names lead the underperformance with Enel (ENELIM) widening by up to 12bp, taking the total widening to 10-42bp across the curve over the last week. In industrials, Autostrade per l’Italia (ATLIM) saw a 8-12bp widening in the mid to long part of the curve yesterday. In a sellers-dominated market, some limited buying interest was spotted yesterday in very short maturities of up to one year. While FIG names didn’t witness the same amplitude of spread widening, Italian and French banks are being bid wider, with Credit Agricole (ACAFP) bonds widening by on average 5bp yesterday and Intesa Sanpaolo (ISPIM) by about 4bp. Nordic and Australian names have been the most resilient to the downward market spiral. After a rather busy start of the week, primary markets remained relatively quiet yesterday. Vivendi (VIVFP) flew solo with a 11/2023 bond, pricing € 600m at MS+80bp, only 5bp inside the IPTs. The new offering pushed the longer end of the outstanding curve up to 15bp wider. Choppy market conditions discouraged Louis Dreyfus Company (LOURDRE) from proceeding with a 5yr € offering following the roadshow. BNP Paribas (BNP) and Gas Networks (BOGAEI) announced potential deals.