The euro area economy has indicated signs of a considerable acceleration following a 0.4 percent quarter-on-quarter growth in the fourth quarter of last year. Recently, all business surveys have continuously surprised on the upside, indicating towards GDP growth accelerating closer to 2.5 percent year-on-year, a rise from 1.7 percent year-on-year recorded at the end of 2016. This is stronger than the possible growth estimated at about 1.1 percent year-on-year, suggesting that the euro area output gap might be closing at a much rapid rate as compared to projected earlier, noted Scotiabank in a research report.

Throughout the euro area, Germany is expected to be an economic outperformer, owing to the firming global demand. The latest IFO surveys have come to their highest levels since 2011 when the German GDP growth was growing by over 4 percent year-on-year. But there are also signs that the euro area recovery is widening throughout its member states. The PMIs are rising in Italy and France in spite of the negative effect of increased political uncertainty, stated Scotiabank.

Moreover, increased supportive financial conditions continue to strengthen the euro area economic recovery, with interest rates staying at low levels along with continuing stimulus provided by the ECB. The subdued euro is also giving a boost, with the nominal effective exchange rate trending at its lowest level in nearly 15 years and helping local competitiveness. Hence, credit growth has bolstered, rising to 2.3 percent year-on-year in February, the most robust since 2009 and over double the growth pace witnessed a year ago. Overall, these developments bolster the view that the euro area economic recovery is becoming more sustainable, stated Scotiabank.

“The risk to the Eurozone growth outlook has now shifted to the upside, with both the EU Commission and the ECB revising their real GDP growth forecasts for this year and next year up closer to 2.0% y/y”, added Scotiabank.

The German bunds gained Friday, following a lower reading of the country’s manufacturing and composite PMI.

The yield on the benchmark 10-year bond, which moves inversely to its price, fell nearly 1 basis point to 0.24 percent, the long-term 30-year bond yields also slipped around 1 basis point to 0.95 percent and the yield on short-term 2-year bond plunged 1-1/2 basis points to -0.80 percent by 08:40 GMT.

The Markit Flash Germany Composite Output Index registered 56.3 in April, down from March’s near 6-year high of 57.1. This signaled the first easing in growth of private sector business activity since the start of the year, but still the second-fastest rate of expansion in over three years.

Further, the ongoing strength of business conditions in manufacturing, in particular, was reflected in the headline Markit Flash Germany Manufacturing PMI coming in little-changed from March’s 71-month high of 58.3, at 58.2.

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.

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.

The ECB is not anywhere near the exit of its expansionary monetary strategy as highlighted by a report suggesting that the ECB has been concerned by the recent rise of EMU bond yields. In particular, higher yields in EMU peripheral bonds seem unwelcome, in line with our own view suggesting that within the ‘rule-like’, one-rate-fits-all monetary union with little fiscal integration, it is the credit risk driving monetary conditions. Effectively, diverging credit risks have loosened monetary conditions in Germany and tightened conditions in Italy. The weakening Italian credit suggests the ECB may lean its monetary strategy to accommodate Italy, hoping that the resulting monetary boom in EMU’s low credit risk countries spills over into the periphery.

Yesterday’s report released by Reuters specifically cited the tweak in the ECB interest rate statement axing a reference to being ready to ‘act with all available instruments’. The ECB wanted to hint that tail risks have eased, but it did not want to signal that it is heading towards the exit. EURUSD topped near 1.0906 last week ahead of our 1.0925 key resistance level now facing the risk of breaking lower testing the 1.05/04 support. Note, bullish EUR recommendations have swamped the marketplace over recent weeks, and our positioning tracker shows EUR positioning is now long, suggesting de-positioning activity putting EURUSD under additional selling pressure.

The Fed should continue hiking rates over the course of this year with the debate within the FOMC leaning either towards three or four rates hikes for this year. Comments by Fed’s Williams and Rosengren (non-voters) put this projected rate hike path in the context of current US economic momentum and not based on the prospect of additional policy stimulus by the new US administration. The ‘Trump fade’ would be a big issue if the US economy were to still deploy a large output gap. US consumer confidence has reached levels last seen in the late 90s when James Rubin, the inventor of the ‘strong USD’ mantra, was Treasury Secretary, and the labour market has shown increasing signs of tightness. Interestingly, booming US economic data stand against low and falling Presidential popularity rates. Normally, political and economic support move hand in hand. Their divergence may provide another indication that the output gap-closing US economy has developed ‘animal spirits’ which may no longer need political encouragement.

Meanwhile, the CPI-adjusted US 10-year yield has declined to -0.3%,now running at a similar level witnessed in Japan which is experiencing a 20-year deflation history. We ascribe the low reading of the US real yield to the new ‘availability of capital’ driven by US banks pushing their assets into higher yielding environments. Excess of bank capital and better balance sheet structure allow US banks to deploy a higher VaR. Banks with USD deposits bought short-term JGBs and swapped them back into USD, securing the basis spread as a profit. Japanese investors buying US Treasuries and increasing FX hedges helped US bond yields and the USD to move lower, allowing US real yields to fall against the strong economic uptrend.

The Socialist candidate in this year’s French election, Manuel Valls, the former Prime Minister of France has abandoned his candidacy and instead, he would vote for the independent centrist candidate Emmanuel Macron in order to defeat their staunch rival Front National leader Marine Le Pen. He said on the French television that the Socialist candidate Benoit Hamon is not in the best position to prevent the rise of the dreaded far-right candidate. Mr. Hamon is expected to come fifth in the first round of the election, which will be held on April 23rd. he said that he is not going to take any risk. The incumbent socialist President Francois Hollande is not running for a second term, largely because of his very low approval rating among the French. At one point, his approval rating dropped to just 4 percent. He said repeatedly that as a President it is his primary goal to prevent a Le Pen Presidency as that will not be in the best interest of his country. So far, some 50 lawmakers have also jumped to Macron’s boat in order to prevent Le Pen from getting into the second round.

Polls have so far shown that Marine Le Pen getting beaten by Macron in the second round by a large margin of more than 30 percent despite winning the first. But polls have been proven wrong many a time in 2016. The establishment politicians are very scared as the Le Pen Presidency would not only mean the end of their world but the end of the European union and the Euro.

Are investors right to be questioning Trump tax reforms? Maybe not Following a failed last-ditch attempt to secure backing, House Leaders opted to save face by pulling the vote on the GOP healthcare bill late on Friday. While the failure to repeal Obamacare has limited fiscal implications, investors are viewing this setback as a more broader loss of faith in the Trump administration’s ability to deliver on other campaign pledges – namely tax and spending policies which have underpinned risky asset prices since the US elections. Initial noise from the White House suggests that pushing through tax reforms will be the next order of business and in principle, this speculation alone could provide a backstop to the waning US reflation trade. But passing a tax bill will not be easy by any stretch of the imagination; GOP conservatives will want to ensure the package is close to revenue neutral, while any bipartisan deal would surely have to see the Trump team concede on concepts such as a border tax. Either way, a deflated $ will be looking for any glimpses of fiscal support this week and we would expect interest from $ bulls to increase as excessive negative expectations surrounding Trump tax reforms begin to tail off. One thing’s for sure, we don’t expect this EM “sweet spot” to last under the status quo; diminishing US growth expectations will weigh on global risk appetite and this spells bad news for EM assets in general. Watch for turning points in EM FX – in particular recent outperformers KRW and ZAR.

EZ focus will be on the flash Mar CPI estimate (Fri); our economists are looking for above consensus headline and core readings (the latter picking up to 1.0%), which could fuel the current hawkish ECB sentiment in markets. Investors might also be wise to keep an eye on the number of ECB speakers on show this week. Look for any EUR/USD clear out to be limited to the 1.0930-1.0940 for now.

Prime Minister Theresa May is set to trigger Article 50 this week (Wed); while we prefer to view this as more of a symbolic event – with nothing fundamentally changing in the UK’s economic outlook – markets will be looking for any clues to determine whether we’re on course for a soft or hard Brexit. For this, we place a greater focus on the initial response from Brussels – to be delivered by Donald Tusk within 48 hours – which could shed further light on the EU’s negotiating stance and priorities. Current GBP levels are not in our view pricing in the tail risk of a ‘cliff-edge’ Brexit – an automatic default to WTO rules – especially given talk from both sides in recent months over the need for a transition deal. Should EU leaders place greater weight on factors like the Divorce Bill – and demote the need for a smooth transition – then we would expect GBP to react negatively. We do see greater two-way GBP risk around this week’s Article 50 proceedings given the recent BoE-fuelled short squeeze and cleaner GBP positioning. With the two-year clock to strike a deal officially ticking, any initial political stalemate – or anything that pushes us closer towards a cliff-edge Brexit – may tip GBP/USD under the 1.20 level in the near-term and cautious real money investors may view this week’s events as a prompt to hedge for such an eventuality.

Last week, a couple of investment banks have scrapped their 2017 euro-dollar parity call. Citigroup called off its euro-dollar parity call saying that it no longer expects a big rally in the US dollar, which could push it to parity with the euro. The bank now expects the euro to decline to 1.04 against the dollar, revised from its previous forecast of 98 cents on the dollar. The euro is currently trading at 1.086 against the dollar and the bank suggests that it could jump to as high as 1.10 against the dollar over the next three months in the Front National candidate Marine Le pen gets beaten in the upcoming French election.

After Citi, it was Barclays. In a report on last Thursday scrapped the euro-dollar parity call noting that investors are breathing a sigh of relief after the Dutch election, where the euro-skeptic PVV party led by Geert Wilders failed to secure the top position. The bank is now forecasting the euro to reach 1.09 against the dollar in the second quarter of 2017 and drop to as low as 1.03 against the dollar in the fourth quarter and rebound to 1.05 against the dollar in early 2018. The bank now only sees modest US dollar appreciation likely to peak in the fourth quarter. The bank said in its report, “The cyclical advantage of the dollar might erode as more robust global growth and inflation materialize, while sideways moves appear more likely without a significant policy boost that shocks rates and equity risk premia higher. The path for the dollar is subject to uncertainty in fiscal and trade policies, which could lead to vastly different outcomes.”

The strength of the US dollar has recently come under strain as the financial markets pose doubts on the ability of the White House to pass its promises, the hope of which boosted the performance of the dollar since the US election.

Our euro-dollar parity call still remains active, which were given out at then exchange rate of 1.11 against the dollar. We have not scrapped it yet but closely monitoring the fundamental changes.

The German bunds bounced on the first trading day of the week after investors largely shrugged off higher-than-expected Ifo business climate index. Also, market participants are eyeing the European Central Bank (ECB) member Peter Praet’s speech, scheduled to be held on March 28 for further limelight in the debt market.

The yield on the benchmark 10-year bond, which moves inversely to its price, slumped nearly 3-1/2 basis points to 0.38 percent, the long-term 30-year bond yields plunged nearly 4 basis points to 1.11 percent and the yield on the short-term 3-year bond traded 1 basis point lower at -0.62 percent by 08:40 GMT.

German business morale brightened unexpectedly in March, a survey showed today, suggesting company executives in Europe’s largest economy are brushing off concerns about the threat of rising protectionism. The Munich-based Ifo economic institute said its business climate index rose to 112.3 from an upwardly revised reading of 111.1 in February.

“The political uncertainties don’t affect the German economy,” Reuters reported, citing Klaus Wohlrabe, Economist, Ifo, when asked about the policies of U.S. President Donald Trump, Britain’s decision to leave the European Union and the ongoing instability in Turkey.

Lastly, traders also remain skewed to watch the release of Germany’s and Eurozone’s consumer price inflation and the former’s labor market report, scheduled for later in the week.

Centrists at the ECB are continuing to downplay the prospects of early tightening, although markets continue to price a hike in Sep 18. Understandably the ECB is concerned that markets will overshoot on any early hint of early tightening. Look out for Eurozone PMIs today. These have been running strong and suggest Eurozone growth may be running at 2%. We’re still clinging to the view that the 1.0850 area is the top of the EUR/USD range, but that could be severely tested if the US healthcare bill fails in the House today.

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

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

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

The 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.

The UK gilts remained flat Tuesday in mild trading session and after Britons overwhelmingly oppose Theresa May’s plan to quit the EU with no deal in place if Parliament dares to reject the terms she agrees with Brussels, an exclusive poll by The Independent has revealed.

The yield on the benchmark 10-year gilts, which moves inversely to its price, rose 1/2 basis point to 1.21 percent, the super-long 30-year bond yields hovered around 1.82 percent and the yield on the short-term 2-year remained flat at 0.11 percent by 09:00 GMT.

The survey also showed the public are bracing themselves for a Brexit hit on the economy over the next two years as painstaking negotiations over future relations play out. This comes ahead of a major stand-off between May’s Government and the House of Lords, which is demanding Parliament be guaranteed in law the final say on approving her Brexit deal and given the power to send her back to the negotiating table if it is rejected.

A greater proportion, 27 per cent, said May should try to renegotiate a deal, 14 percent said we should stay in the EU on new terms that May should try to negotiate and 15 percent said we should stay in on existing terms, a total of 56 percent who favoured options at odds with the Prime Minister’s plan to quit and trade on World Trade Organization (WTO) rules.

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

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

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

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

USD Strength, European Political Outlook and EURUSD

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

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

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

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

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

FX Update- European Politics and the UK

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

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

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

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

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.

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.

FX Positioning for the week of January 23rd

Since Monday, January 23, positioning is relatively unchanged. In the majors, the largest short is still in GBP; the largest long is still in CAD. USD positioning was reduced to its least long level since the US election. Non-commercial IMM accounts were decent sized sellers,net sellingnearly $5b to bring positioning to +$22.3b.

Positioning for this community is at its least long position since shortly after the election. Similarly, sentiment remains moderately bullish butnear the lower end of the range since the election. However,global macro funds remains very long. We see scope for USD long positions to build from here and like buying USD ahead of the Fed meeting this Wednesday.

GBP positioning was unchanged in short territory. Non-commercial IMM accounts marginally reduced their short positions but remain more short than their pre-Brexit positioning. Similarly, macro funds marginally reduced shorts but still retain large net short positioning. We think shorts can still unwind and are long GBPJPY.

CAD positioning moved further into long territory. Despite the dovish BoC, non-commercial IMM accounts were CAD buyers in the days following to bring positioning to its most long level since last September. Sentiment remains somewhat bullish.Long CAD positioning is another factor supporting our bearish CAD view.

US Bond Yields and USDJPY, US Risk Premium, BoJ Meeting Notes, BoC and EURUSD

US bond yields and USDJPY have scaled back to levels drawing a technical dividing line between a bull and a bear market interpretation. US political volatility seems on the rise in the aftermath of the recent imposition of immigration controls, possibly giving markets the impression that the rules could change quickly for anyone dealing with the US. Our global risk demand index (GRDI*)has scaled back from levels above 2 which is generally associated with markets runninghigh levels of complacency. GRDI was at 1.07 at market close yesterday. Precious metals have turned higher with Silver building a key reversal formation. Today Trump is expected to announce the new Supreme Courtnomination.

Certainly, the risk premium to hold USD denominated assets has increased as US politics have become more difficult to predict. However, we regard the glass still as half full and differentiate USDJPY driven in the near term by risk sentiment, while in the long term higher US capital demand should drive rate and yield differentials in favour of the USD. US December consumer expenditure rose by the highest rate in three months suggesting that the US economy has entered 2017 with strong momentum. The Fed statement tomorrow may reflect recent data strength. Seeing US nominal GDP expanding at a faster pace compared to the rise of US rates seen over the past year plus accelerating credit creation by US commercial banks suggests that US monetary conditions have eased. The Fed may like to reduce accommodation from here which should put the current USD downward correction to rest.

Today’s outcome from the BOJ meeting underlined their firm commitment to managing the yield curve (policy rate at – 0.10%, 10yr JGB yield target at 0%, 80tln annual bond buying). The statement underlining downside risk to inflation indicates that there is little risk of seeing the BoJ moving away from keeping 10-year JGB yield near zero. Interesting are comments from PM Abe’s economic adviser Kozo Yamamoto calling the 5-8% VAT increase of 2014 a mistake, suggesting Japan may operate a new round of fiscal stimulus to ensure the country overcomes inflation. The text book would suggest fiscal expansion supporting the currency, but this interpretation requires the central bank to turn less accommodative in response to the fiscal stimulus. However, Yamamoto has clarified that Japan can only then engage in a fiscal stimulus under conditions of debt sustainability suggesting funding costs staying south of nominal GDP expansion. When the three pillar ‘Abenomics’ kicked in in 2013 with Japan engaging in monetary easing, fiscal stimulus and structural reform, the JPY sold off hard. The JPY is driven by real yield differentials. Japan staying accommodative via its monetary policy and easing fiscally may (via rising inflation expectations) push Japan’s real yield level lower which, in turn, should support Japan’s equity market and weaken the JPY. Note, Japan inflation expectations (10y breakeven) are on the rise again and are thus ignoring recent risk volatility.

BOC’s Poloz will speak today and we think he will present a dovish message in line with yesterday’s comments from the Deputy Governor Sylvain Leduc highlighting the level of household indebtedness and elevated housing prices unlikely to withstand a persistent spike in unemployment. The fact that indebtedness is rising for the most indebted households is ‘really worrisome’ according to the BoC. The employment data for Canada are going to be important to watch for the CAD. The CAD should come under selling pressure today and this selling pressure has the potential to add momentum should oil prices extend recent selling pressure. Oil has broken lower on reports suggesting US rigs reaching their highest level since November 2015.

We remain EUR bearish with potential selling pressures coming from two sides. First, the new US administration focusing its new trade policy on areas running pronounced surpluses against the US may drag EMU into the trade debate. EMU’s crisis response was to consolidate fiscally and to seek higher employment via increasing net trade, allowing the EMU to convert its 2008 current account deficit into a 3% surplus. Secondly, EUR hedging costs have declined as shown in the chart below, which in light of current inner-EMU spread widening could lead to EUR selling. As JPY hedging costs have remained high EURJPY could turn as a catalyst for EUR weakness.



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.

USD technicals and DXY strength, ECB and EUR

The USD has experienced a powerful rebound re-establishing post US election relationships between the performance of risk assets and US bond yields on the one hand and the USD on the other hand. Importantly, suggestions according to which US anti-trade rhetoric would increase US inflation but reduce US growth prospects have been dismissed by yesterday’s price action. A stagflation scenario would push nominal bond yields higher, the curve steeper and the USD lower, which was in line with price action witnessed earlier this week. However, stagflation would undermine shares too, but the share market rallied towards new highs, allowing us to express confidence in our bullish USD call by adding bullish positions to our strategic portfolio.

USD technicals have dramatically improved. The DXY has printed four marginally new lows earlier this week with Wednesday’s low not finding confirmation in the 9-day RSI and creating a ‘positive divergence’. More important has been the BoJ stepping into markets increasing its Rinban operation in the 5-10 year JGB sector from JPY410 to 450bln in line with our projection expressed here yesterday. This operation has steepened the JGB curve further with 40 year yields reachingnew cycle highs which should help banks and insurance companies to boost their profitability, but it does increase the chances too that the BoJ expands its operation into the long-end of the curve trying to reduce volatility. Keeping JGB volatility low must be one of the key BoJ policy objectives to allow commercial banks to shift their JGB holdings accounting for 17% of total assets from the negatively yielding part of the curve into positive yield territory without increasing the critical VAR.

Falling DM productivity rates in conjunction with demographics boosting savings relative to consumption and globalization has allowed DM real rates to decline over the past three decades. Lower real US rates were an important factor driving US financial and real sector investment abroad providing the fuel for the EM economic growth engine. This trend may terminate now with globalization slowing and the demographically related increase of savings relative to investment peaking. US productivity is the next factor to look at. Productivity has a structural and a cyclical component. Higher investment will boost cyclical productivity suggesting US capital demand and US real rates going up, both working in favour of the USD.

The EUR will not withstand these pressures either and we reiterate our view calling the EUR the ‘mini JPY’. Inner EMU sovereign bond spreads have widened with Italy, Portugal and Greece taking the lead, pouring cold water on the idea the ECB may head towards an early reduction of its monetary accommodation. Greece and its EU creditors continued to struggle on Thursday to reach agreement on a key review needed for Athens to unlock new loans and avoid a descent into renewed financial turbulence. Italy’s economy struggles with its real rates which are too high relative to its ailing investment outlook, leaving the ECB with little other choice but to create conditions under which Italian real rates can fall. Tightening its policy too early may come with too high costs putting Italy under even more stress. Hawkish comments from ECB members representing core countries (Mersch, Weidmannn, Lautenschlaeger) may be dismissed as the ECB directorate runs the show and here dovishness has prevailed. The EMU’s core may develop inflation while Italy may prevent the ECB from acting ahead of the curve, creating an ideal environment for EUR weakness.

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).

Mexico: Sharply higher inflation adds to thelist of central bank concerns.

In the firsthalf of January,headline CPI rose much more than expected in Mexico,up 1.51%M vs 1.27%M consensus. On an annual basis, inflation surged to 4.78%, its highest level since September 2012,and substantially higher than the central bank’s 3% midpoint target. The culprit was higher energy prices – on the back of gasoline price liberation that kicked in at the beginning of the year – as well as pass-through to inflation from the depreciation of the MXN. Such price pressures offer Banxico very little room for maneuvering,at a time when Mexico is already facing extreme uncertainty from the north. We see the central bank restricting monetary policy further in its February 9 meeting and expect another 50bp, taking the Fondeo rate to 6.25%. While such a move is already increasingly priced in and local rates are arguably cheap, we stay cautious in the near term on the back of no positive anchor yet in place.

ECB Outlook and New Issue Guidance

The ECB has little appetite to change its monetary policy stance today after having extended the QE programme until the end of 2017 last month. In fact, many of the ECB’s (technical) decisions only came into force on January 13. However, some of the council’s considerations on the changes to the PSPP, as revealed in the accounts of the December meeting, may warrant further questions in the press conference today. Indeed, we would be keen to know (i) whether an increase in issue and issuer limits really is legally out of the question, and (ii) which additional changes to the design of the PSPP on top of the broadening of the maturity range and removal of the depo rate floor the Governing Council foresees if they were forced to “increase the programme in terms of size and/or duration”.

In any case, the ECB will probably reiterate that it expects key policy rates “to remain at present or lower levels for an extended period of time, and well past the horizon of [the] net asset purchases”. However, this hasn’t prevented 1y1y EONIA from moving towards – 30bp again, i.e. to the upper end of the range since November, effectively challenging the ECB’s pledge.

France will launch a new 3yr FRTR 2/20 today and tap the FRTR 5/22 alongside (combined €7-8bn). In linkers the FRTRi 7/21 and the FRTReis 7/27 and 7/47 will be re-opened (combined €1.5-2bn). Elsewhere, Spain will launch a new 5yr SPGB 4/22 and re-open the SPGBs 1/19 and 10/23 alongside (combined €4-5bn). In tapping the shorter bonds Spain has left the door open for a long end syndication in the upcoming week(s). Over the past week the 10 to 15yr sector has indeed underperformed on the SPGB curve. Versus its peers, though, Bonos generally have been holding up very well. Currently 10yr SPGBs trade some 50bps though BTPs, although that may still include some concession for the new 15yr BTP launched yesterday. But 10yr spreads versus Bunds are also at the lower end of their range since Q4 2016.

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.  

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.


RMB Short Squeeze, FED talk and JPY

The RMB short squeeze taking USDCNH back down to levels seen around the US election day seems complete. CNH HIBOR O/N rates at 60% as well as the sell-off in long-end of China yield curve are not durable options for a highly leveraged/overcapacity-running economy. This morning China’s Economic Information Daily calling the recent surge of commodity prices more a financial phenomenon than a result of demand exceeding supply comes close calling the housing market a bubble. Against this background, the PBoC has moved away from its super easy monetary policy approach it implemented in 2015.

China Securities Daily highlighted property developers using foreign currency denominated funds as a substitution for tighter RMB liquidity conditions. Concretely, overseas financing for 40 key Chinese property developers totalled CNY16.7 bln in December, almost tripling from November. Hence, the RMB squeeze did not only send a warning shot to speculative carry trade investors using the RMB as a funding tool, it may also be designed to ease some local balance sheet pressures for those Chinese corporations trying to compensate for tighter RMB funding conditions by funding via non-RMB denominated instruments. However, there is a third and probably most important aspect to consider. After 40 years of over-monetisation China runs excessive balance sheets with liabilities primarily locally funded. The problem is that RMB denominated asset holders aim for currency diversification which would ultimately reduce RMB denominated funding sources. Local capital costs would rise undesirably.

From a global risk perspective it has been good to see China dealing with such pressures pre-emptively, explaining why FX volatility has not spilled over into global equity markets. Instead, China’s RMB squeeze may prove good news for the global reflation trade. Meanwhile, price action seems to generate technical talk explaining why the USD may have topped and may fall further from here. This talk circles around the state of the US economy and whether those expectations concerning ‘Trump economics’ would be too inflated and hence already priced in the USD. Here we raise two topics.

 First, a comment from San Francisco Fed’s Williams calling expectations of three rate hikes for this year reasonable citing the 2% growing economy, the inflation rate moving back to the Fed’s 2% target and full employment as reasons for the Fed turning more hawkish. Interestingly, he added any fiscal stimulus out of the Republican-controlled White House and Congress would have just a modest effect on growth over the medium term, though President-elect Donald Trump’s pledges to cut taxes and unleash government spending will likely cause the economy to grow slightly faster. Williams seems to suggest that the output gap-closing US economy would have to aim for higher interest rates anyway and that the fiscal expansion plan of the incoming government may add to upward rate pressures.

Output gap differentials and flow of funds. Secondly, the BoJ and the ECB as the Fed’s main global counterparts will stay accommodative and over-leveraged and overcapacity-running Asia will have to run through a period of saving, generating balance sheet consolidations. These savings will aim for higher yield and, in the absence of finding adequate investment returns locally, will have to leave the region leading to AXJ currency weakness. Since the USD is used as a local reference currency, these domestic excess savings should find its way into the US.

The release of Japan’s weekly security flow data underlines the reflation link of our JPY bear projections. In the last week of December, Japan saw a JPY3.4895trn money market outflow, representing the highest outflow since 16 March 2016. The JPY has re-emerged as a global funding currency suggesting the trend of JPY weakness will resume with calming RMB markets and a potentially strong US labour market report working as the catalyst. Technically, USDJPY closed the post December Fed opening gap at 115.10. Should today’s US labour market report hold strong as the initial claims report has indicated for some time (Exhibit below) then the USD will re-enter its upward trend today.

December Meeting, US Interest Rates and Rate Projections

At the December meeting, the Federal Open Market Committee followed through on their well-telegraphed intention to hike rates in 2016. The decision was unanimous. Although the rate increase was expected, there were some additional hawkish surprises in the economic projections. Most importantly, the median rate projections increased to reflect three hikes, rather than two, in 2017. The near-term median projection for GDP growth increased slightly, and the median unemployment forecast ticked down for 2017. Some of these hawkish shifts were likely a response to improving data, but the election may have played a role as well. In the press conference, Yellen suggested that some (but not all) participants “did incorporate some assumption of a change in fiscal policy into their projections.”

However, the longer-term framework for the FOMC appears unchanged after this meeting. Forward guidance in the statement continues to point to “only gradual increases in the federal funds rate.” Moreover, the press conference and economic projections reiterated the view that the neutral rate is currently low, suggesting a hiking cycle is expected to be limited. In the press conference, Yellen stressed the “considerable uncertainty” around new economic policies. However, she also expressed some skepticism about the value of stimulus, noting that “fiscal policy is not obviously needed to provide stimulus to get back to full employment.” Moreover, she pointed to some risks of loose fiscal policy, including an elevated debt-to-GDP ratio and the possibility of inflationary overheating. On two occasions, she backed away from her recent speculation that “running the economy hot” may be beneficial to undo some of the long-term negative effects of the recession. Interestingly, in response to a question about her career plans, Yellen refused to rule out that she might stay on the Fed Board of Governors after her term as Chair ends in 2018. It is highly uncommon for an ex-Chair to remain on the committee, but Yellen is technically entitled to serve as Governor until 2024, diluting the FOMC voting power of Trump appointments. Overall, the outcome of the December meeting is slightly hawkish. However, beyond ordinary data dependence, the Fed is also likely to be reacting to the emerging economic policies of the Trump administration. We continue to expect two hikes in 2017, at the June and December meetings, but the outlook is liable to shift considerably in the months ahead.

Markets have interpreted yesterday’s FOMC meeting as hawkish, and interest rates across the curve have repriced higher. How hawkish was the Fed? We don’t think a lot, and while we agree with the levels to which markets have repriced, we are surprised by the pace at which it happened. Indeed, we think it is hard for markets to price in more than the 2.5 hikes currently priced in for 2017 without further evidence of accelerating inflation or the massive and much talked about Trump stimulus materializing. We’re skeptical that we’ll see early evidence for either, but it isn’t something we can entirely rule out either.

While we don’t think there’s much room to price additional hikes in 2017, we believe there’s room for some additional hike pricing in 2018. Markets are currently pricing about two hikes, but given that 2018 is the first year when we expect fully ramped up deficit spending, we suspect there’s room for more. Of course, there’s the risk that a Trump Fed will mean a more pliant Fed that’s less keen to hike even in the face of inflationary pressures, but this risk is somewhat unclear at this point. Further, should Yellen stay on at the Fed after her term as Chair ends in January 2018 – a possibility that she left open – it would likely reduce this risk somewhat (while her term as governor ends in 2024, it is highly unusual for and ex-Chair to remain on the Committee). As a result, we expect that there is some further steepening to go in whites/reds or whites/greens, though absent strong uptrends in inflation readings, the extent of this steepening could be limited.

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. 

Russia Outlook and Central Bank

The main event this week is the central bank’s rate-setting meeting on Friday (16 December). We expect the central bank (CBR) to leave the policy rate unchanged, in line with the CBR’s previous commitment to refrain from policy easing until 1Q-2Q 2017. In our view, the meeting will be crucial in terms of the signal it might provide for the prospects of policy easing in 2017, in the aftermath of the OPEC’s 30 November agreement to cut oil output. Furthermore, the outlook on oil prices will shape the CBR’s forecast revisions that are due to be published the same day in the Quarterly Monetary Policy Report. We believe the CBR will be more optimistic on the pace of recovery in economic activity, as well as more comfortable on the attainability of its 4% inflation target in 2017. We think the CBR will also make a hint this Friday with regards to a possible policy rate cut in the first meeting of 2017 (3 February).

Also this week, the focus will be on the following economic data releases:

 ? Tomorrow, Rosstat will publish the second estimate of 3Q real GDP data and its supply-side breakdown. According to the preliminary estimate, the pace of contraction in real GDP fell to 0.4% yoy in 3Q from 0.6% yoy in 2Q. We expect Rosstat to confirm the preliminary estimate.

? At some point this week, the Finance Ministry will publish the federal budget execution data for November. On a 12-month rolling basis, we expect the federal budget deficit to widen in November from 3.6% of GDP in October.

? On Thursday (15 December), Rosstat will publish the November industrial output data. We expect industrial production to have picked up in seasonally adjusted terms in November, in line with the strong manufacturing PMI data since July 2016.

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.


Renzi and Referandum Defeat, ECB QE and European Banking

Italy’s PM Renzi has resigned after losing the Constitutional Referendum by a surprisingly wide margin of almost 20%. Yes, the market was positioned for the ‘Yes’ campaign to lose, but not at this margin, now raising questions concerning Italy’s long-term capability to reform. We believe that the wide margin at which PM Renzi has lost the referendum will not change the near-term outlook for Italy suggesting the EUR should rebound from this morning’s lows. There are three facts to acknowledge when trading the EUR.

First, Sergio Matterella, Italy’s president, will likely appoint a new prime minister to govern the country until the next parliamentary elections, due in early 2018. The premier’s chief task will be to prepare a new electoral law to replace the present system, which awards bonus seats to the winning party and is intended to ensure a government can rule unchallenged for a full five-year term. Changing the electoral law requires an agreement among Italy’s two main centrist parties which is likely and does reduce Italy’s political tail risk, namely of the next election bringing a populist party into power.

 Secondly, Italy will have now make decisions concerning the re-capitalisation of its banking industry, while the ECB will need to deliver its annual Supervisory Review and Evaluation Process within the next three weeks. Re-capitalisation via the private sector would be the preferred outcome, but should the ECB acknowledge deeper capital loss potentials and not credit existing restructuring operations then the Italian government may have to step in. The problem is that households own about EUR170bn worth of bank bonds. EU rules require junior bond holders to bear the losses, suggesting re-capitalisation via the sovereign comes not only at the cost of increasing Italy’s state debt beyond its current 133% GDP, but it would also come at a potentially high political price namely its electorate turning even more populist.

Third, there is a feedback loop between bank balance sheets and the credit worthiness of the Italian sovereign defined by the banks’ 17% claim (11.5% via BTP holdings) of its total assets holdings. Hence, the performance of BTP’s and not bank share volatility will act as the best indicator for evaluating the EUR’s trading behaviour. The BTP outlook depends on the willingness of the ECB to act de-facto as the ‘lender of last resort’ for Italy. This ‘lender of last resort’ capacity is currently defined the ECB’s OMT and QE program.

This puts this week’s ECB meeting into a very special context. We outline the EUR impact from ECB outcomes here. Ex Bundesbank President Weber suggested that the ECB may have to pull the QE program earlier than currently suggested by markets. However, Italy’s instability will make it difficult to lay out a calendar driven QE tapering schedule when it meets this week. Anyway, markets have not anticipated any ECB tapering talk. On the other hand investors fear BTP volatility. The ECB knowing about the linkage between banks and Italy’s sovereign balance sheet will try to curb BTP volatility. Should this volatility stay within acceptable levels then the EUR should rebound too, moving slowly back to last week’s EURUSD high of 1.0661.

This outcome receives additional support from the fact that the EUR has reached key support on some crosses. For instance, EURGBP has tested levels near its 200-day MAV 0.8281 this morning. The outcome of Austria’s Presidential election showing the moderate center left candidate Alexander van der Bellen winning surprisingly convincingly has interrupted the string of populist election outcomes, providinghope in the France Presidential election showing a moderate outcome.


Italian referendum wrap-up
Uncertainty not to be dispelled immediately… only in the event of a ‘Yes’ victory On Sunday, 4 December, Italians will vote on the constitutional confirmative referendum. Polling stations will open at 7am CET and close at 11pm CET. We expect the result to be known by early Monday morning. Why a referendum? On 12 April 2016, the Italian parliament, in its final reading, passed the Boschi Bill, which seeks to amend part of the Italian constitution. The Bill secured an absolute majority in both branches of parliament, but fell short of obtaining the two-thirds of votes needed to avoid the additional step of a confirmatory referendum. The constitutional referendum is, therefore, a necessary follow-up to confirm the bill into constitutional law. Voters will cast their vote to decide whether to accept (‘Yes’) or not (‘No’) the amendments to the Italian constitution set out in the Boschi Bill, as already passed by parliament. These touch upon various sections of the Italian constitution. The key points of the proposed reforms • Eliminate the current ‘perfect bicameralism’, which assigns the same powers to both the Senate and the House of Deputies. • In an amended setting, power would shift markedly to the Chamber of Deputies. It would have exclusive power to cast confidence votes on the government. Importantly, it will retain the almost exclusive legislative power over ordinary laws and budget law. • The new Senate would become the House of the Regions, representing regional autonomies. It would be reduced in size (100 members; 95 nominated by regional representatives and five by the President of the Italian Republic). Its role becoming that of coordinating central and local administrations. It would no longer have the power to vote on government confidence votes, but would maintain non-binding power to propose amendments and opinions on bills approved by the Chamber of Deputies. • The Boschi Bill also seeks to modify Title 5 of the Italian constitution and the repartition of competences between the central State and Regional Administrations. Majority needed The referendum does not require a quorum. As a consequence, the result will be valid whatever the turnout. State of play A very long and difficult campaign is coming to an end. Attempts made by PM Matteo Renzi to de-personalise the contest have mostly failed. During the final days of his campaign, PM Renzi focused exclusively on the issues that will be voted on. Our feeling is that many electors will still consider the referendum as a test of Renzi’s government. From Saturday 19 November until the polling date of 4 December, Italy is in a blackout period, during which the publication of results of opinion polls on the referendum is prohibited. Up until 18 November opinion polls consistently indicated a widening lead for the ‘No’ camp, irrespective of the twists and turns of the campaign. The last seven days of publicly available polls had, on average, ‘Yes’ at 47.1% and ‘No’ at 52.9% (a 5.9ppt lead), with the percentage of undecided voters (absent in some opinion polls) at 20%. Statistically speaking, these numbers are inconclusive, but the bias in favour of ‘No’ is undisputable. Notwithstanding the clear bias shown in the polls, some caution in considering the result a ‘done deal’ should be taken. Opinion polls did not include expatriate voters, a numerically relevant group that has been addressed by the ‘Yes’ camp with a targeted campaign and who are expected to have a ‘Yes bias. In addition, polls disclosing anagraphical and geographical breakdowns have consistently showed that a propensity to vote ‘No’ was stronger among young voters and in the southern regions. In both groups, the turnout could be lower than the national average. Voter turnout might ultimately play a crucial role in determining the referendum result.


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.


Low Interest Rates in EU and China, European Policy Response

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

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

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

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


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


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.



US Equity Markets, USD Strength, GBP and China

US equity markets have reached new cycle highs overnight with inward looking and cyclical stocks such as financials leading the rally. The VIX index has declined towards its lowest level since August helped further by US real yields no longer rising. Markets have undergone a significant change with many correlations, which were ‘alive and kicking’ in August, either no longer in place or completely reversed. For instance, the higher USD has not prevented US inflation expectations or commodity prices from rising. Today the UK government will release its Autumn Statement. The GBP reaction should be positive if the tone of the government is to help UK businesses.  

 Investors are trying to get a handle on the growth and inflation effect of President elect Trump’s economic program. Some see these measures in the context of what has been claimed by Neo-Keynesians for a long time, i.e. to use fiscal expansion to overcome US investment weakness and hoping these fiscal measures may increase the effectiveness of accommodative monetary policies tools. A second group expects higher inflation, but growth staying subdued as the supply side of the economy may fall behind the demand expansion fuelled by increasing the money multiplier coming on the back of banks growing their balance sheets fast from here. The third group of investors expects the economy to maintain its low growth/low inflation profile citing substantial capacity reserves provided by the US’s main trading partners.

Confusingly, these three potential outcomes offer very different investment conclusions reaching from risk seeking towards risk aversion. What investors often overlook is that strong September and October US data releases currently hitting screens were achieved when markets were under a working assumption that Hillary Clinton was winning the Presidential election. It seems that something happened to the US economy over the summer months pushing it towards acceleration. Fading global headwinds with China’s growth rates stabilising and non-China EM growth accelerating had a supportive impact, but it may not fully explain the magnitude of the improvement. However, should the US have finally closed its output gap at a time when its household sector has completed balance sheet restructuring seems to provide the better explanation. Importantly, this explanation finds support in the way markets have changed trading from late summer onwards. In August, it was all about a liquidity imposed risk rally with the ‘hunt for yield and dividend’ driving markets. The USD was inversely correlated to US inflation expectations and commodity prices. Nowadays, we see the USD staying bid even when commodity prices move sharply higher. Overnight saw an 8% jump in iron ore prices. This new market regime makes sense should the US economy have closed its output gap.

The USD has entered a regime similar to what we saw in 1984 and 1999. In both cases, the US economy ran beyond its optimal capacity use, pushing its return expectations higher allowing the USD to gain exponentially. Only a few months ago, better non-US data would have weakened the USD. This is no longer the case as today’s release of the European November flash PMI’s may prove. Overnight, China’s Business Sentiment Indicator rose to 53.1 in November from 52.2in October. Both production and new orders picked up strongly in November, with the production indicator rising to a thirteen-month high of 58.0. Nonetheless, USDCNY has reached a new high at 6.8925 gaining 2% since the US election day.

CNY put option premiums have doubled over the past couple of weeks reaching their highest levels since 30th June. There are increasing voices in China warning about the impact of USD strength. Today it was Economic Information Daily warning about potential capital outflows from other countries should the USD become too strong. Meanwhile, Chinese reallocation efforts out of RMB deposits into alternative investments seem to have rediscovered the equity market. Outstanding margin trading on China’s domestic equity exchanges rose to RMB950 bln ($138 billion) on Monday, the highest in 10 months, while the Shanghai Composite Indexhas rebounded 22 percent from its January low.


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.


USD Index, US Rate Differential, EURUSD, USDJPY and NOK

The Fed’s broad USD Index surpassed its January high on Friday and is now setup for further gains, marking the next leg of the USD supercycle. USDJPY is leading the way this morning, which we expect to continue as the pair has broken through the July high around 107.50, seeing little resistance until beyond 110. We believe that the DXY should underperform the broad USD index as its largest constituent, EUR, is being supported by real rates, leaving the USD rally to be concentrated on Asian currencies. The US-world nominal rate differential continues to head higher, with focus now on real rates and their potential impact on risk appetite. This week market focus will remain on debating the potential policies from the newly elected US president and on Fed Chair Yellen’s testimony to the economic committee on Thursday.

 Trump continues to make senior appointments to his cabinet. Last night Reince Priebus was named as chief of staff and Stephen Bannon as a chief strategist and senior counsellor. The press is reporting that these appointments suggest that Trump is trying to take views from all sides of the Republican party. Equity investors may now try to put probabilities on each detail of the suggested policies made during the campaign, such as which parts of the Affordable Care act and the Dodd-Frank act could remain. For FX investors, however, it will be about the expected growth and inflationary boost from these policies and whether they will spur the Fed to raise rates faster next year.

Crossing through a previous high at 107.49, we foresee an initial target of 112. We have often said that higher inflation expectations or steeper yield curves would have been required for USDJPY to turn around. However, the reason for steepening didn’t need to come from the Japanese side. The correlation between global bond markets is high, meaning the US 2s10s curve hitting the highest level this year has spilled over into the Japanese curve steepening too. Steepness has been focused on the shorter end of the curve.

As the market prices in a faster pace of Fed hikes due to expectations of higher growth and inflation, there could also be debates forming about whether the ECB will need to extend its QE programme beyond next year. The US 5y5y inflation swap has hit the highest level this year at 2.47%, allowing the eurozone’s equivalent measure to also rise to 1.55%. We expect EURUSD to find support around 1.07, with the January low of 107.11 being key.

 Tomorrow will see the release of Norway’s 3Q GDP, which we expect to be relatively weak as industrial production data have not picked up recently despite the global rise in manufacturing PMIs and commodity prices. Our economists see headline GDP at 0.1%Q and mainland GDP at 0.4%Q. We will be focused on what proportion of growth has been generated by fiscal spending, as government spending is expected to decline next year, presenting a downside risk for NOK. We will also be looking for any signs of Brexit-related weakness. We see upside for USDNOK, which is still loosely correlated with oil and is now breaking through upper resistance at 8.40. We still think the market is long NOKSEK, which failed to break through 1.10, so position adjustment may also put downward pressure on NOK.



China and Commodities, Oil, GBP early elections talk

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

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

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

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

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

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



European Interest Rates -Rising political risk premium in BTPs

10yr Bunds held steady for a second session amid lower volumes, as Eurozone inflation came out in line with expectations and month-end extension flows offered further support (as on Friday). EUR swap 10s30s – one of our favourite harbingers of short-term trends in Bunds – dipped back below 50bp, supporting our view that last week’s sell-off is unlikely to morph into Bund tantrum 2.0 – which we would not expect until the end of ECB QE comes on the horizon. Standing out on the spreads front was the outperformance of Bonos (and the ongoing underperformance of BTPs). Following the formation of a PP-led minority government, investors further priced out the political risk premium embedded in Bonos, while sizeable redemption and coupon flows by Spain may have offered additional support. By contrast, the political risk premium embedded in BTPs – which we currently estimate at around 35bp in the 10yr area – increased further, as polls on the constitutional referendum continued to show the yes-camp lagging behind. Yesterday’s ECB QE data, meanwhile, showed the pace of PSPP picking up again last week to €17.2bn from €16.5bn in the previous week. The weekly data thus far are consistent with an overall pace of QE in October of around €83bn, which confirms that frontloading ahead of the December holiday period has indeed begun. Today is All Saints Day, meaning large parts of Europe will be off. The ECB, however, will publish the country breakdown of the consolidated financial statement of the Eurosystem for end September, which should help shed light on the geographical distribution of the €45bn take-up in the second TLTRO II. There will be no EGB supply today, but tomorrow Germany will tap the 10yr on-the-run, which already traded 75bp special (s/n) yesterday. Spain and France will come to the market later this week as well as Ireland, which will announce the details of the auction later this morning. Note that Austria cancelled the November 8 auction date due to the recent syndicated 7y and 70yr deals.


Global Inflation Break Evens, ECB and Europe

With sluggish summer growth and weak core inflation at just 0.8% in October, the ECB again looks more likely to extend QE in December.

GDP grew at a modest pace of 0.3% QoQ in 3Q16, just like it did in 2Q. This was in line with expectations as Brexit and other political developments caused large economic uncertainty. While post-Brexit economic activity has not come to a halt in the Eurozone, somewhat of a wait-and-see attitude showed from economic surveys over the summer months with businesses and consumers. This has likely caused investment growth to be subdued. The decline in business confidence also came with more cautious hiring, which caused the unemployment rate to stagnate in 3Q. This, together with the higher oil prices has likely also impacted consumption growth. The French data, which already provides a breakdown, shows that consumption indeed stagnated for the second quarter in a row in 3Q. GDP grew by 0.2% overall in France, while Spain saw growth of 0.7%. The higher oil price did cause the Eurozone inflation rate to increase again, from 0.4% in September to 0.5% in October. With the fading out of the negative energy price effect on the inflation rate, the headline number is climbing, but the core inflation rate has yet to move. While the Eurozone economic surveys are now indicating increasing price pressures, they have yet to prevail in the core inflation rate. Price growth of services and non-energy industrial goods was stable at 1.1% and 0.3%, respectively.

This puts the ECB in a difficult spot. The increasing headline inflation rate and strong October surveys about the Eurozone economy indicate that the window of opportunity for extending QE – at the current or maybe even slower pace – is closing, but the ECB will be less than satisfied with core inflation holding steady below 1%. We already liked the December meeting for the announcement of further action and if the current trend of higher inflation and improving economic indicators persists, it will become very difficult for the ECB to wait longer than that.



USD Index, JPY and BOJ, AUD and NZD weaker and driven by bonds

The USD index (DXY)has gained over 4% from its recent September low with USDJPY reaching its highest level for three months. This move has been supported by rising bond yields and the related steepening of G4 yield curves. Given the extent of the recent bond yield increase and the subsequent USD rally, the resilience of risky assets is remarkable suggesting the USD gaining further momentum against low yielding currencies. A lower JPY remains our expectation. This trade has received further support by the release of Japan’s CPI showing October Tokyo inflation reaching positive ground. Today’s market focus will be on the first release of 3Q US GDP.

The combination of higher inflation data and the steepening curve suggests Japan moving slowly away from an environment where the BoJ has no influence on real rates. It was this inflexibility which we described as yield curve exhaustion being the key catalyst for JPY strength experienced from November until September. Now as curves steepen and inflation rises the JPY outlook weakens by the day. Japan’s jobless rate trading at a 21 months low and household spending reducing the pace of its weakening trend are further adds to our bearish JPY call. The performance of bank shares may preclude changes of money velocity. Should Japan’s money multiplier rebound it will convert central bank liquidity into high powered liquidity increasing effective JPY supply. Today’s data showing higher inflation, labour market tightness and a steeper curve should push bank shares up putting Japan closer to a situation where its money multiplier can accelerate.

Between February and March of this year, Japanese investors and corporates started shifting their view on the JPY. Instead of continually expecting BoJ policies to work to weaken the JPY, their habits started to shift towards a neutral JPY stance, which we think added to JPY upside pressure. Today the tide appears to be turning in the other direction, with initial signs that further JPY appreciation may not be expected, perhaps because USDJPY has failed to break back below the psychological level of 100. The USDJPY rally will accelerate as this transition occurs. Driven by the weakness in JGB’s, current valuations are making local investment less attractive. This week four major Japanese insurers said they either plan to cut yen bonds or boost foreign notes. If the cross currency basis makes it expensive to FX hedge or the investor no longer expects further JPY appreciation then they may start to invest in foreign bonds without the FX hedge, which would weaken the JPY. Last week Japanese investors bought JPY773bn of foreign bonds, taking the 12m sum to JPY25.3trn. So outflows have been going on all year and should continue, but the FX hedging activity may change. The Japanese retail FX community have very light positions on at the moment but their activity could soon shift towards taking advantage of the carry trade once again.

The commodity driven currencies are generally the most sensitive in G10 to market volatility, however this week the FX weakness we would have expected has been cushioned by rising commodity prices. We are still short AUDUSD and NZDUSD in our FX Pulse portfolio, partly on expectations of a stronger USD rally. Chinese iron ore prices have rallied 7% this week. It is not clear whether the rally has been supply or demand driven. On the supply side, a few large iron ore companies reduced their production forecasts recently. On the demand side, our China commodity analyst has been suggesting that there is some restocking in place at steel mills. We don’t think the rally is driven by the increasing use of margin trading seen at the start of the year, as the number of days a future contract is held for is currently 6 days, relative to between 2-3in March. For NZD, we think the milk price rise has been driven by reduced supply, with Fonterra reducing their forecast for milk production in the coming year by 4.1%. Higher bond volatility is a negative for both these currencies.



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

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



FED Hike possibility, G10 currencies and USDCNY


Markets now pricing over a 70% probability of a Fed hike this year and inventory data pushing oil down by 2% have caused Asian equities to weaken slightly overnight. However, the weakness has been limited as global cross asset implied volatility has hit the lows last seen in 2014. The set-up fits with our view that the much better fundamentals in EM today relative to the 2013taper tantrum means that the risk-sensitive currencies can handle a rate hike this year and are unlikely to see a similar magnitude move to back then. That said, the current USD momentum and higher global inflation indications suggest that our strategy of buying the USD remains intact, particularly since the Fed’s Broad USD Index is sitting at the top end of a channel. Australia’s headline CPI coming in higher than expectations at 1.3%Y (1.1% e) Trimmed mean inflation remaining steady at 1.7%Y has caused markets to reduce probabilities of a near term RBA cut. We are still looking for a bounce in GBPUSD to sell but are conscious that EURGBP has bounced exactly from a previous upper channel support around 0.89.

Yesterday’s London afternoon USD rally seemed to be led by USDJPY breaking through its October 13high at 104.64. While the momentum for G10 currencies, including GBP which at one point had weakened over 1.2%, faded by the end of the day, there were some interesting observations to make. The press have been focused on USDCNH moving towards multi-year highs, which we still think is a function of a stronger USD; as is the higher USDCNY fixing, which is being adjusted higher against the USD in order to keep RMB stable against the basket. As USDJPY moves higher, all else equal, the CNY basket would strengthen, particularly since the JPY forms around 15% of the basket. Now as USDJPY breaks higher, other currencies must weaken vs the USD, to make the USD generally strong and thus allow the USDCNY to be naturally fixed higher (which may be becoming investor expectation based on the market moves). Our model had predicted a fall in the USDCNY fix today. Click here for our economist capital flow update. Cross asset correlations are still at all multiyear highs, maybe now G10 FX correlations are starting to increase again too.

The market is still marginally long the JPY, according to  trackers and the CFTC contract data but without the extreme long positioning seen at the start of the month, it is hard to justify that USDJPY will strengthen on position adjustment alone. Our regression based analysis is suggesting that in the past 2 months, USDJPY has become more sensitive to the performance of Japanese yields relative to the US. Overall, USDJPY remains the most sensitive to the 10y yield differential but both 2y differential and the 2s10s differential are becoming more important for the currency. The chart below shows that the current level of sensitivity to yields was last seen at the end of August, when USDJPY was trading just below 104. Since the US curve started steepening on 29th August, US 2s10s is up by 15bp, while Japan’s only 7bp, allowing USDJPY to rally by over 1%. Over this time, JPY has become less driven by global equities.

When the SNB tells you they think the CHFis overvalued, you wouldn’t think USDCHF hitting an 8 month high and approaching 1.00 would be an issue. However when the USD has been rallying this month, EURCHFhas been falling to approach the 1.08 level, which we think has been a line in the sand for the SNB before. Of course whether the SNB intervene to stop the CHF appreciating will depend on the pace of the EURCHF move but we are finding that pace is becoming increasingly related to reaching this 1.08 level. Actually the SNB doesn’thide away from the fact they have been intervening since formally removing the floor in January 2015. The SNB’s VP Fritz Zurbruegg said yesterday “We don’thave a fixed limit for growing the balance sheet; it’s a corollary of our foreign exchange market interventions”. Sight deposits, a measure of intervention, have increased by 10.8% since the start of the year. We expect EURCHFto remain in a 1.08-1.10 range, while USD strength should push USDCHF towards 1.01 in coming weeks.