It all started with Federal Reserve Chair Janet Yellen insisting that all meetings are “live”. Recent Fed rhetoric also accentuated the newfound hawkishness, even for some known doves. This week saw Brainard, Williams and Bullard essentially touting the case for serious consideration for a move in March, notwithstanding the fiscal policy uncertainties and as US president Trump’s Congressional speech failed to enlighten us on his exact execution of grand economic plans.

While markets are still waiting for Yellen, Fischer et al to speak this weekend, the futures market has already at this juncture priced in 90 percent probability of the first hike coming in March. No point fighting the FOMC given that both labor market conditions and inflation data have been very resilient. This is clearly a case of the Fed fearing to be labeled being behind the curve, OCBC Bank reported in its latest research publication.

With the SGD NEER trading above parity currently, there is room to be caught wrong-footed by the broad dollar if Yellen cements a green light for the March Federal Open Market Committee FOMC. That said, things will likely get more exciting going into the upcoming FOMC meeting and subsequently.

“As such, we shift forward the first FOMC rate hike scenario to March, with the second hike likely to follow in 2Q17. Assuming that US president Trump delivers on his phenomenal tax plan and the infrastructure investment plan, the Fed may feel compelled to get a third hike in 2H17 as well,” the report commented.

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

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

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

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

The known unknowns of Donald Trump to keep BoC cautious today The BoC meet to set interest rates today. Little is expected at this meeting, with expectations higher for the April 12th meeting, where a new Monetary Policy Report will be released. So far the BoC has been trying to soften any market expectations of tighter policy – and in fact market pricing is quite restrained currently, just 10bp of tightening priced in over the next 12 months. While Friday’s release of 4Q16 GDP data will also add to the picture, our view is that the CAD remains vulnerable to various threats from south of the border, such as i) NAFTA renegotiation ii) the introduction of a border tax and iii) early Fed tightening. 1.3310/20 looks an important resistance level for $/CAD (already broken) and a close above it will add confidence to our 3m forecast of 1.40.

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

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

h2>GBPUSD and Scottish Referandum, Trump and the FED

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

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

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

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

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

Mexican Central Bank, Inflation and Outlook

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


Ruble strength, fiscal rule and CBR

The gov’t/CBR comments that RUB strength is a temporarily fuelled RUB correction. We do see RUB weaker going forward, but generally in a modest/orderly way. There were several officials’ comments about RUB and CBR policy on Friday, which clearly explain some RUB correction. Specifically, CBR deputy Ksenia Yudayeva commented to Bloomberg with the following points:

 · The RUB is not significantly overvalued, its deviations from fair-value estimates are “within the limits of the norms”, and the hot money inflows are not the only factor driving RUB stronger, so the CBR doesn’t see any threat for financial stability from this and, so, there is no need to react.

  • · Not only the level, but excessive RUB volatility adversely affects competitiveness, which requires removing the dependence from oil in the FX rate, which will likely be achieved through inflation targeting and the MinFin FX buying under the “budget rule”.
  • · The focus stays on CPI/anchoring inflation expectations at the 4% target, which may require higher rates for longer, so the current 4%+ real rate may persist.
  • · MinFin FX buying and the disinflationary impact from the transitory factors of RUB and good harvest leave risks to reaching the 4% target, so the CBR remains concerned that the disinflation trend may slow soon.
  • · The lower and shorter recession in 2015-16 than was initially expected justifies the CBR’s cautious stance.

After these, MinEco Maxim Oreshkin also commented saying that the recent RUB strength looks temporary, seasonal and not related to fundamentals, so the RUB may see some moderate weakening followed by a stabilisation. All in all, the CBR comments look like a rather hawkish message also making clear that the CBR doesn’t see any need to react from their side to RUB strength. At this point, the probability of rate cuts in Mar-17 is clearly below 50%, but we think it may still change if CPI slows down as in previous weeks, and the RUB stays resiliently strong. As for the RUB outlook, we do share the view that the recent strength looked excessive, so it would be natural to see some retracement back to 59-60/USD levels all else being equal.

Italy: Risk of imminent snap elections reduced

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

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.

Carry Trades Still Supported, JPY weakness and EURUSD

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

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

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

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

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


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.


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.

Turkish Central Bank Governor Speech, Fitch downgrade and S&P action

Central Bank Governor Murat Cetinkaya will present the bank’s new quarterly inflation report at a press conference tomorrow. The press conference will start at 7:30am London time. The bank will have to raise its previous end-2016 inflation forecast of 6.5% considerably higher given the sharp depreciation of the lira since the end-October inflation report. Cetinkaya is likely to maintain the monetary policy committee’s (MPC) hawkish stance in its post-meeting statement on 24 January which kept the door open for further monetary policy tightening. Cetinkaya’s comments on the lira’s exchange rate and the central bank’s liquidity policy will also be closely watched by the market.

The central bank’s effective funding rate was 10.27% on Friday (27 January), up from 8.28% on 6 January before the sharp sell-off in the lira started. The central bank released on Friday (27 January) the calendar of its MPC meetings this year. The central bank reduced the number of its meetings to 8 from 12 previously. Following the first meeting of the year which has already taken place on 24 January, the MPC will hold meetings on 16 March, 26 April, 15 June, 27 July, 14 September, 26 October and 14 December.

The Statistics Office will release the December foreign trade data tomorrow and the January inflation data on Friday (3 February).  We forecast that the foreign trade deficit was $5.6bn in December, in line with the preliminary estimate and the Bloomberg consensus forecast.  We forecast that the January CPI inflation was 1.4% mom, compared to the Bloomberg consensus forecast of 1.8% mom. If January CPI inflation turns out to be less than 1.8% mom, the year-on-year headline will decline from 8.5% in December due to favorable base effects. We think the margin of error around the January forecast is quite large given the uncertainty around the extent of the pass-through from the lira’s rapid (and somewhat unexpected) depreciation in early January.

Fitch downgraded on Friday Turkey’s long-term foreign currency issuer default rating to BB+ from BBB- and assigned a “stable” outlook to it. Turkey’s previous BBB- rating – the lowest investment grade rating – was placed on “negative” outlook following the failed coup attempt in July 2016, and Friday’s downgrade was widely expected by the market. The main driver for the rating decision was Fitch’s assessment that “political and security developments have undermined economic performance and institutional independence” and that “while the political environment may stabilize, significant security challenges are set to remain.” The rating agency also opined that if the constitutional reform is approved in a referendum, it “would entrench a system in which checks and balances have been eroded.” Fitch also noted that the scope of the “purge of the public sector of the supporters of the group that the government considers responsible for the coup attempt in July” has “extended to the media and other groups” and has “unnerved some participants in the economy.” Additionally, the rating agency said that “high-profile terrorist attacks have continued, damaging consumer confidence and the tourism sector.”

As a secondary driver, Fitch noted that “the failure to address long-standing external vulnerabilities has been manifest in a sharp fall in the currency” and that although the rating agency “does not expect systemic problems that would jeopardize financial stability or trigger a balance of payments crisis,” it “does assume a detrimental impact on the private sector.” Fitch noted that “evolving domestic and external conditions bring the potential for further tests of Turkey’s ongoing resilience in external financing.” The rating agency expects real GDP growth “to average 2.3% between 2016 and 2018, compared with an average of 7.1% over the five years ending 2015 (based on new data after a credible GDP revision).” As for the banking sector, Fitch noted that “sector capitalization, supported by adequate NPL reserve coverage, is sufficient to absorb moderate shocks, but sensitive to further lira depreciation and NPL growth” and added that “refinancing risks have increased, although foreign currency liquidity remains broadly adequate to cover short-term sector wholesale funding liabilities due within one year.”

As for possible rating actions in the future: Fitch said that the country’s sovereign credit rating could see further negative action if, individually or collectively, it observes “heightened stress stemming from external financing vulnerabilities”, “weaker public finances reflected by a deterioration in the government debt/GDP ratio” and “a deterioration in the political and security situation”. For the possibility of a positive rating action, the rating agency has to observe, individually or collectively, “implementation of reforms that address structural deficiencies and reduce external vulnerabilities” and “a political and security environment that supports a pronounced improvement in key macroeconomic data.”

Also on Friday, S&P revised its outlook on Turkey’s unsolicited sovereign credit ratings to “negative” from “stable”. The rating agency affirmed Turkey’s BB long-term foreign currency sovereign rating. S&P said that since it last revised Turkey’s rating on 4 November 2016, “the lira has depreciated by 18% against the US dollar and 15% against the euro”, and that “the monetary policy response to currency and inflationary pressures of Turkey’s central bank may prove insufficient to anchor its inflation-targeting regime.” According to S&P, “given the large-scale dollarization of Turkey’s economy, a weaker exchange rate erodes corporate balance sheets, financial sector asset quality, and growth. “ The rating agency said that the decision reflects “what we consider to be rising constraints on policy makers’ ability to tame inflationary and currency pressures, which could weaken the financial strength of Turkey’s companies and banks, undermining growth, and fiscal outcomes, during a period of rising global interest rates.”

Russia Rate Meeting, Sanctions and FX Interventions

The main event this week is the central bank’s (CBR) rate-setting meeting on Friday (3 February). We expect the CBR to leave the policy rate unchanged, at 10.00%. This is in line with the Bloomberg consensus forecast. Although the majority of respondents to the Bloomberg survey expect the policy rate to remain unchanged, some expect a 25-50bps cut. It is worth highlighting that the CBR is no longer committed to keeping the policy rate unchanged (in contrast to its message in September 2016) and the government has recently decided not to spend extra oil and gas revenues. We see a number of other arguments in favor of a policy rate cut, but none of these is strong enough for the CBR to act at this week’s meeting, in our view. In particular, we would like to highlight the favorable inflation data in January and weak consumer demand indicators in December. We strongly believe that the decision of the Finance Ministry to introduce regular FX purchases is neutral for the prospects of policy easing. We believe this will be explicitly highlighted in the CBR’s post-meeting statement this week. Although the CBR will not hold a press conference or release a monetary policy report (with updated forecasts and assumptions – pretty important in light of rising oil prices) this week, we expect some comments from the CBR officials as 3 February is also the day when the Finance Ministry will reveal its daily FX purchase volumes, according to the intervention mechanism. We expect the CBR to cut the policy rate at its next meeting on 24 March. On Thursday (2 February), Rosstat will reveal the preliminary estimate of real GDP growth in 2016. We estimate real GDP was down 0.4% in 2016 (after a drop of 3.7% in 2015). A Bloomberg consensus forecast for this variable was not available at the time of writing. On Saturday (28 January), Russia’s President Putin had a phone call with US President Trump. It was the first official call among the two leaders. According to a press release by the Kremlin, the two leaders discussed the crisis in Ukraine and the situation in the Middle East, their countries’ cooperation in fight against global terrorism, Iran’s nuclear program and other international issues. The Kremlin concluded that the call was “positive and productive”. On Friday (27 January), the rally in the Russian local markets was driven by comments from US Presidential Adviser Kellyanne Conway, who noted that rolling back of US sanctions against Russia may be discussed between Putin and Trump on Saturday. Although Kremlin’s press release did not refer to this issue, it does not mean that the issue was not discussed. In our view, the current backdrop may be challenging for those investors who are short Russian assets due to a potential positive headline risk as was the case on Friday

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

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

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

USD, Trump executive orders and NFP, GBP and Article 50, JPY Bond Buying 

USD: Trump’s executive orders a distraction from positive macro $ story The dollar is slightly softer in holiday-thinned Asia, with investors demanding a small concession for Trump’s seemingly erratic Executive Orders. The focus here is on the start of Trump’s extreme vetting of immigrants announced Friday, orders which have already been partially reversed by the US courts. That said, we would expect the focus to shift back to the US macro story this week, which looks a dollar positive. As outlined in our team’s FOMC Crib Sheet, we see the Fed potentially sounding less relaxed on inflation at Wednesday’s FOMC meeting. We think at 33% the probability of a March Fed rate hike is priced too low and that the dollar could rally 1-2% against the low yielders on a more hawkish statement. Additionally, the US labour market report (Fri) should show solid Jan average hourly earnings (2.6% YoY) and above consensus NFP (180k). Coupled with the solid US Q4 GDP last Fri (particularly in the context of the strong 3.5% YoY Q3 growth), we see this as being a positive week for the dollar. Favour DXY breaking above 101.00/101.30 resistance this week.

EUR: Higher CPI may cause a headache for the ECB this week The focus is on the January German CPI today which should give us a gentle preview for tomorrow’s flash EZ CPI. We are likely to see another spike higher (due to base effects), towards 2%. While this should add fuel to calls within Germany for ECB policy tightening, for now the effect on the near term ECB outlook should be limited (even if EZ CPI should move to 1.4% tomorrow). This is because the ECB policy stance for the remainder of the year is “fixed” (the commitment to €60bn monthly asset purchases). With inflation expectations rising but the ECB keeping policy rates on the floor, real interest rates should move more negative and be bearish for the EUR.

GBP: Article 50 to be debated this week It looks as though Article 50 will be debated Tuesday night in parliament with a preliminary vote on Wednesday – although a binding vote is not scheduled until Feb 8th it seems. This week will also see a Super Thursday at the BoE, where the MPC will decide on rates and release the February inflation report. The market is still quite short GBP, but we think a messy debate on Article 50 plus the strong dollar story can keep Cable capped near 1.2600 this week.

JPY: BOJ bond buying in focus. Tomorrow’s BoJ meeting has a little more focus than usual in that the BoJ is struggling to keep 10 year JGB yields near 0%. At 8GMT/CET tomorrow, the BoJ announces its bond buying schedule for February. Any increases/tweaks in the JGB buying scheme looks JPY negative. We see $/JPY to 116.80 this week.


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

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


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

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


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

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

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.


USD divergence from bond yields, US savings, JPY curve

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

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


Global equity rally fueled by the US, reflation trade sets in 

The anticipated reflation tradehas set in, with shares and DM bond yields breakinghigher, but USD has not participated in this move. Instead, USD has decorrelated from the performance of the US bond market, drifting lower while the US 10-year bond yield has breached the 10-year 2.52% technical barrier. The government’s monthly sale of US$34 billion in five-year notes drew the weakest demand since July, based on the number of bids received relative to the amount offered, seeing investors switching into equity holdings. Cyclicals such as transportation and financials have led to the upside, suggesting the market making bets on US economic expansion gaining momentum. In this sense the current equity market rally is different to the liquidity-induced, dividend-focused rally seen for most within the post Lehman world. The new structure of this equity market rally makes sense for an economy having closed its output gap now entering into a new area of re-building its capital stock.

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.

Turkey MPC decision, money markets and inflation indexes

Following the MPC decision on Tuesday (24 January), the central bank provided all of its funding at the upper end of the interest rate corridor (9.25%), not at the late liquidity window (11.00%) yesterday. The central bank’s effective funding rate increased accordingly to 9.25% from 9.12% a day ago when the central bank had provided a mix of funding at the upper end of the corridor (8.50% then) and the late liquidity facility (10.00% then). The adverse market reaction to this development shows the significance of the marginal funding rate for the lira’s exchange rate, in our view – although the central bank’s effective funding rate increased yesterday compared to the previous day, its marginal funding rate declined to 9.25% from 10.00%, which did not support the lira. Meanwhile, the overnight FX swap rate declined to 8.00% yesterday from 9.39% a day ago.

The Statistics Office announced methodological revisions for the inflation statistics yesterday. There were adjustments in the weights of food prices (reduced by about 2pps), transport prices (increased by about 2pps) and housing and utilities prices (reduced by about 1pp). The Statistics Office also said that it will use a new methodology for the prices of seasonal products (which would be particularly relevant for unprocessed food items). The Office expects about 10% less volatility in the CPI index with the new methodology, but these changes will not impact the trend of inflation. The Statistics Office will also release new measures of core inflation, but will continue to release core indices H and I, which are widely used.

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

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

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

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

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

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.  

USD Strength to continue, GBP weakness and event risk, CZK

USD: Gentle USD strength throughout the week.  We expect USD to trade with a gentle upward bias this week. The main economic data event of the week is the December US CPI (Wed). We expect the reading to tick above 2% YoY (for the first time since mid-2014). This should benefit USD via the higher UST yield channel. President-elect Trump’s inauguration speech on Friday is likely to strike an optimistic tone, yet in terms of new news flow, it may not be enough to materially move USD.

EUR: The euro reaping the short-term benefits of the Brexit risk. It is a fairly quiet day/week on the EZ data front. Not only should EUR do well against the Brexit-battered GBP, but we also expect Brexit spill-over related EUR gains to manifest themselves against SEK. SEK has been one of the few currencies to negatively feel the Brexit spill-over last year, causing EUR/SEK to trade with persistent Brexit risk premia (as some market participants perceived Sweden as potentially the next-in-line non-EMU country vulnerable to EU exit swings). EUR/SEK to move above the 9.50 level this week.

GBP: More Brexit risk premium to be built into GBP.GBP is under heavy pressure ahead of tomorrow ‘s PM May speech on the UK government’s Brexit strategy. While the Brexit risk premium has yet again started being built into GBP, it is still nowhere near the extreme levels of October 2016 (worth c.10% in EUR/GBP at the time vs 3.3% at this point). We still see more upside to EUR/GBP and expect the cross to break above 0.90 in coming weeks/months, potentially testing the last year’s ex-sterling flash crash highs of 0.9140. This would coincide with the historically extreme EUR/GBP medium term overvaluation. While the potential Supreme Court ruling on Article 50 may provide short-term respite to GBP (if the government is forced to seek the approval of Parliament), this is unlikely to be long lasting as Parliament is likely to approve the June referendum outcome.

CZK: Will more than EUR20bn of speculative capital find a counter-party? We worry the market is getting/going to be excessively short EUR/CZK. Based on our estimates, there may be around EUR 20bn of “fresh” speculative capital currently waiting for the CNB exit from the EUR/CZK floor (and more may flow in coming weeks/moths). This may make the price action on the EUR/CZK floor exit day rather tricky – even if the EUR/CZK declines towards its far value of 25.50 over time. Hence, to err on the side of caution, we close 50% of our short EUR/CZK position as a correction in overstretched long CZK positions may be overdue.

Eurozone: Political clouds, Yields and Rates

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

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

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

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

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


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

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

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

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

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

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

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

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


USD Strength, Chinese Reserves, Low yielding currencies

Our bullish USD call and global reflation will work hand in hand as long as USD strength mainly works out against low-yielding currencies. The December US labour market report – released last Friday – is consistent with our view of seeing the US closing its output gap. Related labour market tightness has pushed average wage growth up to 2.9%, representing its highest reading since June 2009.Fed comments suggest that the balance of risks has shifted from the Fed being too optimistic on rates towards assuming that the Fed may have to hike more than currently priced in by the markets. The Fed’s Kaplan and even the super-dovish Evans see two to three rate hikes as appropriate. Jerome Powell said “overheating has shown up in the form of financial excess”, suggesting that continued equity market strength may increase the pace of Fed rate hikes. Lastly, the Richmond Fed’s Director of Research Kartik Athreya warned Friday that the fed funds rate may have to be hiked faster than markets currently anticipate as economic conditions are more uncertain than usual now. On Friday, 10-year US bond yields rose by 9bp, pushing USD higher.

Low yielders suffering most: It is global reflation pushing relative real yields in Japan and EMU lower which works against JPY and EUR as long as the BoJ and the ECB maintain their dovish courses. The BoJhas signalled that it may consider moving away from keeping JGB 10-year bond yields near zero when inflation exceeds 2%Y. Even so Japan has closed its output gap and now sees wages and unit costs movinghigher, so it will take some years before inflation reaches the BoJ’s target. In the case of the ECB, the matter is economic divergence leading to an overheating core while the periphery continues to struggle. In the absence of further political integration pushing the ideas of a fiscal and a bankingunion forwards (which is unlikely to happen in a German election year), the ECB may have to stay accommodative. Accordingly, rising inflation rates push real yields lower,not only translating into a weaker JPY and a weaker EUR, but also allowing the Japanese and European stock markets to seek higher valuation levels.

China’s FX reserves: China seeing a US$41.1bn fall in its currency reserves in December, moderating from a US$69.1bn decline in November, provides a better headline than suggested by the currency valuation-adjusted reading of its reserves. Adjusting for the effects of FX valuation,actually FX reserves fell faster in December (by US$29bn) relative to November (US$, reaching the largest outflow since March 2016. The Exhibit below shows that, relative to M2 growth, China’s currency reserves have fallen to their lowest level since 2002, possibly suggesting that China should aim for a more careful use of its monetary policy.

Dealing with outflow risks: Last week’s RMB short squeeze coming on the back of sharply higher RMB-denominated short-term funding costs bear goods news. It shows that China’s authorities pre-empted the increased accumulation of outflow risks, which is good news for risk-takers. However, should China fail to remain on top of this issue, it may have the potential to undermine the global reflation trade, with falling commodity prices acting as a catalyst. The other risk to our short EUR and JPY strategies could come via USD strength increasingly materialising against high-yielding EM currencies. EM currency weakness tends to tighten global liquidity conditions, as witnessed in January 2016 when EM weakness translated into outright JPY and relative EUR strength.

These risks about global liquidity conditions are not trivial; therefore it is important to add GBP shorts into our portfolio. Last week we added short GBP/SEK and today we propose short GBP/USD. It is not only that Britain’s current account deficit may not adjust as quickly as previously hoped as post Brexit domestic demand has remained strong – thus keeping the UK dependent on international funding – but also the absence of a Brexit negotiation strategy now being suggested by the British press. The UK’s ambassador to the EU Ivan Rogers’ resignation and his critical remarks (Brexit leading to “mutually assured destruction”)have put market focus back on the UK experiencing a potential cliff edge when exiting. With less than 50 days left before the UK may trigger Article 50 – according to its government’s current timetable – GBP-denominated assets may see their risk premium rising again.

The first cabinet meeting dealing with the EU will be held on Thursday. The cabinet may have to discuss a strategy should the Supreme Court force the government to seek parliamentary approval when triggering Article 50. The Supreme Court’s ruling is expected on January 23according to the Sunday Times. Next Monday, PM May is expected to outline her Brexit strategy. In a Sunday morning interview with Sky News she said that Britain will make a definite break with the EU. Closing North Sea oil platforms costing£24bn and PM May calling for a bigger government as she moves from Cameron’s ‘Big Society’ towards a ‘Shares Society’ concept will not help GBP either, in our view.

Developed European Bonds Markets

Market activity was extraordinarily muted yesterday as the US and the UK were still closed. But the ECB resumed its QE purchases after a one-and-a-half-week pause, helping to push the 10yr Bund yield to a near 2-month low of 0.16% (before closing at around 0.19%). A key trend of late has been the rally in real rates towards levels last seen in the run-up to the Bund Tantrum of April 2015. Indeed, the yield on the DBRI 0.1 4/26 briefly reached a 20-month low of -1.20% yesterday, while the yield on the DBRI 4/23 hit a fresh record low of -1.41%. This may be related to the extreme circumstances seen in repo markets (the DBR 8/26 still traded at -6.3%(!) T-N yesterday).

 However, 10yr real swap rates are also close to extreme lows . This reinforces the risk of a near-term correction in our view. EGB supply-wise it will remain quiet this week with only France and Spain coming back to the market. Next week will see more action as the Netherlands, Austria and Italy will hold taps while Germany (and maybe Belgium) will launch a new 10yr. Rating reviews will also resume next week, with DBRS set to review Italy’s A (low) rating on Friday the 13th. A downgrade would imply higher haircuts on collateral in ECB refinancing operations. The busy political risk calendar for 2017 arguably makes for a potentially dangerous cocktail for spreads.

The French presidential elections due for April/May should ensure that 10yr OATs will continue to trade at a minimum (curve-adjusted) 5-10bp pick-up versus 10yr Belgium (temporary new issuance concessions notwithstanding). Moreover, Dutch spreads over Germany also are also likely to come under some widening pressure in the run up to the March elections and new 10yr DDA in February. But if the Dutch/German 10-year spread (currently: 13bp) got out to 25bp that would be a good time to get back in.

10yr BTP/Bund spreads look most vulnerable given the increase in BTP supply and possible snap elections in late 2Q17 in the context of a population that has become increasingly euro-sceptic. However, we would also flag the possibility of another referendum in Catalonia – as again promised by Catalan president Puigdemont recently – weighing on 10yr Bonos, which still look 20bp too rich.



OPEC oil output: The new year sees the start of the output cuts that were agreed between OPEC and some non OPEC producers. Kuwait has reportedly cut output by 130Mbbls/d to 2.75MMbbls/d to meet their end of the deal. Meanwhile nonOPEC member, Russia saw oil output over December total 11.21MMbbls/d, unchanged from the previous month. • US oil rig count increase: There appears to be no stopping the rig count in the US, which as of the 30th December stood at 525, up 48 since the start of December 2016, and the highest level seen since early January 2016. The stronger prices we are currently seeing, should support a further increase in the rig count moving forward.


Peru copper output higher: Copper production in Peru over November 2016 totalled 210,718 tonnes, up almost 33% YoY. Stronger production has come about as a result of an expansion in mine capacity in the country. However looking forward, don’t expect to see these impressive growth rates maintained. • Aluminium 2017 outlook: Chinese analyst, SMM are expecting that 2017 will see the global aluminium market return to a surplus of 1m tonnes, from a deficit of around 650,000 tonnes over 2016. The group expects Chinese production to increase by 13% YoY to 36m tonnes on the back of capacity additions.


• Indian sugar output: The Indian government expect that sugar production over the current 2016/17 season will total 22.5m tonnes, down from 25.1m tonnes last season. The government estimate that carryover stocks from last season stood at 7.71m tonnes, and so believe that there is sufficient supply in the country in order to meet domestic consumption • Ivorian cocoa arrivals: Cocoa arrivals at ports in the Ivory Coast for the week ending 25th December 2016 totalled 73,000 tonnes, compared to 60,000 tonnes for the same period last year. Cumulative arrivals so far this season (starting October) total 723,500 tonnes, compared to 808,000 tonnes for the same period last year.

USD Strength, China and Yuan Weakness, AUDUSD

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

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

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

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

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

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

Brazilian Government announces measures to boost growth

Today (15), the Brazilian government announced the following ten actions to stimulate economic growth, most of which focus on improving the business environment and lending.

1. Tax compliance: Installment arrangements can be made to pay off tax debts of individuals and legal entities due on or before November 30, 2016.

2. Incentive for real estate loans: Regulation of Covered Real Estate Bonds (LIG), an instrument for raising funds for real estate lending. The objective is to expand the supply of long-term credit for construction.

3. Reduction of bank spreads: (i) Creation of electronic trade acceptance for the registration of financial assets that can serve as security for credit transactions and (ii) enhancement of positive credit reporting by reducing the paperwork needed to adhere to the program and to exclude information from the database.

4. Credit cards: (i) Allowing different prices to be charged for different payment methods (e.g., cash, bank payment forms, debit cards, and credit cards); (ii) reduction of period for payment by acquirer to storekeeper; and (iii) standardization of payment methods at commercial establishments, preventing exclusivity of issuers and merchant acquirers;

 5. Reduction of paperwork: (i) eSocial: simplification of payment of labor, social security, and tax charges in connection with the employer-employee relationship; (ii) Public Digital Tax and Accounting System (SPED): unification of the provision of accounting and tax information for tax administrations and regulatory entities and reduction of the costs of providing the information; (iii) national implementation of electronic tax invoice for services rendered; (iv) simplification of procedures for reimbursement and setoff of taxes administered by the Federal Revenue Service; and (v) implementation of the National Network for Simplification of Registration and Legalization of Companies and Businesses (Redesim).

6. Improvement of management: Implementation of the National System for Management of Territorial Information (Sinter), which contains a national register of real estate and deeds and documents integrated with notarial registers and shared by various entities of public administration. 7. Competitiveness and foreign trade: (i) Expansion of Unified Foreign Trade Portal and (ii) expansion of the Authorized Economic Operator, which facilitates customs procedures in Brazil and abroad and other activities such as agricultural inspection, sanitary compliance, and the army. 8. Access to credit and debt renegotiation: (i) Facilitated access to credit from the Brazilian Development Bank (BNDES) for micro, small, and medium enterprises and (ii) renegotiation of all debts of small and medium enterprises with the BNDES (larger companies can apply for refinancing of overdue installments with funds from the Sustained Investment Program – PSI).

9. Severance Pay Fund (FGTS): (i) Gradual reduction in additional fine of 10% of FGTS balance in cases of dismissal without cause and (ii) distribution to workers of earnings from investment of FGTS amounts: 50% of FGTS earnings ascertained after all fund expenses, including housing subsidy, will be incorporated into the workers’ accounts. 10. Productive microcredit: (i) Expansion of limit for program qualification from BRL120K to BRL200K in revenues per year and (ii) change in operating rules to facilitate concession and monitoring of the credit. The government said that there is no estimate of the impact these measures will have on GDP growth but that most of the impact will likely be felt as of 2018. Although it is not possible to estimate the impact on GDP growth, the set of measures will probably be favorable for Brazil’s long-term growth. The real impact will depend on how fast the government will be able to implement the announced measures. However, we believe that these measures will not be sufficient to reverse the current path of contraction in economic activity in the short term.

IBC-Br contracted -0.5% mom (-5.3% yoy) in October, close to market expectations The Economic Activity Indicator (IBC-Br) posted a contraction of -0.5% mom (-5.3% yoy) in October, close to the median market expectations and our forecast, both of -0.6% mom (-5.5% yoy). October’s IBC-Br figures confirmed the negative dynamics of economic activity in the beginning of 4Q16, as already suggested by the performance of the main economic activity indicators (e.g., industrial production, real retail sales, and monthly services survey) in the period. The stability of the IBC-Br in November and December at the same level of October would represent a contraction of -0.3% qoq (-3.0% yoy) in 4Q16, versus -0.6% qoq (-3.6% yoy) in 3Q16. The coincident indicators already released suggest an increase in industrial production in November, what should contribute to a moderate increase in the economic activity indicator in the month. As a result, we believe the most likely scenario continues to be a milder contraction of GDP in 4Q16 in comparison to the previous quarters. We expect a GDP contraction of -0.4% qoq (-2.2% yoy) in 4Q16, after a decline of -0.8% qoq (-2.9% yoy) in 3Q16.

US Treasury Holdings in Asia, QE and USD Strength, 5Y5Y Inflation Expectations

The relationship between Japan’s and China’s holdings of US Treasuries provides another indication of changing international USD liquidity conditions. There is an increasing divergence between domestic and international USD liquidity. Ironically, some of the current USD shortage is a reflection of second-round effects coming on the back of QE.

Concretely, QE has boosted cross-border asset and liability holdings and laid the foundation for ‘commodity dollars’ (a wider definition of petro-dollars) moving into EM and here mainly into Asia,helping to create unprecedented debt piles. As now some of these commodity dollars make their way back towards their origination (e.g., Saudi Arabia issuing USD debt), the cost of the international USD has started to rise. Cross-border asset and liability holdings requiring currency management (which often means hedging)has boosted hedging costs. Commercial USD deposit-funded banks used to arbitrage the rising spread between domestic and international funding costs, but regulation restricted banks’ arbitraging capacity. US prime funds now funding fewer international issuers has reduced the effectiveness of a tool converting domestic into international USD.

Official versus private USD flows: In October, China’s holdings of US Treasuries (US$1.12trn) declined (-US$41.3bn) to the lowest level in more than six years as the world’s second-largest economy uses its currency reserves to support the yuan. Japan overtook China (under the TIC’s official country reporting) as America’s top foreign creditor (US$1.13trn),as its holdings edged down at a slower pace. Currency reserves are the residual of global liquidity and, since China’s capital account has been regulated for long, China runs most of its foreign asset holdings via its reserve managers. In Japan, private holdings dominate. When private demand for USD assets rises and the US fails to increase its international USD supply, for instance by running a wider current account deficit, or increasing international access to US domestic funding tools, then rising private demand for USD-denominated asset leads to a USD shortage.

JPY: Largest mover under USD shortage: This USD shortage has become best visible by the widening cross-currency basis impacting markets in a textbook fashion. JPY should remain the largest mover under the USD shortage for now as rising international USD funding costs have pushed hedging costs higher. We see two effects working through markets. First, Japan’s FX over-hedged foreign asset holders are likely to let hedges expire, keeping JPY on the back-foot. The spread between hedged and unhedged returns has increased by the day, adding to pressures to take hedges off.For the10 largest lifers the hedging ratio went up from 57% to 67% (March-Sept).   Second, we think that an increasing share of Japan’s new capital exports will now run without FX hedges (as some life insurers indicated a month ago). Hence, it will be the volatility-adjusted return differentials moving increasingly into focus when Japan’s investors decide where to place bets. Here high-yielding currencies offer traction, helping to explain why high-yielding EM currencies have weathered the ‘USD storm’ remarkably well. Rising US real yield: Caution is warranted, nonetheless. A quick look at the 5y5y US inflation swap tells us why. Early December inflation expectations peaked near 2.55%,having falling to 2.37% since then and, while nominal yields have kept rising, real yields have jumped higher .For comparison,5y5y inflation expectations rose in the days after the Fed hiked rates in 2015, despite oil prices falling. Today’s decline of US inflation expectations has materialised despite the CRB Rind index trading near cycle highs, leaving the rising USD and the more hawkish Fed as the main reasons for this inflation expectation decline. Sure, EM economies are resilient compared to 2013 or last year when an equivalent rise in US real yields undermined the high-yielding EM asset class instantly. Higher US real yields tell us that EM risks have increased. AUD and KRW shorts: However, instead of shortinghigh yield EMFX, we are using this market as an indicator for how big the USD-low yield FX move will be. The longer the relative EM high yield resilience lasts, the higher USD will rise against low-yielding currencies such as EUR and JPY. Should – under the weight of rising real yields – EM wobble then we would reduce our low-yieldingFX short positions. We suggest selling KRW and AUD aggressively. Both currencies react adversely to falling risk appetite. Rising real rates have increased downside potential within risky markets such as shares. Most tactical share market indicators have reached frothy levels. Generally, we look into currencies from the bearish side where there are banks covering most of their liabilities via wholesale operations. Australia falls into this category. Its yield advantage to US Treasuries has declined to 27bp.

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

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

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

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

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

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

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

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


China 7 Day Repo and Monetary Policy

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

USD Index Momentum, the FED meeting, GBPUSD and China

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

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

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

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

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

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. 

USD Strength, ECB tapering, GBP and Commodity Currencies

The prospect of looser fiscal and tighter monetary policy has propelled the USD higher since Trump’s election. Our baseline assumes Trump’s trade policy is one of pragmatism over antagonism and that USD remains modestly bid through 2017. Risks to that view primarily stem from Trump talking the USD lower or the Fed backing away from tightening in light of USD strength.

The ECB has delivered a cute policy of tapering while keeping EUR strength in check. Eurozone politics can now drag EUR/USD close to parity in 1Q17. Yet assuming Le Pen does not win in May, more ECB tapering next summer, plus extreme under-valuation, can send EUR/USD above 1.10 by the end of 2017.

Elsewhere in Europe, London’s collision course with Brussels suggests current EUR/GBP weakness be used to hedge against a future GBP sell-off. A difficult fixed income environment in 1Q17 will leave bond-sensitive currencies such as PLN and HUF vulnerable through the early part of the year.

Commodity currencies have been performing a little better as global demand prospects improve. RUB and BRL remain our top picks in this space. Further commodity FX strength assumes that the PBOC is successful in keeping USD/CNY under 7.00 and suffering some CNY strength against the basket.

Turkey Update on Economic Measures Taken

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

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

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

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

South Africa Update

The Reserve Bank’s Quarterly Bulletin for 3Q 2016 will be published today at 8:00am London time. It is likely to show that the current account deficit in that quarter widened to an annualized 3.4% of GDP, according to our estimates, from 3.1% of GDP in 2Q 2016. The median consensus estimate, according to Bloomberg, is 3.6% of GDP. Industrial production volumes in October were down 1.3% mom (in seasonally adjusted terms), having been up a revised 0.7% mom in September and 0.1% mom in August, according to our analysis. Volumes on a three-month moving average basis in October were down month on month and up only 0.1% year on year, with this growth rate having turned positive in June following eight consecutive months of decline.

 ? The manufacturing sector, which accounts for an estimated 56% of the industrial sector, recorded a decline of 1.9% mom in volumes in October, according to data published yesterday. Volumes were up month on month in September by 1.3% and down 1.0% in August.

 ? The mining sector, which accounts for an estimated 34% of the industrial sector, recorded a decline of 1.2% mom in volumes in October, according to data published yesterday. Volumes were down month on month in September by a revised 0.1% but up in August by 2.4%.

? The electricity sector, which accounts for an estimated 10% of the industrial sector, recorded positive growth of 1.5% mom in volumes in October, according to data published on 1 December. Volumes were down month on month in September. Real GDP growth in 4Q 2016 looks likely to have remained below 1% qoq annualized, according to our preliminary estimates. There are downside risks to the Reserve Bank’s and National Treasury’s real GDP growth forecasts of 0.4% yoy and 0.5% for 2016, in our view. October data for the domestic trade sector – retail sales, wholesale sales and motor trade sales – will be published in the week of 12 December.

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.

Rosneft Sale, Oil Price and Ruble

The government managed to sell its 19.5% stake in oil company Rosneft for EUR10.5bn ($11.3bn). The stake was sold to the consortium of Glencore Plc and Qatar Investment. Both will have 50% share in the stake. In a meeting with Rosneft’s CEO, President Putin urged Rosneft to develop a joint plan with the central bank (CBR) and the government for a smooth conversion of FDI inflows into rouble. We are not aware of the details of this scheme, but given the context of Putin’s comments the implications of this deal on the market should be neutral for the rouble. Having said that, we think this deal should be positive for the sentiment in the local market, as the market did not expect foreign investors to be involved in this privatization. Following this news (late in the evening local time), the rouble strengthened by almost 1.0% against the dollar. Inflation expectations improved only marginally in November. According to the central bank survey, year-ahead inflation expectations (based on normal and uniform distribution) fell to 5.6% and 5.5% in November, from 5.8% and 5.7%, respectively, in October. According to the CBR’s statement, inflation expectations remain elevated relative to the CBR’s 4% inflation target. In the CBR’s view, elevated inflation expectations justify a relatively tight monetary policy stance. Inflation in the week to 5 December was 0.1% wow, on par with the previous week. On our estimates, headline inflation was down to 5.7% yoy as of 5 December. We expect headline inflation to reach 5.6% yoy by the end of this year, which is consistent with the CBR’s forecast. According to Finance Minister Siluanov, the government may spend the windfall oil revenues in 2017. In our view, this is a very likely scenario if the average Urals oil price stabilizes above $40/bbl in 2017 (the base assumption for the federal budget law in 2017- 2019). The increase in spending will be supported by the proximity of presidential elections in early 2018 and an almost two-year-long recession. The news is negative for the prospects of a decline in nominal interest rates, in our view.

USD Bond Markets, Emerging Markets FX, GBP recovery, ECB

The USD bond markethas provided the signal for a USD downward correction. On Monday we discussed that US bond yields had risen too far, too quickly.Late last week volumes were higher for bond option investors to sell (put) rather than buy (call), reaching levels which in the pasthave signalled markets correcting their recent surge towards higher yields. While this extreme has come down somewhat, we still think there could be a pre-Christmas USD correction, which has been supported by China taking measures to curb FX outflows.

From its November 24 top, the Fed’s broad USD indexhas lost 1.3%, with most of the decline seen over recent trading days. In line with our projections, ithas been high-yielding EM currencies benefiting most from this USD correction, which makes sense with downward correcting US nominal bond yields pushing US real yields lower too. US real yield is the most important ‘external’ variable steering the performance for high-yielding EM FX. Over the course of the next couple of weeks we think this USD downward correction has further legs to run, with FX markets continuing to take the lead from the US bond market. Within the G10 we continue seeing value in GBP and CAD.

GBP has been helped with the UK government showing increasing sensitivities to avoid a ‘cliff edge’. Yesterday, PM May agreed to publish her negotiation plans and promised that MPs could vote on the final exit deal. A hard or closed Brexit will be more difficult to achieve under these conditions, suggesting GBP reducing some of its Brexit risk premium. Other ways the Brexit premium could be reduced are via the UK’s Supreme Court asking the ECJ to decide whether Article 50 is ‘irrevocable’ or Britain finding its negotiation enhanced by a possible interpretation of Article 127, suggesting that leaving the EU would not automatically cut the UK out of the single market. While yesterday’s release of weak November industrial production led towards a GBP setback, this morning’s release of a strong RICS house price indicator should provide GBP with some cyclical strength. GBPUSD should see 1.30/31.

Today’s focus will be on the ECB, which may steer its communication towards keeping EMU’s financial conditions stable. Click here for our ECB scenarios. The volatility of the peripheral bond market should be watched by markets. At this critical juncture, where Italy’s banks try to recapitalise any peripheral bond volatility, this would be unwelcome and expose long-term stability risks, with peripheral banks’high claims against their national sovereign providing the link. Note that yesterday Moody’s revised Italy’s outlook to negative. Hence PM Draghi may welcome better economic data releases, but these better data have not compensated for political risks when it comes to sovereign bond market spreads.

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

AUD GDP Miss, CAD Divergence and OPEC, JPY correction, Interest Rate Drivers of FX
The focus is all on AUD today which weakened,at its most 0.7% overnight,as 3Q GDP contracted by more than the market was expecting (- 0.5%Q, market -0.1%Q). The story is clear – the prior quarter saw an upside surprise as public spending picked up by 4.8%. This couldn’t be repeated again at that pace of spending as the government is worried about losing its AAA credit rating. The result was 3Q public spending contracting by 2.4%Q,nothelping the overall GDP print. Usually the idea of government consumption is to boost business investment too, but as the mining industry is still dealing with a terms of trade shock and restaurants and retail consumption isn’t sufficient to compensate, the ‘fiscal boost’ of 2Q was short-lived. Even after today’s downside surprise, the market is still not setup for the RBA to cut rates next year, which we are forecasting. We believe that AUD remains a sell from current levels, especially on the crosses, with AUD/NZD helped by yesterday’s strong dairy auction.

2014 saw massive monetary policy divergence within the G4 space,allowing USD to rally over 15%. Now we look at the policy divergence in the commodity currency space and see renewed opportunities that are not yet priced in. From the USD side, the market is already expecting 1.7 x 25bp of hikes in 2017,and it is for this reason that we expect a short-term USD pause.From the AUD side,however, the markethas only priced 7bp of cuts by the middle of the year, while our economists expect 25bp. It may now take the RBA to shift its tone from yesterday’s note on downside surprises to growth to explicitly saying that it is worried and could act to make the rates markets reprice cut expectations. The RBA minutes, released on December 20, will now be in focus together with 3Q house price data on December 13. Of course, today’s strong iron ore trading during Asian hours again supports the terms of trade but we don’t think it is sufficient to keep AUD supported. The Canadian rates market is more fairly priced for BoC expectations, we believe. Today’s BoC meeting should help our short AUD/CAD position to break through the August lows.

USD/CAD has started to diverge from the 2y rate differential, but it should still be the monetary policy outlook driving the currency today. In general, our constructive outlook on CAD is based on the idea that the BoC is to keep rates on hold for now and the US economic growth expected in 2017 should spill over to Canada too. Yesterday’s Canadian trade balance was strong on the headline number -1.13b (-1.7b exp.) but was mainly driven by a contraction in imports. Non-commodity export volumes fell by 1.5% and, while this is not great for an economy that is trying to deal with a terms of trade shock and like Norway is also seeing a bit of a fiscal support, the data aren’t sufficiently bad to make the BoC take action to cut rates. This is why we see CAD outperforming on the crosses, with potential for EUR/CAD to cross below its December 2015 low around 1.40. Today we think the BoC could note that there are downside risks to growth, but we think that this isn’t sufficient to make it want to look to cut rates next year. Oil prices need to be on their way back to the US$30s for that to occur. Oil prices remaining fairly well supported after the OPEC deal should also help CAD on the margin. This environment of a tactical pause in USD could see MXN recover too, towards the 20 level. Mexico’s deep water oil auctions went well, with eight out of ten blocks awarded, while very strong bids for bonds issued by state oil company Pemex highlight strong demand for Mexico paper.
We outlined yesterday that we expect a short-term pause in USD’s appreciation, meaning even USDJPY could see a setback towards the 112level. However, we are not participating in the setback and would only use it to add to short JPY positions. This morning the BoJ’s Iwata reiterated the bank’s stance to buy as many JGBs as required to keep the 10y close to 0%, in particular he thinks the bank will need a large scale of JGB purchases to control rates. The expansion of the BoJ’s balance sheet and the interest rate differential with the world should continue to weaken JPY over the medium term. What is now becoming a driver of the story is the development of local risk appetite. Favourable tax policies and an outperforming local equity market should push more investment into riskier assets. Those riskier assets may be outside the country, which would weaken JPY if done on an FX-unhedged basis.