USD has potential to rally further, helped by hawkish Fed commentary, rising US bond yields and, last but not least, investors adjusting their super-bearish USD book. The Fed’s Dudley said he is confident that the economic expansion has a long way to go and that a strong labour market will eventually trigger a rebound in inflation. Precious metals have turned lower, with a potential of developing a ‘double top’ formation, pushed lower by the recent rise in US real rates. Importantly, rising US real rates did not prevent risk appetite from staying supported, which we attribute to the new availability of capital.

There are two new sources of capital and liquidity which will keep risk assets supported for now. First, US banks now running solid balance sheets seem to benefit from potential deregulation imposed by the US Treasury. In order to enact its ambitious fiscal plans, the US administration needs the economy to accelerate from here urgently. Only with growth getting closer to 3% will its current budget plans have a chance of being viewed as credible by markets, in our view. The upcoming mid-term election in November 2018 adds to this urgency. Hence, the US administration has significant interest in boosting the economy with the help of better capital availability provided by the US financial sector.

USDJPY has reached levels near 111.80, trying to reenter its previous upward channel. The importance of last Friday’s BoJ statement for the valuation of JPY has not yet been fully priced in by markets. The BoJ suggesting that it stood by its JPY80trn QE target has not only dashed hopes that the central bank was in the middle of ‘stealth tapering’, it has also underlined that compared to the size of its current effective QE operation of JPY60trn, it seems ready to increase its Rinban operations by 25% should upward pressure on BoJ yields become undesirably strong. The BoJ’s intention is to keep real rates low, allowing local asset prices to stay supported and JPY to weaken.

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

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

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

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


Political risk remains a key driver for FX markets, with a mix of predictable and unpredictable drivers. While the upcoming French presidential election and the weekend’s Turkish referendum have featured on calendars for some months, risks such as those associated with US foreign policy or South African politics have not. The latest “out of the blue” event is Theresa May’s decision to call for a UK general election on June 8. The move has been well received by GBP, based on the thesis that the Conservatives are likely to win by a landslide and have a clear mandate to push through Brexit negotiations without too much inconvenient domestic opposition. Remember that the next parliament would run through to summer 2022, giving plenty of time to negotiate and implement Brexit outcomes. Assuming an easy Conservative win with a large majority is indeed the election outcome, which is not unreasonable based on the latest polls, presumably this would also allow PM May more degrees of freedom to negotiate a softer form of Brexit than the market currently feels is achievable. After all, a large majority won directly by PM May would leave her much less vulnerable to rebellions from hawkish factions than she is today, given she currently has only a slim and inherited majority now.

One factor that helped the market price a form of “hard Brexit” in Q4 2016 was PM May’s 2 Oct 2016 speech to the Conservative Party autumn conference, where she suggested a firm commitment to contentious policy aims such withdrawing the UK from the European Court of Justice and seeking full control over UK immigration policy – policies seen as totally at odds with core EU principles and single market membership. In this context, it’s worth noting that May had claimed till yesterday that she did not believe a new election was in the national interest, but now “reluctantly” has changed her mind.

The same PM May was also a “remain” supporter who presumably only “reluctantly” is driving Brexit through having triggered Article 50 last month, at least based on her original position. As such, there is also room presumably for PM May to again “reluctantly” decide that the pledges she made last autumn are no longer in the national interest if they would lead to a disruptive form of Brexit. Simply having to price in higher odds of this series of events going forward are GBP positive in our view, even beyond the possibility of stable government being more likely. Finally, it’s worth noting that the June election could also pose a tricky test for the Scottish National Party. After all, it will be hard for the SNP to better its 2015 general election showing when it took nearly every Scottish seat in the UK parliament. Anything that falls short of that in June would allow PM May to attack the legitimacy of new moves towards a fresh Scottish independence referendum as SNP leaders have pushed for, again helping GBP on the margin.
The steady outperformance of EM currencies since the US election suggests that markets have been very willing to discount expectations that the US administration will deliver on the protectionist promises made during the campaign. We have ourselves participated in this trend, as per our long Mexican peso position.

The US administration’s aggressive stance on trade has also been a reason behind our ongoing bearish stance on the Canadian dollar. Last week the Bank of Canada made a significant shift in a less dovish direction, moving the projected date at which the output gap will close from mid-2018 to earlier in the year.

For Asia FX, slowing global industrial growth momentum is likely to become a key theme. We judge this global IP momentum to already be slowing from about 5% 3m/3m to closer to trend growth of about 3%. Although this would be a modest slowing in IP momentum by historical standards, it nonetheless seems to be having a historically standard negative effect on risk appetite. Core yields have fallen, core equities have begun to struggle and our technical analysts argue for further downside.

The pace of credit growth to households and businesses in the Eurozone edged lower in February, data from the European Central Bank showed Monday. The broad money measure, M3, rose 4.7 percent year-over-year in February, slower than the 4.8 percent climb in January, missing expectations for a 4.9 percent rise. The Eurozone money supply growth eased for the second straight month in February.

Within M3, the annual growth rate of deposits placed by households stood at 5.4 percent in February, down from 5.5 percent in January. While, deposits placed by non-monetary financial corporations registered a decline of 2.0 percent.

The ECB has maintained an ultra-loose monetary policy with low interest rates and stimulus measures which have helped bolster credit growth in the Eurozone over the last two years. The narrower aggregate M1, which includes currency in circulation and overnight deposits, remained unchanged at 8.4 percent in February.

Details of the report showed that the annual growth rate of total credit to euro area residents decreased to 4.3 percent in February from 4.6 percent in the previous month. The yearly growth rate of credit to general government moderated to 9.8 from 10.5 percent.

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

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

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

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

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

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

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

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

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

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

Growth in Japan is holding up nicely and economic activity has gained momentum since 4Q16 with the pickup in the global capex and manufacturing cycle. Inflation has started to push back above the waterline. But as Governor Kuroda emphasized at a press conference last week, inflation expectations remain stuck, something highlighted by this year’s spring wage negotiation projected to produce only modest wage increases. With price pressures nailed to the floor, the Bank of Japan (BoJ) doesn’t seem to be in a hurry to raise rates.

“With our USD rates forecasts pushed upward, we now expect that the BoJ will taper its asset purchases at a somewhat slower pace than previously and that QE will end in H2 2019, instead of mid-2019. JGB rates unchanged,” said DNB markets in a research note to clients.

There is an ongoing debate whether the BoJ will have to raise its 10-year bond yield cap because of the lack of JGB liquidity. There seems to be still a split of views inside the BoJ on whether the Bank should or should not raise the 10-year yield target when the real interest rates decline further. The longer the BoJ keeps the 10-year yield target unchanged, the more rapidly it will have to adjust the target later.

Analysts expect the BoJ to maintain the current 10-year yield target through year-end, but if it sees greater yen weakness, it would adjust the target in 2H17. BoJ will have to strengthen communication strategy with forward guidance on its yield curve control (YCC) policy to manage market expectations. It would probably provide the conditions under which the BoJ would raise the 10-year yield target.

“While we expect the BoJ to introduce forward guidance on its yield curve control (YCC) policy relatively soon, we think it would do so in July at the earliest, when the BoJ reviews its economic outlook and discusses its monetary policy stance in the Outlook Report. If it may take time to build a consensus among the board members on this issue, delaying its introduction until October,” said J.P. Morgan in a report.

USD/JPY trades below 100-day moving average. The pair is tracking DXY lower, amid holiday-thinned markets (Japan closed for Vernal Equinox Day) and lack of fresh fundamental drivers. Technical studies are bearish, RSI and stochs are biased lower and MACD has shown a bearish crossover on signal line. 112 levels in sight, violation there could see test of 111.60 and then 111 levels.

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

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

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

The Political establishment in Washington went into a frenzy last year after then-candidate Donald Trump said that he wants to restore relations with the Russians. Every time, Mr. Trump refused to criticize either Russia or Russian President Vladimir Putin, the established anti-Russia establishment in Capitol Hill went after him and that includes several media outlets like CNN, which colluded with the Clinton campaign during the election and more. The skepticism with Russia runs so deep in Capitol Hill and within the establishment that President Trump is considered by many as a Russian spy and they are still looking to prove connections between Trump and Putin.

A recent incident in Capitol Hill proves how deep the hatred runs. Senator John McCain of the Republican Party presented a proposal that envisions bringing Montenegro, a small Balkan country within the umbrella of North Atlantic Treaty Organization and that proposal was rejected by another Republican senator Rand Paul, who did not want to make additional military commitments when the US debt is already at $20 trillion. Russia allegedly took part in a failed coup during last year’s Montenegro election. Mr. Rand Paul’s refusal triggered a furor in Senator McCain, a well-known Russia hawk, who accused Mr. Paul of working with or for the Russian President Vladimir Putin.

Russia-US-Montenegro are part of global geopolitics and there is also nothing wrong being a Russia-hawk but when one accuses a colleague of working for Russia, then probably it’s not just hawkish; it’s a phobia, Russia-phobia.

The real question is, can President Trump overcome these phobics and reconcile with Russia?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

President Donald Trump’s Treasury Secretary Steven Munchin has warned the both houses of congress in an open letter of the looming debt ceiling, which is expected to get hit on March 15th. The image of the letter is attached. In the letter he said that the suspension of the statutory debt limit which was done via a bipartisan budget act of 2015 will expire on March 15th of this year and from March 16th, the outstanding debt of the United States will be at the statutory limit. He warns that after that treasury will have to take up extraordinary measures to temporarily avoid defaults on obligations. He adds that after March 15th, it would halt sales of state and local government series (SLGS) and the suspension would continue until the debt limit is either increased or suspended.

Lastly, he encourages the congress to raise the limit at the earliest. President Trump has been critical of debt-ceiling increases in the past. In 2013, he had tweeted the followings,

“I cannot believe the Republicans are extending the debt ceiling—I am a Republican & I am embarrassed! Republicans are always worried about their general approval. With proposing to ‘ignore the debt ceiling’ they are ignoring their base.”

However, this time around, he is likely to support an increase.

Speaking with the BBC, Scottish first minister Nicola Sturgeon said that she has not decided whether to push for another independence referendum but insisted that she is not bluffing with her demands to the UK government for special concessions for Scotland. Previously she had said that she has cast iron mandate as her party was overwhelming elected in the regional election and because in the last referendum it was publicized that only by remaining in the UK, Scotland would have access to the EU single market. Her government brought a litigation saying that the parliament in Scotland should have voting power over Article 50, which was denied by the highest court. She has repeatedly accused Prime Minister Theresa May’s government of overlooking her demands.

While she kept her Scoxit referendum date thinly veiled she seemed to be agreeing on the time suggested by her predecessor Alex Salmond, who resigned after losing the first referendum. The time suggested by him is autumn 2018. According to Ms. Sturgeon, the time suggested makes sense as the major outline of the Brexit deal would be clear by then.

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

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

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

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

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

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

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

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

Doves – Neel Kashkari.

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

Unknown – Jerome Powell

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

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

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

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

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

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

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

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

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.

h2>US: Dudley, Williams talk up prospects of March hike

After looking quite foolish for much of this quarter, our forecast of a March Fed hike is now gathering greater momentum, and according to Fed funds futures and the Bloomberg implied rate probability function, markets are now pricing in around 80-85% probability of a March hike. Importantly, one of what we term the Fed “insiders”, the NY Fed President, William Dudley, said overnight that the case for tightening had become “a lot more compelling”, and that “the risks to the outlook are now starting to tilt to the upside” He was joined in sentiment by San Francisco Fed Chief, John Williams, who said that an interest rate increase would receive “serious consideration” at the next meeting. We might quibble over the exact numbers delivered by Bloomberg, but whatever the actual number, a March hike would no longer be a market surprise – about the only credible excuse left to the Fed to delay hiking on March 15. Whilst this looks very comforting for our long-held outlier house view (which we expect to be joined by the consensus of forecasters over coming days), there are still a few more hurdles to cross before we can claim that this hike is “in the bag”. Firstly, the PCE date released on 1 March – should take PCE inflation to 2.0%, and eradicate the only target the Fed has not yet hit, given that rising wages signal that full employment was reached some time ago. And there is still a possibility of a disappointing Labour market report on 10 March – though we are actually expecting this to another good release, especially on the wages front, where we see scope for a strong upside surprise.

The bearish flattening seen in the US yield curve and the move in two year USD swap rates to new highs has pushed US-Germany two year spreads towards levels not seen since the late 1990s. It is surprising that EUR/USD is not a lot lower. Severe under-valuation is probably playing a role here, as is the fact that Trump has Germany’s large trade surplus in his sights. For today, we’ll see German Feb CPI, seen rising to 2.1% YoY from 1.9% – providing clues on EZ CPI tomorrow. On balance, Trump’s plans, yield spreads & EZ politics suggests EUR/USD stays pressured and 1.0500/0520 comes under heavy pressure again.

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.

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

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

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

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

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

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

Chair Yellen and Rate Outook for the USD

Chair Yellen may opt to play it cool at today’s semi-annual testimony to the Senate (1500 GMT), but with markets pricing in just a 30-35% chance of a March rate hike, we see limited downside risks to the dollar if the status quo is retained. The Fed chief may alternatively look to nudge expectations up to 50:50 in a bid to keep the option of a March hike on the table. Here’s our take on the hot topics: ? Prospects of a March hike: She is most likely to keep her options open, reiterating that all meetings are “live” and decisions are “data-dependent”.

Working down the Fed’s Balance Sheet: The Fed has said that it would consider stopping reinvestment of maturing assets when tightening is “well underway”. ? Trump and Fiscal policy: This is still very uncertain. Her easiest dodge would be to say that it is impossible to judge how the Fed would react without knowing the finer details, though Republicans may push back by saying this could be known in “2-3 weeks”. She could state that productivity-enhancing policies are better for the US.

Policy rules (eg, Taylor Rule): Favoured by some Republicans, but she’ll probably reference her latest speech which noted issues in estimating policy rule inputs.

Financial regulation – in particular Dodd-Frank: She typically says that Dodd Frank helped strengthen the financial system and should not be rolled back. She could repeat her sympathy with the notion that it is too onerous for smaller banks.

Foreign dumping of Treasuries: This is an old favourite and senators like to cite large overseas holdings of US Treasuries as a risk. Yellen will aim to stay apolitical.

Daily FX Outlook, USD, EUR, GBP and HUF

USD: Yellen testimony provides asymmetric risks into USD favour The key event of the day is Chair Yellen’s semi-annual testimony to the Senate. With the market pricing rather a benign probability of March rate hike (30-35%), risks are asymmetric into USD favour. If the status quo is retained and no hints at higher probability of March rate hike are presented, USD downside should limited. On the other hand, if Yellen chooses to look to nudge expectations up to 50:50 to keep the option of a March hike on the table, the upside to USD should be more pronounced due in part to the less overcrowded USD positioning. See Will Yellen keep March alive? DXY 100.08 support (100-day MA) to hold, while the break of the 101.44 resistance (50-day MA) at risk.

EUR: Limited impact of EZ data on EUR; Yellen a bigger driver Our economists expect Eurozone industrial production to have come down substantially in December, given weak German numbers (due to the cold Christmas weather related issues). While not EUR positive, its effect on the currency should be rather marginal. EUR/USD to be largely driven by the Yellen testimony, which poses downside risks to the cross (towards the 1.0500 level).

GBP: Sterling gains from higher UK CPI to be short-lived UK Jan Inflation looks set to hit 2%YoY today (vs 1.9% consensus) as the effect of sterling’s post-Brexit collapse continues to feed through to prices. This is particularly evident in food and fuel prices, which are being lifted by surging input price inflation. While this may provide short-term support to GBP today (to the extent to which it translates into market expectations of higher probability of BoE rate hike – following the change in the BoE bias from dovish to neutral and the introduction of the two-way risk to policy rates), we would fade any move in EUR/GBP lower / GBP/USD higher as the UK activity data later this week (softer employment report and retail sales) should weigh on GBP.

HUF: High Hungarian CPI to create false hopes for tighter monetary policy Our economists look for a meaningfully above consensus Jan CPI (2.5% YoY vs 2.1%). Not only will base effects from higher oil prices kick in significantly, but the market is likely overestimating the degree to which the recent VAT tax cuts weigh on prices (as pass through is unlikely to be 100% and usually takes three months to feed in). We expect the higher CPI to be HUF positive due to false market hopes that high inflation will cause the NBH to move closer to policy normalisation/tightening. As per yesterday’s NBH’s FX swap tender (ie, an example of an ongoing unconventional easing), we don’t think this will be the case and the NBH will retain a dovish bias in coming months. EUR/HUF to break below 308.00 level today and PLN/HUF to converge towards the 71.00 level.

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.

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

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

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

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

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

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

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.

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.”

European Fixed Income Markets

Risk assets and EGB spreads decouple. Equity markets hit fresh highs this week, while the iTraxx Senior Financial index touched a 5-month low. In this context, safe havens underperformed, with 10yr Bund yields rising to the highest level in 12 months (i.e. 0.50%).

The risk-on mood, however, did not extend to EGB spreads, which have remained under widening pressure (new issue concessions notwithstanding). This is not just political risk premia creeping into markets such as France (where underperformance versus Germany is now also showing up in equities), or Italy (where the Court ruling has paved the way for possible snap elections in late Q2/Q3). Also Irish and Belgian spreads over Bunds have remained on a widening trajectory, suggesting that ECB tapering fears may also be in play.

That said, 10yr Bono/Bund spreads have continued to buck the widening trend (Figure 1), and accordingly 10yr SPGBs now look more than 30bp overvalued on a RV basis according to our fair value model. We suspect that at some point, either risk assets will struggle to make new highs or EGB spreads will start to re-tighten. We deem the former slightly more likely, although we do see value in EGBs which are less exposed to political risk (for example Ireland). Alternatively, we would suggest to go long Ireland versus Austria.

In money markets, meanwhile, we find the 1-month Eonia forward for mid-2018 having risen further, to 8bp above the current fixing – even more at odds with the ECB’s forward guidance that policy rates won’t go up until “well after the horizon of the net asset purchases”. EGB supply to remain above €20bn (Figure 20). On Monday, the Tesoro will launch a new 10yr BTPS (€3.5-4bn) as well re-open the BTPS 0.35 11/21 and CCTS 2/24. The new 10yr is trading 2-3bp cheap on the low-coupon curve in the grey market, and as highlighted above, has lost significant ground versus Spain, which should support demand at the auction. The CCTs 2/24 trades a tad rich relative to the low-coupon BTP curve, but at a juicy 19bp pick-up to the adjacent CCTS 7/23. Elsewhere, Germany will issue a new 5yr OBL, while markets are still awaiting a syndicated deal from Finland (10yr or 30yr). For a complete overview of next week’s supply and rating reviews please see pages 5 and 6.

Energy

• 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.

Metals

• 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.

Agriculture

• 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 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.

Russian Oil Revenues, Budget Outlook and USDRUB levels

Inflation in the week to 16 January slowed to 0.1% wow, from 0.3% wow in the first nine days of January. On our estimates, headline inflation was 5.3% yoy as of 16 January, down from 5.4% yoy in the previous week. We expect headline inflation to drop to 5.1%-5.2% yoy in January. In its meeting last Monday (16 January), the government decided not to spend windfall oil and gas revenues. According to Finance Minister Siluanov (who revealed this news yesterday), the government made a decision to save extra oil and gas revenues from higher oil prices, instead of spending it. According to the government estimates, the government will receive additional RUB 1tn (1.1% of GDP) with the average Urals oil price at $50/bbl, or RUB 1.4tn (1.6% of GDP) with the average Urals oil price at $55/bbl. (In the federal budget law, the government assumes average Urals oil price at $40/bbl in 2017- 2019.)

The decision to save windfall oil and gas prices is favorable for the prospects of the policy rate cut by the central bank (CBR) and for sovereign credit (as Russia would not use its declining fiscal reserves for financing the deficit). Although the government is unlikely to reduce net OFZ issuance in the local market (according to the law the government will increase net issuance to 1.2% of GDP in 2017 from 0.5% of GDP in 2016), the CBR’s more accommodative policy will support demand for OFZ from local investors. In our view, the decision should be taken positively by fixed income investors. Another near-term implication of this news is that the market should price in a policy rate cut as early as in the next rate-setting meeting (on 3 February).

We are not saying that the CBR will cut the policy rate at that meeting but the likelihood of such an outcome has increased to around 25%, in our view. We are still expecting the first policy rate cut in the second meeting of 2017 (on 24 March). The CBR may consider regular FX purchases for the replenishment of Russia’s FX reserves, if the scenario with higher oil prices materializes. Such FX policy will be coordinated with the Finance Ministry, in the absence of a fiscal rule. Although this news (revealed yesterday) is in line with our expectations, it does not provide us with any new information about the conditions under which the CBR will resume regular FX purchases. However, we reiterate our view on that issue.

We expect the CBR to resume FX interventions (to buy FX) in 1Q 2017, as it did in 2015, when the rouble strengthened beyond 50 against the dollar. Our view is based on the idea that, in real effective exchange rate terms, the rouble is trading as strong as in 2015. In 2015, the CBR held volume-based intervention in the amount of $200mn a day (for more than two months) and purchased roughly $10bn in the local FX market. In our view, both, the CBR and the government are quite sensitive to potential further strengthening of the rouble (especially in real effective exchange rate terms). In our view, the CBR will be reluctant to allow the rouble to strengthen beyond 57-58 against the dollar.

Hungary Central Bank

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

USD 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.

2017 Start, Trump, G10 and Emerging Markets

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

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

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

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

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

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.

 

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

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

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

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

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

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

 

 

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.