While President Trump did say that he would nominate a new Fed Chair around mid-October, it looks like the search is nowhere near being concluded – with White House Chief of Staff John Kelly last week noting that interviews are still in the ‘first round’ stage, while Treasury Secretary Mnuchin hopes that a nomination will be made within the next month.
We strongly believe that it is way too early to make any sweeping assumptions about what particular nominees would mean for the future of Fed policy. Yet, we are wary that markets are likely to react to President Trump’s nomination based on their current preconceived ideas. And while perceptions and reality may be two different things, our scenario analysis table below aims to provide a snapshot of what we expect to happen in markets if one of the leading Fed Chair candidates were to be nominated in the coming weeks.

Given that uncertainty over the next Fed Chair is likely to be weighing on short-term rates – not least because it currently makes any US monetary policy call largely invalid beyond Feb-2018 – the nomination of a new Chair would be USD positive. But most of the candidates would not be game-changing for our strategically bearish USD view and we would be inclined to fade any post-announcement moves.

In fact, we think only John Taylor – renowned economist and pioneer of a rules-based monetary policy framework – would pose serious risks to the current ‘goldilocks’ market environment. But again, the reality may not be what it seems on paper; even Mr. Taylor knows that for his more radical rules-based policy proposal to work, it requires international coordination to the likes not seen since Bretton Woods. The likelihood of this happening is trivially low.
Elsewhere, we do see the next few weeks as a window of opportunity for the EUR. It’s somewhat disappointing not to see the EUR higher on the latest ECB ‘sources’ floating the idea of a cut in monthly asset purchases to EUR 30bn from January 2018. However, expect more of these ‘sources’ and ‘leaks’ to sporadically appear in the build-up to the 26 OctoberECB meeting – and it’s hard not to see Eurozone yields and the EUR moving higher on any relatively aggressive QE taper speculation.
Discounting the hurricane-related distortions to headline CPI and retail sales, the softer 0.1% MoM change in core CPI has dented any trivial US inflation optimism. The fallout may be limited given the lack of inflation premia priced into markets, though the lack of any upside risks to the long-run US economic outlook reaffirms the idea of structurally low bond yields for longer. Such an environment supports our strategically bearish USD view. Fed speakers this are unlikely to rock the boat – especially as the Sep minutes suggest that confusion seems to reign within the committee.

The Austrian elections over the weekend should have a limited impact on the EUR. Reality is that the currency will shift its focus to 26 Oct ECB meeting over the coming weeks and any talk from ECB speakers that errs on the more hawkish side should keep the currency bid. We feel the announcement of a ‘lower for longer’ QE taper schedule would drive Bund yields circa 10bps higher, with a one-time move up in EUR crosses. Eurozone data wise, we have the final release of Sep CPI and the German ZEW survey (both Tue), as well as balance of payments data (Fri).

After a few weeks of highly charged political focus, we expect the narrative for GBP to slowly shift towards the November ‘Super Thursday’ BoE meeting. This week’s UK data releases – including the CPI report (Tue), job market report (Wed) and retail sales (Thu) – are unlikely to derail sentiment for a 25bp Bank rate increase next month. While that’s all but in the price of the pound, we prefer to focus on how robust underlying UK inflationary pressures are – and whether any upside surprises prompt the Bank to signal the start of a ‘more than a withdrawal of stimulus’ hiking cycle next month. On that note, Governor Carney testifies to UK lawmakers this week (Tue) – along with new MPC members Ramsden and Tenreyro. Any hawkish signals could steepen the UK rate curve and we think GBP/USD at 1.35 is a strong possibility around the Nov BoE meeting.
Lacklustre US inflation dynamics should see the benign bond market environment persist and the high-yielding AUD and NZD recover some recently lost ground. In Canada, there’s key inflation and retail sales data to keep an eye on before an important Bank of Canda meeting later this month.

It’s a fairly eventful week in the domestic calendar with the September labour market report (Thu) in the spotlight; market consensus is looking for a slowdown in the pace of monthly job gains (+15k), although this will still be seen as signs of a tighter labour market. Some good data needed for the AUD after the disappointing retail sales figures earlier this month.

We’ll also get the October RBA meeting minutes (Tue) – as well as a couple of central bank speakers in Ellis (Tue) and Bullock (Wed). AUD moved lower after the RBA’s Harper recently failed to rule out a rate cut, though we think markets may have overreacted to this. Expect AUD/USD to remain anchored around the 0.80 level in 4Q17 amid the lack of any major directional catalysts.

Canadian CPI and retail sales data (both Fri) will dominate the focus for CAD markets this week – especially ahead of the 25 Oct BoC meeting. Policymakers have been gradually shifting to a more cautious stance over further rate hikes amid concerns that markets may have moved too far too fast for their liking. In the absence of any big positive inflation surprise (consensus is looking for core common CPI at 1.5% YoY), we would expect a pause in the tightening cycle for the remainder of the year.

Watch out for the 3Q BoC Business Outlook Survey this week (Mon) and in particular whether local firms see recent CAD strength as weighing on competitiveness. Manufacturing sales data (Wed) may show some preliminary evidence of this. Equally, ramped up NAFTA uncertainties could keep the BoC in wait-and-see mode for the time being. We expect CAD to remain on the back foot given the more contentious US trade stance, with a move to 1.27 not off the cards if further tariffs on Canadian firms are issued.


New Zealand’s 10-year bond yields rose 2.3bp to 2.83% overnight as the RBNZ signalled it would allow the economy to run hot before starting to reduce monetary accommodation in earnest. Similar to previous Fed communication, it indicated the ‘need for stronger capacity pressure than might otherwise be necessary to generate a given level of inflation’, prompting a fall in real interest rates weakening NZD. The rate projection continued to show the OCR would remain unchanged until mid-2019, in contrast to market pricing for the first hike by around August next year. RBNZ’s Wheeler and Mc Dermott have tried to be as explicit as possible that they don’t like the NZD trading as strong as today. Firstly their NZD forecast is lower than today. Secondly, they referred to the traffic light system of deciding when to intervene in FX markets, as an indication they are thinking about it. Finally McDermott stated specifically that the NZ dollar needs to adjust down. Long positioning in the NZD is at risk. Anyhow, the uncertain outcome of the upcoming General Election, signs of its housing market slowing down from overvalued levels and the upcoming leadership transition within the RBNZ should keep the NZD on the back foot, which should be best expressed by long AUDNZD.

The RMB is trading at the strongest level since mid-March, based on the CFETS basket. High real yields, a stable currency and a resilient economy seem to be transforming China into a local safe haven destination with continued tensions in Korea working as an additional catalyst for RMB strength. RMB strength has FX implications going beyond directly impacted currency pairs. The 10-year US – China yield differential has reached 141bp,not far off the 149bp reached in June. This not only keeps domestic funds within China, thus reducing the capital outflow risk; it may also attract foreign capital too. China’s FX reserves have started to rise again. Rising FX reserves suggest that there is an excess of hard currency to be recycled back into DM bond markets, keeping bond yields lower than otherwise suggested. In addition, some of the reserves may be reallocated away from USD, keeping the USD internationally offered. The second Exhibit shows the relationship between the DXY and USDCNH, suggesting China’s RMB push higher should especially keep EURUSD supported as the EUR acts as the alternative reserve currency to the USD.

Yesterday, we warned about risk turning tactically offered as investors de-risk their portfolios in light of the increasing Korea-related tail risk. Price action confirms that this move is about position squaring and not about the reassessment of the global economic outlook. Corrective activity occurred in places where positioning is extreme, while other market segments with low positioning have not joined the risk downside correction. Concretely, industrial metal prices continued to rally which looks even more impressive in the context of China’s recent tightening of its monetary conditions. The industrial metals rally supports the view of a strongly expanding global economy subsequently leading to reflation. Consequently, we view the current risk setback as providing a buying opportunity.

The result of today’s No Confidence ballot in the South African parliament was 177 votes in favour of the motion, some 24 votes short of the number required to end Jacob Zuma’s eight-year term as South Africa’s President. Understandably the Rand has given back yesterday’s gains – seen when the Speaker announced the ballot would be secret – and perhaps encouraging thoughts of defections from some of the ANC’s 249 members of the 400 seat parliament.
The failure of the No Confidence motion (assuming no more such motions are forthcoming) would leave Zuma in office as President until May 2019. The political focus will then shift to the 54th ANC Congress taking place 16-20 December – where a new leader of the ANC, and Zuma’s likely successor as President, will be chosen.
Here, the two front-runners are: (i) Cyril Ramaphosa, the current Deputy President and Zuma critic, seen as a market-friendly outcome and (ii) Nkosazana Dlamini-Zuma, Jacob’s former wife and favoured by the current President as a continuity candidate.

While we think USD/ZAR should be trading near 12.00 based on long-term fair value and the currently benign external conditions, we suspect Zuma’s survival today will maintain a political risk premium in the ZAR. This was most manifest when Zuma fired his respected Finance Minister, Pravin Gordhan, in March, prompting ratings agency downgrades on governance concerns.
Here we remain concerned that South Africa’s local currency debt remains one notch above junk at the key ratings agencies of Moody’s and S&P. A shift to junk status for the local currency ratings from both agencies would take South African government bonds out of key international benchmarks such as the WGBI and Barclays Global Aggregate, prompting ZAR outflows as much as 2.5% of GDP (around US$8bn), according to the IMF.
We therefore suspect that as long as the market and ratings agencies have governance concerns, and the prospect of the ANC leadership (and Presidency) being handed to his ex-wife remains a possible outcome, USD/ZAR is more likely to trade in a 13.00/13.50 range rather than heading down to fair value closer to 12.00.


Global Yields, Asian Currencies, USD weakness vs JPY weakness
Yesterday saw one of the rare occasions when European 10- year real yield fell faster than nominal yields. Data wise, there was little to explain this move as data globally have stayed strong. US Senator Lindsey Graham not ruling out the US going to war with North Korea had little impact on Asian currencies and, with investors happy to buy risk-related higher yielding assets, we instead attribute current market behaviour to strong liquidity conditions and Secretary of State Tillerson’s more conciliatory tone towards North Korea. US banks deploying their balance sheets to reach for higher yields, plus the US Treasury reducing its cash balance ahead of reaching the debt ceiling in September, have pumped additional funds into the system, keeping risk assets supported. After a meeting with Minority Leader Schumer and Treasury Sec Mnuchin, Senate Majority Leader McConnell said there will be a vote on the debt ceiling ‘next month or so’ suggesting that the US should ‘never ever’ default on its debt. USD cross-currency basis spread arbitrage seems to be working again, converting onshore USDs into offshore USD liquidity, which we view as an important condition for keeping the risk rally alive.

The US auto cycle seems running tired with yesterday’s car sales data (moderately) disappointing again. Consequently, the Dow Jones transportation index – a bellwether of the equity market – has fallen 6.4% from its June top. However, a similar signal emerged in March and did not prevent the equity market from continuing to work higher. This is because European and US equity markets continue to be supported by strong earnings releases. Yesterday’s sharp 3.5% fall in oil prices tells a similar story. API inventories released overnight showed a surprise 1.8m barrel rise in US crude inventories, and OPEC output was reported to have risen in July, according to Bloomberg and Reuters surveys. The commodity market seems split between those commodities facing inventory and overcapacities (such as energy) and other industrial raw materials (such as copper and iron ore) where recent growth in demand have led to higher prices. For risk markets to turn lower we need inflation to pick up, which we only expect late this year going into 2018. Yesterday’s core PCE release coming in at 1.5%Y is consistent with the risk rally extending further from here.

With real DM yields falling rapidly, narrowing interest rate differentials, one would expect the JPY to continue its recent rally. Instead, the JPY has weakened overnight with EURJPY trying to break above its 200-week MAV. EURJPY is one of the currency pairs most sensitive to trends, rarely spending too much time within a corrective pattern. Over the past 10 years EURJPY has crossed its 200-week MAV only three times; all occasions were followed by significant moves. Important to the future path of the JPY will be the policy stance of the BoJ. Some market participants view the JPY as the next EUR with respect to the BoJ changing its stance in light of economic recovery. We disagree with this view. Overnight it was the BoJ’s Funo suggesting the BoJ must maintain its aggressive monetary easing stance to achieve stable 2% inflation, which would create room for lowering real borrowing costs when the economy slumps. USDJPY has formed a tradable bottom and is expected to rally from here.


Global FX, US Inflation Expectations, Real Yields and EMFX
US inflation indicators coming in on the soft side of market expectations suggest risk appetite should stay solid. This morning saw raw material prices breaking higher once again despite the release of slightly weaker Chinese PMIs (July non-manufacturing PMI declined to 54.5 from 54.9, manufacturing PMI fell to 51.4 from 51.7), continuing the bullish trend which started in June, with iron ore prices 38% higher. Asian materials producers have rallied overnight. Some indicators suggest that market participants are not relentlessly bullish: NASDAQ has weakened over the past several days; weekly Fed data suggest primary dealers increased their bill holdings to their highest level since 2014;and foreign investors reduced their holdings in the Korean stock market at the fastest pace since August 2015. It is this ‘wall of worries’ which should keep the bull trend intact. In order to reverse our bullish interpretation, we need to see higher US inflation rates, the Fed signaling a significant increase in its pace of withdrawing monetary accommodation, or US real rates rising with the help of stronger data releases, notably higher capital expenditures. These seem unlikely without a calmer US political environment.

Conditions for a risk reassessment are not yet in place. US real rates have declined over the course of the past week, eeping the USD on the back foot and allowing for a higher valuation of risky assets. It seems that overseas Treasury demand has contributed to keeping US nominal and real yields lower, supporting our thesis of viewing the current macro landscape through the lens of the 2004-2006 cycle. During this period it was US nominal funding costs staying below the anticipated nominal return of investment which led to a leverage boom. Consequently, foreign central bank holdings of US debt at the Fed have jumped to USD3.33tn, the most since 2015. The portion of the Treasury market held by foreign investors is climbing in 2017 after dropping last year.

Reserve managers increasing their foreign asset holdings suggests to us that there is too much hard currency in circulation, which we view as a late cycle effect of DM central banks increasing the size of their balance sheets via QE operations. Initially, QE increased onshore liquidity with DM central banks expanding their balance sheets, but funds remained largely onshore. This created an environment of USD shortage abroad, reflected in the widening of the cross currency basis. It is the new strength of the financial sector now driving offshore USD liquidity conditions. Banks and other investors are arbitraging onshore – offshore spreads, in turn reducing the offshore USD scarcity. The rise in offshore USDs increases reserves. Official institutions invest these reserves into US Treasuries, pushing US bond yields down, reducing the relative attractiveness of USD holdings for private funds, in turn boosting EM inflows and pushing EM FX reserves even higher.

However, the relative decline of US nominal and real yields can only partly explain USD weakness witnessed since the start of the year. Indeed, the USD trades at a politically derived discount as investors have priced out the probability of reforms increasing the growth potential of the US economy. Worse, reform uncertainty has held back investment, suggesting the return of a reliable policy approach could have a significant effect in pushing the US economy towards better growth.


Global FX, USD, FED and China
Ahead of tomorrow’s Fed meeting, markets are staying within tight ranges as tactical versus structural forces maintain balance. Tactically, investors fear the Fed emphasizing the gradual but continued tightening path projected by its dots, which, for a market that is heavily underpricing, the Fed could be a major headache. Structurally, excessive liquidity conditions will stay in place even if the Fed delivers according to its projections. The prospect of US financial sector deregulation has added a new source of capital availability, allowing capital costs to diverge significantly from nominal GDP expansion rates not only in the US, but also globally. Indeed, the testimony of Randy Quarles, who has been tapped by President Trump to serve as Vice Chair of Supervision, on Thursday is likely to support this effort and will have the means to do so. Spreads have stayed tight against warnings that credit spreads should widen when approaching a late cycle. The continued tight spread reading suggests either the market does not believe in the late cycle mantra or that investors, blessed with liquidity looking for yield pickups, are willing to ignore late cycle related credit risks. Regardless of driver, the message remains a risk positive one pushing financial conditions towards new highs.

The Fed may lean against a further valuation acceleration of risky assets. Given FX market positioning, there could be a significant short-term USD supportive impulse created by the outcome of the Fed meeting should its communication signal an earlier-than-expected balance sheet normalization or a faster-than-expected rate path. However, the USD is unlikely to return to its previous long-term bull trend. Indeed, the combination of US growth not accelerating meaningfully from its recent 2% path and financial sector deregulation has created a textbook environment for USD weakness. For the USD to rally lastingly, the US has to shift its growth potential closer towards 3%, which would require critical structural reforms. Fed policy changes may impact the USD tactically, but structurally it is the amount of USD made available for international use driving the USD.
Often we hear investors talking about China’s weakening credit impulse dampening demand for commodities via slowing Chinese economic growth. According to China News, the 25-member group of the Politburo stressed that the government would further regulate “financial chaos”, curb the increase of illegal debt raised by local governments, and stabilize the real estate market. The “barbaric” growth of the Public-Private Partnership projects will be controlled through better management of local government debt, the committee suggested. It seems China is heading towards a period of monetary tightness which does not bode well for the credit impulse. North Korea-related tensions have come back onto the agenda too, with the WSJ reporting that China is preparing for tensions with North Korea.

However, CNY swap rates and bond yields have eased since May. Interestingly, despite the PBoC ‘s tightness, China’s economic growth rate has accelerated over recent quarters. Here too the availability of capital plays in. When China faced strong capital outflows in 2015/16 it was its weakening asset base driving domestic monetary conditions tighter. The now-sealed capital account has stabilised domestic capital supply, allowing CNY spreads to tighten, bond yields to come down, and local equities to rally. This morning China’s Security Journal wrote that the liquidity situation is expected to improve further in the near term as the PBoC is showing a clear bias toward maintaining liquidity stability while positive changes in capital flows are providing additional support. All in, China’s liquidity and capital position is not overly tight.


Emerging Markets, US Yields, Yellen and the ECB
Currencies and asset prices in the EM world have responded strongly and favorably during the past ten days to dovish Fed signals, sharply declining UST yields, and a string of predominantly helpful data releases out of the US and China. The ECB president, Mario Draghi, will have an opportunity to put an end to the party at his press briefing tomorrow, but we do not think he will. If anything, he may be slightly inclined to help halt the euro rally by conveying a dovish message, though we think he is more likely to be neutral. With uncannily poor timing we warned on these pages a week ago (12 July) of possible negative consequences for EM investors of the Fed’s and the ECB’s pending tightening of their balance sheet policies; but a few hours later those concerns were moved to the sidelines by the Fed Chair, Janet Yellen, as she offered Congress and the market new and soothing commentary on the recent low US inflation numbers. Her wording persuaded the broad investor community (and us) that she and her FOMC colleagues feel only halfheartedly committed to their plans for monetary policy tightening.

EM investors responded with enthusiasm. Yellen’s testimony set off a fall in yields on US Treasuries, depreciation of the dollar against most other currencies, and a bounce in the dollar price for EM assets across most of the world. Yesterday’s decision by Republicans in the US Senate to abandon their health care reform plans has further fueled the down move in US yields and the dollar. We still think investors will eventually switch their focus back towards concerns about the ECB’s and the Fed’s pending balance sheet reduction, but this month’s muted inflation data, Yellen’s soothing choice of words, the dwindling chances of US tax reform, and ECB President Draghi’s likely reluctance to push up bund yields (and the euro) at his press briefing tomorrow will probably ensure that investor concerns about potential eventual global monetary policy tightening stay on the sidelines for at least another couple of weeks, as the market waits for the release of further US inflation data that may (or may not) upset the apple cart.

In Yellen’s testimony on 12 July she used the word “partly” to describe the contribution to low US inflation that reflects one-off declines in certain price categories. Four weeks earlier she had used to word “significantly” in the same context. Though the distinction between the two words is subtle, the change of wording is likely to reflect a wish on the part of Yellen to send a signal to the market. In the prepared text for her Congressional testimony, Yellen used text that she had previously published. Text from her last FOMC press briefing was copied wordby-word, except for the replacement of “significantly” by “partly”. The switch of words suggests an increase in her doubt about the likelihood that inflation will really bounce back. US Treasuries rallied strongly in response to the word-switch.

A few days earlier, a batch of US labor market data had conveyed a picture of still-muted wage growth alongside still-strong employment growth. On Friday 7 July, when the data were released, UST yields initially rose by a couple of basis points as investors responded with greater force to the strength of the employment figures than to the muted nature of the wage numbers. However, yields began to drop slowly the following Monday and continued to do so Tuesday as investors swung their focus in the direction of the soft wage data. Thus, bond investors were already primed to question Yellen’s confidence in the prospect of an inflation bounce when she initiated her testimony to Congress. Once she delivered her dovish linguistic innovation (the switch from “significantly” to “partly”), UST yields dropped in earnest. By the end of Wednesday (12 July) ten-year yields were 7 bps lower than they had been by the end of the preceding Friday (7 July).

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.

UK consumer price inflation is getting closer to 3%, but slower growth and political uncertainty mean there is little chance of an interest rate rise. The pound’s collapse since last June’s EU referendum has seen import prices rise across the board, but it has been most felt in food and fuel costs. This has seen headline CPI rise to 2.7% YoY and we look for it to push higher again today. This is primarily due to higher utility bills (gas and electricity) with providers having announced significant price hikes in response to wholesale price moves. There are also tens of thousands of households impacted by fixed term deals coming to an end this month. These people will find themselves put automatically on higher price tariffs.

However, there is going to be some offset from a temporary drop in motor fuel prices (they have risen again in early June), but with an increasing number of retailers facing higher import costs as their currency hedges come to an end we suspect headline inflation will rise to 2.8% before hitting 3% in 4Q17. Tomorrow’s labour report is likely to show wages remain little changed so the squeeze on spending power looks set to intensify. Already, there are worrying signs for consumer spending with this week’s retail sales report likely to post a heavy decline after a bizarrely strong outcome last month. Indeed, Visa, the payment card provider, reported that according to its own internal data consumer spending is now falling when adjusted for inflation. The pain is likely to get worse before it gets better.

The outcome of the election is not helpful for the growth story either. The uncertainty that this generates is prompting a steep fall in business confidence. The Institute of Directors found that 57% of their members were either “quite” or “very” pessimistic about the UK economy over the coming year versus just 20% who described themselves as optimistic. Given the lack of positive news flow on the domestic economy and the political uncertainty the UK faces it is not surprising that financial markets are pricing in a less than 10% chance on an interest rate rise this year, with the probability of a rate rise by the end of 2018 put at just 33%. Given the lack of domestic price pressures (as highlighted by subdued wage growth) we don’t expect an interest rate hike before the official deadline for Brexit talks to conclude in 2019.

Treasury Secretary Mnuchin said that the US government has “backup plans” for funding itself if Congress doesn’t raise the debt limit before lawmakers leave for their August recess as hoped. When the US Treasury used accounting methods to bridge shortfalls ahead of the increase of the 2015 debt ceiling, US front-end rates fell to zero, but this happened within an environment of increasing global deflation concerns and China facing risks of substantial outflows threatening financial stability. Nowadays, global growth conditions are supportive as 2015 global economic headwinds have turned into powerful tailwinds for the US. The Treasury using accounting flexibility suggests it will issue less, which may ease US financial conditions further. There is no need for the Fed to reconsider the pace of its anticipated tightening path, it seems.

Ahead of Wednesday’s FOMC meeting, US financial conditions continue to improve, supported by the US House Republicans passing the vote to revamp the Dodd-Frank Act and repeal the Volcker Rule which restricted banks from making speculative investments with their own capital. This suggests freer investment in riskier assets as well as lower US funding costs. Hence, we pay little attention to the 1.8% decline of the NASDAQ on Friday, considering the resilience of the broader S&P 500 and limited spillover into Asian equity markets. A 25bp Fed Funds rate hike is 95% priced in, suggesting that all eyes will be on the statement in respect of the Fed’s judgement of the future economic outlook, and on the FOMC providing updates on their Policy Normalization Principles and Plans, including a set of gradually increasing caps, or limits, on the dollar amounts of Treasury and agency securities that would be allowed to run off each month, and only the amounts of securities repayments that exceeded the caps would be reinvested each month.

As USD sentiment hits the lowest level since May 2011 (only 5% of traders are bullish), we are now seeing the flows-related impact on the treasury market. Yesterday saw a very weak 1 year US government T-bill auction, where the bid to cover ratio, at 2.84, was the lowest since 2009. USDJPY may have rallied yesterday in response to longer end yields rising but we feel that for the USD to rally more broadly, you need to have the supporting capital inflows to the US. Lack of demand at a bond auction may naturally suggest less global USD asset demand. Recently, foreign investor participation in 10y bond auctions has fallen to 16% relative to a high of 28% in April. We see the USD weakening vs the EUR and tactically further vs NZD.

Political stability and increasing voices from core Eurozone countries to move towards a fiscal union have driven the EUR higher. The improved sentiment and growth outlook supports equity inflows. Helped further by Schauble and Merkel saying the EUR is too low for Germany, foreigners have been buying Eurozone equities on a currency unhedged basis (USD7bn since March via ETFs), in contrast with only a fraction with the FX hedge (USD0.9bn). In 2014, when inflows were with a currency hedge, stronger risk appetite drove EURUSD lower (the negative correlation). Today, stronger risk appetite should drive EURUSD higher (the positive correlation). We are already starting to see the EUR moving in line with positive economic data surprises (see Exhibit). Stronger growth means a stronger EUR.

But what about EUR bond flows? EURUSD is trading much higher than where the German-US 10y spread would suggest. Since August 2016, the correlation between the bond and FX market was close and using that relationship, the EUR should be trading close towards 1.10 (vs 1.1170 today). . The difference, we think, can be attributed to the equity inflows. Bond inflows may have not picked up as significantly due to the uncertainty that ECB tapering may bring for that market. We believe we need to see much higher yields before the equity inflow turns into a more sustained bond inflow. As of the last update of the balance of payments in March, Eurozone investors were still buying more foreign bonds than foreign investors were buying of theirs. Japan’s weekly security flow data is released overnight, where weakness in USDJPY would suggest Japanese had slowed bond purchases last week, but we don’t expect that to last.

As equity volatility has come down to close to its lows (VIX at 10.72),even China’s sovereign rating being downgraded by Moody’s to A1 from Aa3hasn’t dented risk appetite in the Asian market. China was put on negative watch in March 2016, therefore it is the timing of today’s announcement thathas come as a surprise. Moody’s cited an expectation that financial strength will erode somewhat over the coming years as debt increases and potential growth slows. AUDUSD has weakened 0.5% overnight, suggesting the technical uptrend is complete. We keep our bearish AUD bias driven more by domestic factors, such as the housing market. Construction activity fell by 0.7% in 1Q, leading to a 1Q GDP tracking estimate of -0.2% QoQ.

The market prices an 81% probability of a Fed rate hike in June, supported further by the Fed’s Harker saying that a June hike “is a distinct possibility”. The FOMC minutes will be watched to provide clues on the path for rates and how the committee views that tightening measure along with balance sheet reduction. Market expectations for the OPEC meeting tomorrow are for a 9-month extension to the production cut. Today US crude inventory data will be watched for NOK and CAD investors. The US budget proposed yesterday to sell 270 million barrels of oil from the Strategic Petroleum Reserve over the next decade.

The UK gilts traded flat Tuesday, showing modest gains, following the country’s lower-than-expected construction PMI released today. Also, investors are eyeing the February manufacturing production data, scheduled to be released on April 7 for further direction in the debt market.

The yield on the benchmark 10-year gilts, which moves inversely to its price, hovered around 1.05 percent, the super-long 30-year bond yields fell nearly 1 basis point to 1.64 percent while the yield on the short-term 2-year traded flat at 0.10 percent by 10:10 GMT.

The seasonally adjusted Markit/CIPS UK Construction Purchasing Managers’ Index (PMI) dropped from 52.5 in February to 52.2 in March, to signal the joint-slowest upturn in overall construction output since the current period of expansion began in September 2016.

“Survey respondents noted that the resilient economic backdrop and receding Brexit-related anxieties have helped to stabilize client demand after the disruption to development projects last summer,” said Tim Moore, Senior Economist, IHS Markit.

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.

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?

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

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

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

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

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.

The Japanese government bonds traded narrowly mixed Tuesday as investors await to watch the Bank of Japan’s (BoJ) 2-day monetary policy meeting, scheduled to be held on March 15-16, announcing its decision on Thursday.

The benchmark 10-year bond yield, which moves inversely to its price, hovered around 0.09 percent, the long-term 30-year bond yields also traded flat at 0.87 percent and the yield on the short-term 2-year note remained steady at -0.25 percent by 06:00 GMT.

The BoJ is expected to keep monetary policy steady on Thursday and stress that inflation is nowhere near levels that justify talk of withdrawing massive stimulus, as weak consumer spending casts a cloud over an otherwise healthy pick-up in the economy.

Further, at the two-day rate review that ends on Thursday, the central bank is expected to maintain its short-term interest rate target at minus 0.1 percent and a pledge to guide the 10-year government bond yield around zero percent via aggressive asset purchases. Analysts also expect the BoJ to keep intact a loose pledge to maintain the pace of its annual increase in Japanese government bond (JGBs), which is JPY80 trillion (USD696.62 billion).

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

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

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

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

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

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

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

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

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

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

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

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

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.

Commodity markets are taking centrestageas oil had its largest one day fall (- 4.5%) in 13 months. Oil net long positions from the CFTC have been overextended since the start of the year, but it was the combination of technicals and ever more inventory builds in the US that gave investors the signal to take profit. Within G10, CAD has been, and should continue to be, more sensitive than NOK because leveraged market positioning is still very long CAD. CADJPY is sitting on its 100DMA, with a move below 84.20 marking a technical break. AUDUSD is about to break below its 100DMA at 0.75,helped by iron ore prices falling 9% from their peak, keeping us bearish on this pair. AUDUSD has bounced off the top end of a trend channel, bringing the bottom end of the channel at 0.7080 into focus. Even with expectations of a neutral Norges Bank next week (or essentially less dovish than last time), we stick with our tactical long USDNOK trade of the week.

Oil inventory data from the EIA showed a rise of 8.2mb to 528.4m, which is the highest in the data series going back to 1982. US producers appear to be ramping up production quickly, helped by stronger margins from high oil prices and relatively low funding costs. According to Reuters, producers in the red-hot Permian Basin in Texas are expected to increase production soon. An observation from our oil desk highlights the extent of the extreme technicals. They say that there hasn’t been a time in the last 30 years when the weekly front end Brent contract has been in such a tight range, trading sideways for three months. The longer that went on for, the more positioning stresses built up, explaining the sharp drop yesterday. The next formal OPEC meeting isn’tuntil May 25.

The DXY is still under performingtherisein positive US data surprises: Yesterday’s bumper ADP jobs estimate of growth of 298k in February beat market consensus of 187k. Our US economist has revised up his NFP expectation from 200k to 250k. Jobless claims hitting a series of record lows all year, combined with one of the warmest Februarys on record, has helped outdoor industries like construction do well. The market now prices a 100% probability of a hike in rates by the Fed next week, and so any USD strength needs to be driven by expectations of a faster pace of rate hikes in 2018.

JPY: Investors sensitive to US yields: Weekly security flow data for last week showed Japanese net selling of 1.13trn of foreign bonds. There will likely be some volatile data in the run-up to fiscal year-end (March 31) but we think there should be more focus put onto country reallocations for Japanese investors, with a potential to shift into higher-yielding assets. Yesterday the Nikkei reported that the Japanese Financial Services Agency will start to audit regional banks who have large exposures in foreign debt. In particular, concerns have been raised about losses made on US Treasuries. The benefits of USD rising versus JPY as US Treasuries sell off are not there if the bank is holding the foreign asset with an FX hedge. This story needs to be watched to see if changing governance may push Japanese banking sector investments locally instead of abroad. Thinking about that flow, it may actually still be bearish for JPY if it puts downward pressure on JGB yields or increases local lending. If the BoJ’s central bank liquidity turns into ‘high-powered liquidity’ as the banks lend more to businesses, this would help local inflation and thus weaken JPY. Selling EURGBP over the ECB: Today’s market focus will be on the ECB press conference and specifically how much more confident Draghi is about the recovery in inflation. Should the market, against our economist’s expectations, perceive today to be a hawkish outcome, then we think that EUR will trade in two stages. Initially EUR should rally as bond yields rise (with our limit being at 1.08). However, the bond yield rise may be disproportionate across the region, causing spreads to widen. The spread widening is not a good sign for the monetary union as it will highlight further the divergence in economic data performance. EUR should fall as markets realise this and EUR becomes inversely correlated with peripheral spreads. On the UK side, Nicola Sturgeon has suggested to the BBC that a second independence referendum in autumn 2018 would make sense but still stresses thatno final decision has been made. This story adds to our bullish GBP view since it may bring Theresa May’s approach to the Brexit negotiations away from the ‘hard Brexit’ and towards the middle to accommodate Scottish views. We think that Brexit risks are largely in the price and still like selling EURGBP, with a stop at 0.88.

As a harbinger of what may be in store in Friday’s US jobs report, surprisingly strong ADP data pushed bond yields higher yesterday. The 10yr UST yield topped 2.56% as markets assess the Fed’s potential hiking pace for the year. The discounted odds for a hike at the March meeting have risen to 90%. By the end of the year the effective fed funds rate is now seen some 65bp above the current average, which can be interpreted as a c. 60% probability for a third hike this year being discounted.
10yr Bund yields were dragged higher alongside to 0.37% with Bund ASWs largely reversing Tuesday’s widening. EGB spreads versus Bunds saw only moderate widening pressure with 10yr OAT/Bund widening just 1bp yesterday, while only slightly underperforming OLOs. With a new Harris poll showing Macron overtaking Le Pen in the first round, OATS may receive some tailwind today.
ECB meeting. Today’s focus will be squarely on the ECB, but we do not expect any changes to policy or communication against the backdrop of increased political risks. Rather we believe that the ECB will want to reinsure markets with more dovish tones. Nonetheless, the money market curve re-steepened yesterday, dragged higher with the overall rates market. The June 2018 ECB dated EONIA forward is up at -0.24bp again, some 11bp above current average EONIA fixing. We doubt whether the ECB will alter its forward guidance already at today’s meeting, although a risk remains that larger revisions of the staff forecasts might outweigh an unchanged guidance. Our economists believe smaller upticks to the headline inflation projection on the basis of adjusted underlying assumptions regarding oil prices and/or the exchange rate might be possible. However the core inflation profile should be more important, and here the ECB is more likely to reiterate that there is little evidence of self-sustainable inflation yet. Accordingly, we do not expect any discussion regarding a tapering to have occurred at this point.
EGB supply. Only Ireland will be active today reopening the IRISHs 5/26 and 2/45 for a combined €1-1.25bn. Italy announced a new 7yr BTP 5/24 (€3-3.5bn) for auction on 13 March. Alongside the Tesoro will also reopen the BTP 10/19 (€2.25-2.75bn) as well as the BTPs 9/33 and 9/46 (combined €2-2.75bn).

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 Japanese government bonds traded flat Wednesday as investors digested the upswing in the country’s fourth-quarter gross domestic product (GDP).

The benchmark 10-year bond yield, which moves inversely to its price, hovered around 0.07 percent, while the long-term 30-year bond yields jumped 3 basis points to 0.87 percent while the yield on the short-term 2-year note traded flat at -0.28 percent by 06:40 GMT.

Japan’s GDP gained 0.3 percent on quarter in the fourth quarter of 2016, the Cabinet Office said in Wednesday’s final revision, missing forecasts 0.4 percent and was up from last month’s preliminary reading of 0.2 percent. GDP gained 0.3 percent in Q3.

On a yearly basis, GDP was revised up to 1.2 percent from 1.0 percent, although that also missed forecasts for 1.5 percent. GDP gained 1.4 percent in the three months prior. Nominal GDP was bumped up to 0.4 percent on quarter from 0.3 percent in the third quarter. That missed forecasts for 0.5 percent but was up from 0.2 percent in the three months prior.

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.

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

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

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

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

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

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

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

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

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

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

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

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

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.

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

With January meeting gone, there are eight more Fed meetings scheduled ahead for this year and according to the December projection, the Fed is expected to hike rates by 25 basis points in three of them. Let’s look at the market pricing of the hikes,

March 15th meeting: Market is attaching 73 percent probability that rates will remain at 0.5-0.75 percent, and 27 percent probability that rates will be at 0.75-1.00 percent
May 3rd meeting: Market is attaching 48 percent probability that rates will remain at 0.5-0.75 percent, 43 percent probability that rates will be at 0.75-1.00 percent, and 9 percent probability that rates will be at 1.00-1.25 percent.
June 14th Meeting: Market is attaching 30 percent probability that rates will remain at 0.50-0.75 percent, 45 percent probability that rates will be at 0.75-1.00 percent, 22 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 25 percent probability that rates will remain at 0.50-0.75 percent, 42 percent probability that rates will be at 0.75-1.00 percent, 25 percent probability that rates will be at 1.00-1.25 percent, 7 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 17 percent probability that rates will remain at 0.50-0.75 percent, 37 percent probability that rates will be at 0.75-1.00 percent, 31 percent probability that rates will be at 1.00-1.25 percent, 12 percent probability that rates will be at 1.25-1.50 percent, 2.5 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 15 percent probability that rates will remain at 0.50-0.75 percent, 34 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, 15 percent probability that rates will be at 1.25-1.50 percent, 3.5 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.
December 13th meeting: Market is attaching 6 percent probability that rates will remain at 0.50-0.75 percent, 23 percent probability that rates will be at 0.75-1.00 percent, 33 percent probability that rates will be at 1.00-1.25 percent, 24 percent probability that rates will be at 1.25-1.50 percent, 10 percent probability that rates will be at 1.50-1.75 percent, 3 percent probability that rates will be at 1.75-2.00 percent, and 1 percent probability that rates will be at 2.00-2.25 percent.

The FED and USD, European Bonds

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

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

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

Commodities, Oil Rig Count, Copper Mine Strike

WTI speculative positioning: It has been another week where speculators have increased their net long in WTI. Over the reporting week, speculators increased their position by 23,299 lots, to leave them with a net long of 413,637 lots. This is yet another fresh record net long held by speculators. This large net long continues to see positioning risk grow.

US oil rig count: Over the week, the US oil rig count passed 600 for the first time since early October 2015. The rig count has increased by 77 since the start of 2017 and by an impressive 286 since the lows of late May 2016. At current prices, we would expect the rig count to continue trending higher.

Escondida copper mine strike: According to Bloomberg, striking workers at the Escondida copper mine will be able to hold out for more than two months. The main trade union for mine workers says that they have a contingency fund to cover strike costs, while they have also secured further funding from a credit union if needed.

Brazilian aluminium import quota: The Brazilian government has lowered the quota for duty-free primary aluminium imports. The government has reduced the quota from 240,000 tonnes to 173,000 tonnes. Reports suggest the quota was reduced as a result of poor domestic demand.

Wheat spec positioning: Over the last reporting week, specs reduced their net short in CBOT wheat by 12,662 lots, to leave them with a net short of 27,385 lots. This is the smallest net short position that specs have held since November 2015. 

EU sugar exports: The European Commission is set to vote this week on whether the second tranche of out-of-quota sugar exports is to be approved. Given a tight EU balance, the EC has held off from allowing these exports. Export licences are usually awarded in January.


h2>GBPUSD and Scottish Referandum, Trump and the FED

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

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

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

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

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

Mexican Central Bank, Inflation and Outlook

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

USD Strength, European Political Outlook and EURUSD

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

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

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

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

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

 

Commodities, US Oil rig count, Copper strikes

US rig count: Baker Hughes data shows that the US oil rig count increased by 6 over the week, taking the total number of active rigs to 597. Since the start of the year, the number of rigs has increased by 72, while from the lows in May 2016 the number has increased by 281. 

WTI speculative position: Over the last reporting week, speculators increased their net long position in WTI by 30,951 lots to leave them with a record net long of 390,338 lots. This sizeable position does continue to pose a risk to the market, although with the right catalyst. 

Escondida strike: Having failed to meet last week, BHP and unions at Escondida copper mine are scheduled to meet today, in the hope of moving closer towards an agreement. Workers at the copper mine have been on strike since the 9th February, which has continued to offer support to the copper market. 

Philippine mine closures: There is still plenty of uncertainty around the closure and suspension of mines in the Philippines. The president will now be reviewing the environmental secretary’s decision, while miners continue to fight the order. The Philippines in the largest nickel supplier in the world. 

Indian sugar production: Cumulative sugar production in India since the beginning of the season to mid-February totalled 14.7m tonnes according to Indian Sugar Mills Association. This is a 15% decrease YoY, and with a number of mills already shut for the season, production will be significantly lower YoY. We continue to believe that India will need to import around 2m tonnes of sugar for domestic needs this year. 

Corn spec position: Speculators continue to build their long position in the corn market, with their net long increasing by 56,527 lots to leave them with a net long of 85,360 lots. This is the longest speculators have been since July 2016, and expectations of reduced US acreage next season has been positive for sentiment. However this is some distance off still, and with good crops expected from South America this season, we would expect the upside in corn to be limited. 

Italy: Risk of imminent snap elections reduced

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

FX Update- European Politics and the UK

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

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

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

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

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.

Carry Trades Still Supported, JPY weakness and EURUSD

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

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

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

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

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

 

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.