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

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

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

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

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

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

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

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

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

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?

The Japanese government bonds remained flat Wednesday 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 rose by 1/2 basis points to -0.25 percent by 05:10 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).

WTI dropped more than 9 percent last week as investors fear increased production in the United States and non-compliance within OPEC with the agreed production deal. WTI is currently trading at $48.7 per barrel and Brent at $51.9 per barrel.

Key factors at play in crude oil market –

February report shows that OPEC still remains in full compliance with the deal as a group but many members are yet to adhere to the agreed levels. Iran’s production crossed the agreed level in February but the country is still in compliance based on average monthly production.
Saudi Arabia could be bypassing the OPEC deal by increasing exports of refined products.
US production rose from 8.428 million barrels in last July to 9.09 million barrels per day last week. This is the highest level of production since last year. Payrolls are once again rising in the oil and gas sector according to ADP job numbers.
Some OPEC members are calling for no continuation of the deal when it expires in June.
Backwardation in the oil market extends further, currently at $1.05 per barrel.
API reported a draw 0.531 million barrels of crude oil.
Today’s inventory report from US Energy Information Administration (EIA) will be released at 14:30 GMT. Trade idea –

We expect the WTI to extend gains towards $59 per barrel, and then towards $67 per barrel. However, a decline towards $46 per barrel in the short term can’t be ruled out. We don’t suspect the oil price to break below $42 stop loss area for the long call.

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.

Latest data released yesterday show that the upward march of inflation that continued early last year is still gathering pace in Europe. Spain released its consumer price inflation report yesterday and it showed that consumer prices in February rose at the fastest pace since 2012. In February, Prices were up by 3 percent from a year ago and on a monthly basis it is up by 0.3 percent from January. Two major contributors were transport prices that rose by 8.2 percent and housing prices which rose by 5.9 percent. Furniture and household good is the only sector that took a dip of 0.4 percent compared to the year-ago level. Spanish inflation came in line with that of the entire Eurozone, where the price rose by 2 percent, highest level in four years and above the target of the European Central Bank (ECB).

Data from Poland points that the return of inflation is not just a Eurozone development it’s pan-European and global as well. Inflation in Poland rose by 2.2 percent in February, which is again the fastest pace in four years.

However, one should pay an ear to the European Central Bank (ECB) President Draghi’s comments that the central bank is not worried about inflation as it is being largely driven by an increase in the prices of commodities. Lately, the prices of commodities, especially energy and industrials have taken a hit and it is likely to get reflected in the numbers going ahead. We at FxWirePro expect the European Central Bank (ECB) to continue its easing as declared and throughout the year.

The euro is currently trading at 1.063 against the dollar.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Energy • US oil stockpile and production: EIA weekly data shows US oil inventory increased 8.2MMbbls over the week ended 3 March 2017 marking nine consecutive weeks of inventory build-up. The US oil stockpile has gained c.50MMbbls since the start of the year raising some doubts over the effectiveness of OPEC cuts. Crude oil production in the US also increased to a one year high of 9.1MMbbls/d. • China coal output restrictions: China doesn’t intend to reintroduce the mining curbs on coal as long as prices stays within the ‘reasonable range’. Last year, China has introduced certain measures including reducing the operating days for coal mines from 330 days to 276 days pushing coal prices higher. However, these measures were removed this winter as heating demand for coal increased. Reintroduction of these curbs would have tightened market balance significantly.

Metals • Fed rate hike expectations: Bloomberg data shows that the market is factoring in a 100% probability of a Fed rate hike of c.0.25% (to 0.75-1.00% range) at the upcoming 14-15 March meeting. Rising bond yields lower the appetite for nonyielding assets including safe haven gold. • Indonesia nickel ore exports to resume: Indonesia’s top nickel producer, PT Aneka Tambang, could resume low-grade nickel ore exports soon easing the supply tightness in the Chinese market. Indonesia would be restarting nickel ore exports after nearly three years of gap and would offset the supply disruption from Philippines on environmental concerns.

Agriculture • Rubber output drops: Association of Natural Rubber Producing Countries (ANRPC) data shows global natural rubber output dropped 2.2% YoY to 1.71m tonnes over the first two months of 2017; demand has increased 3.3% YoY over the same time period tightening the physical market balance. However, ANRPC estimates the supplies to improve in key growing areas over the March-May 2017 with full year production likely to increase 4.2% YoY to 11.2m tonnes • Vietnam coffee exports: coffee exports from Vietnam increased 4.3% MoM (23% YoY) to 146.4k tonnes in February 2017. YTD exports are still down 2.6% YoY at 286.6k tonnes.

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

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

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

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

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

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

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

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

Doves – Neel Kashkari.

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

Unknown – Jerome Powell

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

The 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.

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 .

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

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

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.

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.

European Bonds and Credit

It was quite a rollercoaster ride in Eurozone government bonds yesterday, mainly in semi core EGBs, which was in part related to thinner-than-usual liquidty due to closed US markets. Although opening tighter, semi-core EGBs soon started to underperform Bunds, and after the news that Ms Le Pen had gained some ground on her main election rivals sparked strong selling in the 3-5yr OATs, 10yr OAT/Bund spreads suddenly leapt 4-5bp to exceed 82bp for the first time since August 2012. In this context, the 2yr Schatz yield plunged to a new all time low of -0.85%, helping to push Schatz ASW to 70bp. Meanwhile, the 10yr OAT/OLO spread – one of our favourite measures of the French politcal risk premium – even briefly touched the 30bp level. Later in the afternoon – when French Finance Minister Michel Sapin warned that betting against France would be costly – OAT/OLO spreads re-tightened, although the 3-5yr area struggled to reverse the heavy underperformance  Based on recent performance trends versus Austria and Finland, DSLs still hardly suffer from any political risk discount, even though they trade cheap versus Bunds by historical standards. Against this backdrop, we find 3-5yr BNG and NEDWBK trading at very attractive spreads versus KfW. 10s30s struggled to flatten yesterday, despite the broader risk-off mood, especially after the EFSF announced the intention to launch new 4yr and 39yr lines. When the ESM launched a new 40yr bond back in 2015, the extension in ASW from the existing 30yr line amounted to around 20bp. Applying this to where the EFSF 2047’s are currently trading we would arrive at around MS +68 for the new EFSF 2056 as an indicative pricing. Adding a NIP of abound 10bp (which is slightly more than the one seen in the recent ESM 11/46 deal) to the current 9bp curve extension from the ESM 45’s into the 55’s yields a roughly similar result. Elsewhere, ECB data revealed that PSPP purchases accelerated slightly last week, to €17.2bn from €16.9bn the week before. However, total APP purchases slipped to below €20bn due to slower covered bond purchases. Even so, the ECB remains well on track for another €85bn of asset purchases for this month.

Mexican Central Bank, Inflation and Outlook

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

 

Ruble strength, fiscal rule and CBR

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

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

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

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

Italy: Risk of imminent snap elections reduced

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

Monthly Global EM Outlook, Trump Policies and Inflation

From the current starting point, the near-term inflation outlook is generally unthreatening in most markets that have a large weight in the international benchmark indices for EM local currency debt.

Inflation has risen in some EM countries during the past half year in response to currency depreciation and increases in global oil prices; but the CPI impact of exchange rate weakness has in most cases diminished and the oil price effect is probably about to peak. Beyond the group of EM countries that now have large weights in the EM debt indices, it is notable that core inflation is on the rise in China.

 The current level of core inflation (2.2% year-on-year) is not seriously disconcerting but if it continues to creep upwards then it will eventually become a constraint on China’s monetary policy. This represents a risk for the entire EM/commodities complex, but it is more likely to be a risk for the second half of 2017 than a focal point in the next few months. More imminently, the main risk of abrupt policy rate increases in the EM universe comes from the US in the form of the possibility of a surprisingly large batch of Fed rate hikes during the remainder of the year and/or a border adjustment tax. Either of these shocks could force a swathe of EM central banks to choose between raising their policy rates substantially or having to live with undesirably steep currency depreciation.

Given the current predominantly unthreatening EM inflation trends and residual labor market capacity slack in many countries, a large share of the EM central banks – especially in Asia – look set to be able to leave their own policy interest rates unchanged if the Fed keeps raising rates at a gentle pace and if the US border adjustment tax fades away.

An important source of inflation volatility in the EM world in recent years has EM currency depreciation (in nominal trade-weighted terms) that has led to increases in prices not only for imports, but also for those domestically produced goods that compete against foreignproduced items either in the domestic market or the export market. However, this problem dissipated in most of the EM world during the course of 2016, and only a few of the large EM countries – Mexico and Turkey to be precise – are seeing this problem unfold right now

Two other large EM countries – Brazil and Russia – are in the opposite camp. Inflation has fallen sharply in both countries in the past year. This reflects in part a swing from large-scale currency depreciation in late 2015 and early 2016 to equally forceful currency appreciation during the past 12 months. Deep recession, widening output gaps, and cautious monetary policy in both countries have also helped contain inflation. The view of our Brazil-based economists is that recent currency appreciation will continue to help drive down the country’s inflation in the present year whereas the main drivers of last year’s fall in inflation were a large decline in the pace of adjustment in government controlled prices (in part reflecting currency dynamics and a big change in global oil price inflation), the depth of the recession and, related to this, weakened wage pressure in the labor market.

To be sure, the behavior of EM currencies, inflation and policy rates would be highly likely to become much messier if the Fed were to accelerate the pace of its rate hikes substantially beyond what is currently priced into the US rates curve, perhaps in response to stronger wage data or aggressive future plans for unfunded US tax cuts. There is also, in our view, a very real risk to EM investors associated with the plan of Republican members of US Congress for border adjustment taxation (BAT), or from the possible imposition by the US of other types of import taxation. As we have argued multiple times on these pages, the BAT and import tariffs are likely to be highly dollarsupportive. If Trump’s decides to support either, and if he secures congressional approval, dollar-based holders of EM local-currency-denominated assets are likely to take a hit.

It might seem inviting to think that the BAT would help curb inflation in the EM world, because it would be likely to drive down the dollar price that EM-based importers pay for goods from the US (as US exporters would be entitled to a new subsidy) while also driving down the dollar price that EM-based exporters would obtain from sales to the US (because their sales would be subject to taxation at the US border). But the inflation “benefit” would be eroded by EM currency depreciation against the dollar. EM currency depreciation would most likely be sufficient to drive the local-currency prices for EM countries’ exports and imports (in trade with the US) almost all the way back to their pre-BAT levels.

 

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

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

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

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

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

Chair Yellen and Rate Outook for the USD

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

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

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

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

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

Global FX Stories, USD, EUR, JPY and PLN

USD: Focus turns back to the domestic drivers The lack of focus on the currency manipulation rhetoric’s during the Trump-Abe meeting on Friday (note JPY was one of the currencies mentioned recently by the US administration as being unfairly kept weak) should allow USD to re-focus back on its domestic drivers. Bar the expectations of the details about the ‘phenomenal’ Trump tax plan, markets will be closely watching Chair Yellen’s testimony to the House (Tue) and Jan CPI and Jan retail sales (both Wed). With market pricing rather benign 30% probability of Fed March rate hike and much cleaner long speculative USD positioning, the bar is not very high for USD to record more gains this week, particularity vs low yielders such as EUR and JPY.

EUR: EUR/USD to move towards the 1.0500 level Very calm week on the EZ data front suggests that EUR crosses will be driven (a) news/data from elsewhere (b) potential additional increase EZ political risk. On the latter, EZ political risk premium pricing in EUR remains still very benign, allowing for more downside to EUR. We look for EUR/USD to move towards the 1.0500 level this week.

JPY: Scope for USD/JPY to resume its upside Japan Q4 GDP modestly disappointed the consensus expectations (0.2%QoQ vs 0.3% expected). Yet with the little scope for material shift in the BoJ policy stance in coming months, the driver of USD/JPY remains the USD side of the equation. Following the non-negligible adjustment in USD/JPY lower since the beginning of the year, the potential for higher UST yields and cleaner USD/JPY speculative positioning (ie, the speculative community is currently net short USD/JPY) point to USD/JPY re-testing the 115.00 level this week.

PLN: Boost from Jan CPI to provide a good entry point to short PLN Our economist look for an above censuses Polish Jan CPI (1.8%yoY vs 1.7%). While this may provide a boost to PLN, the zloty gains are likely to be short lived given the already stretched EUR/PLN levels. Equally, we don’t expect the Friday’s PiS leader Kaczynski’s confirmation on a dilution of CHF bill (see Snap) to lead to persistent PLN gains due to: (a) with PLN no longer pricing a domestic political risk premium (on short term basis), the Friday’s good news should not lead to material re-pricing of PLN risk premium; (b) the EZ politics and negative spill over into CEE FX should kick in as we approach Dutch and French elections. We retain negative PLN view and stay long EUR/PLN.

Carry Trades Still Supported, JPY weakness and EURUSD

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

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

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

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

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

 

FX Positioning for the week of January 23rd

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

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

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

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

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

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

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

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

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

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

 

 

European Interest Rates and Equity Divergence, EGB Spreads

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

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

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

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

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

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

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

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

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

Russia Rate Meeting, Sanctions and FX Interventions

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

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

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

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

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

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

European Fixed Income Markets

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

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

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

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

Energy

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

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

Metals

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

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

Agriculture

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

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

 

USD divergence from bond yields, US savings, JPY curve

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

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

Turkey MPC decision, money markets and inflation indexes

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

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

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

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

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

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

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

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

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

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

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

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

ECB Meeting & Expectations Beyond January

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