Forces of Movement in FX: The Week Ahead

<br /> Forces of Movement in FX: The Week Ahead – Marc to Market<br />


The US dollar’s sell-off accelerated.  It has been
selling off since the start of the year.  The first phase of the
decline at the start of the year seemed similar to what happened at the start
of 2016.  Following the Fed’s first-rate hike at the end of 2015, the
dollar weakened in the first several months of 2016.  Disappointing
economic growth, deferred expectations for another hike, and position
adjustments were the key drivers.  Similarly, the dollar traded
heavily at the start of 2017 after rallying strongly in H2 2016. 
The second phase began in late April.  Recall that
the fear at the start of the year was that the populist-nationalist wave that
was said to have been behind the UK decision to leave the EU and the Trump’s
victory in the US was going to sweep across Europe.  The dollar’s
consolidation of the first part of the year ended abruptly when it became clear
in late April that the National Front was going to be defeated.  Indeed,
the euro gapped higher in response and has not looked back. 
The shortage of dollar that was evident in
its rapid appreciation and the extreme premium for dollar’s in the
cross-currency swaps eased dramatically.
  It appeared to partly be a function
of the US Treasury Department drawing down its cash balances at the Federal
Reserve as it maneuvered after the debt ceiling that had been hit. 
The third phase was seemed to be a
function of a mini-convergence wave.  
The eurozone experienced
an inflation scare around the same time as it became clearer to investors that
despite a Republican in the White House and a Republican majority in both
houses of Congress, the legislative agenda tax reform, deregulation, and
infrastructure that was to boost the growth potential of the world’s largest
economy was unlikely to be delivered. The eurozone inflation spike sparked speculation that the ECB could
hike the negative 40 bp deposit rate before the asset purchases were completed. 
US headline and core inflation trended
lower starting in February.
  It did not prevent the Fed from hiking in March
and June.  However, the yield curve flattened as the long-term yields
fell more than the short-end.  Most recently, yields continued to
fall as the business wing of the Trump’s coalition peeled away following
Trump’s controversial response to White Supremacy incited
violence.   Cohn, the President’s chief economic adviser, was
the odds-on favorite to succeed Yellen when her term as Chair of the Federal
Reserve ends early next year.  However, his mild and belated
criticism of Trump appears to have been seen as a sign of disloyalty, and
appears to have taken him out contention. 
Meanwhile, Cohn, whose chief task apparently was
to draft a bold tax reform program fell out of favor.
 By late August it was clear that this
was not going to happen.  The White House retreated and returned the
initiative, outside of some broad principles, including the jettisoning of the
controversial Border Adjustment Tax.  The fractured nature of
Congress does not make investors particularly confident in the process or outcome.  The
weak price impulses, and the soon changing composition of the Federal Reserve
has prompted the market be skeptical that rates will rise again this year or
There are two anomalies about the dollar’s
accelerated decline.  
First, even though the market does not expect the
Fed to hike rates, it is convinced that the Fed will begin allowing its balance
sheet to shrink starting in Q4.  It begins slowly to be sure, and it
will take place without the sales of a single instrument.  It simply won’t
reinvest the full amount that is maturing.  The ECB made it clear
last week that it is no hurry to exit its extraordinary policies.  It
is not convinced that inflation has yet to enter a sustainable and durable
path.  This suggests that the ECB’s balance sheet is likely to expand
by more and for longer than may be appreciated by market participants, many of
whom are concerned that the ECB will run out of assets it can buy under the
current self-imposed rules. 
If the ECB were to cut its purchases in
half to 30 bln euros in the first half of next year, the balance sheet would
expand by another 180 bln euro by the end of June 2018, after expanding by 180
bln euros in Q4 17.
  If the Fed begins its balance sheet operations in
October, by the end of June 2018, its balance sheet would shrink by $180
blns.   The ECB also reiterated that it will not raise rate
(deposit rate at minus 40 bp and refi rate is at zero) until after its asset
purchases are complete.
NY Fed President Dudley suggested before
the weekend that the two hurricane’s that have ravaged parts of Texas and
Florida may impact the timing of the Fed’s next rate hike.  
He had recently suggested
could take place before the end of the year, provided the economy evolved as
the Fed expected.  However, the market had already reduced the
chances of a December rate hike to about a 25% chance, down from a little more
than 40% the previous week.  
While the tighter financial conditions in
the EMU are thought to make for a cautious ECB, investors are not nearly as
convinced that the easing of US financial conditions will spur the Fed into
 We suggest that this is partly because many participants do not
think the Fed places the same amount of weight to the financial stability
mandate as they do to the short-hand talk of a dual mandate.  We think
this is a mistake.  Also, the cautiousness expressed by several Fed
presidents and Governor Brainard, in light of the coming personnel changes,
many expected easy money to prevail.   
The second anomaly is politics.  Much has been
made about the erosion of public support for Trump, who did not win the
majority of the popular vote, but, carried the electoral college, which is
where the election is decided.  We have expressed concerns that the
business-wing of his coalition and the Republican Establishment that had joined
him are peeling away.  Too often charts claiming to show that the dollar
is tracking the president’s popularity show the two variables on the same chart
with two scales.  With that methodology one can prove nearly
Ironically, since mid-May, the same
methodology could show that the dollar is tracking the decline in support for
 Although the new elected French President enjoyed a large
parliamentary majority, his public support is more or less at the same level as
Trump’s.   Some labor unions are staging protests early next week, but
Macron can rule by decree.  What economists call labor market rigidities
are part of the social contract whose unilateral abridgment is likely to have
longer-term consequence on cohesion and trust, even if the direct economic
impact is minimal.  
In the UK, Prime Minister May lost the
Tories majority in the snap election earlier this year.
  She is trying
to govern as if the majority was preserved.  The second reading of the
Great Repeal on Monday at it appears the government is going to have to
compromise, even not with Labour or LibDems, but with Tory MPs.  The Dutch
have not been able to forge a government for six months (and the economy is poised
to grow its fastest this year since the start of EMU).  
Italy is on its fourth un-elected Prime
Minister with the same parliament.
  Elections must be held by next
spring.  The rules of the electoral process have not been agreed upon
after the old rules were ruled unconstitutional.  Berlusconi and a
far-right party (or two) may shortly announce so joint effort.  While many
have noted the recent easing of talk of leaving the EU or EMU, perhaps helped
by the better economic performance, there remains cause for concern with the
talk of a parallel currency, which, when asked, Draghi, reiterated the obvious:
there is only one currency for EMU members.    Italy addressed some
it urgent banking challenges earlier this year, but the political risk remains.
While Italy’s political risk will not come
to a head until well into next year, Spain’s challenge is around the
 Despite Spain’s high court ruling against them, Catalonia is
pushing ahead with its referendum for independence on October 1.  With no
minimum turnout requirement, Catalonian leaders seem confident of their
victory, though opinion polls show a close contest.  The leaders claim
that within 48 hours of the referendum they are prepared to declare their
Madrid is in an awkward position.  If it seeks
to enforce an injunction, which requires its police powers, it may alienate
more Catalonians.  If it allows the vote but declares it illegal, it may
still have to enforce its decision. Spanish bonds have under-performed Italian
bonds (by six basis points last week and 15 basis points over the past month).
 Spanish stocks have also lagged behind Italian stocks, with over half
this year’s under-performance taking place over the past month.  
A year ago, as the LDP altered their rules
to allow Abe a third term, he seemed unassailable. 
 Now wracked by
scandals and a stunning loss in the local Tokyo elections, and forced to
reshuffle his cabinet, apparently giving room to rivals, Abe looks
vulnerable. Unlike, Trump, Macron, or May who have a few years before
having to face voters, Japan’s lower house election must be held by the end of
next year.  Surely, with Kuroda’s term ending next April, and no precedent
in the past 50 years of a BOJ Governor given a second term, policy uncertainty
looms large.  
Meanwhile, leaving rhetoric aside and
focusing on real actions, the limited achievements of the Trump Administration’s
first few quarters is well within the US liberal tradition.
 As he signed the
executive order that pulled out of the TPP, he noted that both Clinton and
Sanders were also opposed to it.  Clinton too had been critical of the
DACA program.   His nominee to the Supreme Court is also within American
tradition. Trump’s first Fed nominee, Quarles, was approved in committee
last week and now faces a vote in the whole Senate.  He could be easily
approved as early as next week.  
In other areas, as we have argued before,
the system has proved resilient. 
The judicial branch has limited his efforts to
bar immigrants from certain countries and extended families of people already
in the US.  The legislative branch passed sanctions on Russia, Iran, and
North Korea, which although Trump signed reluctantly, they curb the power of
the “imperial presidency.”  
The Bank of England and the Swiss National
Bank hold policy making meetings in the days ahead, and Norway goes to the
 Neither central bank is likely to alter policy and Norway’s
election will likely confirm the status quo.  
Before the Bank of England meets, it will
see the August inflation report.
  It is likely to have risen, largely
as a result of depreciation of sterling after the June 2016 referendum.
 Still, there is good reason to expect the peak in inflation in the coming
months, even if CPI gets closer to 3% first.  The UK’s labor market
continues to absorb slack and the risk to the unemployment rate is on the
downside, even though it has already fallen to 4.4% from 4.8% at the end of
last year.   However, earnings growth is slipping further behind the
inflation, and this is likely to squeeze discretionary consumption over time.
Sir Ramsden has assumed his role as the
new Deputy Governor for the Bank of England. 
 It is now fully
staffed with nine members.  Two of whom are likely to continue to dissent
in favor of a hike, but they have been unable to convince their colleagues.
The Swiss deposit rate will remain
unchanged at minus 75 bp.
  The OECD still regards the Swiss franc as the
most over-valued currency in its universe (~23.5%).  The SNB seems content
to lag well behind the ECB and Fed in the monetary cycle.  It may repeat
it warning that it is prepared to intervene in the foreign exchange market if
We argue that one of the key drags on the
dollar is coming from the drop in interest rates.
  Data due out
in the coming days are unlikely to change sentiment.  Specifically, there
is risk that the core measure of CPI continued to decline last month.  It
peaked this year in January at 2.3%.  It has been stuck at 1.7% for three
months through July.  The risk is that it slipped to 1.6% in August, which
would be the lowest since January 2015.  
Retail sales are unlikely to have repeated
July’s 0.6% rise.
  Auto sales will be a major drag on the headline.
 The components that feed into GDP are likely to have risen around 0.3%,
which is about the average so far, this year.   Similarly, industrial
output growth likely slowed in August after a meager 0.2% increase in July
which matches this year’s average.  The jobs growth in manufacturing
suggest that output in that sector likely fared better than over all industrial
output.  However, there is nothing in these data points that suggests the
US economy has accelerating.  
Lastly, the US has reportedly notified the
respective parties that it will seek new sanctions against North Korea by the
UN at the start of the week.
  In addition to a ban on oil exports,
reports suggest the US will also seek an embargo on textile trade, accepting
guest workers from North Korea, and freezing Kim’s assets.   The cost of
the such proposal would likely weigh heaviest on China, but the US does not
appear to be offering China anything to offset this cost.  
China cannot accept precipitating a crisis
that would lead to regime change and the risk that US interests dominate the
the same, time, China seems to recognize that North Korea’s six nuclear bomb
tests, and even more missile tests, encourage the further deployment of missile
defense systems in South Korea and Japan immediately, which could also
ostensibly be used against it.  A friendly vote from China would be to
abstain, while the US course risks a veto unless it can be amenable to
compromise.   The failure of the UN to agree on more sanctions could
further encourage North Korea and discourage risk taking.  

Forces of Movement in FX: The Week Ahead
Forces of Movement in FX:  The Week Ahead

Reviewed by Marc Chandler

September 10, 2017

Rating: 5

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