FX targeting is back at the BoE, the question is can they maintain this GBP strength. In my view, there are two potential paths, and they are both quite binary for GBP. 1) Carney's rhetoric post the MPC statement was crucial in the fact that it gave more of a legitimacy to a near term move. I think the BoE learned a lot from their August meeting and inflation report. In that presser, Carney tried to steepen the OIS curve, which he thought would be GBP friendly, but did not give enough indication of when the first move will actually come. Which in essence, is what Carney's ideal would be, he thought if he could provide more scope to a future tightening cycle, GBP would catch a bid, but the market called his bluff. It turns out to steepen the SONIA curve, Carney had to show near term intent, and he did. Now, short sterling rates have priced in a bit more, but still the market is skeptical there is any significant scope to the BoE's move. Given the internal economic sluggishness and extreme economic beta to increases in rates, Carney could get stuck in a one and done sort of situation. If that transpires, the market will punish Carney and GBP, and since the market reaction in GBP has already been so strong, the likelihood of this sort of move has only increased in my view. 2) The BoC model has to be at play as too many got burned by Carney's old stomping ground. Are the situations analogous, well, not really in my view, but it may make people more hesitant about fading the move. Sure, real estate linked debt is high in both countries, but Poloz and Wilkins have wage growth and improving retail activity, that is to say, the BoC has domestic "reasons" to move from the zero lower bound while Carney is in effect just lagging external factors, i.e. the EUR. So while I reject the comparison, the market will likely wait to meaningfully fade this GBP move, and shorts could continue to get squeezed. I am inclined to think the former case (1) is the more likely outcome, but I will be patient.
As I was saying, as opposed to the BoC, Carney has an external variable which he needs to lag in FX to cap cost push inflation. So, if Carney's move is really about the EUR, the September MPC told us a lot more about the ECB than it did anything else. As we have discussed, it's hard to believe given meager wage growth and Brexit effect on domestic investment, that Carney actually wants to go, which means, Draghi won't try and push the EUR lower in October. Why would Carney feel the need to get in front of continued EUR strength if Draghi was going to try and move it lower over the coming weeks? ER curve is too flat. I still prefer m8m9 steepeners.
EUR/USD inv v US 2s Schatz Spread
It is my preferred lever, if you will, to play a narrowing of the schatz US 2s spread instead of being long EUR/USD. However, I want to look at this chart from an ECB perspective and why the ECB could be less inclined than you think to try and reverse the EUR twi move. I think we have gotten a few hints of this, Draghi's September presser, Couere's recent speech on FX pass through and in my view, Carney's decision to likely get a rate hike in by years end. The question is, if EUR strength really is "endogenous" which is likely to be a key buzzword, will Draghi try and fight flows going into year end, I don't see it. My pontification is, when the market becomes more aware that Draghi is not a catalyst for sub 1.15 EUR, then the front end rate spread being held back by those very concerns can begin to narrow. Consensus is, Draghi can't touch depo and get EONIA closer to zero because of what it will do to the EUR, well maybe 1.25 EUR is more tolerable than the market currently believes...... Another element is, in trade weighted terms, if the ECB is moving the front, you better believe Rix, SNB and BoE are as well; that could diffuse some of the externality ccy strength. Combo of depo and longer but lower QE remains alive and well to me.
Relative spread in E$ and ER, z7z9 vs US Dollar
Other than external flows, potential policy scope has played a large role in both the EUR's rise as well as the USD's fall. One of the reasons, barring any funding problems in EM, I do not see how the dollar has a sustained move higher, is what is the scope for Fed moves relative to other CB's. I.e. lets say USD weakness has fostered a meaningful uptick in global growth and inflation will move higher, will that be an exclusivity to the US economy? If oil goes to $60 and US CPI is meaningfully above target, is that a world where EUR, CAD, GBP, SEK, etc is also not seeing inflation targets met? If that is the case, all of those CB's have a lot more of an adjustment to do in the front than the Fed does. I guess, my larger point is, if r* is not meaningfully higher in the US than where it is now, the potential scope of tightening for other G10 central banks is greater. Which is why I will say, despite this being quite contentious, a Fed hike in December doesn't really matter. Sure, if the Fed gets it priced rates, e$'s, and the dollar will adjust, but not meaningfully as it is hard to see the economy making a significant move above potential. Flip side, it does and global synchronized growth takes the next step, does schatz stay at -65 bps, in fact, it probably has tighten much quicker than US 2s. 200 bps in schatz US 2s spread is much too steep for me and it carries positively. Also, final point, if the ECB wanted to move EUR, why come out in advance of Q4 base effects on HICP inflation as transitory, surely that could have been a weapon to talk EUR twi lower.....
https://www.ecb.europa.eu/pub/pdf/other/ebbox201706_07.en.pdf
That brings us to another point, why is the market projected scope for further Fed hikes so shallow, especially considering the known positive knock on effects of the weaker USD into growth and inflation. There are likely many reasons but I want to offer one that is a little off the beaten path. Yes, inflation has been persistently low and we have no idea what a Trump Fed will look like, but there is another potential factor in my view. We'll likely find out on Wednesday that beginning in October the Fed will begin its SOMA adjustment, and ya, UST vol is on its ass.... My thinking is, what if the market is potentially pricing in that "vol" in richer e$'s...... Bare with me. The September 2014 statement regarding balance sheet was pretty clear, the reason the Fed had to get o/n rates meaningfully above the zero lower bound before doing b/s runoff was so that they had a lever to pull if we tantrum part two or if it effects the outlook. In this context, it makes a little more sense why the Fed path is this shallow; either b/s has replaced hikes as the tightening mechanism or the market quietly thinks the pain threshold for runoff is much lower than the "like watching paint dry" Fed does and they expect SOMA changes to run into problems over the next two years. When it does, o/n rates will be the first lever they pull. Just a thought, as it also confounds me how low rates vol is given this backdrop, but just maybe, the market is pricing in potential problems elsewhere.
$ Funding looks Relatively Healthy, For Now (JPY and EUR 3m basis swap)
The dollar thesis I am most sympathetic to is the liquidity one. As I have touched on, the profound amount of dollar liquidity unleashed this year has been a large global stimulant. We know the dollar short position in EM issuance and even in spot has moved considerably this year, the question is, what upsets the apple cart. So far, dollar funding is normalizing and none of Trump's trade restrictions that could potentially mess with current construct of the current account look very likely. So, in my view, until the balance of liquidity is to recede, if that is normalization of bill issuance or an EM problem (China), its hard to see a change in the current FX trend. I still believe, if there is a trend change, funding and shortage is likely the cause for a dollar rally, but those stresses do not appear to be there just yet.
Does USD/CHF, lose Either Way?
One of my mentors sent me a chart of CHF/JPY during one those of risk off nights emanating from the Korean Peninsula. He was saying, quite rightly, how does the country which the missile is going directly over, have their currency appreciate against swissy?! It really is something. What I saw in the chart was, CHF/JPY over the last year is just a 10y bunds chart. Kind of interesting, maybe easier to sleep at night being long CHF/JPY than short RXZ7? Anyway, this point and really the causality behind the correlation has ramifications for the dollar swissy cross. What if the CHF v USD can play in reflation and kill it on flows if global econ turns lower again? CHF playing in a positive economic upswing is super odd, but maybe in this cross it could work. A little more background as this idea came to mind from discussing the SNB with a very smart macro guy, who brought up the idea that the SNB could go a lot sooner than people think. Anyway have to give him credit. We know how CHF will outperform, if shit hits the fan, flows overpower Jordon and the SNB's best attempt to talk it lower. Now, the flip side is where it gets interesting, as CHF is the ultimate funder in a positive risk environment. Lets say, global growth chugs along, FDI flows from Swiss reverse and the ECB begins its move in tightening. Well, CHF will lag that, won't it? In the latter scenario, global growth continues its upswing, EUR/CHF is likely +1.20, which is all the SNB is really going for as they don't really have an inflation target. In the September SNB statement, there was a language shift regarding CHF overvaluation, it went from "significantly" to "highly valued", almost as if to say, the conditions are getting there. And there is another crucial element, part of the SNB tightening mechanism, I.e. less of a need to weaken CHF, will be selling some risk assets, which happen to be largely USD denom. Yupp, positive capital account adjustment, despite "risk on." So, the latter scenario (upswing in growth continues), which is likely the bigger risk to the trade, the SNB could hike rates in first half of '18 and be repatriating some USD assets all while the Fed is on hold..... The prospect of a currency with an 11% current account surplus actually moving tighter on o/n rates, despite how ridiculously low their deposit rate is now, is a very powerful force, one the market is likely underestimating. Another thing, it gives you some positive correlation to G10 rates. If you can live with the carry, this trade could work, time to look at some one touches.
Back to US Econ
As I said in my previous post, in my view, which is likely contentious, this Fed tightening cycle has been quite "normal." In shadow rates (Wu-Xia), the average tightening cycle post Volcker has been around 300 bps, we are at 298 before the September meeting. I know, impossible, there is no way the terminal rate is sub two and a quarter and even if it is, FCI's are super loose. The latter is true, but also more of an equity/dxy story. Maybe policy is tighter than financial liquidity infers. Bank lending has collapsed, M2 growth in YoY terms is meh to weak, and velocity continues to suck. It is feasible that the rebuild from these storms will be the boost the economy is looking for, but to me, it still looks weak relative to the rest of the world. And this only feeds into the lack of scope in terms of monpol action. Despite this, it's still hard to like duration in USTs because my handle on China continues to be weak, the positive knock on effects in inflation from a weaker dollar have only really begun to pass through the system, and positioning is still super long. Curve steepeners could be a better play.
Oil boost since November OPEC deal (Yes, this is a chart crime, but point is important)
I'll leave the science behind legacy wells and depletion rates to the pros, but from what I have been reading, the US cannot grow oil production in perpetuity, in fact rig growth looks likely to be topping out. This week the EIA revised slightly lower shale output numbers for the first time in a while. The consequences of peaking US oil production is massive in terms of price and inflationary expectations, but I want to look at it in terms of how big of a boost US oil has been since the OPEC deal last November to GDP. Gross private fixed investment has been kinda dependent on a growing oil patch, as we saw in Q1. What if investment dies as a result of a peak in domestic oil production? Is the knock on in capacity utilization rates back at 75 and a turn lower in industrial production, it is beginning to look that way to me.
Can the Oil Curve get over the Shale Hedgers?
Somehow I always end up coming back to the Fed, and here is more. Given the recent Chinese PPI number there is plenty of reason to think US inflation will rise in the coming months. This is likely behind the recent steepening in the e$ curve. As Fed rhetoric from Evans, Brainard and Kaplan have suggested, they are uncomfortable with the current state of inflation, so it will likely take more than one or two good readings for the Fed to get excited. Also, despite the recent rally in spot, under the Fischer 2015 Jackson Hole view, looking at oil prices two years in advanced, prices don't indicate significant future price pressure. Does inflation pick up into year end, maybe, but are they for US centric reasons, I.e. the Phillips curve, not so sure. The tradable side of imports is not really big enough to make the weaker USD a US only story, which really caps any meaningful dollar strength.
End on CAD, as I have been as Wrong as Anyone on Fading Poloz
If you are looking for a Phillips curve sighting, Canada may have it. As unemployment has come in close to 6, wage growth has started to really pickup, the question is will prices follow. I was as a quick as anyone in wanting to fade the BoC, as I just didn't see how growth in retail consumption could have been kept up given concerns in household debt and a lack of gains in the oil sector, only bolstered by the currency strength. Well, I'm not sure I have changed my view, but maybe for the first time I can sort of see what Poloz and ToTEM (BoC DSGE model) are seeing. If retail activity is going to be a buffer for reduced investment and housing, it may have legs given that its growth is quite organic with this upturn in wages. And if retail activity is expanding, despite the currency appreciation, prices should follow. The question we have to ask ourselves before getting excited about fading CAD or BA's is, if these wild ones felt comfortable initiating a tightening cycle at 1.2% inflation, lets say we get to 1.7%...... Inverting the curve does not seem to spook them. So ya, maybe BAX strip over 30 for next year makes a sense.
On the side
If anyone wants to send me data sets on JPY holding of foreign govies, it would be much appreciated. Think the potential for a breakdown in USD/JPY 10y UST relationship post BoJ YCC, could be almost be upon us. Food for thought until next time.
Thanks for reading, if you would like to reach out, my email is jonturek@gmail.com
