First of 2018

Well, it's a new year, and with it comes expectation for extensive shifts in DM central bank policy, which is exciting. As a whole, there are a few potential themes I am currently interested by. First, how sustainable are these effective ECB forward guidance pegs, especially if the Italian elections in March slow recent rhetoric from Nowotny and Couere down. I think there are some broader non EUR European crosses that play on this theme in a relatively outcome agonistic way. Second, there seems to be a paradigm shift in China, or one I am late to, and it has large ramifications for FX and rates. And finally, the dichotomy between improving economic fundamentals and worsening geo politics will make for some interesting trades in FX, as in some cases, the latter has been sorely under priced. I am usually scared of making calls in January, as it tends to be a month where consensus wins, but I did anyway.....

Heres to a great 2018 for Macro

FX Seems to be lagging this chart (ERZ8ERZ9 - EDZ8EDZ9)



While everyone is obsessed with rate diffs and historic wides in US 2s and schatz, reds/greens in STIRs have been widening in the other direction, and FX has clearly lagged them. It is clear that the market took Coeure's interview towards year end (Dec 30) as a tone change re APP and its sustainability given the transition of econ to expansion instead of recovery. In a forward guidance sense, "markets have to understand QE will not last forever", was very important. A key principle of the ECB's forward guidance in keeping curves repressed is using QE a curve anchorage mechanism in terms of pushing off the market pricing a DFR hike. Is that the inflection point here? I would guess Mario will wait until after March 4th before we get over excited. The spill over from this is obvious as other European economies tied to ECB forward guidance which warrant tightening in their respective policy rates, follow. As I've said before, without any structural shortages in USD funding, DXY is a one trick pony reliant on relative policy divergence. Now, given the markets allocation of future policy scope, with ERZ8ERZ9 15bps outside EDZ8EDZ9, the dollar will struggle. However, given the coming political event, I could see EURUSD taking out 1.20 in next few weeks and be back at 1.16 by end of Feb as crowded longs fret over FI being the most likely to build a coalition in Italy. With that said, being short EURUSD would not be my expression as I agree with Coeure, the European recovery has transitioned into an expansion and it has momentum.

BTP/Bund spread will make EUR longs nervous into March 4th



Interesting way to play Italian elections; short GBPSEK

My thinking is, I have no idea if M5S can build a coalition or not, nor how EU friendly will a FI coalition be, but these sort of political events do tend to narrow down the macro variables in a more binary fashion. Short sterling v stocky to me seems innately asymmetric going into the vote. There is an inflation report from the BoE in Feb, which does complicate this trade a little given my BoE view from prior notes. So keep previous short in short sterling whites, play steeper L H8M8. Back to the the election: From a bivariate reasoning perspective, its simple to see how this trade can work. If political risk rises, EUR sells off and ECB tones down APP shift speak. Now, in that case, SEK data for Q1 is going to be strong and EUR/GBP will likely sell off, BoE gets the luxury of taking foot off the pedal, but CPIF comfortably over 2, can Rix? I.e. the Rix peg to ECB forward guidance will likely have to give if Italian elections go to shit, given Kix weakness from end of last year, Q1 data should be quite strong. Ingves will test me on this one, but it seems to me if political risk in Europe rises, Ingves may have to ignore it while Carney would welcome it. The flip side is simple policy scope. Center right coalition in Italian parliament, EUR will do well, EONIA curve prices up hikes and Rix goes this year as ECB finally "lets" them. Yes, GBP will have lagging to do as EURGBP will selloff, however, Carney has already tried to talk down potential scope, and it is innately weak given mortgage resets. So, win/win? We could go back 11.15 given BoE rhetoric, but setup into end of March looks good for being short this cross.

Side note: fascinating BoE paper on mortgage market vulnerabilities using comp sci metrics, new form of economics. 

GBPSEK

Given Kix Move in Q3-Q4, Q1 data should be SEK +ve 



Its sorta hard to reconcile a pullback in EURUSD with being short USDSEK, but I think a divergence in data in Q1 should favor this cross being weaker. Given Italian elections, I am targeting a move to around 7.90 and then reevaluate. Core thinking is, US CPI comps are very tricky for the next two months, peaking in Jan at .31%, CPIF in SEK has ~4M Kix/PMI lag which should keep inflation elevated in Q1. USD already not getting much love and March implieds could be priced lower on weak n/t inflation numbers..... Data divergence narrative, especially in inflation, looks strong, a retest of recent low looks likely.

EURGBP, rhetoric divergence before March 4th

There is a strong possibility I am allocating to much attention to this Italian election, especially as I have no edge on the outcome. With that said, the precedent on ECB action into perceived political risk events has been a sure thing under Draghi. With everyone long EUR, on what cyclically is a worthy story, Draghi could enact some n/t dovish pain, while Carney is still dealing with 100bp inflation overshoot and negative real wage growth. If BTP/Bund spread picks up a bit, EUR will take notice. Couple this with the fact that Draghi has a 1.20 EUR and a political event at the same time; rhetoric could turn more dovish. With 3% inflation in the UK, that luxury does not exist. Back to .87 on EURGBP seems likely given CB rhetoric divergence for the next few weeks. Reds/greens, probably have to come back down to earth a bit, while BoE won't do much to allow implieds to move much lower.

Politics vs Economics, The former needs to be further priced in CEE's

Besides the potential shifts in monetary policy, I think the dichotomy between an improving global economy and deteriorating geo-political environment is very interesting. CEE's such as Poland and Hungary are first to come to mind.

EURPLN

Looking at the theme of effective ECB pegs, CEE's are an interesting case. As we all know, many of the CEE's are booming and policy is stuck effectively pegged to ECB forward guidance, so FX has been pricing it as rates can't adjust. Poland is a good example of this, everyone and their mother knows the NBP is behind the curve with wage growth over 7% and inflation at target. Paying long end rates would be a better way to play as despite political tension, econ has momentum. Consumption is booming and given wage growth and relatively low HH debt, it should continue.  However, what if a continued deterioration in the political situation in Poland continues....  I think FX has to price it. The EU triggered Article VII of Lisbon Treaty against Poland; Poland is a huge beneficiary of core EU transfer payments, FDI and exports, 30% go to France and Germany. A widening gap between the EU and Poland's PiS controlled government could meaningfully effect the perceived trajectory of the capital account, which would foster a decent reversal in EUR/PLN. There is a chasm building between east and west in Europe and FX is ignoring it, I could see that changing in the new year. 

Tax reform, NKY surge, and widening rate diffs; USDJPY stuck

Back to my favorite trade, as much of the themes I am thinking about can be boiled down to being short USDJPY. A break of the range would make me nervous, but think about it, rate diffs have blown out again, NKY is at 20yr highs and tax reform got through, and the cross is stuck. I have made the flows case a few times, but it really does seem to me, that Japan's balance of trade will improve at a time the investment side of the current account also does. Marginal room for them to be more long USD assets, especially if the spoos/blues model is questioned this year, not really there. Another perk of this trade, if the markets favorite trade, long disinflation breaks, you get vol exposure being short USDJPY. On the trade front, their biggest Asian trade competitor had its currency appreciate +10% vs the dollar in 2017, while JPY weakened.... This sets up a comparative advantage relative to KRW going into 2018. Also on the trade side, Japan machine orders are booming, i.e. if you want to be long Asia FX on rebirth global trade and strength in the business cycle, JPY has to lag it as 55% of their exports go to Asia. Market is pricing that JPY post YCC will follow rates and not comparable FX (ADXY), that could be reevaluated in 2018. Onto the BoJ. I have gone into the ramifications of Kuroda's November speech in Switzerland and how the BoJ ipso-facto established a put in the slope of the yield curve. They clearly now understand the feedback loop of the destruction of liability based biz on consumption, which means only place to go in curvature is steeper; even if they don't actually, the asymmetric scope is FX significant. Japan is growing at 1.5 despite a 1% decline in labor force, thats pretty good going. Given fiscal side, rates cant really move, so maybe the currency will do some of the tightening in 2018 like we saw in Europe in '17. The biggest risk to this trade in my view is a passive melt up in US equities and bonds, i.e. vol remaining on the floor. With that said, given exposure to pickup in Asian economic activity, this trade in my opinion can be sort of growth agnostic. O, and, 2s30s in JPY, steeper than US......

Paradigm Shift in China (ya, I could be a bit late)

While there are plenty to choose from, I think my biggest miss last year was missing the lagged effect of Chinese industrial activity, excess capacity reforms and fiscal impulse on the rest of the world, besides paying KRW rates on lag to copper, I missed legit everything else. And, all of these China positives coincided with a fairly broad USD sell-off and tame central banks, a perfect storm. To me, it looks like it could be another interesting year in China but in a different way. In short, China's transition from a mercantilist beast and further moves in belt road mean despite the move in current account, regulators will continue to keep CNH steady to strong.

The introduction of the CFETS basket was a key move in the PBOC's move to become a bit less USD reliant. These efforts will likely intensify in '18 as China would ideally like to finance belt road in Yuan, which sort of explains Xi's recent globalist push. The ramifications of a changing recycling model of USDs from the PBOC, or even China eventually fighting the US Treasury for excess Asian savings and reserves are a problem for USTs and USD. In general it seems, the combination of Trump potentially taking a more hawkish trade stance with China trying to take some reserve currency hegemony, to finance belt road in Yuan; the market will have to reprice the status quo of the UST reserve model. In a sense, this should be an easy test case as the reciprocal would present itself in an obvious way, i.e. PBOC says USDCNH needs to go back to 6.75.

The feeling, especially in academic circles is, with JGBs and Bunds at 0 and 40 respectively and a global savings glut, where can backend yields go, i.e. new normal for term premium (TP). Well, what if in a year of increased issuance and the FOMC reaching autopilot on SOMA, the UST reserve model is further questioned. CGBs yield 3.9, a fight for liquidity would hurt duration along with inflation ticking up after Q2. In a sense, this also plays into my USD/JPY short and why the post YCC correlation of 10Y yields and USD/JPY is breaking as GPIF pension money will have a new place to go. Mnuchin or Powell may not know it, but they will have to compete for Asian savings surplus' and reserves. The Fed is ahead of the curve on b/s as academics are stuck in a new normal for TP given global savings glut and shortage of HQLA's. Rates vol should pick up this year, paying long end USTs makes sense, as 30s should be above 3% on growth alone, let alone this change in supply/demand dynamics. The two biggest marginal buyers of duration, Fed and foreign $, are slowing/selling into increased issuance.....

I would leg into this given my inflation concerns in near term, strong comps for CPI until March number. In general, inflation in the US is a bit tricky given pick up in rental vacancies and what that will mean shelter component of CPI. However, normalization in one offs, pickup in goods thanks to consumption move in Q3-4 and USD weakness should be able to alleviate some OER weakness. And this is another reason why USDJPY is the way to play it, as it has so many outs. Worst of with USH8 is a fine idea but think of the outs for USDJPY in this scenario: if weakening UST supply/demand dynamics come at a time of weakening inflation, or inflation does move and makes Japanese holders uncomfortable in big USTs position. Basically unless rates vol stays on its ass and we steadily move higher in yields, short USDJPY should benefit if either variable is the marginal driver of yields in 2018.

A new CNH world or Beginning of Reversal?



PBOC has a knack for stepping at 6.45 to soften the blow. I think in general, PBOC reaction to strengthening CNH will tell us a lot about directionally where China is going,

Stronger Yuan, Inflationary

(Since 2008, Inputs YoY: REER, credit impulse, imports, m1)



I have been looking at creating an indicator for Chinese industrial activity and what it means in a global econ lag sense. I also wanted to involve FX, to me, Asia FX is one of the best global economic indicators. I could have been a bit less lazy and used a moving average so its a bit cleaner, but the gist is the same, DM world econ is in process of lagging renewal in Chinese industrial strength. China being the worlds most important marginal consumer, a strong currency likely means continued strength in world trade. China probably did double digits nominal growth last year into 19th NPC, which of course means econ should be a bit softer this year, so this indicator will be important as the credit impulse for this year is lower. Think as an offset you could have some 1050 knock ins in long USDKRW. Either CNH reverses higher or BOK will ramp up activity on weakening FX.

Does Buxl finally break.....



Interesting paradox for long end of German curve with EUR up here. The question is, does the long end discount the the thing that pushed EUR here (econ expansion), which has growing momentum, or does it discount what 1.20 means for future growth. The inability for Bunds to take out 50bps in yield and flattening in 2s10s, suggest the latter is meaningful, especially as it will likely take down staff macro forecasts for HICP at the ECB. To me, until Chinese economic activity meaningfully slows, the market will continue to try and get the back end off of this forward guidance curve anchorage. Germany is doing over 4% nominally and surveys are at record highs, coupled with rhetoric on APP changes turning more hawkish, long end should be under some pressure even if Italy dampens risk appetite and ECB tone.

All the best in 2018, email jonturek@gmail.com is best way to be in touch re questions/comments.