Dollar Resilient as Cracks in Risk-On Appear

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Win Thin
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• Some cracks have appeared in the market’s risk-on sentiment
• We continue to believe that recent developments take some pressure off the Fed to cut rates again this month
• Our base case for a Brexit delay has been strengthened; UK reported weak labor market data
• The situation is Turkey continues to develop negatively for asset prices; trade data out of China once again showed the impact of the trade war and the resulting global slowdown
• RBA minutes were released; Japan is readying a supplemental budget to help address the damage from typhoon Hagibis

The dollar is mostly firmer against the majors as the US returns from holiday. Sterling and yen are outperforming, while the Antipodeans and Scandies are underperforming. EM currencies are mostly weaker. TRY and THB are outperforming, while HUF and INR are underperforming.  MSCI Asia Pacific was up 0.7% on the day, with the Nikkei rising 1.9%. MSCI EM is flat so far today, with the Shanghai Composite falling 0.6%. Euro Stoxx 600 is up 0.5% near midday, while US futures are pointing to a higher open. 10-year UST yields are down 5 bp at 1.68%, while the 3-month to 10-year spread has fallen 3 bp and stands at +4 bp. Commodity prices are mostly lower, with Brent oil down 1.7%, copper down 0.6%, and gold up 0.3%.

Some cracks have appeared in the market’s risk-on sentiment. Perhaps it was the realization that the partial trade deal wasn’t all that it was cracked up to be. Or perhaps it was the realization that a Brexit deal remains very difficult to reach. Or perhaps it was the unfolding chaos in Syria. Whatever the reason, the dollar came roaring back Monday and it has added to those gains today. Whilst we acknowledge risks of periodic dollar weakness, its resilience is noteworthy and we retain our strong dollar call.

The US-China trade takes are over and all we have is a handshake deal and a few tweets to lean on. The agreement is as tenuous as ever, but it should be enough to provide some near-term stability for investors. In short, “phase one” meant no near-term tariff escalation from the US and China buying more agricultural products and taking steps on the currency and intellectual property. But most importantly, it gives both countries enough to spin the mini-deal to their domestic audiences.

Geopolitical risks are clearly rising. After the US pulled out of northern Syria and Turkish forces moved in, the Kurds had no choice but to look to Syrian forces loyal to President Assad. Reports suggest ISIS prisoners have escaped, making the regional outlook even more unsteady. The US has called for an immediate ceasefire but really, it has lost any voice in this conflict now. Surprisingly, oil prices fell Monday and have added to those losses today.

AMERICAS

Believe it or not, the US economic outlook still remains solid. The Atlanta Fed’s GDPNow model is tracking 1.7% SAAR growth in Q3 vs. 1.8% previously, which is still near trend (~2%) with some drop-off from 2.0% in Q2. Elsewhere, the NY Fed’s Nowcast model is tracking 2.0% SAAR growth in Q3 while its forecast for Q4 growth is tracking 1.3% SAAR, both steady from last week.

We continue to believe that recent developments take some pressure off the Fed to cut rates again this month. With the improved market mood, Fed Funds futures are pricing in less Fed easing now. The implied yield on the January 2021 contract is around 1.21%, which is only slightly more than two cuts priced in for the rest of this easing cycle vs. nearly four earlier this month. The US 3-month to 10-year curve remains positive at +4 bp, still the most since early May. If sustained, this move to positive slope will significantly push down perceived recession risk. WIRP suggests 70% odds of a cut October 30, down from the 85% peak earlier in the month and continue to fall steadily. Bullard, Bostic, George, and Daly all speak today.

EUROPE, MIDDLE EAST, AFRICA

Our base case for a Brexit delay has been strengthened by the combination of hopeful headlines and an impossibly short timeframe to pursue the proverbial “pathway” to an agreement. Sterling has been bouncing to the tune of official comments, down 0.5% yesterday after EU negotiators deemed Boris Johnson’s proposal as too complex and “not good enough,” but up by the same amount today after the EU said more time was needed to hash out a Brexit deal. The plan on the table supposedly involves keeping Northern Ireland in the UK’s customs area but with some vague solution to track the destination of goods crossing the border. It’s also unclear about the proposal to grant Stormont veto power.

The EU summit starts in Thursday, so the two sides need to make a lot of progress quickly. The EU acknowledged that talks are likely to continue after the summit ends Friday, suggesting some limited scope for flexibility. But remember that even if Johnson gets that agreement, he still needs to pass it through Parliament during Saturday’s special sitting. When all is said and done, our base case remains that enough progress towards a deal will allow for yet another extension.

Meanwhile, the UK reported weak labor market data. Employment fell -56k vs. +26k expected for the three months ending in August, while the unemployment rate rose a tick to 3.9%. Average weekly earnings and ex-bonus earning growth both eased a tick to 3.8%. Sterling continues to have trouble breaking above the 200-day moving average near $1.2715 currently. That level also corresponds with the 62% retracement objective of the May-September drop. This will provide strong resistance but a break above it would target the May 6 high near $1.3185. Cable’s 1-month implied volatility shot up to 13% and the 1-week measure is now over 18%.

The situation is Turkey continues to develop negatively for asset prices, as we had expected. Both US and the EU are stepping up pressure by threatening sanctions and arms embargo. Presided Trump increased tariffs on imported steel to 50% and imposed sanctions on three Turkish officials. Meanwhile, Syrian President Assad has reached a deal with the local Kurdish forces (YPG) and started to send troops to the region to face off the Turkish incursion. The next piece of the puzzle is Russia and the extent of its support for Assad’s efforts with, for example, air support. So far, Putin seems to be playing mediating role, tempering the risk of a direct confrontation between Turkey and Syria. The lira has stabilized this morning and the nation’s stock index is up 1.8% as many observers considered that the measures the US imposed against Turkey were not as bad as expected. Local rates remain very volatile, but also appear to have stabilized in today’s session.

Poland’s elections over the weekend went as expected with a victory for the ruling Law and Justice Party (PiS). The PiS is set to take some 44% of votes compared to the opposition with 27%. This was less than polls had suggested and less than what the party won in the European Parliament elections earlier in the year. Still, the government will see this as enough to underpin its mandate to continue its controversial judicial reforms (despite the confrontation with EU) and boost its welfare expenditures. Still, there is nothing really new here and shouldn’t make any difference for Polish asset prices.

The local elections in Hungary were more surprising. Many seats, including the Mayor of Budapest, have fallen into the opposition’s hands. This development seems to echo the recent local elections in Turkey, where the AKP lost control of Istanbul and Ankara. The win in Hungary was helped by a united opposition fielding joint candidates, and by a political scandal involving the incumbent mayor from the ruling Fidesz party.  Here too, there will be little near-term impact on Hungary but certainly bears watching ahead of the next national elections due in 2022.

ASIA

Trade data out of China once again showed the impact of the trade war and the resulting global slowdown. Both imports (-8.5% y/y) and exports (-3.2% y/y) in China declined by more than expected. Both readings worsened from August. The economy is likely to continue slowing even if there is a partial trade deal. If so, we see more stimulus ahead but believe the PBOC will refrain from outright rate cuts for the time being. The data also shows the now-familiar pattern of shrinking trade with the US and redirecting to other countries, especially in Asia.

Elsewhere, September CPI came in slightly higher than expected at 3.0% y/y while PPI came in at -1.2% y/y vs. -0.8% contraction in August. The gap between the two readings can be explained in a single word: pork. Food prices were up 11.2% y/y, driven by surging pork prices to the tune of 69%. That is why we view China’s agreement to buy more US agricultural goods as being in its own economic interests. Lastly, credit continues to expand in China with aggregate financing surprising on the upside at CNY2.27 trln, rising over four of the last five months. Broad M2 supply expanded 8.4% y/y, consistent with the recent monetary easing measures by the PBOC. Chinese equity markets underperformed, down 0.6% and the yuan is slightly weaker against the dollar.

RBA minutes were released. It cut rates 25 bp then to a record low 0.75% and said that it is prepared to ease further if needed. However, the RBA expressed some concerns about the recent jump in house prices. The bank also discussed the potential for running out of ammunition but ultimately decided to cut rates sooner rather than later.

Japan Prime Minister Abe said he is readying a supplemental budget to help address the damage from typhoon Hagibis. Elsewhere, BOJ Governor Kuroda said he won’t hesitate to add stimulus if risks to rising inflation materialize. WIRP suggests 88% odds of a cut October 31 but this seems too soon after the October 1 consumption tax hike. USD/JPY has stalled out near 108 but we believe it is still on track to test the August 1 high near 109.30. The 200-day moving average comes in near 109.05 currently.