September Monthly

Three forces are shaping the investment climate.  The US-China trade conflict escalates at the start of September as both will raise tariffs on each other's goods and are threatening another round in mid-December (US 25% tariffs on $250 of Chinese imports will increase to 30% on October 1).  Some third parties may benefit from the re-casting of supply chains, but the first impact is understood to weaken growth impulses.  That is aggravating the slowdown already evident in several large economies in H1, including the US, China, and the EU.  The deflationary winds of softer economic performance and weaker price pressures are boosting pressure on central banks to ease policy.  The Federal Reserve and the ECB are widely expected to take new accommodative steps in September. The combination of slowing trade, weakening growth and prospects for rate cuts have driven yields lower and spurring curve inversions.   There are around $17 trillion of negative-yielding bonds, including more than $1 trillion of corporate bonds.

In the foreign exchange market, these forces weighed on those currencies that often appear sensitive to world growth.  Among the major currencies, this means the dollar bloc and the Scandis underperformed.  It also means that those currencies that are often used to fund the purchases of riskier assets, like the Swiss franc and Japanese yen, outperformed.  Emerging market currencies weakened in August.  The Thai baht's 0.8% gain was the sole exception.  The JP Morgan Emerging Market Currency Index fell by a little more than 5% in August.  That is the most since last August (-6.2%), which itself was the most since May 2012.

There has been much discussion in recent weeks about steps that the US may take to drive the dollar lower.  We recognize intervention as an escalation ladder, and the low rungs are about verbal intervention.  Although President Trump has said many provocative things about currency manipulation in China and Europe, we do not expect material intervention.   We are not so much concerned about the operational challenge: Will the Federal Reserve cooperate?  Does the Exchange Stabilization Fund hold sufficient dollars to make the intervention credible?

Our concerns are where the rubber meets the road:  Selling dollars is fine, but what to buy?  Should the US buy the onshore or offshore yuan and help fund the Chinese government, the People's Liberation Army, the Belt-Road Initiative and help make a larger reserve asset?   If the US intervenes to buy euros or yen, will it really pay Germany or Japan to hold our money, which is what negative interest rates imply?  And how will other countries respond?  After years that many cried wolf, would this trigger the dreaded currency war?  If the US buys the yuan, what if China went in the next day and sold twice the amount of yuan and bought dollars?  

Nor do we expect China to "weaponize" its Treasury holdings by selling them.  Given the near-insatiable appetite demonstrated by the sharp decline in yields, any practical divestment from China can be easily absorbed.  The US 10-year yield fell about 52 basis points in August, the most since January 2015  The 30-year fell by nearly as much to push below 2.0% for the first time ever.  The 2-10 year yield curve inverted while the three-month bill to 10-year curve has been inverted since May.  Inverted curves are associated with the conditions that lead to recessions, usually with a substantial lag.  

With the Queen's support, UK Prime Minister Johnson suspended Parliament from September 12 through October 14, when the Queen's Speech will lay out the government's program.  The idea is that without Parliament's obstructionism, Johnson has a stronger hand to negotiate with the EU.  The strategy will be legally challenged, as the UK's Supreme Court ruling had secured the right of Parliament to have a say on how the UK leaves the EU.   

Dollar:  There is little doubt that the Federal Reserve will deliver its second rate cut of the year at the conclusion of its meeting on September 18, when it will updates its forecasts as well.  The economy appears to be continuing to grow a little faster than the Fed estimates to be the long-run non-inflationary pace.  While job growth has slowed (165k average through July vs. 227k in the first seven months of 2018), it is sufficiently robust to ensure unemployment and underemployment remain near cyclical lows.   Household consumption remains strong.  Business investment has been dominated by the energy sector, and there are some preliminary signs of that moderating.  The positive yields in the US contrast with the negative yields in Europe and Japan. At the same time, we think it is important that the US premium on two-year borrowing over Europe (Germany) and Japan peaked last November and set new two-year lows in August.   Dollar strength in the face of the narrowing of short-term interest rate differentials that we have seen may be indicative of the last phase of a big dollar bull market.  What has consistently taken the wind from the dollar sails is an escalation of the trade conflict that spurs investors to price in more aggressive Fed easing.  

Euro: Germany, Europe's largest economy, continues to struggle.  The root of the problem appears to be in the auto sector, which relied more on diesel and China than may have been appreciated.   The economy has contracted in two of the last four including a 0.1% decline in Q2 19.  The Bundesbank warned that the economy may have contracted in Q3 but is reluctant to endorse fiscal stimulus.  The German government may ease its purse strings grudgingly, and it can borrow money out 30 years at negative rates.  The ECB will likely complement it with a dramatic easing at President Draghi prepares to handoff to Lagarde.  The ECB may cut the deposit rate (presently at minus 40 bp) and announce plans to renew its asset purchase program when it meets on September 12.  The euro finished August below $1.10 for the first time since May 2017. The next important chart levels are not found until closer to $1.08.

(previous in parenthesis, end of July indicative levels)

Spot:   $1.0982 ($1.1076)     Median Bloomberg Forecast  $1.1037 ($1.1228)    
One-month forward $1.1010  ($1.1106)     One-month implied vol  5.8%  (4.9%)  

Yen: The Japanese yen was the strongest currency in the world in August, appreciating about 2.2% against the US dollar.   Falling interest rates and a four-week slide in the S&P 500 (a proxy for risk appetite) pushed the dollar to new lows for three-year lows on August 26 a little below JPY104.50.  The yen's strength works against Bank of Japan efforts to boost inflation, but officials must be careful not to antagonize the Trump Administration.  Still, we suspect the official concern rises as the JPY100 level is approached.  Japan is demanding an exemption from all new tariffs on autos and auto parts to complete a trade agreement in September.  Japan is going forward with the sales tax increase on October 1.  This could bring forward some durable good purchases, but this was not significant before past sales tax increases.  The Bank of Japan meets on September 19, and with the 10-year bond yield trading outside of the +/- 20 bp band, it may reduce again the amount of longer-term bonds it buys.  However, the fate of the yen seems more driven by external developments than domestic.

Spot:  JPY106.28 (JPY108.78)     Median Bloomberg Forecast JPY105.96 (JPY108.06)   
One-month forward   JPY106.05 ( JPY108.49)  One-month implied vol  8.1% (5.1%)

Sterling: Brexit continues to suck up all the oxygen in the UK.  By suspending Parliament from September 12 to October 14, Johnson is pressing harder his case that he is prepared for the UK to leave the EU on October 31.  It appears to be a risky strategy.  It will intensify the effort in Parliament and courts to overturn Johnson's move (that the Privy Council and Queen made possible). The gamble is that this will make Europe more willing to compromise, but so far the EC seems nonplused.  Sterling recovered from the test on $1.20 in the middle of August but faltered near $1.23.  Implied two-month option volatility that covers the exit date is above 14%, and the uncertainty has lifted the one-month volatility four-month highs above 11%. The euro peaked at a three-year high against sterling near GBP0.9325 in the middle of August before correcting lower to test the GBP0.9000 area.  We suspect that if the collective wisdom that is being expressed in prices is vulnerable, it is that it wants to believe that a solution at the last minute will be found to avoid a no-deal Brexit, which Johnson has previously handicapped as one in a million.  

Spot: $1.2156 ($1.2159)  Median Bloomberg Forecast $1.2192 ($1.2402)      
One-month forward $1.2172 ($1.2180)   One-month implied vol  11.0% (7.0%)  

Canadian Dollar:   Among those currencies that seem most sensitive to risk-taking appetites, for which we include the dollar bloc and Scandinavian currencies, the Canadian dollar fared the best in August.  It fell about 1.2% against the US dollar.  Although the dollar was mostly confined to a CAD1.3200-CAD1.3350 trading range, it finished August with a seven-week rally in tow.  The pendulum of market sentiment has swung toward a rate cut in October.   At the end of July, the derivatives market was discounting about a one-in-five chance of a rate cut in October, and now the odds are closer to two-in-three.  The Bank of Canada meets on September 4.  Confidence that the Fed will cut rates in September and the weaker global economy may see officials soften their neutral stance. If officials do not prepare the ground for an October move, the Canadian dollar may appreciate.  The national election will be held in October, a week and a half before the next central bank meeting on October 30.  The wagers at PredictIt.Org give about a 60% chance that Trudeau remains Prime Minister.  

Spot:  CAD1.3311 (CAD1.3191)    Median Bloomberg Forecast CAD1.3283 (CAD1.3140)

One-month forward CAD1.3305 (CAD1.3180)    One-month implied vol  5.6% (4.8%)

Australian Dollar: Disappointing economic data and the slowdown in China are prime suspects of the drivers for the six-week downtrend that the Australian dollar will carry into next month.  These are the same forces that have seen iron ore prices fall 25% in its six-week slide and saw copper prices hit two-year lows.   The Reserve Bank of Australia does not seem to be in a hurry to cut rates after the back-to-back cuts in June and July.  It meets on September 3.  The combination of past rate cuts, the weaker Australian dollar, tax cuts, and spending increases may keep the wolf from the door for a bit longer.  Unless the outlook improves, speculation may increase of an October 1 rate hike.     

Spot: ($0.6845)      Median Bloomberg Forecast $0.6750 ($0.6931)  
One-month forward $0.6740 ($0.6855)    One-month implied vol  7.8% (6.5%)  

Mexican Peso: Like the Australian and Canadian dollar, the peso will be taking a losing streak into September.  The peso has fallen for seven weeks, depreciating by about 5.7% over the span.   There are global and domestic drivers. The depreciation of the Chinese yuan and slower growth projections weighed on emerging market currencies broadly, and the peso is liquid, accessible proxy.  The peso is the second most actively traded emerging market currency after the yuan.  The central bank, Banixco surprised many with a 25 bp rate cut amid sluggish growth and policy uncertainty under AMLO.  The cut likely signals the beginning of a series of cuts, with the next one likely not at the September 26 meeting, but at the following meeting on November 14. The dollar finished August at new highs for the year against the peso.  The 2018 high was near MXN21.96 and the 2017 and record high set a little below MXN22.05. 

Spot: MXN20.06 (MXN19.15)   Median Bloomberg Forecast MXN 19.99 (MXN19.26)     
One-month forward  MXN20.17 (MXN19.25)    One-month implied vol 11.4% (8.9%)

Chinese Yuan:  As trade tensions escalated and emerging market currencies were coming under pressure, Chinese officials allowed the dollar to rise through CNY7.0 on August 5. It has not looked back and poked a little through CNY7.17.  A ten-day advance was broken on August 29.  Chinese officials may be signaling that it is not desired for the dollar to rise through CNY7.20.  Chinese corporations have been significant borrowers of dollars, and a weaker yuan lifts debt servicing costs. A weaker yuan discourages Chinese companies from moving up the value-added chain.  "Talk and fight" seems to be the slogan, which allows for negotiations to continue even though a second tariff truce has ended.  A substantive agreement between the US and China is looking increasingly remote, and we suspect that the end game is disengagement.  It will take a few years, and it will not and cannot be complete, but the trust and the good-will account is bankrupt.   

Spot: CNY7.1560 (CNY6.8850)       Median Bloomberg Forecast  CNY7.1375 (CNY6.8915)       

One-month forward CNY7.1470 (CNY6.9050)    One-month implied vol 6.4% (3.1%)  

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