USD Followup and Fed Preview

A couple of charts and some thoughts to follow up on Detroit Red’s post about the potential for a

bounce in USD.

There has been a clear break in what is historically a strong correlation between the 1y3y US/EU interest rate spread--DR highlighted this in looking at breakevens and copper--I think this chart refines that point and shows there is very little change in medium-term inflation expectations in either market, as proxied by the spread of short-term rate expectations 3 years from now. Yet EUR (and pretty much every other currency) has been ripping vs. USD since this correlation broke down over the past couple of months. So something else is going on here.

DR circled the right factor by looking at copper. This breakdown coincided with the time when cooper went from having a nice run to giving (old) traders flashbacks to 2005.

Yet this is the second derivative--copper is cruising because of resurgent global demand--which is code for “China.” the PBOC has had more success stifling capital flight this year, which has contributed to the USD move--but as I highlighted here in a post last week, that misses the broader point that the growth trends in China are looking very, very good.

Stronger Chinese demand is the jet fuel for the German export machine--so while that strength may not manifest itself in interest rate differentials it certainly does in capital flows and long-term expectations for return on capital, both of which were at historical extremes for EUR in 2016 after the ECB finally pulled the trigger on QE.  Yet since then the euro area current account surplus has only continued to rise.

Similarly, as I noted back in June when this move was getting going, technical positioning in the EUR was also coming off of perma-short levels. This doesn't necessarily show up in CTFC spec charts--much of the outflows were domestic corporates and real money fleeing negative rates and leaving foreign purchases of bonds and equity unhedged. As the economy rebounds, that money is repatriated or hedged back into EUR.

To the extent there is any tradable info at all in CFTC spec positioning charts, I dug up this on current USD positioning--a dramatic shift towards short USD over the past month--but note how long, in size and duration--the spec community was in USD pretty much non-stop since 2014, with only one real reversal last year ahead of the US election. Bottom line: the market is short USD...but not in any meaningful way, especially compared to the tailwind of economic growth and trade flows in Europe.

(the blue line is the spec position...the black line is a dubious measure at best)

And forward rates at large popped last week but still not getting away from themselves, which argues the market hasn’t quite bought into the economic momentum story yet.

Looking at economic expectations and interest rate differentials there is good reason to believe there could be a reversal in USD, but the big driver is China and the related moves out of the US and into, well, pretty much anywhere. Is the short USD trade overcooked? Maybe, but...

As much as both DR and I want to avoid the forecasting and prediction game….there will need to be a catalyst for a significant reversal, unless we are just catching knives for a move back to 1.17, which would be what the mean-reversion/regression scatter would seek to target. That leaves a structural long USD position on the wrong end of a few pain trades--an air pocket in Chinese growth, lower commodity prices/demand, a train wreck in corporate debt and/or EM, or….higher US inflation, a selloff in US rates, a steepening of 2/10s, or a more hawkish FOMC.

Frequent readers of the blog will know I’m not betting heavily on any of those--I agree that there is some evidence that the market is too complacent to an acceleration in wages or demand-pull inflation, but until I see evidence to suggest otherwise, I’ll stick with what this guy is says:

Turning to the Fed…the higher than expected CPI print last week did indeed wake up a few traders to the notion that there is indeed a Fed meeting next week, and the quarterly one where we get an update of the Summary of Economic Projections. Let's take a look at what might change.

Here is a summary of the median responses from the governors were in the June SEP.

I don’t think there is a great argument that we will see much change in any of those variables--while GDP for 2017 could be marked lower, it will be reversed out with higher estimates for 2018 due to one-offs from Hurricanes Harvey and Irma.

PCE inflation has been the story of the year, as the Fed has wrestled with “the conundrum” of lower inflation and higher employment.

While you see that the governors already marked down inflation expectations last quarter, only last week was there any reason to believe there wouldn’t be more to come. Yellen has made some rumblings about one-off impacts on inflation from medical prescription and cell service prices, but those can’t be big enough factors to change the trend.

The trend of lower inflation since the June SEP could force the governors to again mark down expectations for PCE inflation...

in the famous dot plot...

The risk would be to lower forward rate hike expectations and a flatter curve rather than backing off of the pledge to continue monetary normalization in the short-term.

Having lost the great Stan Fischer, Janet and Dudley are now the dynamic duo, and both have continued their hawkish rhetoric...so they can raise rates, if only! If only wages start to rise and takes inflation with them.

The statement, press conference, and SEP will seek to preserve their optionality while again trying to maintain some credibility in recognition of flatter curves and low inflation.

Going full circle back to USD and rates, that result isn’t going to give much of a push to the dollar--in fact it is more likely to keep the curve flat and allow the equity market to keep on keepin’ on. There just isn’t much evidence to suggest the FOMC will upset the apple cart quite yet.

Shawn
TeamMacroMan2@gmail.com
@EMInflationista