Communication blunder

Summary

• Global update.

• A failure to communicate — Hammering home the ammo problem. 

• Currency manipulation — The threat of FX intervention seems overblown.

We may be amid the summer doldrums but there is still a lot going on in markets. There is always risk and uncertainty in the markets but it’s funny how unlikely scenarios gradually turn themselves into likely scenarios over time. Think about earlier this year when the President of the US moved to increase tariffs on Chinese goods — The worst-case scenario quickly turned into the base case. And so the story continues with the slew of trade-related issues that Europe is now going to be forced to contend with by years end. As a quick reminder, back in May, the US was considering imposing US$ 11 billion worth of tariffs on European goods in response to allegations that Airbus was receiving unfair subsidies. This ultimately led to the US administration also considering tacking tariffs on automobiles (which the US agreed to delay until the end of the year). These continue to remain unresolved and will undoubtedly be cause for concern in the coming months. The biggest development since the last email came from New York Fed President Williams' speech on Thursday which rattled expectations for a rate cut in July (more on this below). Meanwhile, in US equities, earnings season kicked off with the majority of the US banks reporting fairly somber numbers. Q2 Earnings growth is expected to decline by 3 percent year over year for the S&P500 with just under 80 percent of reported companies issuing negative earnings per share guidance (report here). This shouldn’t come as much of a surprise though given the economic backdrop that we find ourselves in. In the UK, Boris Johnson is set to take the lead of the conservative party (it appears that a no-deal Brexit remains the likely scenario - See odds here). Central banks will remain in the headlines this week with the ECB set to announce some form of stimulus package on Thursday. Some market participants expect the ECB to lower rates, but the more likely outcome will be one in which they lay out their plans and then take action at the following meeting. In emerging markets (EM), several central banks cut rates last week (South Korea, Indonesia, and South Africa) in anticipation for the Fed at the end of the month. This week we have Hungary, Russia, Colombia and the recently beheaded Turkish central bank on deck; All of which are expected to cut or keep rates unchanged. The chart below shows the net number of central bank hikes vs cuts, showing that on aggregate, there have been more rate cuts than hikes over the last 6 months.

Meanwhile, in Asia, protests in Hong Kong have turned more violent this week as reports that China was sending in "Triad gangsters" to hurt protestors surfaced. For those interested, there’s a great video from Vox that explains why the protests started in the first place (click here to watch). In the middle east, tensions grew on Friday as Iran seized a British oil tanker. The seizure was likely in response to the tanker that was seized a few weeks ago by the British in Gibraltar. The UK government plans to hold an emergency meeting this week to discuss shipping security. Amidst all this, the US also shot down an Iranian drone — Needless to say, things remain tense between Washington and Iran. On the topic of Iranian oil, it appears that Iran has been stockpiling oil inventory in storage tanks at Chinese ports. It's important to note that this oil hasn’t crossed Chinese customs and is technically still owned by Iran and thus not in violation of the sanctions. However, the US administration has imposed sanctions on the Chinese company that transports the Iranian crude to these storage tanks (article here). This does have the potential to throw a wrench into trade talks and could encourage Chinese/Iranian cooperation, with the potential to send oil prices tumbling.

The Federal Reserve has now gone into blackout ahead of their next meeting on the 31st of July; a blessing to markets given how much of a mess they’ve made of their communications last week. It’s hard to imagine how the case for a 50 bp rate cut in July has become more compelling since the June meeting. The combination of a strong payrolls report and a hot inflation print has served to undermine the case for a cut. There was a bit of a scare in some of the survey data last month which suggested the global manufacturing slump had made landfall in the US, however, since then, other regional surveys have deflected some of those fears. Were it not for Powell’s testimony before the House of Financial Services committee 2 weeks ago cementing a rate cut for July, it could very well have been the case that the market would have expected the Fed to remain on hold. On Thursday the market was hit with yet another complication where the New York Fed president Williams delivered a speech entitled “Living Near the Zero Lower Bound”. The speech echoed Powell's statement at the June FOMC where Powell flagged research suggesting that it would be better to come out of the gate swinging, delivering rates cuts sooner and by a larger amount, rather than taking the “wait and see” approach to monetary policy. William’s speech shook things up in the market but the message he delivered wasn't a new one. If anything, he was rehashing the ammo problem, one that was rekindled earlier this year when inflation expectations began to fall and global central banks were persistently undershooting their inflation targets. The bottom line is that these rate cuts are coming and, how and when they are delivered is going to be crucial. Fed research suggests that a 50 bp cut in July would be more appropriate but, as the Fed made very clear, what research suggests does not equate to an exact policy response.

Treasury Secretary Steve Mnuchin delivered a series of remarks last week which suggested that the US is considering weakening the greenback. Speculation that the US administration would consider manipulating its currency started about a month ago when the ECB’s Mario Draghi announced that he would consider a new round of stimulus later in the year. The President took to twitter stating that it was “unfair” that the Euro had weakened, fuelling speculation that if the Fed rate cuts weren’t enough to weaken the greenback, the US treasury would step in to finish the job. Realistically, it’s unlikely that the Treasury can unilaterally impact the value of the USD. Any past efforts to intervene were done multilaterally (think of the Plaza accord). That’s not to say that if the US were to intervene it would not create some kind of currency volatility, after all, it would signal the future of the US’ foreign policy. It’s important to note that one of the reasons for the greenback's resilience this year stems from US treasuries continuing to hold a positive yield. There are many foreign investors (Japanese and European) who cannot find positive yields in their jurisdictions and would rather buy US assets (financial market tourists). This has created demand for US dollars which has kept the US dollar strong. What's important is that this dynamic doesn’t appear to be fading, if anything, it is going to get stronger as central banks continue to lower rates. Below is a chart of the US dollar index since 2015. 

Tiago Figueiredo