Same old song and dance.

Summary:

• Macro update: Same script different risk.

• Stronger US dollar: Monetary policy convergence.

• Europe: Manufacturing continues to take a hit.

We are still reading the same macro script from a year ago, albeit with a different risk catalyst.

The market remains captivated by the promise of central bank liquidity.

Whether the risk catalyst is a trade war or a mysterious respiratory virus, the bottom line is that policymakers have remained committed to keeping risk assets buoyant through accommodative policy and forward guidance. There remains little upside to interest rates as central banks are amidst a comprehensive rethink of quantifying their goals and objectives through a strategy review. The primary purpose of these reviews is to try and rustle up some credibility on the inflation front. Ultimately, overshoots in inflation, like the one seen in the US this week, are welcome as the bar for higher interest rates is significantly higher than the bar for lower interest rates. The only thing that's changed in the past month is that, rather than a trade war hampering growth, it's the Novel Corona Virus.

Next week will give us an inside view on central bank thinking and the first real impact of the coronavirus on global manufacturing.

Next week we will get to see the meeting minutes from plenty of central banks, Fed and ECB included. On the data front, we will get a comprehensive update on global manufacturing, with data from Europe, the UK, the US, Japan, and Australia. These prints may give us some early insight into the impacts of the Corona Virus.

The US remains in a good place; however, the case for further rate cuts becomes more compelling as the virus spreads.

Powell's testimony this week reiterated the views from the monetary policy report released last Friday.

Apart from being positively ID'd as someone who attended a party at Jeff Besos' place, Powell's comments were fairly standard. He reiterated that trade tensions had abated and that global growth was inflecting until the Corona Virus outbreak. The bottom line is that growth remains in a good place, albeit moderate, and that economic impact from the virus remains uncertain. In line with market expectations, the Fed did announce that it planned to cut back its repo purchases but would continue the bill purchase program. Many continue to expect the Fed will transition into a bond purchase program by the end of the year.

Bernie Sanders won in New Hampshire.

The markets took the news of Sanders predictable win in stride, riding the hope that if Sanders wins the nomination, Trump would likely be reelected. Buttigieg had a strong showing in New Hampshire and continues to hold onto the delegate lead for now. Meanwhile, both Warren's and Biden's campaigns appear to be sputtering out. I've updated the poll numbers from PredictIt below.

Retail sales in the US came in below expectations.

Consumer spending slowed in January, and there was a downward revision to the December numbers. The US economy has motored along primarily due to robust consumer spending, who has stepped up to the plate during a period where business investment has remained stagnant at best. The more concerning part is that these weak numbers are coming against record-high confidence, record-low unemployment, and a record-high stock market. Of course, this is just one sour print among, generally positive, US data. Industrial production also took a hit last month, although that was mainly due to Boeing halting any manufacturing on their 737 MAX line.

The market shrugged off the largest US inflation increase since 2018.

The rise in consumer prices in January was attributed mainly to higher gasoline prices, along with an increase in housing. After stripping the more volatile components of the index, consumer prices remained steady at 2.3 percent growth year over year. As I highlighted above, no one cares about inflation data right now as any upward pressure yields is being offset by a cocktail of factors keeping safe-havens (Treasuries) in demand. In that respect, the data coming out right now is, in some sense, stale. That's evident in inflation break even's and swap rates, which have continued to decline amidst the Wuhan virus and falling oil prices. The Fed's asymmetric reaction function skewed heavily towards lower interest rates, has also dampened the weight of the incoming inflation data. The Fed has worked hard to characterize monetary policy as being in a "good place," and an inflation overshoot is welcome at this point.

US dollar index is up nearly 2.5 percent since the start of the year.

Most notably, the Euro is nearly 5 percent weaker against the greenback this year alone. The above-trend growth in the US, coupled with the asymmetric impact of a slowing China on Europe, has created a clear divergence in monetary policy between the two regions. As I highlighted last week, a flatter Phillips curve (the relationship between inflation and unemployment) suggests that the US is unable to create strong enough domestic inflation to offset any deflationary impacts from a stronger US dollar. As the US continues to outperform the rest of the world, capital will flow to the US, creating more demand for US dollars and will likely force the Fed to lower rates to control deflationary pressures. The chart below shows that import prices in the US have been declining over the past year.

What happens if the Fed cuts rates in response to a stronger USD?

If the Fed cuts rates due to a stronger greenback, that will result in stronger foreign currencies, which will put pressure on foreign central banks to lower rates further. That creates a feedback loop wherein lower rates abroad force the Fed to continue to lower rates domestically. Ironically, in reducing rates internally, the Fed supports the economy, creating an even more significant divergence from the rest of the world, which puts pressure on the US dollar to appreciate, forcing another round of rate cuts. The feedback loop described above is the underlying notion behind monetary policy convergence. One of the critical things to look for is the compression of the US Treasury-German Bund spread, which is now the narrowest since January 2018. The chart below is an update to the one I showed a few weeks ago.

Several headwinds are emerging that could hamper European manufacturing.

Germany narrowly avoided a recession in Q4 of last year.

After posting some truly heinous data last week, the fact that the German economy posted a 0.1 percent growth clip is more a miracle than anything else. Rather than going into the need for fiscal policy, I'm going to highlight a note from Deutsche Bank (DB), which flags a few risks to German exports. Notably, the Phase one trade deal between the US and China, which is expected to divert Chinese demand for European exports to US competitors. Ballpark estimates from the IFW research institute show that by 2021, EU exports to China will fall by a sizeable US$ 10.8 billion, with the bulk of that decline hitting French and German manufacturing. That's excluding any impact from the Wuhan Virus, which has undoubtedly taken a toll on demand for European goods, particularly cars. The bottom line here is that there is a myriad of links one could make from Germany to the Chinese economy, and the majority of them aren't looking too great.

Chinese auto sales plummeted in January.

Unsurprisingly, Chinese consumers were unwilling to check out auto showrooms in January. That is, assuming they were even open. The Chinese automotive market, the largest in the world, has now declined 19 out of the last 20 months. Apart from the economic deceleration, efforts to curb pollution have also undercut the market. Regulation aside, February is going to be another bad month. Dealers and factories have shut down as a result of the spreading virus. Hubei province also happens to be a major producer of automobiles, with Honda and GM both having factories in the region. If you're wondering how EV's are doing, well, their sales plunged 54 percent last month. German auto numbers also paint a similar story, with Volkswagon, BMW, and others producing a total of 4.6 million cars. That's the lowest number since 1996.

Tiago Figueiredo