Dollar Firm, Markets Fairly Calm After Iran Retaliates

  • Markets didn’t have to wait long for Iran to retaliate; the dollar continues to gain traction
  • The spike in oil prices should be on the Fed’s radar screen; WIRP suggests that a 25 bp rate cut is now fully priced in for 2020
  • ADP jobs, weekly mortgage applications and November consumer credit will be reported
  • German factory orders for November contracted sharply by -1.3% m/m (-6.5% y/y), far worse than expected; BOE Governor Carney made some dovish comments
  • Japan reported weaker than expected November cash earnings; AUD made a new low for this move overnight near .6850 but has since stabilized

The dollar is mostly firmer against the majors after Iran retaliated.  Stockie and Kiwi are outperforming, while the yen and euro are underperforming.  EM currencies are mostly weaker.  ZAR and TRY are outperforming, while THB and KRW are underperforming.  MSCI Asia Pacific was down 0.9% on the day, with the Nikkei falling 1.6%.  MSCI EM is down 0.4% so far today, with the Shanghai Composite falling 1.2%.  Euro Stoxx 600 is down 0.1% near midday, while US futures are pointing to a lower open.  10-year UST yields are down 1 bp at 1.81%, while the 3-month to 10-year spread is down 1 bp at +30 bp.  Commodity prices are mostly higher, with Brent oil up 0.8%, copper up 0.3%, and gold up 0.1%.

Well, the markets didn’t have to wait long for Iran to retaliate.  In the early hours today, Iranian forces launched rocket attacks on two US-Iraqi airbases located in Iraq.  The Islamic Revolutionary Guard claimed responsibility for the attacks, which the US said were launched from inside Iran.  US President Trump reacted with a tweet saying that “all is well,” while Iran’s Foreign Minister reaffirmed that the regime is not seeking an escalation and that response was “proportionate.”  The big question now is whether the US retaliates.  Markets seem to be pricing in some de-escalation ahead, but it seems too early to sound the all clear.

Oil and gold spiked on the initial headlines but gave up most of their gains into the London open. On net, Brent crude is up nearly 1% and about $3 higher than a week ago.  Global equity markets are on their back foot but the moves haven’t been dramatic, with declines of about 0.5% in Europe and US futures slightly negative.  US Treasury markets are little changed with the 10-years trading just below the 1.8% level.  Gold made a new multi-year highs above $1600 before falling back below.

The dollar continues to gain traction.  DXY is making new highs for this move and has retraced over half of its late December swoon.  Break above the 62% level near 97.259 is needed to set up a test of the December 23 high near 97.817.  The euro is leading this move as it is already broken below its 62% retracement objective of the same move near $1.1130.  Sterling remains within recent ranges but feels heavy.  USD/JPY is playing some catch-up and we may see an outside up day today that points to further gains.

 

AMERICAS

The spike in oil prices should be on the Fed’s radar screen.  It remains to be seen how protracted this spike will be, but a long one would certainly qualify as a “material change” in the Fed’s outlook.  The Fed has reacted to oil shocks in different ways in the past.  After the first one in 1973-74, Fed officials were more concerned about a recession than inflation and so kept policy loose.  After the second shock in 1979, the Fed became more concerned about inflation and tightened rates aggressively.  While it is still too early to gauge the potential impact of higher oil prices now, we suspect the Fed would follow the 1973 rather than the 1979 one.

Indeed, WIRP suggests that a 25 bp rate cut is now fully priced in for 2020, compared to about 15 bp of easing priced in at the end of last year.  The move is understandable as the recent events force investors to price in some probability of military confrontation. That said, we think this move lower in implied rates will ultimately prove to be an opportunity. First, we maintain of view that—all else equal—there no reason for the Fed to cut rates this year. Second, we think it is highly unlikely that Trump will let the situation escalate to the point of impacting the US economy, especially in an election year.

The US has a busy data week, capped off with December jobs data Friday.  Today, ADP will provide the final clue for nonfarm payrolls and consensus sees 160k private sector jobs added.  What are the other NFP clues so far?  Weekly jobless claims for the BLS survey week rose to 235k, the highest for a survey week since December 2017 (244k), whilst the employment component for ISM manufacturing PMI fell to 45.1 from 46.6 in November.  Employment fell by a smaller amount in the ISM non-manufacturing report, to 55.2 from 55.5 in November.  Consensus for Friday’s jobs report sees 160k jobs added vs. 266k in November.  All told, the clues warn of a downside surprise to nonfarm payrolls.

Along with ADP jobs, weekly mortgage applications and November consumer credit will be reported.  We will have a couple of weeks of Fed speakers before the media embargo for the January 29 FOMC meetings kicks in.  Brainard speaks today.

Chile reports December CPI and it is expected to rise 3.1% y/y vs. 2.7% in November.  If so, inflation would be the highest since September 2018 and above the 3% target though within the 2-4% target range.  Next policy meeting is January 29.  It’s a tough call but we think the central bank will err on the side of caution and keep rates steady at 1.75%, especially with the peso coming some pressure again.

 

EUROPE/MIDDLE EAST/AFRICA

German factory orders for November contracted sharply by -1.3% m/m (-6.5% y/y), far worse than expected.  We are inclined to discount it somewhat as data do not yet reflect the improvement in the trade outlook and the positive implications for the German industrial sector.  Still, the figures make it hard to imagine that we will get more than a tepid recovery for the country in Q1 2020.  Germany’s final December manufacturing PMI released last week was a bit better than expected, but at 43.7 remains well in contractionary territory.

BOE Governor Carney made some dovish comments late yesterday.  He noted that the BOE can still cut rates close to zero and also use macro-prudential tools, adding that his successor will still have monetary policy tools at his disposal.  Yet Carney then admitted that central banks globally have “much less ammunition” than they previously had, adding that it’s not clear if they have enough to combat anything worse than a “conventional” recession.

The upcoming January 30 policy meeting will be Carney’s last and no change is expected then.  The short sterling strip is pricing in steady rates through 2022, followed by very low odds of a rate hike at we move through 2023 and 2024.  Sterling remains heavy and has been unable to sustain moves above the $1.22 area.  We think a lot of good news remains priced in, suggesting potential for a move lower on any disappointment regarding Brexit.

In that regard, UK Prime Minister Johnson meets today with new European Commission President von der Leyen.  He is expected to call for a quick free trade agreement by year-end that does not align the UK closely to EU rules.  Therein lies the rub.  A quick deal is only possible if the UK maintains a close relationship with regards to EU regulations.  The more that have to be renegotiated, the longer it will take.  Stay tuned.

 

ASIA

Japan reported weaker than expected November cash earnings.  Headline earnings fell -0.2% y/y vs. -0.1% expected, while real earnings fell -0.9% y/y vs. -0.7% expected.  The October readings were revised down significantly too, and the data bode ill for spending going forward.  USD/JPY traded at its lowest level since October 10 near 107.65 but has since reversed higher.  A clean break below 107.70 is needed to set up a test of the October 3 low near 106.50.  Much will depend on whether we see further bouts of intensifying risk-off sentiment.

AUD made a new low for this move overnight near .6850 but has since stabilized.  Again, there was little fundamental news driving the move beyond intensifying risk-off sentiment.  Odds of an RBA cut February 4 have risen in recent weeks to 57% currently.  Please see our recent piece “Some Thoughts (and Prayers) on the Australian Wildfires” for an in-depth look at the situation.  Aussie is on track to test the December 10 low near .6800, and a clean break below the .6860 level would set up a test of the November 29 low near .6755.