Dollar Mixed, EM Crushed as Risk-Off Sentiment Intensifies

  • Markets are pricing in increased US recession risks; US July CPI will be reported
  • Weak ZEW readings for August were reported; the UK reported firm labor market data
  • Japan July machine tool orders contracted -33.0% y/y; Singapore revised down its 2019 growth forecast significantly
  • Market reaction to the Argentina primary election was swift; we downplay contagion risk to wider EM

The dollar is narrowly mixed against the majors as risk-off sentiment picks up.  Yen and the Antipodeans are outperforming, while Nokkie and Loonie are underperforming.  EM currencies are broadly weaker.  The CEE currencies are outperforming, while PHP and TRY are underperforming.  MSCI Asia Pacific was down 1.2%, with the Nikkei falling 1.1% after Japan returned from holiday.  MSCI EM is down 1.2% so far today, with the Shanghai Composite falling 0.6%.  Euro Stoxx 600 is down 0.7% near midday, while US futures are pointing to a lower open.  10-year UST yields are down 2 bp at 1.63%, while the 3-month to 10-year spread has inverted 1 bp to stand at -33 bp.  Commodity prices are mostly lower, with Brent oil down 0.3%, copper down 0.2%, and gold up 1.4%.

Markets are pricing in increased US recession risks.  The US 3-month to 10-year curve is currently near -33 bp, the low for this cycle.  Equity markets are also waking up to the possibility of a US recession, with the S&P 500 down nearly 5% from its July peak.  Yet through it all, the dollar remains firm as negative developments elsewhere suggest the US remains in relatively better position compared to the rest of the world.  EM in particular remains very vulnerable as global growth concerns intensify.

US July CPI will be reported.  Headline inflation is expected to pick up a tick to 1.7% y/y and core to remain steady at 2.1% y/y.  July PPI last week came in slightly lower than expected and so there are downside risks to the CPI reading today.  There are no Fed speakers today.  WIRP suggests 100% of a cut September 18 with 37% odds that the move will be 50 bp.

We are surprised by the hand-wringing on the part of the Fed and many market participants regarding US inflation.  Core CPI above 2.1% y/y seems normal.  Core PCE, the Fed’s preferred gauge, rose 1.6% y/y in June but was at the Fed’s 2% target as recently as December.  It’s not like the US is stuck in a deflationary spiral (Japan), or missing the inflation target by nearly a full percentage point (eurozone).  That is why we fundamentally disagree with markets pricing in basically a disaster scenario for US rates (three cuts this year and two next year).

Weak ZEW readings for August were reported.  In Germany, current situation plunged to -13.5 vs. -6.3 expected, while expectations fell to -44.1 vs. -28.0 expected.  Eurozone expectations sank to -43.6 from -20.3 in July.  These readings suggest the economy continues to weaken in Q3.  Germany reports Q2 GDP tomorrow and it is expected to contract -0.1% q/q and -0.3% y/y.  EUR continues to oscillate around the $1.12 level and we look for an eventual downside break.

The UK reported firm labor market data.  Employment rose 115k in June vs. 60k expected, while weekly earnings accelerated to 3.7% (3.9% ex-bonus).  Unemployment ticked up to 3.9%, however, as more people started seeking work.   WIRP suggests only 8% odds of a cut at the September 19 BOE meeting.  However, odds rise to 42% November 7 and move to 70% by January 30.  Sterling remains heavy and is likely to test the recent cycle low near $1.2015.

Japan July machine tool orders contracted -33.0% y/y vs. -37.1% in June.  This will be followed by June core machine orders Wednesday.  USD/JPY remains heavy and continues to make new lows for this cycle.  The January flash crash low near 104.85 is nearing and then the March 2018 low near 104.55.  After that, there are not many chart points until 100.

Singapore revised down its 2019 growth forecast significantly.  The government now sees growth this year between 0-1% vs. 1.5-2.5% previously.  The MAS said it was not considering an intra-meeting move.  It next meets in October and we think odds are rising that it eases policy then.  Singapore and Korea are both considered to be bellwethers for the region and signs out of both are not good.

Market reaction to the Argentina primary election was swift.  The peso weakened to nearly 62 before rebounding to end near 53.0, down “only” -14.5%.  While Argentine assets are likely to continue underperforming due to political uncertainty, the contrarian in us thinks that perhaps Fernandez won’t be as bad as markets fear.  The populist/statist model that Kirchner and Fernandez followed was simply unsustainable and already unraveling when Macri came to power.  Why shouldn’t Fernandez keep Macri’s reforms in place and get all the credit when the economy finally turns?

We downplay contagion risk from Argentina to wider EM.  Argentina is too small and isolated to have much impact beyond Brazil and Uruguay.  That said, EM was already in the midst of a broad-based sell-off and so markets will be looking for any excuse to sell.  The correlation between ARS and MSCI EM FX is currently around -.30, well below the recent peak near -0.40.  That suggests that contagion from ARS weakness to other EM currencies is likely to remain limited.

India July CPI is expected to rise 3.10% y/y vs. 3.18% in June.  If so, inflation would remain in the bottom half of the 2-6% target range.  WPI will be reported Wednesday, which is expected to rise 1.87% y/y vs. 2.02% in June.  RBI just delivered a dovish surprise last week and we expect further easing at the next policy meeting October 4.  Recent INR weakness has been limited despite EM selling and rising India-Pakistan tensions.