Rates as of 05:00 GMT

 

IDEAS FOR THE DAY:
• Sell AUD/NZD:  The interest rate picture for NZD has changed dramatically, but the market’s view hasn’t. NZD may continue to appreciate.
• Buy NZD/JPY:  Continuing on with the NZD theme and assuming that the “risk on” mood continues
• Sell USD/CAD:  Different rate expectations between US and Canada, plus some recovery in commodity prices should support CAD

 

Market Recap

Fed Chair Powell surprised the markets (and me, I must admit) by implying that the Fed could cut rates if the US trade war with China and now Mexico started to impact the economy. Before his opening remarks at a Fed conference, he made what was clearly a well-thought-out statement addressing market concerns. He mentioned the risk that the trade disputes pose to the US and global economy and said the Fed is “closely monitoring the implications of these developments for the US economic outlook” and that it would “act as appropriate to sustain the expansion.” “Closely monitoring” is Fed code for “we’re worried about this.” “Act as appropriate” means “cut rates.”

The context of Powell’s comments is crucial. They followed Monday’s comments by St. Louis Fed President Bullard, one of the most dovish members of the FOMC, who said the Fed might have to cut rates soon to sustain the economy. Bullard’s comments ignited a huge move in the Fed funds futures to discount lower rates in the future. If Powell had wanted to challenge the market’s view, he would’ve done so. He purposely didn’t. On the contrary, he used that opportunity to more or less confirm what Bullard had said.

Powell’s comments were backed up by Vice Chair Clarida, who also used the phrase “appropriate policy” in an interview on TV. “Whether or not that means acting preemptively or when the data comes in is just going to depend on the context at the time,” he added – thus holding out the possibility that they could even move before the data starts to turn. Clarida will make some brief remarks today at a Fed conference, but his views are now known so they will probably have little effect. 

The astonishing thing however is that while the implied yield on the short-term Fed funds futures fell slightly (October 2019 down 2 bps), the implied yield on the longer-dated futures actually rose anywhere up to 6.5 bps for the longest-dated contracts. The reasoning is probably that cutting rates further than expected earlier than expected means less need to cut rates as deeply as expected later on.

US stocks had a tremendous day, with the S&P 500 up 2.1%. Hopes for lower rates were clearly one reason; also helping the rally were signs that Trump has “jumped the shark”* this time with his tariffs on Mexico. Senate Republicans, who normally docilely acceed to anything that Trump proposes, met to discuss the subject and apparently concluded that they had an “overwhelming majority” ready to vote against the tariffs. Trump can veto their vote, but they can override the veto with a two-thirds majority in both the House and the Senate. It’s not clear yet whether Congress could muster the votes to override a veto, but opposition to the tariffs is strong among both Democrats and Republicans, since they mostly work against US companies that manufacture in Mexico.

Furthermore, there are hopeful signs coming out of Mexico. Mexican President Andres Manuel Lopez Obrador said he’s hopeful that Mexico will reach a deal to avoid the tariffs, while Mexico’s Foreign Minister said there’s an 80% chance that the two countries will find common ground. As a result, USD/MXN fell 0.45% (i.e., the Mexican peso strengthened vs USD) and US auto stocks gained.

*For those who are not familiar with American slang, ”jumping the shark” is an American idiom used to describe the moment in the evolution of a television show when it begins a decline in quality that is beyond recovery. It comes from the time when a character on a once-popular TV show tried jumping over a shark while water-skiing.

In this “risk on” environment, the FX market performed as one might expect:  the commodity currencies outperformed and JPY and USD underperformed.

NZD was the best performing currency after relatively hawkish comments by Reserve Bank of New Zealand (RBNZ) Assistant Gov. Hawkesby. He made a speech in Tokyo on May 30th that wasn’t widely reported at the time (it didn’t even show up on the Bloomberg economic calendar). The text was just posted this morning on the RBNZ’s website.* In it he said the RBNZ’s central view is that “interest rates will remain broadly around current levels for the foreseeable future.” Although oddly enough, the market is now putting an 84.5% probability on a rate cut this year, up from 81% on Monday. In fact, the market clearly favors the idea that there will be more than one cut this year, while putting zero probability on rates being unchanged. So unless “the forseeable future” is restricted to the next RBNZ meeting (June 26th), when the market sees only a 15% chance of a cut, the RBNZ’s views as expressed by Hawkesby are distinctly different from the market’s. NZD positive

*Maintaining credibility in times of change. Available on the web at https://www.rbnz.govt.nz/research-and-publications/speeches/2019/speech2019-05-30

 

Today’s market

The European day starts off with the service sector purchasing managers’ indices (PMIs). For France, Germany and the Eurozone as a whole they’re just the final version of the preliminary ones.

The focus will be on the UK services PMI. After a disastrous manufacturing PMI (49.4 vs 52.2 expected) and yesterday’s equally disastrous construction PMI (48.6 vs 50.6 expected), can the service sector PMI actually rise, as expected? Since 2013 there have been 23 times when both the manufacturing and construction PMIs were down. In those cases, the service sector PMI was up 10 times and down 13 times – so it’s somewhat more likely to be down than to be up, but not really enough to bet on. (Similarly, the manufacturing and construction PMIs were both up 18 times, and the service sector PMI was up 10x and down 8x, meaning again it went with the other two more often than not, but not enough to rely on). GBP has been down several days in a row now. If this PMI does come out higher, as expected, then I think there could be a modest rebound in GBP. If not, then it will confirm the most negative views on Britain and probably trigger another leg down.

The ADP employment report is the big indicator of the day, since it’s seen as a big indicator of the big indicator of the week, the notorious nonfarm payrolls (NFP). Automated Data Processing Inc. (ADP) is an outsourcing company that handles about one-fifth of the private payrolls in the US, so its client base is a pretty sizeable sample of the US labor market as a whole.

The market is forecasting a healthy but below-trend rise of 185k, which is well below trend for both the ADP (6m average = 216k) and the NFP (6m average = 208k). My guess is that people have in their mind the previous average for the NFP, which was running closer to that level for some time. The Bloomberg “whisper” number, which is just calculated from whoever wants to put their estimate into their Bloomberg terminal, is a somewhat higher 203k, which is more in line with recent results.

One point to note:  The ADP’s figures are adjusted to match the final estimate of the NFP, not the initial estimate that we get this Friday. So while they are one of the best guides to the NFP that we have, they aren’t perfect by any means – in fact, neither is the NFP figure itself, since it’s always revised. Over the longer term (six months or so) the differences between the ADP and the initial NFP tend to even out, but any given month they can be quite large – the standard deviation of the difference over the last three years is 72k. It may be the best we’ve got, but that doesn’t mean it’s good. 

The Fed releases the “Summary of Commentary on Current Economic Conditions,” aka The Beige Book (which actually looks green to me, at least the version you can buy in the store) as always two weeks before the next FOMC meeting. It’s significant for the market because the first paragraph of the statement following each FOMC meeting tends to mirror the tone of the Beige Book's characterization of the economy. The book doesn’t have any number attached to it that quantifies its contents, but many research firms do calculate a “Beige Book index” by counting how many times various words appear, such as “uncertain.” In any case, the book is largely anecdotal so you’ll just have to watch the headlines as they come out.

Overnight, Australia releases its trade balance for April. The trade surplus is expected to be a little bit higher than in March, which was pretty close to the record high set in February. In other words, the figure is expected to be nearly another record high. That should be positive for AUD.

 

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Marshall Gittler

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