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“Who Needs Vacation Anyway”

Courtesy of ZeroHedge. View original post here.

Earlier today, we presented some of the "meatier" excerpts from Ian Lyngen and Jon Hill's morning wrap. However, since we believe the commendable piece should be read in its entirety, we reproduce it below for our readers as the comprehensive picture it paints is arguably one of the best post-mortems of what took place in the past few days… and also because its implications are rather damning for risk assets.

Who Needs Vacation Anyway?

by Ian Lyngen and Jon Hill of BMO Capital Markets

The wait is over for those wondering how Beijing would respond to Trump’s recent tariff announcement. The result: the yuan was allowed to depreciate well beyond 7.0 with CNY (onshore) at 7.046 and CNH (offshore) reaching 7.11 overnight. In addition, state-owned Chinese firms were instructed to discontinue the purchase of US crops. As a result, there was the obligatory flight-to-quality which pushed 10-year yields to 1.74% as 2s kept pace reaching 1.597% in an impressive move that suggests August will not experience the traditional summer doldrums. Who needs vacation anyway? The most significant unknown at this moment is how much further the yuan will be allowed to fall given that it’s already the weakest since 2008. The best, albeit imperfect, guide one might use is the experience of June/August 2018 when the trade war was in its initial stages.

During this period, CNY went from 6.40 in mid-June to an extreme of 6.93 in mid-August for a roughly 7.8% depreciation. This was in direct response to 25% tariffs on ~$250 bn of Chinese imports into the US. The current round of currency adjustment has been driven by an additional 10% levy on ~$300 bn of goods. While this is a gross oversimplification to be sure, if $62.5 bn of tariffs last summer led to 7.8% in depreciation, $30 bn currently implies a yuan which is 3.74% weaker. Using 6.9 CNY as the departure point, 7.16 isn’t an unreasonable expectation for gauging just far this move will run. We by no means have any comparative advantage in forecasting the moves in Chinese currency, but with the performance of global financial markets so contingent on the yuan valuation at this moment, we’d be remiss not to at least offer a framework of sorts. We’d love to hear any more sophisticated or nuanced projections.

Our biggest takeaway from the prior yuan adjustments is that they tend to occur over several weeks or months; again using summer 2018 as a guide, as long as there isn’t material evidence of capital flight from Beijing (yet), one should expect the weakening trend to persist.

With this backdrop, it is very difficult to fade the strength in the Treasury market and we’re content to emphasize how well the price action conforms to the traditional seasonal patterns in US rates. This points toward a move beyond 1.75% in 10s and we’ll be using the summer-2016 trading range as near-term parameters for the time being. Excluding the extremes (which saw 10s dip as low as 1.32% for a brief moment), the bulk of the trading during this period occurred between 1.45% and 1.75%; there is a significant volume bulge at 1.55% that we suspect will provide a bit of magnetism as August is now poised to be a particularly bullish month for the Treasury market. With 2s dipping below 1.60% overnight, any pushback the Fed might have wanted to give related to the prospects for a September quarter-point rate cut just became a lot more difficult to envision.

The futures market is currently pricing in 34 bp of easing in September; an unmistakable signal that investors are adhering to the two 1990s examples of ‘fine tuning’ rate cutting campaigns as the base case. Any attempts on the part of Fed officials to dissuade these expectations will undoubtedly be met by ‘policy error’ concerns which will be manifested in a flatter 2s/10s curve. This morning, the 2s/10s curve remains just below 15 bp and given the aggressive amount of easing priced into the 2-year sector, the new question is whether or not Powell will drop policy rates below 1.0% before the end of 2020. For context, the January 2021 fed funds futures contract is trading with an implied rate of 1.095% as investors are interpreting the last week’s developments as confirming a ‘fine turning’ easing effort will not be enough and eventually a full rate-cutting cycle will be required.

* * *

There are several important takeaways from recent events which warrant exploring. First, the Fed’s attempt to deliver a single (as-expected) quarter-point cut while leaving open for the prospect of more only if necessary created greater confusion than clarity. A solid example of the Fed’s present communications challenge can be seen in the Chair’s observation that “It's not the beginning of a long series of rate cuts. I didn't say it's just one.” Yep, that clears it all up… wait. To Powell’s credit, if the purpose of his statement was to communicate that the fine tuning effort is more than one and done, but not to anticipate reaching the lower bound anytime soon – the message was sent and received. What was missing was anything akin to the ‘gradual’ = 25 bp per quarter that was established early during the normalization effort.

Immediately in the wake of the Fed, the biggest question was whether to expect 25 bp a quarter, a meeting, or without a known cadence. Well, The Donald cleared that up rather quickly via the escalation of the trade war (now well into the fourteenth month) and as a result an additional quarter-point cut in September is now completely priced in. In fact, with 34 bp of easing reflected in the October 2019 fed funds futures contract, the parallels to expectations ahead of the first cut are striking – 25 bp and reasonable odds of even more. This is also very consistent with our operating assumption that ‘two cuts and a pause’ will become the norm for forward pricing of the Fed. Said differently, for every realized cut, investors will be anticipating two more.

This represents the biggest risk for the Committee; i.e. the market demands more accommodation than the Fed believes is needed to extend the expansion. The performance of risk assets tells a cautionary tale. Throughout 2019 the stock market had a very strong run predicated on Powell’s pivot and the promise of eventual rate cuts. Now that one cut has been delivered and two more priced in, we find the S&P 500 nearly 4% off the highs. What will it take from here to prevent a Q4-style spike in equity vol that materially tightens financial conditions? This is the paradox that the Fed was always going to face, how Jay addresses it will be the defining policy moment for the balance of 2019.

There are two outcomes we can envision. One, once September’s cut is completed, the Fed-speak shifts to a neutral/ wait-and-see stance and while that won’t eliminate the need for an October ease, it will ideally convince investors the Committee is adhering to the 75 bp cumulative strategy to be followed by a period of reassessment. Now this assumes the domestic data holds up and Trump’s 10% is the last levy of the year – both are significant unknowns. How then do risk assets respond to a steady balance sheet and effective funds at 1.65% – the Fed is betting positively in this regard. In the event fine tuning proves inadequate, then 2020 will be dramatically bullish for the Treasury market. The second scenario is identical to the first up until the December meeting; if the Fed gets itself into a cycle of giving into the market’s demands for accommodation, the effective lower bound will very quickly come into focus and balance sheet expansion will once again become topical. So much for normalization.

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