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Friday, May 5, 2017

MARKET INSIGHTS: Euro Under Severe Pressure From Which It Is Only Just Now Starting To Recover.

Payrolls was estimated yesterday at 180,000-195,000( Actual 177,000), with the unemployment rate the same at 4.5% and average hourly earnings up 0.3%. Reports differ on how strong the jobs market really is. Market News reports it’s a job-seeker’s market these days for every job from nurses to CPAs. Its “Reality Check” on the job market finds employers willing to forego background checks to get the bodies in the door. Pay demands are being met and exceeded with health insurance, vacations and (gasp) flexible hours.

We have to expect a modicum of the usual tap-dancing around the number after the first response, generally a spike—what is the participation rate, what is the real unemployment rate (U6), etc. But assuming it’s a decent number inside the forecast range, traders should fall back on the Fed statement—any weakness is transitory and we can still expect two more hikes this year. Normally this would be dollar positive, but something else is happening—the US is in pretty good shape, but the eurozone is catching up with some serious momentum and growth is outpacing the US. And traders respond to relative change as much as anything. The wild euro rally yesterday could mark a genuine sea-change in sentiment toward the euro.

Nobody is bothering to explain yesterday’s euro rally of over 100 points. Granted, we have seen such moves before and sometimes they are inexplicable, but the timing of this one is really odd. Unless we want to attribute the rally to relief that LePen looks like losing the French election, we have a relatively big move with no single trigger behind it, implying that the euro’s giant move up in a single day was due to substantial positioning by traders with some deep pockets.

Were they correcting a too-short euro position now that the relative strength of the eurozone is more impressive than the US economy—or were they positioning ahead of the payrolls release this morning? Normally on payrolls day we get a spike in one direction and then a spike in the other direction and an ending level not that far from the opening level but with whatever bias the report implies. But normally they wait for the release before taking to the dance floor. Payrolls is a day for the big players to tapdance around and show off (and we small fry should stay out of the way).

The euro rally is even stranger when you consider the Atlanta Fed forecast for US Q2 GDP is a resounding 4.2%, implying the first quarter slowdown was a seasonality thing and as the Fed said, transitory.

What does the eurozone have that beats 4.2% growth in the US? It wasn’t yields, although the Bund is nearing its recent high while the US 10-year is barely above the 100-day moving average and still under the March high. It wasn’t another market—commodities are tanking, including oil, although European equities are outpacing the US indices. It might an unspoken and undiscussed expectation of ECB tapering, but that was the idea of a single guy and hardly a widespread whisper campaign. And at  least two big banks are abandoning the euro-parity story, Citi and Barclays, but again, this is not mainstream chatter just yet.

And the euro rally can still collapse. After payrolls on morning, we will get a flurry of speeches by no fewer than six Feds, including Yellen. Supposedly the Feds do not coordinate their comments ahead of time and all the speeches will have been prepared well in advance of payrolls, but remember the Fed speeches ahead of the March hike. The Feds single-handedly turned the money market and fixed income market away from the no-hike expectation to “Yes!” in about two weeks. It was a remarkable performance and a remarkable response. Nobody thought the Fed could herd those cats.

And now we could be getting a replay. What does the Fed want to see? The 2-year yield needs to match -and-surpass the recent high at 1.40% from March. Today it’s 1.314%. If the market really believes in the June rate hike, the 2-year yield needs to dig itself out of the mud and get going. As we saw in yesterday’s yield differential charts, the euro is outpacing the relative yields, likely because the German 2- year is rising faster than the moribund US 2-year. In this respect, it’s the US that needs to catch up with Europe. After all, the US is actually getting normalization while Europe hasn’t even started talking about it, if Mr. Draghi is to be believed (and he is). The 2-year is not exactly flat-lining, but needs to pick up the pace.

We feel like a dog with a bone. We really want to know why the euro rallied. When in doubt, find a chart. Here is the euro on a monthly chart below. Nobody in his right mind would trade on such a thing, but notice that the channel—which was drawn to end at April 2015 and then extended out artificially by hand—indicates the euro has been oversold since then. We have plenty of other indicators that identify overbought/oversold, including the fairly unreliable stochastic oscillator, but this channel is interesting because it shows that during 2014, the euro was under severe pressure from which it is only just now starting to recover. So what was happening in 2014? (Good thing we have 17 years of archived reports).

Two things stand out—Russia invading Ukraine and worsening economic conditions that finally led to the ECB adopting QE in Jan 2015. That’s hardly the whole story, of course—Greek debt crisis, Spanish debt crisis-- but if the 6-year linear regression in the center is what the euro should revert to, we could see 1.2219 by July.

Sounds nuts, but it’s not until the past few months that the eurozone has shown real signs of a sustainable and robust recovery. We could be seeing a reversal of fortunes as the US plods along while Europe races ahead. In the US, we have the promise of greater things if we get tax reform and a big-enough infrastructure initiative (except consider the person doing the promising), so it’s not a case of the US falling into the slough of despond while Europe takes the lead. But we should consider that Mr. Draghi should be a fairly happy guy these days, despite labor market rigidities and governments that won’t hold up their end on the fiscal side. Heavy weights are being lifted off the euro, including political weights. France is not going to vote for a Trump-like person. Even Greece can see the light at the end of the tunnel. Spain is positively radiant. The relief rally could be enormous and this could be the start of it.

But don’t expect a straight line. Apart from payrolls, we could get a pullback on Sunday afternoon after the Macron win in France is announced. Some nay-sayers think LePen could still win, but only if a very large number of voters stay home. Maybe the euro rally was being fed by relief that the election will not deliver a female version of Trump and once it’s over, the euro will sag. Today more than ever, we advise staying out of the market if you can stand it.

Tidbit: On oil prices, the WSJ has an interesting take. Commodities were overly impressed with noise from the US about reflation but ran head-first into the brick wall of political reality and came to an abrupt halt. Iron has given up all its gains and Brent fell 5% yesterday. But everybody’s PMIs are far ahead of a year ago and at multi-year highs, if with a modest pullback in the US just recently. We really do not need to expect a reprise of the 2014 commodity collapse. A key factor is the amazing efficiency and flexibility of shale producers, now able to adjust supply quickly to every twitch in oil prices. See the chart. OPEC has lost control of prices (again) and the new sheriff in town is the shale producers. The WSJ doesn’t put it quite this way, but it’s a bit of a chicken-and-egg situation. The chart (Below) indicates shale producers should trim back to sync up with the new lower prices.

This is new. We are accustomed to commodity output taking a really long time to adjust to prices because of the high cost of exploration and production. Jimmy Rogers wrote about it at length in Adventure Capitalist—The Ultimate Road Trip. Now oil is working on a new model. The old model will still be valid for metals, including the rare stuff located in distant places. But the dynamics of supply in oil are now in the hands of shale. OPEC is relegated to a far less relevant role. All those folks impressed by the output cut agreement were wrong, as the critics expected. The critics thought the output cuts were too small to make much of a difference, and also that OPEC members would cheat, as they always have over almost the entire life of OPEC itself. Shale was a third factor. Now shale is the primary factor.

The WSJ doesn’t go into oil’s effect on inflation, but if this perspective is correct, oil is probably capped at $55-60. The days of $150 oil are over. Shale may be terrible for the environment, but it’s good for stabilizing oil prices and preventing inflation spikes.

Tidbit 2: The Shanghai stock index fell to the lowest in 6 months. Chinese FinMin Xiao had to give up a meeting with Japan and S. Korea on the sidelines of the Asian Development Bank to take care of an unnamed emergency at home. The three countries are meeting to talk about Trump’s trade position, among other things. Now if only we knew what that position really is. The group has already embraced the G20 sentence that had been removed in March at the US’ request: "We will resist all forms of protectionism." Washington snorts in derision at these countries getting holier-than-thou when they are the ones who subsidize and protect so much. 


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