As results come in from the Bavarian election in Germany, the Christian Social Union (CSU) is forecast to have taken a hit. The CSU is set to take about 39% of the seats, with the far right Alternative for Deutschland (AfD) projected around 11%. This will give the far right group seats in Bavaria for the first time.
Why this matters to the markets is in how it will shape the ability of Germany to play a role outside the country. With the need for deeper integration between European counties to stabilize the currency longer term having a inward, nationalistic, shift will make this more difficult. Macron of France came into office on the premise that he would be able to better integrate Euro countries in a tighter union. With his domestic policy running into problems his ability to influence other countries into this union is becoming more difficult.
Italian markets dropped and bond yields increased as the government created a budget outside the agreed upon fiscal policy measures. This will no doubt cause tensions between the EU and Italy in the coming month when they have to submit the finalized budget. How this gets resolved will be important to watch as a gauge of the political unity within the Eurozone.
Political concerns are creeping up all over Europe with Brexit and populism growing in traditionally stable countries like Germany. The immediate fallout from the Italian budget getting passed will not be severe, but it would show the willingness of other Euro countries to enforce agreed upon measures with a new government. Failure to do wo would empower far right groups elsewhere to push for more nationalistic economic measures. Should this happen the fiscal issues that are isolated to Italy could be factored into markets on a country by country basis.
The Euro countries see this and will most likely try to contain the measures that Italy is proposing. By rejecting their plan they will show there is a 'penalty' for not agreeing to historical agreements. This is bad news for Italy and expect more volatility in the month ahead.
The Bank of Japan didn't rock the currency or the markets with its policy. The bank stated that their stance on easing will be dependent on the 2% inflation target being hit. They are looking to have the range in which they allow bond yields to move (currently floored at 0%), this will give some insights into the Bank's willingness to let rates rise when they feel comfortable with the direction inflation is heading.
In Europe we saw the Pound increase against the dollar as CPI came out better than estimated. The Bank of England is more on the fence with where policy is headed, with bullish indicators pointing to policy moving towards tightening, while the members are concerned about the looming Brexit implications.
This is a good reflection of the data dependency and tightening bias the markets are placing on it. This s a small example of a larger trend playing out, where investors are looking for yield as concerns arise over signs of weakness globally. Any indicators of a strong economy or higher inflation will see those respective currencies increase on rate anticipation.
The Bank of Japan is having an interest rate meeting Tuesday morning Tokyo time. This is preceded by a press conference later on. There is no expectations of actions from this meeting but it will be worth taking note to determine the language of the central bank of how it is positioning along side other banks.
Currently the US is the only bank with a focus on tightening, but the ECB isn't too far behind the US. With strong economic indicators in the Eurozone, the ECB will be cutting their stimulus another 15 billion a month and ending the program all together by the end of the year. The bank of England is expecting to see growth pick up in the coming year. The bank is holding off on any rate increases until more is seen from the Brexit talks. A good scenario in Brexit will see the bank become more bullish and a bad scenario could see a drop in the pound and more inflation imported. These situations will both lead to the bank having a hawkish stance.
Japan is one of the last central banks to not shift towards a tightening policy, or make any indications they think they will have to soon. This will be important to watch to determine how the markets will react to a combination of tightening across major currencies. The general rise in interest rates across the globe could cause a re pricing in assets, especially in the US where capital flows have increased over the past couple of years on the back of a stronger Dollar, higher rates, and a strong (but not too strong) economy.
Many factors are going around for the cause of the Emerging Market selloff. Trade wars, high debt loads, or trade deficits. These factors are always a tinderbox for a financial or economic crisis but not the spark. In this case the main factor of the strain is not a tweet or a 'sudden' realization of poor economic fundamentals. It was the steady and consistent rise in the Dollar.
The rise in the Dollar starting in late 2014 has put a strain on emerging markets but interest rates in the US were still very low compared to local currencies. in 2017 we saw rates on the 2 year and other shorter dated securities start to rise as rate expectations took hold in the markets. It wasn't until Sept. of 2017 that markets started to believe in the FEDs message and rates went up aggressively on the short end of the curve. This is where the real pain came in for EM as higher rates and a stronger Dollar made it very difficult to get out of debt obligations as well as finance the existing ones.
With the Jackson Hole meeting coming up at the end of this week we may see another turning point this September as well. One where the Fed talks back some of the recent hawkishness in light of the global signs of a slowdown or the more likely scenario. The data in the US shows there to be more need for rate increases to keep inflation at bay. There is little evidence in the US that higher rates are affecting the economy so there is no reason for the FOMC to worry, and it would be prudent to have higher rates in the future so the US can better stimulate the economy if the slowdown does occur. This message does not bode well for Emerging markets. But in this lies opportunity, with the US market hitting a record high again today, it might be a good time to pull some money off to the sidelines and await a good buying opportunity in EM. After all you are getting a higher yield while you wait.
The markets are experiencing downward pressure in Asia that is sure to flow into the US by morning. The US has laid out more tariffs to put in place after China retaliated to the first set of tariffs that took effect last Friday. This back and forth will not end well, specifically for the US as they import more from China than China does from the US. The news talks a lot about the trad spat affecting the US economy and there are legitimate concerns as the trade war heats up. It is important to look at China as well and the measures they will have to take to keep the economy on stable footing.
As of now we are seeing the currency weaken and the stock market sell off to some degree. But the important thing to look out for is instability in the financial and property markets. Bad signs in these sectors will show there could be coming problems in the debt market possibly starting a crisis where the government will have to step in.
In a light week for the US a lot of data that will be impacting the current economic story will be coming out. The market movements after quarter end, during a holiday week, will be difficult to get any meaning from. Some of the important takeaways for the broader narrative are as follows:
Oil supply: As President Trump tweets that Saudi Arabia is going to increase output by 'up to 2 million barrels' a day, the price of oils is going to be squarely in focus. For this week we have Thursday and Friday oil inventory and rig counts respectively. This will be important to see how much of the US is ramping up production to fill the demand left from Iran and Venezuela having a decrease in output. Should Saudi Arabia increase output at the same time as US companies try to ramp up production, we could see oil come off its highs.
FOMC minutes: The minutes to the Fed meeting will help to solidify the perception of the US continuing to increase rates at a time that other countries are struggling to get their economies to a level where they can stop stimulus and increase rates. Economic news out of the US seems to support this, the only surprises that could come out of the minutes would be worries on trade or global growth. This could link the political and macro environment closer to future rate expectations.
Jobs data: The actual economic indications of the US economy will be important because of the US currently being an outlier. In order for the markets to keep with the notion that the US is strengthening despite the global markets, the data will have to continue to support that assumption. Should this not occur, many of the correlations we are seeing could start to break down.
Political headlines: Finally the political headlines out of Europe, with Germany's coalition back in crisis, and the US rhetoric on trade wars; there is no doubt to be some chop this week. These issues have been spooking investors in the equity markets and currencies to an extent, but the bond market is still sticking with the broader story that the above data points will be a factor in.
The ECB comes out leaving rates unchanged, until at least a year from now. Asset purchases are to remain until the end of the year. The news was overall expected because of the talks Draghi had in the past week. The interesting news I on the time frame that is given for the interest rate increase.
By putting the interest rate increases a year out, the ECB seems to be using language as a way to express loose policy and not to cause a panic in the markets of raising too soon. This had the Euro adjust drastically to the dollar, the longer term trend will come from the believability of the ECB statement.
If the Fed can continue to raise rates alone, while the ECB stays put for at least a year, the Euro will be beaten up by the dollar over that time frame. If the signals from economic data in Europe start to challenge that assumption we could see the Euro having to play catch-up. The speech will be important to see how strong these statement beliefs are.
Wednesday of this week will most likely see the Fed increase interest rates to 2%. The economic data has been strong enough to convince the committee that more rates are needed to stay ahead of inflation. The rate increase, and the language of the statement, are expected to confirm the growth differential between the US and other major economies. If this occurs then the rally in the dollar could continue. The result of the Fed meeting will shortly be followed by the ECB meeting on Thursday.
After taking a more bullish tone recently, the ECB has an opportunity to align market expectations to theirs at this meeting. Since the Italian elections and the threat of a referendum that would put into question the need to stay into the Euro we have seen market participants put a gloomier outlook on the Euro countries than the ECB.
Eurozone CPI had a preliminary reading of nearly 2% and that is being confirmed this week. Core inflation is still low, but is also showing a spike in the preliminary reading. GDP, while recently pulling back, is close to multi year highs. There is a growth differential at the current moment. Whether the US comes back into the fold of the rest of global performance, or is leading the way to higher growth rates in the developed world will not only be decided by the markets, but checked by the data and the Fed. This week will be one of those checks.
Today there was some ease in the Italian bond market as the country successfully auctioned off intermediate term debt without any issues. This was good to see a drop in yields for the country but also a rise in the Euro, which has been highly correlated to the conditions coming out of Italy. This is welcome news as the perception of immediate danger to Italy (and the Eurozone as a whole) are put into perspective. Longer term there are still dangers that exist and need to be addressed for a true reversal to take place.
The issues with Italy have just started to spread to the global markets and this relief of pending doom was much needed. In order for it to last the Italian government will need to change their tone on the need to stay within the Euro and build a strong coalition that believes in carrying out existing contracts with Europe. This prospect might be too much to ask without another round of elections to (hopefully) show the people's discontent with the League and Five Star's abilities to manage a coalition. This is not something that will happen overnight, but steps in the right direction as the coalition scales back their rhetoric in order to form a government will go a long way.
Another important factor that needs to take place is to have the rest of the Eurozone acknowledge this issue and start to be more vocal about further integrating the currency bloc. By showing a willingness of other major countries to go in the right direction, and build a more stable monetary union, markets will keep the contagion of the Italian election to Italy. Positive news of better monetary integration would help to defang the message that the far right used to get elected, forcing them to change tact.