Oil will continue to be in the news this week, and it will continue to impact inflation expectations. With risks of inflation fading, the Fed changed its tone, and Trump may have revealed more than he intended about a potential US-China trade deal.

Rate Outlook Challenged

In the past week, there has been a significant change in USD interest rate expectations. The Fed’s vice chairman, Richard Clarida, hinted that the Fed may stop hiking at the neutral rate. Despite increasing wages and a booming US economy, the Fed may be sensing trouble on the horizon. The trade war and the severe correction in crude oil prices are now flagging disinflationary pressures. Futures are also pricing in a pause in the Fed’s rate hikes in 2019.

In our note to clients on 29 October 2018, we wrote that one of the markers we were looking for to call a top in the US equity markets is the Fed’s pause in interest rate hikes. While the S&P 500 is still up for the year, having closed at 2736 on Friday, the recent volatility may be an early warning sign that end of the bull run is near.

US Core CPI came in at 1.6%, and with the recent spectacular plunge in crude oil, the market’s inflation expectations have also corrected lower.

Emerging Market Reprieve

High oil price and a strong US dollar were mostly hurting emerging market economies. The oil exporting ones did not benefit much from the recent surge on oil prices because they were still suffering the results of previously implemented fiscal and monetary policy tightening.

Many of these emerging markets saw their currencies rise against the US dollar in the last month. For the most part, the rise in floating emerging market currencies was due to their central banks’ interest rate hikes in response to capital outflows.

While emerging markets are dancing to a different tune, the heavyweights have not been fairing so well against the dollar. The market is beginning to realize that Brexit is not only bad for the GBP, but it is also Euro-negative. While we refrain from taking sides in this battle over sovereignty in the EU, we do not see a good outcome for either side. Even if Theresa May survives the Tory rebellion, we view it is highly unlikely that her Brexit deal will pass through Parliament.

The other heavyweights are the Swiss franc, Japanese yen, and Chinese renminbi. The yen and Swiss franc no longer pack the same punch as they used to, with the safe-haven advantage now dominated by the mighty US dollar. Meanwhile, market forces are pressuring the Chinese renminbi lower, despite the PBOC’s line-in-the-sand just below 7.

Therefore, we view any general dollar weakness to be temporary.

Trump Reveals Hand

As many of our clients know, we are avid fans of Daniel Kahneman’s Prospect Theory, which forms the basis of the risk assessment service we offer to all our clients. Kahneman’s book, Thinking, Fast and Slow, inspired many others to write and expand on our mental models for decision-making. One of those books was Super Forecasting: The Art and Science of Prediction by Philip Tetlock and Dan Gardner. In the hallmarks of superforecasting, the authors find that a common trait among the best forecasters is the ability to break a seemingly complex problem into tractable sub-problems.

We have such a problem on our hands: will the US and China agree on a trade deal? Despite the negative news and the advertised hostility at the APEC summit, in which everyone was expecting the US and China to come out with a joint statement on trade. Needless to say, no such statement was issued by the two largest trading nations. There’s nothing particularly unique about this specific time and place; there will always be another summit as a venue to issue a symbolic statement. Next up: G20 summit in Argentina.

JP Morgan came out with a timely note that bears more resemblance to the scientific approach we take on event probabilities. In its note, JP Morgan’s Marko Kolanovic writes about the significance of Trump’s statements that the “China list is pretty complete” and that there are “four or five things left off.” Kolanovic rightly points out that the original list had 142 requests. So if we were to break down this complex question into a simple tally of equally-weighted requests, Trump’s statement implies that 96% of items have been addressed, which makes it highly probable that the US and China will agree on a trade deal.

The Week Ahead

It will be a relatively light week for economic data. US Durable Goods Orders, PMI, and housing data should give us some insight into the longevity of this expansion. Eurozone PMI levels and German GDP will be published on Friday.

Safe@Harbour

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