Overview: The US dollar's post-Fed gains have been extended, though the upside momentum appears to be stalling. Japan's Nikkei advanced 1.35% on the back of the yen's declines and reached its highest level since 1991. Chinese shares (A and H) rallied amid reports that MSCI and FTSE-Russell are boosting Chinese shares in their benchmarks. Chinese markets are closed next week for the national holiday. European shares are snapping a three-day advance with the Dow Jones Stoxx 600 off about 0.3% to halve this week's gain. Italy is bearing the brunt with more than a 2% decline. European financials are the worst performing sector. Here too Italy is showing the way. Its bank index is off 5.5%, today and 6.6% for the week. The bank index had rallied about 13.5% over the past three weeks. Core European bond market yields are 2-4 bp lower, while Italy's coupon curve is 25-30 bp higher, after what appeared like successful auctions yesterday.  

Italy: The government inherited a budget deficit target of 1.8% of GDP this year. The League and the 5-Star Movement insisted that people voted for a change and both parties campaigned for some form of fiscal expansion. The League wanted to lower taxes. The MS5 wanted a "citizen wage." The centrists tried blocking it, but in the end, could not resist and next year's deficit will be 2.4% of GDP. The Bloomberg survey covering the past fortnight produced a median deficit forecast of 2.2% of GDP. Note that Italy is in a favorable position where it has about two-thirds more bonds maturing than it needs to sell in the next two months. An EU official quoted on the news wires suggested that the deficit should be closer to 1.6% of GDP. This sets up a confrontation with the EU next month. 

Euro: The single currency declined steadily in North America yesterday. The nearly 0.85% decline was the largest in six weeks and took the euro about $1.1640, its lowest level in ten days. There is follow through today. A break of $1.1600 signals a near-term move toward $1.1530-$1.1560. If the euro stabilizes, options expirations may cap its ability to recover. There are 4.2 bln euro in a $1.1630 option that expires today and 1.3 bln euros in options at $1.1650-$1.1655. There appear to be at least four drivers. First, despite talk about the dollar having topped out and Draghi's "vigorous" comment, the bulls could not establish a foothold above $1.18. Second, Powell left no doubt that the Fed would continue to gradually hike rates. Peak divergence still lies ahead. Third, the protracted debate over the Italian government's fiscal stance injected volatility. Fourth, there was a dramatic jump in the benchmark three-month cross-currency basis swap. This reflects the strong demand for dollar-funding both end the end of this month, which is quarter-end and for some businesses and government's fiscal year-end, and the turn of the calendar year-end. This might be exacerbated by US corporates repatriating offshore funds.  

EMU Data: The eurozone preliminary September CPI was mixed. The headline unexpectedly slowed to 0.9% from 1.0%. Economists expected a 1.1% pace, especially after Germany, surprised to the upside. The core rate rose to 2.1% from 2.0% as expected, but does not appear to the "vigorous" acceleration that Draghi claimed. France reported a slight decline (2.5% vs. 2.6%). Italy's CPI was unchanged at 1.6%, and Spain was steady at 2.2%.  Separately, France reported a strongest than expected rise in household spending (+0.8% in August after flat July) and Germany reported an unexpected decline in unemployment (5.1% from 5.2%) as the unemployed queues were reduced by 23k.  

UK: Growth in Q2 was confirmed at 0.4%, but the year-over-year pace was shaved to 1.2% from 1.3%. Total business investment fell more than expected and the current deficit was larger. Brexit looms large as the Tory Party Conference begins over the weekend and culminates with Prime Minister May's speech in the middle of next week. We have argued that May faces a trilemma in being unable to appease three stakeholders, the EC, the Tory Party, and Parliament. It had looked as if an agreement with the EC was closest, but May rejected its Irish border proposal and now is at risk satisfying no one.  Sterling was sold to two-week lows against the dollar near $1.3035. There is an option at $1.30 for roughly GBP230 mln that expires today. A break of $1.2980, which houses the 50-day moving average and a retracement objective would likely be understood as confirming the end of the upside correction that began on August 15 near $1.2660.  

Japan: The Bank of Japan signaled it will likely reduce the amount of long-term JGBs it buys next month. This month it targets buying JPY50-JPY150 bln of bonds with maturities 25 years and longer. In October, it indicated it will purchase JPY10-JPY100 bln. Under its yield curve control policy, it appears to be engineering a steeper yield curve at least in part to blunt some of the unintended consequences especially for financial disintermediaries, including banks and insurance companies. Separately, Japan reported the first rise in industrial production in four months (0.7% vs. expectations for a gain twice that) and stronger than expected retail sales (2.7% year-over-year vs. expectations of a 2.0% increase). Japan also reported a decline in unemployment (2.4% vs. 2.5%) and an increase in Toyko CPI (1.3% headline and 1.0% core, both up 0.1% from August). Note that the week;y MOF flows showed Japanese investors continued their strong buying of foreign bonds, while foreign investors continued to sell Japanese stocks and sold the most Japanese bonds in two years. The dollar reached nearly JPY113.65 in Toyko before consolidating around JPY113.40 in the European morning. This will be the third week the dollar has gained against the yen, the longest streak in Q3. There are two expiring option strikes that could be in play if the dollar trades heavily in NY. At JPY113.00, there is a $1.6 bln option that will be cut, and at JPY112.85, there is another $975 mln option.  

North America: The US economic calendar includes the August personal income and consumption data, which economists will use to fine-tune Q3 GDP.  Yesterday's news of a larger good deficit prompted some economists to revise down Q3 GDP forecasts. The core PCE deflator, which the Fed targets, is expected to be unchanged at 2.0%. The Chicago PMI and the University of Michigan's consumer confidence and inflation expectations are unlikely to distract the market ahead of month and quarter end. Canada reported July GDP. A 0.1% gain would likely see the year-over-year pace slow to 2.2% from 2.4%. The US dollar has gained about 0.8% against the Canadian dollar this week. It had approached CAD1.3080 yesterday but is back testing CAD1.30 today. NAFTA has missed many deadlines over the past year and today is no exception. Over the weekend, the White House will submit the text of the agreement with Mexico to Congress to begin the process.