It has been said that the economy is one dog with two owners, the government and the central bank. The problem for the dog is which one has the best treats and which one has the leash.

In the last 10 years it’s been the FOMC to lean on, now it’s the US President. For markets, it’s the balancing of bonds against stocks.The cost of money matters as it sets the value of future cash flows, puts a number on growth potential and solves for the base case for profits. We had a one dog market last week as the bond market rout drove down equity prices, put fear in credit and lifted the USD back higher despite doubts about the US trade and fiscal policy.

US 10-year yields touched 3.25% back to 2011 highs. If the last week brought expectations for US economic outperformance with unemployment at 39-year lows and Services ISM at a record, then the next week brings a return of China/US trade worries and US C/A doubts with a $230 billion deluge of debt sales. The dogged equation of higher real growth means higher real rates hits globally.

The reality check next week will be US CPI along with more reactions from Fed speakers. Rates are the dog that wag the tail of the economy after the bone of price increases change the business cycle. Whether the Fed is ahead or behind the curve becomes the likely new obsession which won’t mix well with the threat of a prolonged trade war with China, rising doubts about EU politics and jitters about higher energy prices into winter. The problem in the week and month ahead may be best described by the removal of the central banker’s accommodative policy that intrinsically supports risk-taking.

The chart of returns (from Bloomberg using SocGen CTA index and the S&P Risk Parity 10% vol for risk-parity programs) makes this clear with the January turnaround fully reversed into October but recently and perhaps most troublingly, unwinding last week. There is no Powell S&P 500 put. As for the CTA models in markets, the run-up in oil, USD and rates has helped trend followers regain some ground but they remain well off the January highs. Perhaps the only safe bet is that volatility will follow as systematic approaches to trading face a Fed less inclined to trust their models.

What Happened over the Weekend? 

Kavanaugh wins a seat on the US Supreme Court, China PBOC cuts the reserve ratio for the fourth time this year, Brazil elections start with 147 million choosing their next leader, elections also being held in Bosnia and Cameroon along with a referendum on same-sex marriage in Romania. US Secretary of State Pompeo and North Korea Leader Kim agree to a second US-North Korea summit as soon as possible.

Risk of 3.60 in BRL after election

• Polls suggest Bolsonaro over Haddad but run-off likely. The polls put far-right Bolsonaro a 15% lead over his closest rival, the Workers’ Party (PT) candidate Fernando Haddad, with about 40% of intended votes – not enough to prevent a run-off on 28 October.

• China PBOC cuts the reserve ratio for some banks by 1% effective Oct 15. The cut releases CNY1.2 trillion of liquidity with CNY450 billion in MLF coming due offsetting some of the easing. The move puts the RRR at 14.5% for large banks and 12.5% for smaller ones. This follows the April similar 1% move. The central bank said on Sunday it would continue to take necessary measures to stabilize market expectations, while maintaining a prudent and neutral monetary policy. The PBOC would "maintain reasonably ample liquidity to drive the reasonable growth of monetary credit and social financing scale," it said.

Question for the Week Ahead: Did QE and negative interest rates work?

Ten years after Lehman and investors are still concerned about a liquidity trap. The US FOMC, by removing its accommodation and unwinding the balance sheet bloated by bond buying, is the exception, not the rule for global central banks. The next year will be a crucial test of whether QE and negative rates can be unwound without a divisive crisis. he success in the US and other QE policy has been clouded by the rise of populist policies – some of which have been blamed on the plans intent to inflate risky assets. While this all sounds logical, the success of such policy in keeping people working and economies growing shouldn’t be lost and the costs of doing nothing would have led to much more painful politics. The IMF released its reckoning of the policies 10 years on and its required reading for all investors fearful of its removal. 

The crisis resolution included fiscal spending – notably in China and other EM – and bank bailouts – notably in EU and US. The relationship of global banks to supporting EM changed after the crisis and that remains a significant question about trade and growth. The rise of China and its belt-road initiative and lending to frontier and EM nations followed. Many would suggest that a China slowdown induced by a prolonged US trade war will continue to hamper EM recoveries regardless of their FX devaluations. 

The lessons for the next crisis maybe about fixing the banks faster as the chapter spells out. The logical responses for China and perhaps India in the months ahead could be important to their own present shocks.

Market Recap:

The start of the week brought a new and improved NAFTA now named USMCA. Global PMI reports were modest except for the US Services ISM setting a new-record high. Wednesday was also shared by a hawkish tilt from FOMC Powell on rate hike risks. News from Bloomberg on Chinese microchip hacking of US companies was the Thursday driver while the price action in US bonds dominated Friday as 10-year touched 3.25% after a slightly better US jobs report. US unemployment drops to 3.7% but the NFP rose just 134,000 with sharply higher revisions to July and August adding back 87,000. The IMF warned on global growth risks in its run up to Indonesia blaming trade tariffs and rate hikes.The RBI skipped on its rate hike and that left INR testing 74 and the stocks market there as the worst performer for the week – along with its shadow banking default risks higher. Brazil and Argentina were the other side of the EM divide with the election moving towards a run-off and the ARS steady after IMF deal part 2 and new central banker sounded supportive of new policy.  

Equities 

The MSCI all-country World Index fell 1.85% to 514.69 on the week. The MSCI EM index fell 4.72% to 1000.76 on the week. Major bourses all suffered – all 8 fell with India leading the drop and the US and France doing the least harm.

• The US S&P500 fell 0.97% to 2,885.57 on the week. The DJIA fell 0.04% to 26,447.05 on the week. The NASDAQ fell 3.21% to 7,788.45 on the week. Energy and financials outperformed last week with higher oil and higher yields supporting, but utilities also gained despite US rates suggesting a return to defensive allocations. Amazon led the path lower with consumer discretionary after a $15 boost to its minimum wage and with the Chinese hacking concerns.  The Cboe VIX index rose 21.47% to 14.82% on the week, or up 2.7pp – still below the 16% long term average.
• The Stoxx Europe 600 fell 1.77% to 376.41 on the week. The UK FTSE led losses off 1.35% to 7,318.54 while Italy MIB was a close second at -1.30% to 20,345.96. The hopes for a Brexit deal supported GBP and hit UK shares, while the Italian budget and EU rift drove up bond yields and hit banks there. The German DAX fell 1.08% to 12,111.90 on the week while the French CAC40 fell 0.95% to 5,359.36.
• The MSCI Asia Pacific Index fell 3.56% to 159.65 on the week. The index fell every day last week with China on holiday and Korea and Hong Kong and India having short weeks. Focus was on Technology shares and China growth slowing  – Taiwan TAIEX fell 4.44% to 10,517.12 on the week – the second worst performer – while Hong Kong Hang Seng fell 4.12% to 26,572.57 for third worst performer and Indonesia Jakarta Composite was fourth off 4.09% to 5,731.94. Australia ASX200 was the best off just 0.36% to 6,185.49 on the week. The second-best performer thanks to weaker JPY, Japan Topix fell 1.35% to 1792.65 while the narrower Nikkei 225 fell 1.39% to 23,783.72. The Korea Kospi fell 3.73% to 2267.52 on the week while the India Nifty 50 was the laggard off 6.02 to 10,316.45 on the week as the RBI held policy and the INR dived over 74 to USD.

Fixed Income

The move up in US rates grabbed the headlines with the 10-year touching 3.25% back to 2011 highs. 30Y bond yields also broke a key technical at 3.25% ending a multi-decade bull run for bonds. Most of the move was linked to higher US growth and a more hawkish sounding Fed. However, the effect of steeper yield curves in Japan and Europe may be part of the story. European bonds focused on the Italian pain trade with its budget and EU on a collision course still despite talk otherwise. UK Brexit deal hopes added to the mix. The German Bund yields breaking 0.50% and holding over that open more risk for yields to rise with the ECB on watch for its tapering and QE end. The equity pain trade did little to support global bonds as FX moves in EM worried and supply concerns returned.Next week, the focus will be on the US and EU bond auctions along with the US CPI.

• US bonds see bear curve steepening with biggest drop since February.2Y up 6.5bps to 2.885%, 3Y up 10bps to 2.982%, 5Y up 11.5bps to 3.069%, 10Y up 17.5bps to 3.233% and 30Y up 20bps to 3.404%.
• Canadian 10-year bond yields jump 17bps to 2.595% on the week – matching US move, watching oil and BOC rate hike risks post USMCA. Trade good, jobs mixed.
• Japan JGB yields up 3bps to 0.145% on the week – BOJ kept buying intact with focus on Abe/Trump trade hopes, Rinban sizes and IMF vs Domestic data showing growth.
• Australian 10-year bond yields rose 4.5bps to 2.71% on the week. RBA on hold, sounding upbeat but with China growth fears and risk-off mood supporting.
• UK Gilt yields rose 15bps to 1.72% on the week – Brexit deal hopes, UK May Tory speech and slightly better data helping drive along with US and German moves.
• German Bund yields rose 10.5bps to 0.57% on the week – mixed data but more ECB tapering talk and push back on Italy as an excuse – technical 0.5% break opens 0.75% next
• French OAT yields rose 10bps to 0.901% on the week – better data, more Macron leadership gains in EU.
• Italian BTP yields rose 28bps to 3.42% on the week – all about EU/Italy budget clash risks and doubts about growth and debt sustainability. ECB push back key.
• Spanish Bono yields rose 8bps to 1.575% on the week – supply, growth doubts, tracking Bund – all driving.
• Portugal 10-year bond yields rose 6bps to 1.93% on the week – with focus on growth, budget deals and contagion from Italy being restrained.
• Greek 10-year bond yields rose 36bps to 4.45% on the week – worse than Italy and more vulnerable given bank doubts, ECB tapering and growth fears.

Foreign Exchange

The US dollar index rose 0.52% to 95.62 on the week with Thursday 96.12 highs reversing on the 95.85 break Friday with short-term risk for 95.30 retest given overbought conditions but 97 remains bull target. 

In Emerging Markets – the USD was bid except in LATAM (all moves for the week)  – EMEA: ZAR off 4.25% to 14.768, TRY off 1.25% to 6.1330 – oil and rate policy, RUB off 1.6% to 66.604; ASIA: INR off 1.7% to 73.767 with 74 break Friday key, KRW off 1.9% to 1130.50 with 1130 break key, TWD 30.847 off 1% to 30.847 and CNH off 0.3% to 6.8950 with 6.92 key resistance on China return; LATAM: MXN off 0.55% to 18.825, despite early USMCA gains, BRL up 5.5% to 3.84 on election hopes, ARS up 9.1% to 37.852 with hopes for IMF deal 2 and new central bank governor.

• EUR: 1.1525 off 0.7% on the week. Watching 1.1450 and 1.1580 for next 1% with ECB vs FOMC key.
• JPY: 113.75 flat on the week and EUR/JPY 131 off 0.7% - all about EUR and risk-off mood in equities with higher US rates helping and hurting. 114.50 toppy with 112 retest risks.
• GBP: 1.3120 up 0.70% on the week and EUR/GBP off 1.4% - all about Brexit deal hopes and better data with 1.30 pivot opening 1.3250 and 1.3350 retest risks
• CHF:.9920 off 1.05% on the week with EUR/JPY 1.1435 up 0.35% despite the Italy noise – SNB and rates driving.
• AUD: .7050 off 2.4% on the week – opens risk for .70 barrier stopfest and 0.68 test - big selloff on China growth fears, RBA on hold, crosses with NZD off 2.65% to .6440 with focus now on 0.625%
  CAD: 1.2940 off 0.25% on the week – despite the USMCA, C$ hit on rates, crosses and politics with 1.2880 and 1.2750 USD support and 1.3050 stop risks.

Commodities

The S&P/GSCI total return index up 1.71% to 2908.43 on the week. Leaders for the week were Sugar, Rice, Hogs and Coffee while Orange Juice, Cocoa and Copper lagged.

• Oil: $74.34 up 1.5% on the week. Brent up 1.75% to $84.16. Oil held bid tone with US production concerns offsetting capacity story from Russia/Saudi and with global demand doubts rising. Technicals still have $87 target in Brent and $79 in WTI.
• Gold $1203.65 up 1.1% on the week – breaking out of 55-day resistance at $1202.50 with $1215 needed to get momentum, gains despite USD up. Silver off 0.15% to $14.63 still holding $14.50 base for $14.77 upside breakout. Platinum up 0.8% to $822.50 and Palladium off 0.3% to $1071.75.
• Corn: $368.25 up 3.3% on the week – with USMCA the driver despite China/USD worries. Wheat up 2.35% to $521 and Soybeans up 2.8% to $869.
• Copper: $2.8075 off 0.3% on the week while futures fell 1.5% to $276.30.All about china/equities/US rates with Iron Ore futures (Oct) off 1.5% to $66.66 and (Nov) $66.50.

Calendar for the Week Ahead

The return of China from holiday, the IMF meetings in Indonesia, the Brazil election results and ongoing Brexit deal hopes will likely drive markets early even as the data is slow to start with US, Canada and Japan holidays Monday. US earnings for 3Q and Fed speakers are key for the US along with the US mid-term election and Trump campaigning. Data focus is on US CPI and PPI, Trade reports from China, Germany, UK and on the consumer mood from Japan Ecowatchers to EU Sentix to US NFIB and University of Michiga consumer sentiment.

Monday, October 8: Japan Sports Day, Canada Thanksgiving, US Columbus Day holidays, China Services PMI, German IP.

• 0945 pm China Sep Caixin Services PMI 51.5p 52e / Composite 52p 52.5e
• 0145 am Swiss Sep unemployment 2.8%p 2.5%e
• 0200 am German Aug industrial production (m/m) -1.1%p +0.5%e
• 0430 am Eurozone Oct Sentix Investor Confidence 12p

Tuesday, October 9: Japan and German trade, Japan Ecowatchers, US NFIB optimism, IMF meetings start.

• 0750 pm Japan Aug trade balance BOP basis –Y1.0bn p +Y245bn e / C/A Y2.0bn p Y1.89bn e
• 0830 pm Australia Sep NAB business conditions 15p 9e /confidence 4p 5e
• 0100 am Japan Sep EcoWatchers Outlook 51.4p 50.6e / current 48.7p 48.9e
• 0200 am German Aug trade balance E15.8bn p E19.0bn e / exports -0.9%p +0.2%e / C/A E15.3bn p E17.5bn e
• 0430 am UK FPC Statement
• 0600 am US Sep NFIB small business optimism 108.8p 107e
• 0815 am Canada Sep housing starts 201k p 222k e
• 1000 am Chicago Fed Evans speech
• 1000 am US Oct IBD/TIPP economic optimism 55.7p 55.3e
• 1130 am US sells $48bn 3M and $42bn 6M bills
• 0100 pm US sells $40bn in 4-week and $26bn in 52-week bills
• 0400 pm Argentina central bank rate decision – no change from 60% expected

Wednesday, October 10: French, Italian and UK industrial production, UK trade deficit, US PPI, Fed speakers

• 0730 pm Australia Oct Westpac Consumer Confidence 100.5p 102e
• 0750 pm Japan Aug machinery orders (m/m) +11%p -4%e (y/y) 13.9%p 1.6%e
• 0915 pm NY Fed Willams speech
• 1010 pm RBA Coombs speech
• 0245 am French Aug industrial output (m/m) 0.7%p 0.3%e
• 0400 am Italy Aug industrial output (m/m) -1.8%p +0.7%e
• 0430 am UK Aug industrial production (m/m) +0.1%p +0.1%e (y/y) 0.9%p 1.1%e /Manufacturing production (m/m) -0.2%p +0.1%e (y/y) 1.1%p 1.5%e
• 0430 am UK Aug Goods Trade Deficit GBP9.97bn p GBP12.39bn e / total trade GBP-0.111bn p -2bn e
• 0430 am UK Aug GDP (m/m) 0.3%p 0.1%e
• 0500 am BOE Haldane speech
• 0500 am UK 10Y Gilt sale
• 0540 am German 10Y Bund sale
• 0600 am UK Sep NIESR 3M GDP estimate 0.6%p 0.5%e
• 0830 am US Sep PPI (m/m) -0.1%p +0.2%e (y/y) 2.8%p 2.8%e / ex food/energy -0.1%p +0.2%e
• 1000 am US Aug wholesale inventories 0.6%p 0.7%e
• 1130 am US sell $36bn 3Y notes
• 1215 pm Chicago Fed Evans speech
• 0100 pm US sells $23bn 10Y notes
• 0430 pm US weekly API crude oil stocks +0.907mn p -0.52mb e
• 0600 pm Atlanta Fed Bostic speech

Thursday, October 11: ECB Minutes, Sweden CPIF, US CPI, US 30Y bond sale

• 0630 pm RBA Ellis speech
• 0750 pm Japan Sep Domestic Corporate Goods Prices (domestic PPI) (m/m) 0%p 0.2%e (y/y) 3.0%p 3.0%e
• 0900 pm Australia Oct consumer inflation expectations 4%p 4%e
• 0245 am French Sep final HICP (m/m)0.5%p -0.2%e y/y) 2.6%p 2.5%e
• 0300 am Spanish Sep final HICP (m/m) 0.1%p 0.6%e (y/y) 2.2%p 2.2%e
• 0330 am Sweden Sep CPIF (m/m) -0.2%p +0.4%e (y/y) 2.2%p 2.4%e
• 0545 am Italy sells 3-7-30Y BTPs
• 0730 am ECB monetary policy meeting accounts
• 0830 am US weekly jobless claims 207k p 205k e
• 0830 am US Sep CPI (m/m) 0.2%p 0.2%e (y/y) 2.7%p 2.5%e /ex food+energy 0.1%p 0.2%e 2.2%p 2.3%e
• 0830 am Canada Aug new housing prices (m/m) 0.1%p 0.1%e
• 1100 am US weekly EIA crude oil stocks +7.975mb p +5.082mb e
• 1200 pm US WASDE report
• 0100 am US sells $15bn 30Y bonds

Friday, October 12: IMF meetings in Indonesia, China trade, China M2/new loans, Spanish Holiday, Eurozone IP,

• 0830 pm Australian FSB review
• 0830 pm Australia Aug home loans (m/m) 0.4%p 0.1%e
• 1000 pm China Sep trade surplus $27.91bn p $21bn e / exports 9.8%p 9.1%e / imports 20%p 15%e
• 0200 am German Sep final HICP (m/m) 0.0%p 0.4%e (y/y) 1.9%p 2.2%e
• 0400 am China Sep M2 8.2%p 8.3%e / CNY new loans 1.28trn p 1.35trn e / TSF CNY1.52trn p CNY1.53trn e
• 0500 am Eurozone Aug Industrial Production (m/m) -0.8%p +0.4%e (y/y) -0.1%p -0.3%e
• 0800 am India Aug Inflation (y/y) 7%p 3.5%e
• 0800 am India Aug Industrial Production (y/y) 6.6%p 4%e
• 0830 am US Sep export prices (m/m) -0.1%p 0.2%e / import -0.6%p +0.2%e
• 0930 am Chicago Fed Evans speech
• 1000 am US Oct preliminary Univ.Michigan Consumer Sentiment 100.1p 100.5e
• 1230 pm Atlanta Fed Bostic speech
• 0200 pm US Sep monthly budget deficits $214bn p $47.3bn e

Conclusions:

Did the US jobs report confirm US growth divergence? The US unemployment rate at 3.7% and the 3M moving average of jobs created suggests the 4Q growth rate in the US is off to a great start. Markets are pricing in more rate hikes and more growth accordingly. The ability for this to continue rests on the feedback loop of the FOMC, the rest of the world’s reaction to higher cost of money and the ongoing confidence to hold. The big four indicators for the US economy are going to come out in the next 2 weeks and their matching the jobs report will confirm this argument.

Risks to the market rest with trade policy and the fear that a China trade war turns into a cold war. They rest on the FOMC being neutral not restrictive. They rest on Italy and EU differences over budgets not getting worse.They rest on the price of oil remaining in a zone where it doesn’t tax consumers or kill corporate profits. They rest on Brexit plans to become a non-event with some trade deal to follow.

These fears remain in play and are best measured by the USD – which seems to be in a short-term overbought position but one that ultimately sets up for 97 index retests and more trouble, like February 2018.Divergence of US policy and growth means less global convergence, more volatility and more uncertainty for any investor.

The alternative measure that many also want to watch is CNH which has managed to follow the EM crisis more than lead it as it did in August 2015. Whether China allows the CNH and CNY to depreciate beyond 7.00 will be a key focus in the weeks ahead. The easing of policy and its contrast to the US tightening will add to capital outflow pressures and only make more draconian policy from Beijing. China seems to be flipping back to the State as everything model and this puts it on a collision course with the US in the weeks ahead.