Headlines in the week ahead will revolve around political turmoil both at home and abroad, as the US government shutdown drags on and the Brexit vote looms large in the UK.
As far as the impasse inside the Beltway is concerned, there was no progress as of Sunday afternoon. The shutdown is now the longest in modern history and concerns are growing that it if it isn’t resolved soon, it will adversly impact the economy.
Sunday brought more of the same from Trump on the wall. Indeed, you could argue that his rhetoric has grown even more shrill, assuming that’s possible. Over the weekend, the President tied illegal immigrants to sexual assault against America’s youth. “Thousands of illegal aliens who have committed sexual crimes against children are right now in Texas prisons”, he shrieked on Sunday, adding that “most came through our Southern Border.”
The jury is still out on whether he’ll ultimately declare a national emergency and/or move to loot disaster relief funds to pay for the wall. Such a move would invariably face legal challenges and would cause a firestorm on Capitol Hill.
Meanwhile, lawmakers are struggling to conjure the proper response to reports out over the weekend which suggest US intelligence and law enforcement agencies believe the President might be a Russian asset.
To call it all “surreal” would be to grossly understate the case.
Rally mode, but for how long?
It looks like some of the data releases in the U.S. will be delayed by the shutdown. Everyone generally knows the narrative after the Fed spent all of last week driving it home. The committee is a very “patient” bunch right now and they are “listening” and watching and waiting and also hoping that their job doesn’t get any harder. That dovish relent has managed to rescue markets from the December doldrums. Stocks are up three weeks in a row.
The risk-on mood is readily apparent when you look at what’s outperforming. Small caps are on fire, for instance. The S&P has underperformed the Russell 2000 for three straight weeks with last week marking one of the best relative weeks for small-caps versus the broader market since the election.
Cyclicals are back, and it’s entirely possible this has run way too far, way too fast.
The dollar is of course squarely on the back foot, having fallen for four consecutive weeks amid the dovish pivot from the Fed and as worries about the economy and D.C. gridlock weigh.
“A continuation of the risk-positive environment, supported by expectations of a Fed pause and perceived progress on US-China talks, while ignoring slower global growth, could keep weighing on the USD in the near-term”, Barclays said over the weekend, on the way to noting that the shutdown “has also contributed to the relatively negative sentiment around the dollar, and seems unlikely to be solved in the near term.”
Folks are also watching high yield closely. The rally there is astonishing as documented extensively in the amusing “Dissecting The ‘Incredible’ Junk Rally And The Case For A 24-Pound Bucket Of Mac-&-Cheese.”
Despite the manic bounce, we’re hardly out of the woods yet. “Risk sentiment remains fragile, in our view, and data reminding markets of the global growth backdrop can bring volatility and a respite to the dollar”, Barclays went on to warn on Sunday.
Brexit (again, dammit)
On Brexit, the situation is as convoluted as ever. Theresa May’s plan will likely fail in Parliament on Tuesday and Labour leader Jeremy Corbyn is set to call a no confidence vote in the Prime Minister, just a month after she survived a party challenge.
“In the likely scenario that the vote fails, price action for GBP spot and vols will depend on three factors, i) the magnitude of the loss initially; ii) the political ramifications within the UK and iii) the reaction by other EU member states”, Barclays wrote Sunday, adding that the “risks [are] skewed to the downside.” Here’s a bit more:
A large defeat opens up the possibility for further UK political turbulence weighing on the pound and resulting in higher realized volatility. The UK Government would be given three days to propose a “Plan B”, which under the Grieve Amendment, would have to be voted upon by parliament. Since we think market participants have started assigning a higher likelihood of the Article 50 being extended beyond end-March, a non-mention of A50 extension by the UK government will likely disappoint markets and push near-term (1-3m) GBP vols higher. The immediate reaction by EU member states also will be critical. Unanimous support in PM May’s government by EU leaders and the scope for some concessions likely would cap some of the downside in the pound. Yet, meaningful concessions are unlikely, in our view.
Don’t discount the possibility of more FX volatility. Remember, traders were preparing for chaos prior to last month’s planned vote and since then, we’ve seen a dramatic FX flash event. Cable logged its fourth consecutive weekly gain last week, presumably on the hope that Brexit would ultimately be delayed. That’s the best run in a year.
Here’s a 1-week riskies chart, for reference:
“We identify two major developments over the past months that support our view that all pathways are leading to a soft Brexit”, BofAML wrote, in a note dated Friday flagging Parliament’s increased scope for controlling the narrative and the likelihood that “discussions around an extension of Article 50 are likely to intensify, particularly given the legislative log-jam of bills as part of the EU Withdrawal Bill.”
A bubblin’ crude
Crude is obviously on fire, up more than 20% off the lows. Benchmark prices finally took a breather on Friday after a ridiculous nine-day win streak.
Al-Falih was on the tape with a series of comments on Sunday. He struck a generally benign tone, but suggested Russia isn’t moving fast enough for his liking. “We’ve done enough and been decisive in our action, not only the kingdom but other countries,” he said in Abu Dhabi, before noting that “Russia has started slower than I like, but they have already started, and I am sure — as they did in 2017 — will ultimately catch up and be a positive contributor to balancing the market.”
Crude’s resurgence has aided and abetted the risk-on move and breathed new life into the reflation narrative at a time when it seemed to be dead and buried.
EM FX is riding a sharp rally to start the year, benefiting (obviously) from the weaker dollar and buoyant risk sentiment, so folks will be keen to see how sustainable that is, especially in the context of the “convergence” narrative. China trade data is on deck and that will be watched closely for obvious reasons. Reports out over the weekend that John Bolton asked the Pentagon for options on a possible military strike on Iran back in September may add a little spice to an already scorching-hot geopolitical recipe.