Hard Brexit speculation has brought a break in the correlation between Pound and UK assets

Outlook:

Now that the UK inflation report is out and the market shrugged, the US CPI this morning gets the focus. Headline CPI could be as high as 0.3% for 1.5% y/y, although the core is likely to be the same 0.2% or 2.3% y/y. This would give impetus to the Fed to hike--except the Fed is not looking at it, preferring the PCE version.

Expectations that CPI today will fire up the Fed are entirely misplaced. Nothing much fires up the Fed, anyway. It's still muddling along about a decision the market thinks has been made. We continue to think that if the Fed were to defer the hike at the December meeting, all hell would break lose. All the same, traders are not 100% confident that Dec is a firm date and a done deal. If they were, the CME Fed Watch tool based on futures would be higher than 64%, barely changed from a month ago. See the CME chart below.

Uncertainty at this high level is probably the reason why yields are back-sliding after an abrupt but short -lived burst upward yesterday. Besides, we have the strange picture of rising yields not necessarily boosting a currency, as we see in sterling. The UK reported higher inflation today, as expected, with a lot more to come, as we wrote about yesterday. The BoE is willing to accept inflation a little too hot, like 2.4%, but is not prepared for what some private forecasters are seeing, another 1% higher. When inflation rises, yields "should" rise in lockstep, right?

Well, no. Not when the link between fundamentals and market sentiment is broken by intervening uncertainty at the level we see in the UK today. Yes, it's rare for the GBP and Gilts to be sold off at the same time. But, as a Nomura analyst tells the FT, "The speculation about Hard Brexit has brought not just a change in investors' confidence but a break in the correlation between the pound and UK assets."

Normally you might expect such a break to be temporary. But this time "The typical reserve currency relationship with higher yields that would see sterling higher on a gilt sell-off, has been broken," he says — and that signals problems for relying on the inflows to fund the UK current account deficit." The longer the break persists, the more likely is additional sterling devaluation. Others think a funding crisis is a long way off and therefore the normal relationship should be restored at some point soon. This is the view of JP Morgan, which sees a rally in sterling's future, maybe, if yields keep rising. The analyst says "If yields continue to rise to such an extent that it could stem the currency weakness that would change the dynamic — but we remain far from that point today."

Decoupling of bond yields and currency levels is abnormal. The Morgan Stanley analyst says "Right now, the degree of uncertainty in the UK makes it a natural focus for investors questioning their bond holdings.... His advice is: ‘If investors want to feed their inner bond bear, we suggest selling gilts.'" Puzzling inflation data remains at the heart of the yield story.

Bloomberg has one of its cute stories about inflation actually appearing these days. See the chart. We say that even if inflation is on an upswing, the biggest threat to financial market instability is that trad-ers today never lived through an inflationary period. The last time we had a major inflation problem was 1979 when Volcker was Fed chairman. (We were trading Fed funds at the time and remember it well.) The new crop of traders don't have a clue, and even if they did, would the Fed behave the same way now as it did then? Perhaps the lack of experience with inflation accounts for the decoupling of sterling and Gilts, too. If something similar happens in the US, the reverberations would be far, far worse—US markets are just so much bigger.

Be careful what you wish for.

US Politics: Mrs. Trump said Billy Bush egged on Donald to "boy talk" and that's not the person she knows. Trump continues to disavow DNA results showing the Central Park Five were innocent and insists that because they confessed, they are guilty, as though perps are never strong-armed into confes-sions. Trump persists in saying the election is rigged and vulnerable to voter fraud, despite numerous studies showing the incidence of voter fraud is near zero. As for rigging, the supposed conspiracy be-tween the press and the Dems, Trump fans are physically attacking reporters, which shows their mob mentality.

In other words, the repulsive Trump continues to sell the ugly and the untrue. He would also censor Saturday Night Live, which mocks him. First Amendment, any-one? In a way, Trump is the US' Brexit. Elect this guy and the dollar and stock market crash, and gold goes through the roof. What would be the risk premium the US would have to pay on the 10-year note? The mind boggles.