Huge troubles and challenges ahead, but oversold USD might run out of sellers

Outlook:

We have a slew of factors potentially roiling markets today, starting with the Bank of Canada policy meeting. Canada has the highest growth rate among G7 and is the most likely to raise rates before year-end. We could get a hike as early as today or at least an encouraging comment. This has been so long anticipated, as shown by the bubbly CAD, that we need to worry about sell-on-the-news.

To imagine a rising US dollar takes some imagination. The underlying environment is terrible. The Federal Emergency response agency, FEMA, runs out of money by the end of this week. The US government runs out of money before the end of September. Bloomberg writes that T-bill traders are so worried about Congress screwing up raising the debt ceiling that they forced the 4-week bill auctioned yesterday to a "ghastly" yield of 1.30%. Then there's the president ending DACA, the Obama program whereby immigrants brought here as children get a path to citizenship, including teachers and soldiers.

The Attorney General falsely said the DACA program is unconstitutional. That's an opinion, not a fact. DACA was never taken to a high court for a test of constitutionality. Previous presidents, including the sainted Reagan and Bush I, had issued executive orders on immigration. In any case, Congress could just pass the DACA executive order as a law and be done with it, but that would be too simple.

Given all these terrible troubles and challenges, why would the dollar get a reprieve? Simply because it's oversold already. When every big player has a short dollar position at his institutional maximum, the market literally runs out of sellers. It doesn't always take an Event to trigger a buy-back—they can come out of the blue—but this week we have a dandy excuse—Mr. Draghi repeating that the ECB is not contemplating tapering. This won't be an outright lie, but it won't be the whole truth, either. The executive board may not talk about tapering, but that doesn't mean the economic team in the background has not prepared top-secret scenarios in preparation. See below for more on tapering.

As for the immediate data, in the US, we get the Beige Book, the service sector ISM for August, and the July trade balance. Nobody paid much attention to trade until Trump, and after a drop in the deficit in June, economist expect another drop today, to the neighborhood of $44.6 billion (from a sharply contracted $43.64 billion in June). A great deal of the deficit is with China, and that raises the question of what Trump will do, if anything, about trade with China as a response to the North Korea situation or as a fulfillment of his campaign promises.

The thought of an embargo on Chinese goods in both directions is the most intriguing idea to make an appearance in a long while. As noted yesterday, it would almost certainly work to sharpen China's attentiveness to the North Korea problem. But it would work only if everyone knew upfront that the embargo would be temporary and the end of it would be tied to achieving specific goals. That would reduce the havoc wreaked on both economies... but still open a window of opportunity for China's competitors.

We like to joke that China has power over the US financial system and the dollar because it owns so much US government debt, but it was unthinkable that the US would cut back imports from China in any meaningful way... until Trump, who is just nuts enough to do it. We say "nuts" but trade embargoes have a long history and contrary to public opinion, do achieve their goals, at least sometimes and to some extent. Think the OPEC embargo in 1973, rather than the Cuban or VietNam embargoes. From China's point of view, one way to head off an embargo is to have so much invested by the embargoing country that an embargo causes too much harms to its own companies. CEO's would march on Washington to get an embargo lifted... and China is the single biggest consumer society on the planet. Think Band-Aids and toilet paper, not to mention Boeing and Detroit. And indeed China is making an effort to raise incoming foreign direct investment as well as to clamp down on outgoing flows.

On direct investment, China has been announcing "measures aimed at attracting greater flows by making it easier to invest in more sectors, loosening rules around the repatriation of profits and extending tax breaks to foreign investors in preferred areas of the economy," according to the FT. At the same time, it's banning overseas direct investment in morally questionable areas like gambling.

See the chart. "FDI growth into China has stuttered and shrank last year, which is in sharp contrast to ODI, which overtook FDI in 2015 for the first time. As Chinese companies have become increasingly bold in searching for growth in overseas markets, ODI hit a record high of $183bn in 2016 — or nearly 50 per cent more than FDI.

"The disappointing growth in FDI is down to several factors. A shortage of skilled labour and the subsequent increase in wages have diverted the attention of foreign investors to cheaper alternatives, such as Vietnam and Indonesia. In addition, as a non-member of the WTO Government Procurement Agreement (GPA), the Chinese government still gives preference to domestic companies over foreign companies when awarding contracts. Beijing understands that a declining FDI rate will have a negative economic impact that extends far beyond the dollar amount received. Sales, employment and spending are generated as a consequence of the operations of foreign invested enterprises and will all be affected. FIEs also help to modernise Chinese industries by importing new technologies and improving best business practices. To avoid these areas taking a potential hit, relaxation of restrictions on FDI becomes essential."

China is taking these actions to make its economy more balanced and growth more sustainable, but is has the indirect effect of attracting US companies who would squawk at any interference from Washington. An embargo is not really likely, although with the erratic Trump, you never know. He may decide to ramp up his tirade against NAFTA (again)—instead of going after China, or as a prelude to going after China. Yesterday the NAFA talk team claimed to have been working at "warp speed" and to have made progress on digital trade, the environment, and services, with wages, local content rules and the US deficit to be addressed at the third round starting Sept 23. The goal is a new deal by year-end, but doubts are rising that it's a deal Trump will like or accept.

Of more immediate interest is the ECB policy meeting on Thursday. Nobody expects a change in the interest rates, but a reduction in QE purchases is considered likely. Speculation centers on a cut from £60 billion/month to £40 billion, although the timing is up in the air. Never mind—the announcement effect is the same whether the do it in October or not until next June or even later. As we wrote in August, mention of tapering depends almost entirely on how Mr. Draghi and his economists view soft inflation that is not yet "sustainable" and the euro appreciation that contributes to that soft inflation. If the inflation projection is downsized specifically because of the rising euro, inflation sustainability is pushed out, perhaps for years and not just months. See the handy inflation chart provided by Econoday.

Econoday writes that "...the rise of the euro, compounded by some dollar weakness, already poses a threat to the medium-term inflation outlook and any move to reduce the degree of monetary accommodation could simply exacerbate the problem by driving the currency still higher. The unit's trade weighted index is up around 8 percent since January which, in terms of its impact on monetary conditions, is roughly the same as a 1 percentage point rise in interest rates.

"This makes an aggressive move on Thursday very unlikely and may well see the announcement of any QE adjustment delayed until October, now the market's preferred call. Certainly, should the central bank introduce tapering this week, expect it to be couched in decidedly dovish terms."

We say this sounds exactly right. It's not that Draghi is dragging his heels. It's that he trusts the economic analysis. The question is whether the euro drops on the policy statement and press conference. But still, the euro is the least dirty shirt in the pile of laundry.

After the dollar, the dirtiest laundry is the pound. Why sterling persists in an upmove remains a mystery. Traders are not responding to the political situation, which is dire and getting worse by the day. The deputy Brexit negotiator said she is skeptical trade talks can begin as scheduled in October because so much of the preliminary work has not been done, including non-citizen labor rights. The opposition Labour party opposes the legal regime May has proposed, and the new May plan for immigration excludes all but the most highly skilled workers. Who is going to sweep the streets?

Bottom line—the dollar is toast and should be toast on the facts, but market positioning is extreme and may be due for a correction. Whenever we see record-breaking data like the 10-year yield at a multi-month low, 5-year TIPS going negative and 4-week bill at the ghastly 1.30%, we need to worry that the bottom is in. Any dollar bounce would be short-lived and shallow, but watch out. When 95% of indicators say sell, it's getting to be time to buy.

Fun Tidbit: Among all the talk of how much, exactly, the UK will be paying in committed budget contributions to the EU, along comes a NYT story on subsidies to farmers, including the Queen (who gets $675,000 this year, down from $975,000 the year before) for Sandringham and Balmoral, and Price Charles, who gets more than $130,000 for his estate in Cornwall. The more the acreage, the bigger the subsidy, much resented by small farmers in the north and those who strive for environmental protec-tion. Labour is happy that the entitled will have to pay their own way. Economists of all stripes are hap-py to stop rewarding people for large land-holdings. Henry George would approve.

Separately, the new head of the Liberals, the aptly named Mr. Cable, complains bitterly about income inequality and calls for higher taxes on property and inheritance. Don't raise taxes on income—raise taxes on wealth accumulation. The rchbishop of Canterbury also weighed in, saying the economic model is "broken." Bernie Sanders would be right at home.

Currency	Spot	Current Position	Signal Date	Signal Strength	Signal Rate	Gain/Loss
USD/JPY	108.74	SHORT USD	07/19/17	STRONG	111.96	2.88%
GBP/USD	1.3030	SHORT GBP	08/11/17	WEAK	1.2961	-0.53%
EUR/USD	1.1938	LONG EURO	06/28/17	STRONG	1.1218	6.42%
EUR/JPY	129.81	SHORT EURO	08/14/17	WEAK	129.40	-0.32%
EUR/GBP	0.9161	LONG EURO	04/25/17	WEAK	0.8490	7.90%
USD/CHF	0.9545	SHORT USD	08/10/17	STRONG	0.9655	1.14%
USD/CAD	1.2384	SHORTUSD	08/24/17	WEAK	1.2533	1.19%
NZD/USD	0.7224	SHORT NZD	08/11/17	STRONG	0.7275	0.70%
AUD/USD	0.7978	LONG AUD	08/17/17	WEAK	0.7931	0.59%
AUD/JPY	86.75	LONG AUD	09/05/17	WEAK	87.30	-0.63%
USD/MXN	17.8932	LONG USD	09/05/17	WEAK	17.8312	0.35%
USD/BRL	3.1170	SHORT USD	09/05/17	WEAK	3.1409	0.76%