Jackson Hole is going to be under the microscope

Outlook:

The roller-coaster ride of most currencies yesterday would not have been so violent if we did not have a big black cloud named the Trump presidency looming over the economy, the markets and public sentiment. It's not just that attention keeps being turned this way and that way—war with N. Korea, white supremacism—but that while Trump is distracting himself and everyone else with tweets and disruption, the work of governing is not getting done.

The US government failed, spectacularly, to keep its promise of health care reform. Now we are sup-posed to move on to tax reform. But analysts of all political stripes say the probability of tax reform—due in six weeks, remember—is well under 50%. Some say the probability is zero. And Trump dis-banded not only the two CEO advisory panels, but also the panel on infrastructure.

The more hysterical of the critics say "nobody is running the economy." This is as preposterous as Trump claiming his inaugural crowd was bigger than Obama's. One of the virtues of a free market economy is that its components run themselves. Factories keep producing goods. Ships come and go from ports. Amazon continues to sell stuff. FedEx and UPS still deliver packages. Municipalities re-pave roads. Hospitals and schools are open. The key effect of a dysfunctional federal government is on capital investment plans and other growth-related activities.

For our immediate purpose of forecasting the dollar, we continue to think that all the uncertainty Trump is creating not only puts long-term plans on hold, it also creates a flight to safe-havens. Logi-cally, the dollar can't be a safe-haven if its leader is the one causing the uncertainty. The effect on cur-rencies is mixed. The euro is the top beneficiary as the benchmark currency, and the falling Bund yield reflects that. But the euro has its own issues, including ECB worries about overshooting that could trig-ger verbal invention and/or a delay in tapering.

Sterling is a risky currency, so should be under pressure. The yen is a safe-haven to the Japanese and should rise. The ultimate safe haven is the Swiss franc, which has already gained against both the dollar and euro. With major country yields falling, you'd think higher yields in emerging markets would look wonderfully attractive again, but maybe not if risk aversion is getting a grip. And go back and take a look at the gold chart. Gold is not a currency, of course, but is a safe-haven bolt-hole in times of stress.

Much is being made of Yellen's speech at Jackson Hole next Friday with a focus on financial stability, a really interesting choice of topic. It has sent analysts back to the July minutes to take note of an over-looked phrase that got one headline in the WS\J but then was outweighed by Dudley's remarks. It was that the board notes "vulnerabilities associated with asset valuation pressures edged up from notable to elevated." In other words, equities are bubbly. We deleted that phrase from our Briefing the next day because we thought Dudley was overriding it with his remark that asset prices were commensurate with growth and other fundamentals.

Maybe that was a mistake. If the Fed feels markets are vulnerable by being overpriced, it's a solid reason to pursue tightening even in the absence of inflation. The Fed's third mandate after employ-ment and inflation is to maintain financial market stability. Ever since Greenspan declined to fiddle with the stock markets on the grounds that you know you had a bubble only after it has burst, Fed offi-cials have steered away from judging the level of asset prices of all stripes—bonds, stocks, housing.

As for inflation, the story is not changing. The Cleveland Fed offers an inflation expectation model whose last release (Aug 11) shows the public expects inflation over the next 10 years to be 1.81%. Ten years.

Jackson Hole is going to be under the microscope for other reasons, too. Reuters reports that about $45 billion of euro/dollar options will expire in the three days leading up to Jackson Hole, with $23 billion expiring on Thursday alone. Brown Brothers' Chandler explains it as an appropriate tactic: "With vola-tility so low, it is cheaper to put on option trades to express their currency views rather than execute them in the cash markets which can become erratic during the thin August summer days."

What about a statement from Draghi? Unnamed sources already told the press earlier this week that Draghi will not use the Jackson Hole venue to deliver a fresh policy message, but hope springs eternal that he may let something slip, especially after the minutes disclosed worries on the ECB board that the euro is overshooting. Remember that the "overshooting thesis" is the core standard theory from a now-defunct economist named Dornbusch, who said interest rates everywhere are the same except for ex-pectations of currency appreciation or depreciation. Currencies overshoot their true value and there is a circular cyclone effect as the overshoot gets adjusted.

We found a perfectly adequate explanation of the overshooting theory at Wikipedia: "According to the model, when a change in monetary policy occurs (e.g., an unanticipated permanent increase in the mon-ey supply), the market will adjust to a new equilibrium between prices and quantities. Initially, because of the ‘stickiness' of prices of goods, the new short run equilibrium level will first be achieved through shifts in financial market prices. Then, gradually, as prices of goods "unstick" and shift to the new equi-librium, the foreign exchange market continuously reprices, approaching its new long-term equilibrium level. Only after this process has run its course will a new long-run equilibrium be attained in the do-mestic money market, the currency exchange market, and the goods market.

"As a result, the foreign exchange market will initially overreact to a monetary change, achieving a new short run equilibrium. Over time, goods prices will eventually respond, allowing the foreign ex-change market to dissipate its overreaction, and the economy to reach the new long run equilibrium in all markets."

We know you want a fast forecast and not a treatise on arcane and seemingly silly economic theory, but pay attention: the central idea is that QE has pumped so much money supply into the European economy that inflation MUST by definition be on its way and the proof lies in the rise in financial asset prices, especially the currency, long before the adjustment hits the real economy. When the ECB governing board utters the word "overshooting," it means "we must taper and PDQ."

Remember that the ECB has only one policy mandate—to manage inflation. QE was intended to halt deflation. Now the euro itself is signaling that inflation is on its way. All the chatter about the optimum way to communicate with markets is just fluff. Also fluff is babble about which aspect of QE to tackle first, jiggering policy components, and supposed concern about a strong euro suppressing trade and other negatives. The currency alone is the message.

It's not unreasonable to expect Draghi to say something, anything, on the two occasions before the Sept 7 policy meeting. Ahead of Jackson Hole, Draghi has a speech in Germany next Wednesday. Every ear will be cocked to any mention of the euro. Draghi is a smart guy and he knows it. Therefore, whatever he does say has to be interpreted very carefully indeed.

Our guess is that Draghi will indeed let a little of the cat out of the bag and deliver a hint that tapering will not be announced at the Sept meeting but within the fourth quarter. He will try to reduce the effect of the statement by noting that tapering is scheduled to continue well into 2018, so tapering won't begin until the second half. This is not going to stop FX traders, but it may dampen the size of the inev-itable move.

US Politics: We are now accustomed to a fresh Trump Shock every few days to distract attention from the last one. Today Trump is working on Afghanistan. Here's a scary thought: not being dismissed out of hand is a proposal from military contractor Erik Prince to privatize the war. For under $10 billion per year, Prince would take over the war in Afghanistan. Prince is the brother of Education Secretary Betsy DeVos.

The scaredy-cat Republicans are starting to crumble away from unerring support of the purportedly Republican president. First was S. Carolina's Senator Graham, who said "Because of the manner in which you have handled the Charlottesville tragedy you are now receiving praise from some of the most racist and hate-filled individuals and groups in our country. For the sake of our nation -- as our president -- please fix this. History is watching us all."

Next is Tennessee Senator Corker, who said "The president has not yet been able to demonstrate the stability nor some of the competence that he needs to demonstrate in order to be successful.... there needs to be radical changes take place at the White House itself. ... the president needs to take stock of the role that he plays in our nation and move beyond himself -- move way beyond himself -- and move to a place where daily he's waking up thinking about what is best for the nation."

Wow, not stable and not competent. Remember we have a Constitutional provision that allows the Cab-inet, with the consent of the Senate, to remove a sitting president for mental instability and incompe-tence.

House Speaker Ryan and Senate Majority Leader McConnell condemned racism but did not mention Trump by name, the cowards. Ryan is being challenged in his home state by a steel-worker named Randy Bryce who has a genuine working-man pitch. The next primaries and elections may become a tipping point. Alas, we keep thinking Trump has passed many a tipping point, starting with the birther nonsense and moving on to McCain not a hero, insulting Gold Star parents, grabbing ladies' private parts, etc. But so far what should be a tipping point never is. Bill Moyers has a timeline of Trump's bad actions starting in 1979 and cross-referenced with top names in the story. Trump supporters won't read it because they are not interested in Facts, but the rest of the world should read it.

The excellent NYT writer Charles Blow has an op-ed piece that closes with this: "White supremacy, all across the spectrum, is what lights the way to the final step as the Rev. Dr. Martin Luther King Jr. artic-ulated in his "The Other America" speech in 1967:

‘In the final analysis, racism is evil because its ultimate logic is genocide. Hitler was a sick and tragic man who carried racism to its logical conclusion. And he ended up leading a nation to the point of killing about six million Jews. This is the tragedy of racism because its ultimate logic is genocide.'"

Tidbit: On Monday, North America gets a full eclipse of the sun. It will be only partial in Washington and New York, but let's see what happens in financial markets when the sky goes dark.

Currency	Spot	Current Position	Signal Date	Signal Strength	Signal Rate	Gain/Loss
USD/JPY	109.09	SHORT USD	07/19/17	WEAK	111.96	2.56%
GBP/USD	1.2890	SHORT GBP	08/11/17	WEAK	1.2961	0.55%
EUR/USD	1.1745	LONG EURO	06/28/17	WEAK	1.1218	4.70%
EUR/JPY	128.11	SHORT EURO	08/14/17	WEAK	129.40	1.00%
EUR/GBP	0.9111	LONG EURO	04/25/17	STRONG	0.8490	7.31%
USD/CHF	0.9617	SHORT USD	08/10/17	WEAK	0.9655	0.39%
USD/CAD	1.2652	LONG USD	08/11/17	STRONG	1.2730	-0.61%
NZD/USD	0.7324	SHORT NZD	08/11/17	STRONG	0.7275	-0.67%
AUD/USD	0.7923	LONG AUD	08/17/17	WEAK	0.7931	-0.10%
AUD/JPY	86.41	SHORT AUD	08/07/17	STRONG	87.66	1.43%
USD/MXN	17.8732	LONG USD	08/07/17	WEAK	17.8507	0.13%
USD/BRL	3.1748	LONG USD	08/11/17	WEAK	3.1751	-0.01%