Traders may punish the Euro if Draghi doesn't pullback from QE

Outlook:

Eur o tr ader s put in a tr emendous move in a shor t per iod of time, near ly 300 points off the Renzi mow Sunday at 1.0504 to a high of 1.0797 yesterday. A pullback on profit-taking and second thoughts is only to be expected. So far at 7 am we have a dip to 1.0728. But the die is cast—after the pullback today and perhaps tomorrow, we must resign ourselves to another upward wave, probably to 1.0904, the 50% retracement of the move. Or maybe not—the euro upmove is probably counting on Mr. Draghi pulling back from QE at least a little, such as changing the monthly amount from €80 to €60 billion per month. If traders don't get it, they may punish the euro.

It's not clear that good US data is going to affect the exchange rate much. We get Oct new factory orders, forecast up a robust 2.6% m/m after a lousy 0.3% in Sept over Aug. But good orders could be offset by a reprise of a rising trade deficit, forecast at $41.18 billion from $36.4 billion the month before. And we continue to appreciate the Atlanta Fed GDPNow estimate for real Q4 growth, also out today. On Dec 1, the estimate was raised to 2.9% from 2.4% only a few days before on the ISM manufacturing PMI and some other data. The Atlanta Fed tracker is not yet a must-follow bit of data but it should be. Traders respond to PMIs more than any other factor except payrolls, so they ought to know the net overall effect.

Besides, the Fed meets next week, with a rate hike baked in the cake but almost no commentary on the path for future rate changes. For a very long while, Fed speakers emphasized gradualism. Then after Trump was elected, over-optimism led some to say hikes could number four, one per quarter. Not even the smart Fed staffers can predict what the erratic Trump will do, of course, but as a practical matter, presidential announcements have little effect on the overall economy, at least near-term.

If we expect a faster hiking schedule from the Fed, we need to find the justification in the data. And it's there. The service sector ISM yesterday shows hiring at a good pace, such a good pace that economist Sheperdson worries about a labor shortage and thus wage increases. And however much we want to make fun of the insignificant oil output cut, even if it's OPEC 1.2 million bpd plus 600,000 from non-OPEC, rising energy prices flow through all other prices. We will likely get some inflationary pressure from oil as well as wages. At some point, the new perspective on US inflation will start changing the interest rate outlook. Stay tuned.

Meanwhile, the first salvo was fired in the Brexit war. And war it will be. The UK Supreme Court will not be delivering a judgment on Parliament's role in Article 50 until January, but the EU finance ministers are not going to wait. First up is their rejection of the UK proposal to exempt financial traders from new EU rules addressed at tax-dodging.

More importantly, the ministers decided negotiations on Brexit need to be completed within 18 months and Brexit completed by March 2019. The draft deal should be ready by October 2017. EU chief nego-tiator Barnier said talks should begin as soon as possible and "Time will be short... [it's] clear that the period that the time for the actual negotiations will be shorter than two years."

Of the Oct 2017 draft deadline, Downing Street was flustered. "We haven't heard of that timetable be-fore." Well, no kidding. Also, according to the FT, "Along with the divorce, Mr Barnier said the UK and EU would eventually discuss the framework for a ‘new partnership' after Brexit, which would be crucial a reference point for a possible transition." This conditions is trickier than it looks at first glance. It seems to mean that the relationship, the new partnership, has to be defined first and the trade deal comes later. The new partnership will like a legal agreement and for all we know, it will be an ac-tual legal agreement.

And Barnier made it clear that the topmost goal is preserving the unity of the remaining members. This doesn't mean Brexit will be hard or soft, just that the EU knows which side of the bread its butter is on.

Barnier is taking his job seriously. After being appointed in July, he has visited 18 EU countries and his team has identified all the EU legislation that affect Brexit terms. Press reports seem to imply that the Europeans have done more preparation work than the British. Just one of the issues is whether the UK gets a transition exemption for finance and auto industries and another is whether the UK has to pay into the EU budget. The Guardian reports that Barnier estimates the UK will have to pay around €60 billion to settle commitments when it leaves.

The normally calm and laid-back Eurogroup chief Dijsselbloem said today Brexit "can be smooth, it can be orderly, but it requires a different attitude I think on the part of the British government. The things I've been hearing so far are incompatible with a smooth and orderly. There are different options that are not available and if the U.K. wants to have access to the internal market, it will have to accept rules and regulations that will go with internal market."

And while May dithers, all 28 countries will send senior officials to a meeting on Dec 12 to talk about Brexit strategy, hoping to get a joint position ahead of the Dec EU leaders' summit on Dec 15. Yikes! That's only a little more than a week away. Theoretically, the absence of deals set ahead of Article 50 could put the UK in the same position as any other non-EU country. The Confederation of British In-dustry and British Bankers' Association are starting to panic and have enlisted BoE chief Carney, who says conditions for the transition are "absolutely desirable." Chancellor Hammond is on board, too. He said it's "in everybody's interest" to reach a deal "that minimises the threat to European financial sta-bility."

Is it possible that internal politics prevent PM May from getting a favorable deal? You bet. History is littered with the corpses of bad British decisions and not just on the battlefield. Barnier asks the UK to be "realistic" about Brexit terms in the FT headline today. The obvious implication, which echoes Dijs-selbloem, is that so far the UK is not being realistic.

So far, Brexit worries are not harming sterling, which is on an upward trajectory as economic data shows the economy not cratering. Relief rallies can morph into serious trends, but require a constant diet of fresh food to fuel them. Failure by the May government to start talking turkey can all too easily derail this rally.