Let Me Be Clear

Said Powell, beginning next year
More frequently from me, you’ll hear
But that doesn’t mean
We’re any more keen
To raise rates, please let me be clear

“Growth is strong. Labor markets are strong. Inflation is close to target.” So said Chairman Powell yesterday in the wake of the FOMC raising rates by 25bps such that Fed funds are now 1.75%-2.00%. While the market was virtually certain this would occur, the Fed was still able to surprise with some of its actions.

First, there are now eight members of the Fed who anticipate a total of four rate hikes this year, up from seven at the last meeting, and thus the median forecast is now set at four. Arguably, the changing view of one member shouldn’t make that much difference, but it underscores the fact that the committee recognizes the chance that growth in the US could lead to an overheated situation. Remember, inflation data continues to grind higher and shows no sign of slowing down. In fact, Tuesday’s 2.8% headline CPI print was the highest since 2011.

In addition, they reduced their forecast for unemployment this year to 3.6%, down from the previous estimate of 3.8%, and yet they continue to believe that NAIRU is 4.5%. That means they expect an even larger gap, and given their favored models, expect that wages are going to continue to rise and drive inflation with them.

Finally, Chairman Powell explained that beginning in 2019, there would be a press conference following every meeting, not every other meeting. Given the pattern we have seen since press conferences were instituted in 2011, that policy changes are only made during press conference meetings, arguably this means that every meeting is truly ‘live’. While Powell downplayed this concept, describing it merely as an effort to improve communications, the market clearly sees this as the key ramification.

And they made one other, technical change; they raised the IOER rate by only 20bps, leaving it at 1.95%. Prior to this, IOER had been pegged at the top of the FOMC range for Fed Funds, but recently, actual Fed Funds trading had been pushing the rate to the top, and sometimes beyond the Fed’s target. This may well be the first inkling that the Fed has managed to engineer a liquidity shortage between raising rates and their shrinking balance sheet. This is exactly what emerging market central bankers have been complaining about, and one of the key concerns about Fed policy going forward, namely, just how large is the Fed’s balance sheet going to be when they achieve a neutral status in policy.

While nobody knows the answer to that question, it seems that guidance from banking regulators has been pushing for banks to favor excess reserves over Treasury bill positions as a better liquidity buffer on their books. This will have two effects; first the demand for Treasury bills is likely to decrease at the margin thus driving yields there higher; and second, the Fed balance sheet is likely to remain quite bloated and they are likely to end the balance sheet runoff process sooner than currently expected. Consider the following: prior to the financial crisis, the Fed’s balance sheet was approximately $900 billion. When they completed all their QE purchases, it had grown to be $4.5 trillion. With the implementation of the strategy to normalize policy starting back in October, it has fallen to ~$4.3 trillion and most economists have been expecting that to continue until it reaches somewhere in the $2.5 trillion – $3.0 trillion level. However, if banks continue to demand reserves rather than T-bills, it is possible that when the balance sheet reaches $3.5 trillion, that will be the end of that program. So despite much new information regarding the Fed, there is still a great deal yet to be determined.

One other noteworthy event was the fact that the PBOC did NOT raise its repo rate after the Fed yesterday, something that surprised the market. It seems that the Chinese economy is slowing a bit more rapidly than they would like, and therefore higher rates are not called for. Remember, the PBOC is walking the fine line between reducing leverage in the Chinese economy, and still supporting growth. Last night’s Chinese data showed that Fixed Asset Investment, Retail Sales and IP were all disappointingly lower than expected and seem to indicate that the PBOC may be leaning too heavily on the leverage button. The upshot is that CNY is a bit firmer this morning, rising about 0.3% since this time yesterday.

Of course, this morning brings the ECB, where the big question is whether they will describe their view as to the timing of the end of QE, or whether they will wait until their next meeting in July. My money is on July, as Draghi will fight vigorously to get as much time as possible to see how the Eurozone economy is faring. For example, yesterday’s Eurozone IP data showed yet another decline (-0.9%), the fourth in the past five months, and yet another sign that the slowdown in Q1 was not aberrational, but rather this is the new trajectory. Combining the slowing data with the ongoing concerns over how the new Italian government addresses its finances, I think they will want to wait to the last possible second to make any decisions. The ECB’s problem is that if the growth story in the Eurozone is truly slowing again, and GDP is heading back to 1.5%, it will be that much harder for them to end QE.

With all that said, I would argue the market is expecting the announced end of QE which is one of the reasons that the euro is firmer this morning, up 0.3%. In fact, the dollar, despite what appeared to be a pretty hawkish Fed, is softer across the board. The pound has been the biggest beneficiary (+0.45%), as UK Retail Sales data was much better than expected, rising 1.3% in May. But the dollar is soft everywhere. Stronger Japanese IP data helped the yen rally 0.3%. Inflation data that continues to edge higher around the world has helped underpin many currencies, both G10 and EMG, with the only laggards the ones we would expect, TRY, BRL and INR.

But for now, all eyes are on the ECB. With the Fed out of the way and the BOJ yet to come tonight, traders are continuing to digest the information from this extremely busy week. Given where I believe expectations are, it seems to me the risk is for the euro to retrace its gains as if I am correct about the ECB delaying the decision to end QE, the market will infer that there are other issues under consideration by Draghi and friends.

I would be remiss if I didn’t mention US Retail Sales data is to be released this morning (exp 0.4%, ex autos and gas 0.4%) as well as Initial Claims (224K), but I don’t think anyone will be paying attention unless the number is a blowout. Instead, today is Mario’s day.

Good luck