Said Powell, we’re now “just below”
The neutral rate, thus we’ll forego
Too many more hikes
The market said yikes!
And saw all key price metrics grow
If you wonder why I focus on the Fed as much as I do, it is because the Fed continues to be the single most important player in global financial markets. This was reinforced yesterday when Chairman Powell indicated that the current Fed Funds rate, rather than being “…a long way from neutral at this point,” as he described things on October 3rd, are in fact, “…just below” the neutral rate of interest. The implication is that the Fed is much closer to the end of their rate hiking cycle than had previously been anticipated by most market participants. And the market response was immediate and significant. US equity markets exploded higher, with all three major indices rising more than 2.3%; Treasury yields continued their recent decline, with the 10-year yield falling 4.5bps to levels not seen since mid-September; and the dollar fell sharply across the board, with the euro jumping 1% at one point, although it has since given back about 0.3% of that move. But it wasn’t just the euro that rallied, overnight we saw IDR and INR, two of the worst performing EMG currencies, each rally more than 1.0% as a more dovish Fed will clearly bring relief to what has ailed economies throughout the emerging markets.
It is abundantly clear that a more dovish Fed will have significant consequences for markets around the world. In this event we can expect the recent equity market correction to come to an end, we can expect the dollar to give back some portion of its recent gains, and we can expect Treasury yields to level off, especially in the front end, with fears over a yield curve inversion dissipating rapidly. However, is the Fed really changing its tune? Or is yesterday’s market reaction significantly overdone? Unfortunately, it is far too soon to judge. In fact, this will add further significance to the FOMC Minutes from the October meeting, which will be released at 2:00pm today. Remember, that meeting was held nearly four weeks after Powell’s ‘long way from neutral’ comments, so would reflect much more updated thinking.
Something else to keep in mind regarding the potential future path of interest rates is that we continue to see evidence that key sectors of the US economy are slowing down. Yesterday’s New Home Sales data reinforced the idea that higher mortgage rates, a direct consequence of Fed actions during the past two years, continue to take a toll on the housing sector as the print was just 544K, well below expectations and indicative of a market that is flatlining, not growing. We have also seen the trade data deteriorate further despite the president’s strenuous efforts at reversing that trend. In other words, for a data dependent Fed, there is a growing segment of data showing that rates need not go higher. While Powell was clear that there is no preset path of interest rates, the market is now pricing in just two more hikes, one in December and one in March, and then nothing. If that turns out to be the case, the dollar may well come under pressure.
Of course, FX is really about interest rate differentials, not merely interest rates. And while changes in Fed expectations are crucial, so are changes in other central bank actions. For example, early this morning we saw that Eurozone Consumer Confidence fell for the 11th straight month; we saw that Swiss GDP shrank -0.2% unexpectedly in Q3; and we saw that Swedish GDP shrank -0.2% unexpectedly in Q3. The point is that the slowing growth scenario is not simply afflicting the US, but is actually widespread. If Eurozone growth has peaked and is slipping, it will be increasingly difficult for Signor Draghi and the ECB to begin to tighten policy, even if they do end QE next month. The Swedes, who are tipped to raise rates next month are likely to give that view another thought, and the Swiss are certain to maintain their ultra-easy policy. In other words, the interest rate differentials are not going to suddenly change in favor of other currencies, although they don’t seem likely to continue growing in the dollar’s favor. Perhaps we are soon to reach an equilibrium state. (LOL).
On Threadneedle Street there’s a bank
That raised interest rates to outflank
But now fears stagnation
If they walk the Brexit gangplank
The only currency that has not benefitted from the Powell dovish tone has been the British pound, which has fallen 0.5% this morning back toward the bottom of its recent trading range. The Brexit debate continues apace there and despite analyses by both the government and the BOE regarding the potential negative consequences of a no-deal Brexit (worst case is GDP could be 10% smaller than it otherwise would be with the currently negotiated deal) it seems that PM May is having limited success in convincing a majority of MP’s that her deal is acceptable. Interestingly, the BOE forecast that in their worst-case scenario the pound could fall below parity with the dollar, although every other pundit (myself included) thinks that number is quite excessive. However, as I have maintained consistently for the past two years, a move toward 1.10-1.15 seems quite viable, and given the current political machinations ongoing, potentially quite realistic. All told, the pound remains completely beholden to the Brexit debate, and until the Parliamentary vote on December 11, will be subject to every comment, both positive and negative, that is released. However, the trend remains lower, and unless there is a sudden reversal of sentiment amongst the politicians there, it is feeling more and more like a hard Brexit is in our future. Hedgers beware!
Quickly, this morning’s data brings Initial Claims (exp 221K), Personal Income (0.4%), Personal Spending (0.4%), and the PCE data (Headline 2.0%, Core 1.9%) as well as the FOMC Minutes at 2:00. Unless the PCE data surprises sharply, I expect that markets will remain quiet until the Minutes. But if we see softer PCE prints, look for equities to rally and the dollar to suffer.