Problem’s Aplenty

Two stories have traders’ attention
The first showed the Fed’s apprehension
That their preferred path
Was earning the wrath
Of markets, thus causing dissention

The other is that the G20
(According to the cognoscenti)
May let Xi explain
A trade war’s insane
Since both men have problems aplenty

Once again the market has narrowed its focus on two things only, in this case the Minutes from the November FOMC meeting and the upcoming dinner between Presidents Trump and Xi at the G20 meeting in Buenos Aires. It seems that traders in virtually every market are taking their cues from these stories.

Starting with the Minutes, it is clear that the Fed finds itself at an inflection point in their policymaking with the easy part now behind them. Up until September, it was evident that policy was extremely accommodative, and the Fed’s goal of gradually reducing that accommodation was easy to achieve, hence the steady pace of a 25bp rate hike every other meeting. However, despite the fact that nobody actually knows where the neutral rate of interest (also known as r*) is, it is apparent that the current Fed funds rate is much closer to that mythical rate than it used to be. Hence the dilemma. How much further should the Fed raise rates, and at what pace? The last thing they want is to raise rates sufficiently to slow the economy into a recession. But they also remain quite wary of policy settings that are too easy, since that could lead to financial instability (read bubbles) and higher inflation. This is why they get paid the big bucks!

Signals from the US economy lately have been mixed, with the housing market slowing along with auto sales, but general consumer confidence and spending remaining at very high levels. Underpinning the latter is the ongoing strength in the labor market, where the Unemployment rate remains near 50 year lows of 3.7%. There is a caveat with the labor market though, and that is the Initial Claims data, which had been trending lower consistently for the past nine years, but has suddenly started to tick higher over the past month. While this could simply be a temporary fluctuation based on changes in seasonal adjustments, it could also be the proverbial canary in the coalmine. We will have a better sense next Friday, when the November NFP report is released, but based on the recent Initial Claims data, a soft employment report is entirely within reason.

The upshot is that the Fed is no longer certain of its near term rate path which means that many of the investing memes of the past ten years, notably buy-the-dip, may no longer make sense. Instead, the volatility that we have seen lately across all markets is likely to be with us going forward. But remember, too, that volatility is a market’s natural habitat. It has been the extreme monetary policies of central banks that have moderated those natural movements. And as central banks back away from excessive monetary ease, we should all expect increased volatility.

The second story is the upcoming meeting between Presidents Trump and Xi tomorrow night. Signals from Trump going into the meeting have been mixed (aren’t all his signals mixed?) but my take is that sentiment is leaning toward at least a pause in any escalation of the trade war, with the true optimists expecting that concrete progress will be made toward ending the tariffs completely. Color me skeptical on the last part, but I wouldn’t be surprised if a temporary truce is called and negotiations restarted as both men are under increasing domestic pressure (China’s PMI just fell to 50.0 last night indicating the economy there is slowing even more rapidly than before) and so a deal here would play well both on a political level, as well as to markets in each country. And when the needs of both parties are aligned, that is when deals are made. I don’t think this will end the tension, but a reduction in the inflammatory rhetoric would be a welcome result in itself.

Recapping the impact of the two stories, the fact that the Fed is no longer inexorably marching interest rates higher has been seen as quite the positive for equities, and not surprisingly a modest negative for the dollar. Meanwhile, optimism that something positive will come from the Trump-Xi dinner tomorrow has equity bulls licking their collective chops to jump back into the market, while FX traders see that as a dollar negative. In other words, both of the key stories are pointing in the same direction. That implies that prices already reflect those views, and that any disappointment will have a more significant impact than confirmation of beliefs.

As it happens, the dollar is actually a bit firmer this morning, rallying vs. most of its G10 counterparts, but only on the order of 0.2%. The pound remains under pressure as traders continue to try to handicap the outcome of the Parliamentary vote on Brexit on December 11, and the signs don’t look great. Meanwhile, the euro has softened after weaker than expected CPI data (headline 2.0%, core 1.0%) and continued weak growth data are making Signor Draghi’s plans to end QE next month seem that much more out of touch.

This morning brings a single data point, Chicago PMI (exp 58.0) as well as a speech from NY Fed President John Williams. However, at this point, given we have heard from both the Chairman and vice-Chairman already this week, it seems unlikely that Williams will surprise us with any new views. Remember, too, that Powell testifies to Congress next week, so we will get to hear an even more detailed discussion on his thinking on Tuesday. Until then, it seems that the dollar will continue its recent range trading. The one caveat is if there truly is a breakthrough tomorrow night in Buenos Aires, we can expect the dollar to respond at the opening in Asia Sunday night. But for today, it doesn’t feel like much is on the cards.

Good luck and good weekend
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