Whom He Must Obey

The question is, what can he say?
You know, course, I’m talkin’ ‘bout Jay
Can he still, more, ease?
In order to please
The markets whom he must obey

Fed day has arrived, and all eyes are on the virtual Marriner Eccles Building in Washington, where the FOMC used to meet, prior to the current pandemic.  In the wake of Chairman Powell’s speech at the end of August, during the virtual Jackson Hole symposium, where he outlined the new Fed framework; analysts, economists and market participants have been trying to guess when there will be more details forthcoming regarding how the Fed plans to achieve their new goals.  Recall, stable prices have been redefined as ‘an average inflation rate of 2.0% over time’.  However, Powell gave no indication as to what timeline was considered, whether it was fixed or variable, and how wide a dispersion around their target they are willing to countenance.  So generally, we don’t know anything about this policy tweak other than the fact that, by definition, inflation above 2.0% will not be considered a sufficient reason to tighten monetary policy.  There are as many theories of what they are going to do as there are analysts propagating them, which is why this meeting is seen as so important.

As it is a quarterly meeting, we will also see new Fed economic forecasts and the dot plot will be extended to include the FOMC membership’s views of rates through 2023.  As to the latter, the working assumption is that virtually the entire committee expects rates to remain at current levels throughout the period.  Reinforcing this view is the futures market, where Fed Funds futures are essentially flat at current levels through the last listed contract in August 2023.  Eurodollar futures show the first full rise in rates priced for June 2024.  In other words, market participants are not looking for any policy tightening anytime soon.

Which begs the question, exactly what can Jay say that could be considered dovish at this point?  Certainly, he could explain that they are going to increase QE, but that is already defined as whatever is deemed necessary to smooth the functioning of markets.  Perhaps if he defines it as more than that, meaning it is supposed to help support economic activity, that would be interpreted as more dovish.  But isn’t infinite QE already as much as they can do?

It seems highly unlikely that the committee will give a fixed date as to when policy may eventually tighten.  But it is possible, though I think highly unlikely as well, that they define what level of inflation may require a change in policy.  The problem with that theory is there are too many potential paths down which inflation can wander.  For instance, if core PCE increased to 2.5% (a BIG if) and remained stable there for six months, would that be enough to force an adjustment to policy?  Would one year be the right amount?  Five years?  After all, core PCE has averaged 1.6% for the past ten years.  For the past twenty, the average has been 1.72%.  In fact, you have to go back over the past 32 years in order to calculate the average core PCE at 2.0%.  And of course, this is the problem with the Fed’s new framework, it doesn’t really tell us much about the future of policy other than, it is going to be ultra-easy for a long, long time.

It is with this in mind that the market has embraced the idea that the dollar must naturally fall as a consequence.  And that is a fair point.  If the Fed continues to out-ease all other central banks, then the dollar is quite likely to continue to soften.  But as we have seen already from numerous ECB speakers, and are likely to see from the BOE tomorrow, the Fed is not acting in a vacuum.  FX continues to be a relative game, as the differential in policies between currencies is the driving factor.  And while Madame Lagarde did say she was not concerned about the euro’s strength, you may recall that she also indicated, once upon a time, that it was not the ECB’s job to worry about Italian government bond yields.  That was her position for at least a day before the ECB figured out that was their entire job and created the PEPP.  My point is, if Jay comes across as more dovish somehow, you can be certain that every other central bank will double down on their own policy ease.  No country wants to be the one with the strong currency these days.

But for now, the market is still of the opinion that the Fed is out in the lead, and so the dollar continues to drift lower.  This morning, we see the dollar weaker against the entire G10 bloc with NOK (+0.6%) the leader on the back of oil’s 2.5% rally, although GBP (+0.5%) is also firmer after UK inflation data showed smaller declines than forecast, perhaps alleviating some of the pressure on the BOE to ease further.  At least that’s the thought right now.  But even the euro, after ultimately slipping yesterday, has rallied a modest 0.15% although it remains below 1.19 as I type.

Emerging market currencies are behaving in a similar manner, as the entire bloc is firmer vs. the greenback.  Once again ZAR (+0.95%) leads the pack on the combination of firmer commodity prices (gold +0.5%), the highest real yields around and faith that the Fed will continue to ease further.  But we are seeing MXN (+0.5%) gaining on oil’s rally and CNY (+0.35%) following up yesterday’s gains with a further boost as expectations grow that China’s economy is truly going to be back to pre-Covid levels before the end of the year.  Overall, it is a day of dollar weakness.

Other markets have shown less exuberance as Asian equity markets were essentially flat (Nikkei +0.1%, Hang Seng 0.0%, Shanghai -0.3%) and European bourses are also either side of flat (DAX -0.1%, CAC +0.1%, FTSE 100 -0.1%).  US futures, naturally, continue to rally, with all three indices looking at gains of 0.4%-0.6% at this time.

Government bond markets remain dull, with another large US auction easily absorbed yesterday and 10-year yields less than a basis point different than yesterday’s levels.  In Europe, actually, most bond yields have edged a bit lower, but only one to two basis points’ worth, so hardly a sign of panic.

As to the data story, yesterday saw a much better than forecast Empire Manufacturing number (+17.0) boding well for the recovery.  This morning brings Retail Sales (exp 1.0% headline, 1.0% ex autos) at 8:30, and then the long wait until the FOMC statement is released at 2:00pm.  Chairman Powell will hold his press conference at 2:30, and if he manages to sound dovish, perhaps we see further dollar declines and equity rallies.  But I sense the opportunity for some disappointment and perhaps a short-term reversal if he doesn’t invent a new dovish theme.  In that case, look for the dollar to recoup today’s losses at least.

Good luck and stay safe
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