Said Jay to the world through the Press We’ve certainly had some success But patience is key As resolutely We stop any signs of regress Does this mean that next time we meet Our actions will be a repeat? The answer is no We’re not certain, though We could if inflation shows heat And what about Madame Lagarde Have she and her minions been scarred By Europe’s recession Or will their suppression Of growth lead to outcomes ill-starred
By this time, you are all almost certainly aware that the Fed raised the Fed funds rate by 25bps as widely expected. You may not be aware that the FOMC statement was virtually identical, with only a change in the description of economic growth from ‘modest’ to ‘moderate’, apparently a slight upgrade. This was made clear when Chair Powell, at the press conference, explained the Fed staff was no longer forecasting a recession in the US. Perhaps the following Powell quote best exemplified the outcome of the meeting, “We can afford to be a little patient, as well as resolute, as we let this unfold,” he said. “We think we’re going to need to hold, certainly, policy at restrictive levels for some time, and we’d be prepared to raise further if we think that’s appropriate.”
So, what have we learned? I think we can sum it up by saying nothing has changed the Fed’s mindset right now. They continue to focus on the fact that inflation remains above their target and will continue to implement policies that they believe will address that situation.
The thing that makes this so interesting is everybody seems to have a different interpretation of what that implies. The two broad camps are 1) this was the last hike as inflation continues to fall and they are already hugely restrictive compared to their historical activities; and 2) given the upgrade in economic forecast, and the fact that inflation seems set to remain higher than target for a long time yet, there are more hikes to come.Given the math that goes into the CPI data, it is quite easy to forecast Y/Y CPI if you assume a particular M/M figure for the next period of time. BofA put out a very good chart showing the potential evolution of headline CPI going forward.
The implication here is that unless the M/M data falls to zero or negative, CPI is going to start climbing again. The Fed clearly knows this as does the market. The only disconnect is the question of how the Fed will respond in the various cases. Remember, too, that oil and gasoline prices have risen 13.7% and 11.2% respectively in the past month. The idea that the energy component of CPI will do anything but rise sharply this month seems absurd. As such, I expect that the Fed will continue to lean toward another hike going forward.
The problem they have had is that the pass-through from Fed rate hikes to the economy has been greatly diminished by their previous policy of excessive ZIRP. It is estimated that roughly 80% of US home mortgages have fixed rates below 4%, with half at 3% or less. At the same time, the average duration of corporate debt has lengthened to 6.4 years as the refinancing activity that occurred during the ZIRP period saw extension of tenors widespread. As such, other than the Federal government, who managed to shorten the duration of their outstanding debt during the period of ZIRP, most borrowers are in pretty good shape and not impacted by the Fed’s policies. In fact, they are earning much more on their cash balances. The point is, there is a case to be made that the Fed can maintain ‘higher for longer’ for quite a while without having a significantly deleterious impact on the economy. Perhaps the soft landing is possible after all.
Now, if they continue to hike rates, and there are a number of analysts who believe we are heading to 6% or beyond, things may change. We are already seeing a significant diminution of demand for bank loans, which while that may not bother large corporates, implies that the SME sector is going to break first. Does the Fed care about them? They will only care when the Unemployment Rate rises substantially. This comes back to why I believe that NFP is still the most important data point, regardless of the inflation discussion. Summing it up, the Fed will see two more CPI, PCE and NFP reports before they next meet on September 20th. It is impossible, at this time, to estimate their actions with this much more data still to be digested. However, if my inflation view is correct, that it will remain stickily higher, I see a very good chance of at least one more Fed funds rate hike.
A quick look across the pond shows that the ECB will be making their latest rate decision this morning with the market expecting a 25bp hike. Unlike in the US, the OIS market is pricing in one further hike after today’s and then that will be the end of the cycle. But…can Madame Lagarde continue to tighten policy if Europe is actually in a recession? We already know that Germany is in a recession, and forecasts for Q2 GDP in Europe, to be released next week, are at 0.3%. The Citi Economic Surprise Index remains mired at -136.7, a level only seen during Covid and the GFC, hardly the comparisons desired. I believe it will be much tougher for an additional rate hike by the ECB unless the data story turns around quickly, and I just don’t see that happening. Overall, it is this dichotomy in economic activity that underlies my bullish thesis on the dollar.
At any rate, the market response to the FOMC has been one of sheer joy. Well, that and the fact that there are still some pretty good earnings results getting released, at least relative to recent expectations, if not on a sequential basis. But it is the former that matters as that is what gets priced into the market. So, equity markets, after yesterday’s breather in the US where they didn’t rise sharply, are mostly higher around the world. Both the Hang Seng and Nikkei rallied nicely, and European bourses are quite robust this morning, with many exchanges higher by > 1%. US futures, too, are in the green, with the NASDAQ showing great signs of strength.
Meanwhile, bond yields have edge a touch lower virtually everywhere with most of Europe seeing declines between 1bp and 2bps, although Treasury yields are less than 1bp lower this morning. There appears to be little concern that Madame Lagarde is going to spoil the party and sound uber hawkish. Even JGB’s are a touch softer, -0.4bps, as the market prepares for tonight’s BOJ announcement. However, there is absolutely nothing expected out of that meeting.
In the commodity space, oil (+1.1%) is higher again this morning as are gold (+0.25%) and the base metals (CU +0.1%, Al +0.6%). The soft(no) landing scenario seems to be gaining some traction here. Either that, or the dollar’s weakness today, which is widespread, is simply being reflected as such.
Speaking of the dollar, it is definitely on its back foot as the market is essentially saying the Fed is done. It is softer vs. the entire G10 bloc, with NOK (+1.05%) leading the way on the back of oil, but SEK (+0.9%) and NZD (+0.7%) also rising nicely alongside the commodity space. Even the euro, which has no commodity benefit whatsoever, is firmer this morning by 0.5% as the market awaits Madame Lagarde.
In the emerging markets, the picture is similar with almost every currency firmer vs. the buck led by HUF (+1.1%) and ZAR (+0.8%). The rand is clearly a commodity beneficiary, while the forint has gained after a story about the ECB being willing to consider Hungarian legislation that will avoid the need to recapitalize the central bank despite its recent losses. Meanwhile, the laggard is KRW (-0.25%) which seems to have responded to the widening interest rate differential between the US and South Korea.
On the data front, we see Q2 GDP (exp 1.8%, down from 2.0% initially reported), Durable Goods (1.3%, 0.1% ex Transport), Initial Claims (235K) and Continuing Claims (1750K) along with several other tertiary figures. There are no Fed speakers on the docket for the next week and I suppose that given the relative calm following yesterday’s meeting, there is not a great deal of near-term concern they need to change any views. I suspect that if tomorrow’s PCE data surprises, we could start to hear more soon.
Today, the mood is risk on and sell dollars. Barring a remarkable surprise from Lagarde, I would not fade the move.
Good luck
Adf
fxpoetry 