Investors are waiting for Jay
Their fears, about rates, to allay
They want it made clear
That rates will be here
From now ‘til we reach judgement day
From the market’s perspective, the world has essentially stopped spinning, at least until we finally hear the words of wisdom due from Chairman Powell beginning at 9:10 this morning. Trading volumes across products are currently running at 50%-70% of recent average activity, highlighting just how little is ongoing. And remember, too, as it is the last week of August, summer holidays are in full swing with most trading desks, on both the buy and sell sides, more lightly staffed than usual. In other words, liquidity is clearly impaired right now, although by 10:00 this morning I expect that things will be back closer to normal.
As discussed yesterday, the working assumption of most analysts and investors is that Jay is going to explain the benefits of targeting average inflation over time. The implication being that the Fed’s new policy framework, when officially announced later this year, is going to include that as a KPI. Of course, the big question about this policy is the average over exactly which period.
Consider, it has been 102 months since then-Chairman Bernanke established the target for core PCE at 2.0%. During that time, core PCE has been between 1.9% and 2.1% just 12 times with 89 of the other 90 readings below 1.9% and a single print above 2.1%, which happens to have been the first print after the announcement. Meanwhile, this past April’s reading of 0.931% is the lowest reading. The average of the two extremes is 1.53%. Is the Fed going to be happy if core PCE jumps to 2.47% and stays there for a while? The average of all periods since January 2012 is 1.633%, does that mean we can expect the Fed to target 2.367% core PCE readings for the next eight plus years? The point is, without some specificity on what average inflation means, it is very difficult to understand how to incorporate the idea into investment and trading decisions.
But what if Chairman Powell does not bring clarity to the discussion, merely saying that average inflation over time seems like a good future benchmark. How might different markets react to such a lack of specificity?
Starting with equity markets, certainly those in the US will rally because…well that’s all they do these days. Good news, bad news, no news, none of that matters. The rationale will be stocks are a good inflation hedge if inflation goes higher (they’re not) or stocks will benefit from ongoing low interest rates if inflation remains below target. Parabolic markets are frightening, but there is no indication that Powell’s comments are going to change that situation. We need a different catalyst here.
Now let’s look at the bond market and what might happen there. Specificity on how much higher the Fed is going to target inflation is going to be a pretty distinct negative. If you own 10-year Treasuries that are yielding 0.68% (today -1bp), and the Fed explains that they are going to push inflation above 2.0%, there is going to be a pretty spectacular decline in the price of your bond should they achieve their goal. Will investors be willing to hold paper through that type of decline? It would not be a surprise to see a pretty sharp sell-off in Treasuries on that type of news. Remember, too, that Treasury yields have backed up nearly 20 basis points in the past three weeks, perhaps in anticipation of today’s comments. If Powell delivers, there is likely far more room to run. If he doesn’t, and there is no clarity, bond investors will be back to reading the economic tea leaves, which continues to be remarkably difficult at this time.
How about the gold market? Well, here I think the case is quite straight forward. Clarity as to the Fed’s efforts to drive inflation higher will result in anticipation of lower real yields, and that will be an unalloyed benefit (pun intended). A lack of clarity and gold will likely continue to consolidate its recent gains.
And finally, what about the dollar? How will it respond to the Chairman’s speech? Consider that despite the dollar’s recent rebound, short dollar positions remain at near record levels against both the euro and the DXY futures. The market scuttlebutt is that the hedge fund community, which was instrumental in the dollar’s recent modest strength as they pared short dollar positions, is ready and raring to buy euros on the idea that higher US inflation will lead to a weaker dollar à la economic theory. Certainly, if Treasuries sell off, the dollar will see some downward pressure, but one of the things that does not get as much press in the FX market is the equity market impact. Namely, as long as US equity indices continue to set records, international investors are going to continue to buy them, which will underpin the dollar.
But what if the speech is a dud? If there is no clarity forthcoming, then the dollar story will revert to its recent past. The bear case continues to be that the Fed’s largesse will dwarf all other nations’ policy easing and so the dollar should resume its decline. The bull case is that the US economy, at least by recent data, appears to continue to be outperforming its major counterparts, and thus inward investment flows will continue. That current account deficit is only a problem if international investors don’t want to fund it, and with US equity markets amongst the best performing asset classes globally, that funding is easy to find. I know I’m not a technician, but recent price action certainly appears to have created a top at the highs from last week, and a further pullback toward 1.1650 seems quite viable.
It is difficult to draw many conclusions from today’s market activity, which is why I have largely ignored it. Equity markets are leaning a bit lower, although the movement is not large, less than 1%, and the dollar is mixed against both the G10 and EMG blocs.
Arguably, the biggest market risk is that Powell doesn’t tip his hand at all, and that we are no wiser at 10:10 than we are now. If that is the case, I think the dollar’s consolidation will continue, and by the end of the day, I imagine stock prices will have recouped their early losses.
But for today, it is all about Jay.
Good luck and stay safe