Fe Fi Fo Fed

Federal Reserve Building in DC

The much awaited Fed meeting is here.

  • The much awaited Fed meeting is here
  • We have argued the dot-plots have a high noise to signal ratio because non-voters are included
  • The eurozone flash December PMI was mixed; the final read of November CPI ticked up to 0.2% year-over-year from 0.1%
  • The UK employment report was mixed
  • The IAEA voted to end the probe into Iran’s nuclear program, setting the stage for the lifting of sanctions and more Iranian oil on global markets
  • Moody’s cut the outlook on South Africa’s Baa2 rating from stable to negative; Brazil press is reporting that President Rousseff has agreed to Finance Minister Levy’s exit
  • Czech central bank meets and is expected to keep policy steady

Price action: The dollar is mostly firmer against the majors ahead of the FOMC decision this afternoon. The Swiss franc and the Swedish krona are outperforming, while Norwegian krone and the kiwi are underperforming. The euro is trading slightly lower around $1.09.20, while sterling is trading at its lowest level in a week near $1.50 after mixed UK data. Dollar/yen is trading higher and testing the 122 area. EM currencies are mostly softer. KRW, INR, and TWD are outperforming, while BRL, ZAR, and PLN are underperforming. ZAR is back under pressure after Moody’s cut the outlook on its Baa2 rating from stable to negative, while BRL was hurt by reports of Levy’s exit. Bank of Thailand met and kept rates steady at 1.5%, as expected. MSCI Asia Pacific was up 2.2% on the day, with the Nikkei up 2.6%. MSCI EM is up 1.2%, the second straight up day after a streak of nine straight down days. The Shanghai Composite was up 0.2% while the Shenzen Composite was up 0.7%. Euro Stoxx 600 is up 0.5% near midday, while US futures are pointing to a higher open. The 10-year UST yield is up 1 bp at 2.27%, while European bond markets are mostly firmer. Commodity prices are mixed, with oil down 1-2% and copper up 0.3%.

 

The much awaited Fed meeting is here. A 25 bp increase in the Fed funds target range to 25-50 bp is widely expected. The near certainty of this contrasts to the high uncertainty of the immediate impact stocks, bonds, and the dollar.

There are five components of the Fed’s decision that will command attention. First, the rate move itself. This is the most straightforward for the components. Second, the FOMC statement. The economic assessment is unlikely to change much. Part of the statement impact comes from the dissents. There is one voting Fed president (Chicago’s Evans) who has argued to wait until next year. There are two governors (Brainard and Tarullo) that have also voiced opposition to a rate hike now. Governor dissents are less common than dissents from the regional Fed presidents. Any less than three dissents then could speak to Yellen’s leadership.

Third, the dot-plots–the graphic summary of the Fed’s forecasts. The most important aspect is not so much macro-economic, but indications of the appropriate policy. In September, the most recent iteration, the dot-plots indicated that a majority of Fed officials saw four hikes in 2016 and 2017 as being appropriate.

We have argued the dot-plots have a high noise to signal ratio because non-voters are included. In addition, organizationally, we think that not all dots are equivalent, with the Fed’s leadership being critical. However, we also recognize it as a communication tool that the market may be particularly sensitive to now. The Fed can drive home the point that the removal of accommodation will be gradual by reducing the projected hikes from four to three.   Of course, it is not binding, and it is still more than the market has discounted, but it would likely meet a loose definition of a dovish tightening. It would also maximize the Fed’s operational flexibility and prevent a gaming of a hike every other meeting.

Fourth, our understanding is that the Fed will also publish a technical note that will provide some operational details. For most investors, it may be sufficient at this stage to appreciate that reverse repos will be used to put a floor below rates. These could be quite large. The Fed will use the interest on excess reserves, set at the upper end of the Fed funds target range, to cap rates. A key unknown will remain, and that is where Fed funds will trade relative to its range following an increase. One implication of this is that the December Fed funds futures contract may not fully discount a 25 bp hike even after it is delivered.

Fifth, Yellen’s press conference. She is expected to emphasize the gradual and limited cycle. She may remind investors that with a 2% core CPI and 5.0% unemployment, a 25-50 bp Fed funds target cannot be considered tight. It is simply less easy. The data dependency of the Fed’s course will also likely be stressed. At the same time, the overall impression that Yellen will likely give is that while the Fed is treading lightly, it has thought through various issues and scenarios and does not expect this to be a one-off hike, like some of the critics are charging.

There are a few other developments today that are important for investors. First, the eurozone flash December PMI was mixed. Manufacturing was better than expected at 53.1 (from 52.8), but services were softer at 53.9 (from 54.2). This saw a little slippage in the composite to 54.0 (from 54.2). The data point to continued stable quarterly growth of 0.4%. The final read of November CPI ticked up to 0.2% year-over-year from 0.1%. This is the highest since July and is the second consecutive month of improvement. The core rate was left at 0.9%.

Second, the UK’s employment report was mixed. The good news is that the unemployment rate slipped to 5.2%, a new cyclical low. The disappointing news was the 3.9k increase in claimant counts (the fourth consecutive rise) and the third consecutive decline in earnings growth. Excluding bonus payments, average weekly earnings (3m year-over-year) rose 2.0% from a downwardly revised 2.4% (from 2.5%) in September. Wage growth peaked at 2.9% in July. Sterling had been trading heavily after encountering selling pressure in front of $1.5060, and some intraday shorts took profits on the push below $1.50.

Third, we note that the IAEA voted to end the probe into Iran’s nuclear program, setting the stage for the lifting of sanctions and more Iranian oil on global markets. Separately, and ironically we note that UN experts yesterday said that Iran’s missile firing violated the sanctions. Both stories (Iranian oil and the geopolitical challenges it poses) will likely be key issues in the year ahead. Meanwhile, the US is expected to report a small 600k barrel drawdown in oil inventories (though Cushing stocks may increase amid reports of year-end tax-related sales by producers), while distillate and gasoline inventories are expected to rise sharply.

Fourth, the US Congress appears to be moving closer to a large spending and tax bill that will likely include a lifting of the ban on oil exports. There appears to be much horse trading, where pet projects the two parties are included.   Among other things, it will remove the issue from the political agenda during the national election year.

Moody’s cut the outlook on South Africa’s Baa2 rating from stable to negative. The move is notable since it comes after former Finance Minister Gordhan was installed. As we noted before, the damage has clearly been done. All three agencies have now taken negative rating actions this month. Fitch cut the rating from BBB to BBB-, but inexplicably moved the outlook to stable, while S&P moved the outlook on its BBB- rating from stable to negative. Our own ratings model has South Africa at BB/Ba2/BB, and so downgrades to sub-investment grade are likely in 2016.

Brazil press is reporting that President Rousseff has agreed to Finance Minister Levy’s exit. While this is a familiar report in recent months, it never fails to move markets. The report added that Levy has agreed to stay on for a short while until a replacement is found, and that Rousseff plans easier fiscal policy (which Levy opposes). Here too, we think more downgrades to sub-investment grade are only a matter of time, but a Levy exit would move up the timetable. Elsewhere, Brazil reported October retail sales at -5.6% y/y vs. the expected -8.3% and a revised -6.3% (was -6.2%) in September. The economy remains in recession, but rising price pressures could push COPOM into resuming the easing cycle next year.

Czech central bank meets and is expected to keep policy steady. CPI rose 0.1% y/y in November, the lowest since February and well below the 2-4% target range. Deflation risks remain in play, and so there is a risk that the CNB tweaks its forward guidance a bit after the ECB recently extended the timeframe for its QE program.