- The market has mostly interpreted the Fed’s action in line with our thinking
- The BOJ and Norges Bank met
- S&P cuts China to A+; Taiwan and Philippine central banks kept rates steady, as expected
- SARB is expected to cut rates 25 bp to 6.5%; Brazil central bank releases its quarterly inflation report
The dollar is mostly firmer against the majors as it builds on its post-FOMC gains. Nokkie and the euro are outperforming, while the Antipodeans are underperforming. EM currencies are mostly softer. RUB and CZK are outperforming, while INR and KRW are underperforming. MSCI Asia Pacific was down 0.7%, even with the Nikkei rising 0.2%. MSCI EM is down 0.3%, with the Shanghai Composite falling 0.2%. Euro Stoxx 600 is up 0.2% near midday, while S&P futures are pointing to a lower open. The 10-year US yield is flat at 2.27%. Commodity prices are mostly lower, with oil down 0.4%, copper down 1%, and gold down 0.4%.
The market has mostly interpreted the Fed’s action in line with our thinking. Despite the lowering of the long-run Fed funds rate, the shifting one of the three hikes from 2019 into 2020, and recognizing that the weaker price impulses are somewhat mysterious, the Fed clearly signaled its bias toward hiking rates one more time this year and three next year.
The long-term Fed funds rate has trended lower. In March 2015, it was thought by the Fed’s dot plots to be near 3.75%. A year later it had been cut to 3.25%. It briefly fell to 2.88% in September 2016 before being lifted last December to 3%. The cut now to 2.75% has been generally signaled by Yellen (and other officials) suggesting that the long-run rate may be lower.
One of the discrepancies between the Fed and the markets is that investors collectively see the long-run rate as considerably lower than the Fed. Looking at the Fed Funds futures strip to give an approximation suggest the market-based view of the long-term rate is closer to 1.75%. The US 10-year breakeven is 1.86%. The implication is that the investors do not think the real Fed funds rate will be positive in this cycle.
The biggest surprise about the Fed’s balance sheet signal was the seeming confusion of the media and several times Yellen had to repeat herself. The Fed had, we thought, made it clear, that the balance sheet operations were not going to main tool of monetary policy. The operations would be put on automatic pilot and would not be disrupted by short run vagaries in the economy.
Some seemed critical of this process as being rigid. However, if it were subject to regular FOMC decisions, the Fed would likely come under criticism for not aiding market visibility and not being committed to reducing its balance sheet. Some were critical that monetary policy did not address the disparity of wealth and income in the US, but surely this is beyond what monetary policy can do. The Fed’s QE arguably prevented a larger or longer downturn in the economy and this is often forgotten in such discussions.
The cost of a larger and longer downturn falls primarily on the economic disadvantaged. It is true that homeowner and equity owner did well as asset prices rose. Rising asset prices were a means to an end, the end being a stronger economic environment that created more opportunities. Although Yellen did not repeat it as forcefully as the July FOMC minutes, she acknowledged that the Fed was concerned about financial conditions and the elevated valuations of assets. Doesn’t that mean that so-called Greenspan put (Fed would provide accommodation in the case of equity market decline) is less reliable, if it is there at all?
Two other central banks have met today. The Bank of Japan left policy on hold. A takeaway is that a new Board member (Kataoka) argued that more stimulus is needed if the BOJ’s inflation target is to be reached. This is important. Until now, Kuroda was criticized for doing too much. Now a new voice is calling for more, not less. To be sure this does not mean that more stimulus will be delivered but for the first time, there can be a debate within Kuroda’s framework and not simply old Shirakawa acolytes pushing back against the considerably more activist monetary policy.
Norway’s central bank, Norges Bank met. It too left rates on hold, but increased its likely interest rate path for the second consecutive meeting. Norges Bank now sees the first hike toward the middle of the next year. If so, it will raise rates while the ECB’s balance sheet continues to expand, and well before the ECB can raise rates. The krone is the strongest of the majors in the European morning, gaining about 0.5% against the greenback and 0.4% against the euro. The euro held NOK9.30 on the first try. A break could see NOK9.22.
The Antipodean currencies are bearing the brunt of the greenback’s strength today, with the Australian dollar pushing below $0.8000. Trend line support, drawn from the mid-August low comes in near $0.7940 today, which is also near the 61.8% retracement of that move (~$0.7930). A break would warn of the vulnerability of stops below $0.7900.
The New Zealand dollar has come off half has much as the Aussie has. Perhaps it is being supported by the latest polls that seem to suggest increased likelihood that the Nationals will continue to lead the government. New Zealand reported Q2 GDP data overnight, with growth coming in at the expected 2.5% y/y.
The Kiwi had previously under-performed the Aussie and technically it appears poised for a recovery. It is gaining against the Aussie for the fifth consecutive session today and is at its best level in a month. The Aussie is approaching NZD1.0850, which corresponds to a 38.2% retracement of its Q3 advance. The 50% retracement is a big figure lower (~NZD1.0750).
The US reports weekly initial jobless claims. Claims happen to be for the week that the monthly BLS survey is taken. However, this time series is being skewed by the powerful storms that have hit in recent weeks. The noise to signal ratio is high and most likely will not have much impact. The Philly Fed survey for September will be interesting, but Yellen acknowledged yesterday what investors have accepted. The storms will reduce Q3 growth.
Our back of the envelope calculation suggested the hit could be as much as one percentage point. Given that the US economy was growing above trend growth, it can fall back to it (which the Fed estimates the long-run growth is 1.8%). Leading economic indicators for August are expected to rise 0.3%. The monthly increase averaged 0.2% in 2016 and 0.4% thus far this year. The diffusion, how many indicators improved and how many deteriorated will likely confirm Yellen’s assessment that the underlying economy remains strong.
There are a few option strikes that are worth noting. The $1.1950 level seems some distant now with the euro ticking backup barely through the $1.1900 level, but a 1.7 bln euro option struck there will be cut in NY later today. There is a strike at GBP0.8840 for almost 450 mln euros also expires today. There are options struck at NZD0.7300, with a notional value of NZD243 mln.
More broadly the dollar is largely consolidating yesterday’s post-Fed gains. Short-term market participants will not have a lot of conviction of the near-term direction. The dollar bears will emphasize the lower long-term Fed funds rate and note that despite the market pricing in a greater chance of a Fed hike in December, it remains skeptical about hikes in 2018.
The bulls’ argument is mostly based, it seems, on market positioning. However, we argue that divergence is still a powerful force. The political risks in Europe (Catalonia first, Italy next) may reemerge as an important consideration, and the prospects of a tax cuts/reform in the US may be under-appreciated.
S&P cut China’s credit rating to A+ from AA- with stable outlook. Back in May, Moody’s also cut China to A1 from Aa3, and both agencies warned of risks from rising debt loans. Note that all three agencies now line up with our own sovereign rating model.
Taiwan central bank kept rates steady at 1.375%, as expected. Governor Perng took a dovish stance, noting that inflation is very mild and that monetary policy is adequately loose. He also confirmed this will his last term. The economic outlook remains solid, but low inflation should allow the central bank to remain on hold for now.
Philippine central bank kept rates steady at 3.0%, as expected. The bank kept its 2018 and 2019 inflation forecasts steady at 3.2% but raised the 2017 forecast a tick to 3.2% too. Inflation was 3.1% y/y in August, just above the 3% target and within the 2-4% target range. This suggests steady rates for the time being.
Brazil central bank releases its quarterly inflation report. Brazil also reports mid-September IPCA inflation today, which is expected at 2.60% y/y vs. 2.68% in mid-August. COPOM signaled a slower pace of easing ahead, and so we look for a 75 bp cut to 7.5% at the October 25 meeting followed by a 50 bp cut to 7.0% at the December 6 meeting.
The South African Reserve Bank is expected to cut rates 25 bp to 6.5%. A small minority sees no change. Yesterday, South Africa reported August CPI rising 4.8% y/y vs. 4.6% in July. This is still within the 3-6% target range, and should allow the easing cycle to continue today. Lower rates and a widening current account deficit that’s financed by hot money is not a good combination.