A Hawkish Fed Drives Bonds, Rates And The US Dollar Sharply Higher

Originally published by AxiTrader h2 Market Summary/h2

The path to normalisation continues unabated with the Fed announcing unchanged rates but the start of its balance sheet taper at this morning’s meeting. Stocks haven’t moved overly. But it’s clear in bond and forex markets - given the surge in the US dollar and sharp rise in US bond rates – that the market had clearly expected a move dovish tilt at this month’s meeting.

What caught the market by surprise is that the statement, dot plots, and chair Yellen’s press conference showed nary a hint of the dovishness of the last Fed speakers before this meeting. The Fed still holds an expectation - in the dot plot - of another rate rise this year, three more next year, and that over the medium term inflation should return back to the fed’s 2% target rate.

The market is not convinced on this last point. That mitigated the carnage we might have seen from this hawkish tilt from the Fed. But that said we still have a decent rise in the US dollar and bond rates have lifted.

The euro is down 0.84% from yesterday at 1.1893 but down even more sharply from the overnight high around 1.2030. The yen and Swiss franc have also come in for a pummelling losing 0.64% and 0.76% respectively. Sterling is down a little, the kiwi is up half a percent, the Canadian dollar lost 0.35% and the Aussie dollar has had a wild night making a play above 81 cents but is back at 0.8018 up 0.1%.

In bond land, US 2's climbed again and at 1.43% are at the highest closing level since the week of November 7, 2008. US 10's have not leapt as much but are sitting at 2.27% while the curve is at 82 points.

On stocks. the weakness immediately after the FOMC announcement washed away and we saw fresh record highs. The S&P 500 eked back into the black with a 0.77 point rise while the Dow Jones Industrial Average was up 41 points, 0.2%, to 22412. The Nasdaq 100 dipped marginally to 6456.

Europe was very quiet waiting on the Fed while SPI traders have been for a bit of a trip. Down 20 points at one stage the futures are now flat to where they were down 20 points or more at one point after 4 am’s announcement.

On commodity markets gold is on its uppers and sitting at $1300 after testing important support at $1294/95 overnight. Crude is breaking out with WTI up 1.88% to $50.41 and copper has barely moved at $2.94 a pound. Iron ore in Shanghai was down again overnight.

This afternoon we have a speech from RBA governor Lowe in Perth at 3.10 pm AEST. We also have a BoJ announcement.

• You can read the Fed’s statement here , but the highlights are summarised in the first paragraph which says:
• “Information received since the Federal Open Market Committee met in July indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have remained solid in recent months, and the unemployment rate has stayed low. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters. On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.”
• The statement and Yellen also highlighted that the impact of the Hurricanes, is unlikely to materially impact economic growth in the medium term. “Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term,” the Statement said.

• Asked in the press conference about inflation’s undershoot chair Yellen highlighted that the Fed is charged with an employment goal which is being fulfilled with slack in the labour market “largely disappeared” and then explained why inflation had undershot in recent years. But then she said this year’s undershoot is more of a mystery, “and there were risks that inflation stayed under 2%” the reality was that monetary policy acts with a lag and thus with employment markets tight, and with an expectation that will ultimately drive inflation, the Fed doesn’t want to get behind the curve.

• My take on this is that the normalisation process the Fed has been on, that I have been talking about since last year remains intact. This is not a Fed trying to tighten policy and thus slow the economy. It is a Fed that recognises even if inflation is undershooting at present, the economic growth rate, and the tightness in the labour market is consistent through history with a higher Fed funds rate. So they are moving rates back toward those levels. Throw in the expectation that inflation will ultimately pop higher and the Fed sees itself as needing to raise rates once again this year and then perhaps 3 times next year.

• And speaking of dot plots here the latest chart from Bloomberg showing this year's prospective hike and then the moves expected in the following years. What you can see – in the white and purple lines – is that the market doesn’t agree with the Fed, the market is far more dovish. That’s restaining the moves in bonds, stocks, and the US dollar. We need to see improving data – better than expected – for the market to aggressively reprice. But so far futures traders have noted the Fed’s intentions with regard a December hike and increased the chance of a move to above 60%.

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Fed dot plots (Source: Bloomberg)

• On the balance sheet taper, chair Yellen was at pains to make it clear that the reduction in assets the Fed is, and will be, holding is not viewed as a tool of monetary policy. I’m not sure that is really the case given this is in many ways negative QE. But the signal Yellen is sending, in her words and via the process the Fed has articulated, is that the normalisation of the balance sheet will be conducted at such a gradual pace as to not disrupt financial markets and thus not disrupt the economy by adding upward pressure on term rates. We’ll see.

• But too that end the New York Fed, the regional Fed charged with executing the Fed’s interactions with the market, has released a statement regarding the rundown of the balance sheet and table highlighting the path.

• The best question was saved till the end when Michael Mckee of Bloomberg asked Yellen about financial conditions having loosened while the Fed was tightening and did it point to the why of the Fed’s continued path of rate hikes and normalisation. This is an important point. If folks just focus on growth and inflation right now and the Fed funds rate rather than overall financial conditions – which include for one a weaker US dollar – you get a different picture. Here it is:

US Financial Conditions (Source: FRED database)

• Another disappointing day on the local bourse yesterday as the S&P/ASX 200 closed down 4 points at 5,709. But that wasn’t too bad really given the index made a low of 5,680 before recovering. That recovery was looking tenuous a couple of hours ago when futures were down 20 points but they are back to flat now.

• So we have no real guide for the day ahead other than to say we have a not-negative lead from the US but local price action remains mired at the middle to bottom half of the range. What can drive prices at the index level higher?

• We now have another Australian major bank calling for higher rates in 2018 with the ANZ Banking Group (AX:ANZ) pencilling two rate hikes next year. Essentially the reason for the change is that the bank’s economics team sees less downside risk for the economy in the year and years ahead. “We see growth of 2.9% in 2018 and 3% in 2019, with the unemployment rate declining to 5.3% by the end of next year,” ANZ economists said.

• And that absence of downside risk is something RBA assistant governor (Economics) Luci Ellis highlighted in a speech yesterday. Ellis said “"The global economy is looking better than it did a year ago. The turning point was around the end of last year…While it doesn't seem to have picked up further recently, neither is this expansion a flash in the pan." She added that, "there seems a reasonable prospect that – as long as nothing really bad happens – this global expansion could continue for a while."

• Indeed. Recall this chart from the OECD back in August showing all the countries it monitors are expected to be growing in 2018 for the first time in a decade.

OECD Growth outcomes and expectations for member countries

• No wonder the Aussie is bid.

• Dollar, Dollar, Dollar. Oi, Oi, Oi. That’s the chant US dollar bulls were singing in the aftermath of this more upbeat, and as a result hawkish, FOMC statement than many expected in the run up to the meeting. I’ve gone on ad nauseum about what the Fed said above but the critical point for forex traders, given this is still a US dollar bear market for many pairs, is that the data needs to swing in behind the Fed in order to convince traders that the US economy is on the right track and the Fed will follow its dot plot with action. The complication of course is that regardless of what the Fed says about the impact of hurricanes Harvey and Irma medium term they will colour data for a while yet.

• So technical are probably the best guide unless or until that happens.

• To that end, USD/JPY traded up and through, but is now back below my target of the 200 day moving average. That – along with the 1.1820 support in the euro – is the bell ringer for the dollar and its outlook in the near term. A day close above 112.20/25 opens up a move toward the range highs for the year at 114.00/50. The BoJ today is not expected to be a big mover of the rate. But it could be if it reiterates the divergence between itself and the Fed’s outlook – or not as may be the case given the Japanese economic recovery.

• The Aussie had a wild ride in the aftermath of the Fed announcement. Somehow it traded up to around 0.8102. That’s just 22 points below the high for the year and clearly traders reacted to something they thought was dovish. The sellers disabused them of that notion very quickly and the AUD/USD collapsed to 0.7985 before it bounced back as the US dollar lost ground and the euro, among others, fought back. Worth noting the recovery highs arouond 0.8025/30 is the 38.2% of this morning's fall.

• It’s pretty clear the Fed’s move caught the attention of forex and bond traders. But it’s also clear it was paradigm questioning, not paradigm shifting. That means for the moment the Australian dollar is likely to remain bid on any dips.

• The roll is out of the way and Crude prices are free to rally as we head toward Friday’s meeting. Overnight there was some conjecture again about the chances of a fresh deal on another production cut. But that seems to be going nowhere at the moment. Elsewhere thee inventory data showed a rise of 3.9 million barrels, as expected.

• A break of $51 will now confirm the move higher. If it happens

• A hawkish fed, bond rates rising, and a stronger dollar are not a positive recipe for strength in gold. So it’s on its uppers right here around $1300 an ounce and has to hold the $1294/95 region where significant support lies. At present we are jst seeing a garden variety 38.2% retracement of recent strength. But a break would suggest a move to $1280/81, perhaps lower.