Fed pulls off 40-word Houdini

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The Fed kept rates on hold yesterday – pretty much a done deal – and its statement yesterday following its two-day policy meeting was very short on new insights.

But it was in line with my expectation that while the Fed would present a marginally less dovish assessment of the global economy, it would paint a still cloudy picture of the US and nurse the recently faltering rally in global risk appetite. US equities closed up 0.3% yesterday and 2, 5 and 10yr US treasury yields are down 6-10bps since Tuesday.

The Fed faces seven rocky weeks ahead of its 15th June meeting. It will likely want to keep the door ajar for a hike and will therefore not want to see US yields break out of range. But the market’s violent reaction today to the BoJ’s unchanged monetary policy is also a stark reminder that an overly-hawkish Fed could derail global risk appetite and in turn delay any Fed hikes.

With this in mind, my core scenario of a June hike is likely to be tested in coming weeks and the risk remains that flat-lining emerging market currencies will come under pressure.

40 words keep markets guessing

To say that the Fed two-page statement yesterday contained little new information would be an under-statement. Bar the first paragraph, the statement was a copy-and-paste of the March statement, and even then three-quarters of the wording was identical, as highlighted in yellow in Figure 1. New text was limited to 40 words and this meagre offering contained few surprises for markets.

The basic message was that the US macro picture remains patchy – as clearly depicted in my US heat map – but concerns about global developments have abated. The Fed introduced, or at least made more explicit, a few new concerns as well as positives, which were broadly in line with my expectations and are highlighted in green in Figure 1 (see It’s a Fed hiking cycle Jim, but not as we know it, 26 April 2016). Specifically:

New negatives

  • “Economic activity appears to have slowed”. Hardly a surprise, with today’s data showing that US GDP growth collapsed in Q1 2016 to 0.5% qoq annualised from an already tepid 1.4% qoq in Q4 2015, in line with weak monthly indicators including ISM, corporate orders and goods exports.

New positives

  • “labor market conditions have improved further”. A shoe-in of a statement, with the labour participation continuing to climb and initial weekly jobless claims falling to a 42-year low.
  • “Consumer sentiment remains high”: The last time a Fed statement alluded to high consumer sentiment was exactly a year ago, at the 29th April 2015 policy meeting,

New neutrals

  • “Household spending has moderated, although households’ real income has risen at a solid rate”: Again more of a statement of fact than a take on the future, as retail sales were weak in January and March but, when adjusted for slightly lower inflation, household spending is strong enough not to be an immediate Fed concern.

Olivier Desbarres looks at the April Fed meeting outcomes

What the Fed didn’t say says a lot

It is what the Fed left out of yesterday’s statement which was arguably more informative. The Fed removed its previous reference to the (implicitly negative) “despite the global economic and financial developments of recent months”. This suggests that it has taken on board the recovery in global equities and commodities as well as the recovery in Chinese economic activity. But, importantly, the Fed did not actually include a statement about positive global developments. In a similar vein, the Fed removed the reference to US inflation picking up in recent months, a likely nod to the fact that most measures of inflation had softened in March. But the Fed stopped short of spelling this out.

This ties with my view that the Fed is still reluctant to attach too much weight to recent and potentially transitory developments, whether positive or negative. Put differently, the Fed is telling us it needs more data – and by extension time – to come to a firm conclusion on whether it can and should hike rates for only the second time in a decade. With the next policy meeting due on 15th June, the question is whether data in the next seven weeks will provide the Fed with a clearer picture.

June hike still alive…just

The market doesn’t seem to think so. Pricing for a 25bp hike in June has narrowed, based on CME Group Fed Fund futures prices. The Fed will likely want to keep its options open in June and thus be reluctant to see the market totally pricing out a Fed hike, short of the US and global economy slowing more forcefully. US treasury yields are thus more likely to stay within, than break out of, their two-month old ranges if the Fed has its way.

But the Fed will have to contend with markets still attuned to the need and room for other major central banks, including in Australia and New Zealand, to potentially cut policy rates further. The market’s violent reaction to the Bank of Japan’s unchanged monetary policy at today’s meeting was a particularly stark reminder that an overly-hawkish Fed could easily derail global risk appetite and in turn delay any Fed hikes. The USD/JPY cross and Nikkei are both down more than 3% after the BoJ announced that it would not ease monetary policy further for now. While the Fed is arguably not in the same precarious position as the BoJ, it will have to accurately gage how sensitive markets are to even modest changes in its policy stance.

My core scenario of a June hike will therefore clearly be tested in coming weeks. The risk remains that emerging market currencies, which have flat-lined in recent weeks, will come under pressure (see Emerging Market currencies – don’t call this a comeback, 6 April 2016). If the Fed decides that it still needs more compelling evidence for the merits of tighter US monetary policy, the next obvious trigger point is the 21st September policy meeting when the Fed will publish new forecasts and hold a press conference.

The Fed will undoubtedly have an eye on the UK referendum on EU membership (23rd June) and US presidential elections (8th November). It has historically remained apolitical and shown a willingness to look through discrete global events and there is little to suggest this time will be different (see Fed – this is what it sounds like when doves cry, 8 March 2016). But then again monetary policy is a very different beast than it was even ten years ago.

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

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