Article / 28 July 2016 at 13:16 GMT

Fed 'passing the parcel' as USD bulls hold out for hike

Head of Trading / The ECU Group plc
United Kingdom

  • Japan in focus, with speculation rampant on size of impending stimulus
  • Fed keeps rates unchanged, but September rate hike still possible
  • Markets are happy to keep ‘passing the US rate parcel’ lower... for now
  • Macroeconomic backdrop points to USD outperforming going forward 
Tokyo skyline

There could be fireworks for JPY tomorrow, with the much-anticipated announcement from the Bank of Japan. Photo: iStock.

By Neil Staines

“Theories pass. The frog remains” — Jean Rostand

With little in the way of first-tier economic data this week, market sentiment and positioning have been driven by the flow of earnings data in the US (which on the whole has been better than the low expectations, yet still ultimately form the seventh consecutive quarter of declining earnings), fallout from rising geopolitical complexity and, most significantly, expectations regarding the extent of global monetary and fiscal stimulus.

This phenomenon has been particularly evident in Japan this week. The clear and exaggerated correlation between press reports of the size of impending fiscal stimulus from Japanese prime minister Abe and the JPY (as well as Japanese equity markets) highlights the intensity of the market focus and speculation. I doubt that we are the only market participants that are becoming increasingly concerned about the broad market reliance on ever-lower yields fuelling ever-higher equity and risk asset prices. We will have to wait until August 2 for Abe’s stimulus announcement. 

“We face neither East nor West: We face forward”  — Kwame Nkrumah

Last night’s eagerly awaited Federal Open Market Committee announcement saw the Federal Reserve keep rates unchanged, as expected, and issue a statement that retained the possibility (but by no means certainty) of a September rate hike. In doing so, the Fed passed the parcel of uncertainty from its statement to the market.

The statement effectively upgraded the FOMC members’ assessment of the economy, declaring that the “near-term risks to the economic outlook have diminished” and that household spending was “growing strongly”. Furthermore, after May weakness, June job gains were “strong” and labor utilisation had shown “some increase”. 

However, despite the positive aspects of the Fed’s assessment, they stopped short of overtly signalling a rate rise in September through their “soft” assessment of business investment, low inflation pressures (and inflation expectations) and the explicit statement that the Fed expects the economy to evolve in a way warranting only “gradual hikes”. 

"Gradual" is ultimately the key term. With the November 8 Fed meeting falling just a week before the US Presidential election, it is assumed that a Fed rate hike in November is unlikely. That leaves September and December for the Fed to match its own members' expectations (dot-plot forecasts) of two rate rises this year. 

The market reaction to a Fed statement that was only lukewarm to the prospect of a September hike was a fall in (real and nominal) US rates. With nominal GDP growth running at around 3.3% and headline inflation (on the preferred PCE measure) running well below 2.0% (currently 1.6%), the Fed is in no rush. The markets are happy to keep ‘passing the US rate parcel’ lower - at least, until there are clearer signs that the music is about to stop. 

“Teach a child to read, and he or her will be able to pass a literacy test”  George W. Bush

While in the very short term, the fall in (both real and nominal) US yields have imputed a lower USD/higher equity trajectory, the markets are becoming immune to valuation arguments and the overall risks associated with current monetary and fiscal policy. The price action of recent years has taught markets that, in an ultra-low-rate environment, equities rise on forward valuation and yield arguments. Our concern is that this is only true until it isn’t. Markets have become illiterate to the risks.

“The man who is not dead still has a chance”  — Lebanese proverb

In FX markets, we struggle to see how the macroeconomic backdrop can support a sustained USD decline, and would err towards USD outperformance going forward. That is, however, with the exception of the JPY. 

Tomorrow is potentially a very big day for Kuroda, and the JPY. Expectations for Kuroda to unleash additions to each of the three tenets of the current QQE programme are high, and it's difficult to see how Kuroda can deliver in this regard. Failure to deliver would likely see a sharp appreciation of the JPY.

Before dismissing Japan or the JPY, however, there is a possibility, albeit small, that Abe announces a 50-year bond, or goes even further with a perpetual bond in next week’s fiscal stimulus package. This would change the backdrop dramatically and, as portfolio flow data continue to highlight capital outflows, such a development could well be the start of a more prolonged period of JPY weakness. 

At the current juncture, global equity and bond markets have been well supported by the seemingly endless rotation of monetary accommodation from the world’s central banks. However, unlike the traditional game of pass the parcel, in global financial markets, when the music of monetary stimulus stops, you do not want to be left holding the parcel.

parcel delivery

In the market's version of 'pass the parcel', you don't want to be the one left holding the parcel when the music stops. Photo: iStock

— Edited by D. Deacon

Neil Staines is head of trading at The ECU Group


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