Markets testing the Fed's resolve ahead of D-Day
- Fed should deliver tomorrow but equities are a worry
- Equity market reaction will steer hike pace afterwards
- US CPI comes in bang on target - boosts hike expectations
While economists and commentators remain uniformly behind the initiation of the normalisation process by the Fed tomorrow night, financial markets are likely testing the Fed’s resolve. With the commodities, junk bonds (credit), EM and quantitative easing bubbles all bursting, the Fed’s big worry must be that equity markets might be next (and the significant negative wealth effect on the US that accompanies any material fall).
We find it very difficult to find a convincing rationale why the Fed would not deliver a hike tomorrow but it is likely that the pace of hikes from here, or at least the timing of the next rate hike, becomes a function of the equity market reaction to tomorrow’s announcement.
Credit where credit’s due
The news on Friday that Third Avenue Management is winding up its ‘Focused Credit Fund’ prompted plenty of parallels with the closure of mortgage backed credit funds ahead of the financial crisis in 2008. Since 2008, some $240 billion has been poured into junk bonds, financing the US shale gas boom and giving the cheapest money ever to companies deemed by credit rating agency Moody’s to be of “very high credit risk, poor standing”. Now, markets are finding out what happens when the music stops and everyone wants their money back at the same time. Liquidity concerns and deteriorating investor sentiment have already spread from credit to FX and equities, as the whole world steps back to listen to what the Fed has to say. The result, is markedly higher volatility.
This afternoon’s data highlight was the US CPI release for November, which delivered an on-forecast 2.0% annual rise in core prices, in line with the Fed's target. We remain of the opinion that next year the risk is for higher inflation (even after the recent oil price move). As the very steep oil price declines of November and December 2014 fall out of the annual comparison, 2016 should see a marked uptick in headline and core inflation prints globally.
The debate for 2016 is likely over how big the impact is on headline prices globally, and how long the impact lasts in the face of more recent price declines. A 2.0% core inflation print should, in our view, all but confirm a Fed rate hike tomorrow. However, with oil prices and equity markets showing increasing signs of fragility, nervousness over the announcement will likely remain elevated and liquidity will almost certainly remain low.
On the data front, the news from the global economy has been more encouraging of late. The cyclical upswing in the eurozone continues, with signs of stabilisation in a number of core countries as well as the higher beta Spanish recovery story. China data stabilisation (stronger industrial production) over the weekend is also encouraging and while we expect the Chinese growth trajectory to continue to decline over the course of next year, the recent bounce is likely supportive to sentiment, and has certainly helped stabilise AUD and NZD in FX markets.
As we move towards tomorrow’s Fed announcement, FX direction is likely to be more a function of positions being taken off rather than initiated. Illiquidity and volatility have been exacerbated by the extreme moves following the European Central Bank disappointment and the proximity to year end. From there it is down to the Fed.
– Edited by Clare MacCarthy
Neil Staines is head of trading at The ECU Group