Possibility and probability
- Fed's Yellen uttered her most hawkish words of current cycle on Friday
- Markets swung to view that June or July US rate hike is a probability, not possibility
- US consumer seems relatively resilient; other data show only modest recovery
- US 2-year yield returned to where it was before Yellen’s hawkish remarks
- Friday's US jobs report will shape probability of summer Fed hike
- Risks from global economic backdrop remain high
- Japan delays sales tax hike, JPY gains
- Volatilities likely to increase; we favour holding USD and JPY at expense of GBP
- Equity markets on an increasingly fragile footing in June
“Information: the negative reciprocal value of probability” — Claude Shannon
As we limped towards the close on Friday, ahead of the long weekend in the UK and US, Fed chief Janet Yellen gave what could be her most hawkish commentary of the current cycle, when she uttered that “growth looks to be picking up in the recent data” and so a Fed “rate hike in coming months may be appropriate”.
Markets duly altered the pricing of a hike in June or July from possibility to probability.
Today, however, is a new week and a new month. Yesterday’s US data showed personal spending surged in April (albeit at the expense of savings as incomes maintained modest growth), and while this is largely a function of higher oil prices, the consumer does appear to be relatively resilient at this stage of the recovery.
House price data continued to back that sentiment, but sharp and unexpected declines in the Chicago PMI and consumer confidence indices for May highlight that the recovery in the US, while ahead of its peers, remains mixed, and modest.
Looking at the market pricing for US interest rates, it is interesting to note that the 2-year Treasury yield has returned (following a Yellen-induced long weekend jump) to where it was before Yellen’s hawkish interjection. Following the recent mixed data, markets will place substantial emphasis on this Friday’s US employment report to shape the probability of a summer Fed rate rise. Until then, the markets may put off rethinking the Fed’s rethinking.
“The probability of apocalypse soon cannot be realistically estimated…” — Noam Chomsky
Furthermore, risks from the global economic backdrop have remained high, despite the Fed playing them down lately: (i) CNY is pushing at its year's lows (a key factor in the equity rout in January, amid fears of capital flight), (ii) Japan postponed a long forewarned sales tax hike due to persistent signs of consumer frailty, (iii) a return to the polls in (government-less) Spain adds to Eurozone geopolitical risks, and that's not to mention (iv) resurgent "Leave" momentum in polls for the UK's referendum on Europe.
June will most certainly be a month of changing possibilities and changing probabilities of major significance.
“Where ignorance is our master, there is no possibility of real peace” — the Dalai Lama
While we continue to believe that the Fed is significantly behind the curve in monetary normalisation, we would view the risks for Friday’s US nonfarm payrolls as being to the downside, and with that the probability of Fed action in June or July.
As central banks everywhere continue to pursue monetary policies that cause substantial misallocations of capital, Japanese prime minister Shinzo Abe announced overnight that he would delay the planned sales tax hike (a mere 10%) by two and half years to 2019 (to the likely chagrin of rating agencies). Expectations, though complicated by the awaited announcement of an upper house election, are rising for a further fiscal stimulus package. Despite the already vast global stimuli, central bankers and politicians stick to the view that doing more is the answer.
“If there exists no possibility of failure, then victory is meaningless” — Robert H. Schuller”
As possibilities and probabilities evolve in June amid "events" of global significance, it is likely that volatilities increase significantly, so we favour holding USD and JPY at the expense of GBP.
Early this year, the prospect of US interest-rate normalisation, fears of economic slowdown and capital flight from China — against a global backdrop of “miserable” (to quote Yellen) productivity growth, manufacturing and global aggregate demand — caused equities to sell off sharply.
The current situation contains all the aforementioned woes plus the added complexity of rising bond yields. In our view, this puts equity markets (where we view the misallocation of capital caused by global central bank stimulus to be greatest) on an increasingly fragile footing in June.
— Edited by John Acher
Neil Staines is head of trading at The ECU Group