US inflation rises but traders doubt FOMC resolve
- Core CPI rises to 1.8%, just enough to show an improved reading
- Yield curve continues to flatten, making it confusing for traders
- Market doubts FOMC resolve and needs to see a steepening curve
By Max McKegg
The latest inflation update out of the US was a relief to the fence-sitters on the Federal Open Market Committee (FOMC).
Over the 12 month period to October, the core Consumer Price Index rose by 1.8%, just enough improvement on the previous reading to justify the doves coming down off the fence and voting in favour of a rate hike at the Committee’s December 13 meeting.
Market pricing suggests the probability of a 25 basis point move is 90%. Yet the yield curve continues to flatten. No wonder FX traders are confused about the direction of USD.
A rate rise next month has been priced in for a couple of weeks. Yet USD is not impressed. What’s needed to give the buck a boost is a steepening of the yield curve, something these latest inflation numbers did not provide.
As shown in the chart below (click to enlarge), the yield on the five-year Treasury bond is flirting with an upside breakout but just can’t gather enough momentum to push through.
US 5-year Treasury bond yield
As all traders know, a market rally will stall if the bull has too much weight on its back (“weight” being trader positions).
In the bond markets one of the most widely watched positioning indicators is the JP Morgan Investor Sentiment index.
As shown here, investors are the most bearish on bonds since 2005 (expecting prices to fall/yields to rise). It will be hard to get a rally going with that much headwind. A push is needed from the biggest player in the game, the Fed.
Most economists argue that the economic background is supportive of higher bond yields in the US.
GDP is expanding at a rate slightly above potential, jobs growth is strong, the unemployment rate low, financial conditions loose and the oil price is rising.
Investors know all this. That’s why they’re positioned for higher rates. The FOMC seems to have bought into the narrative as well.
Their September “dot plot” for the policy rate showed three rate hikes pencilled in for 2018. But the reason USD traders are holding back is that market pricing is well below the Fed’s flight path and assumes only one rate hike next year, not three, as shown in the chart below.
Yet at the same time, short positioning further out along the bond curve is the highest its been in a dozen years.
What’s needed then is sentiment at the short end of the curve to catch up with that at the medium/long end.
Trouble is, the market has learned from experience talk is cheap and that the Fed has a record of sounding tough but not following through.
The chart below illustrates the FOMC’s record over the last five years. In 2012 the median projection of members was that the Fed Funds rate was on a path to 3.5% by 2017.
That hasn’t happened because having talked the talk they didn’t walk the walk. Similarly in 2013, 2014 and 2015: lots of posturing but little action.
But now, as shown by the “what actually happened” line on the chart, the Fed seems to be backing itself at last, adjusting rates at a pace consistent with their December 2016 projections (endorsed at subsequent meetings).
Yet the market still doubts policy maker resolve: they expect a rate hike next month but doubts whether the FOMC will stick to its trajectory thereafter.
Source: St Louis Federal Reserve
So where does this leave USD?
It’s clear the FOMC will have to do the heavy lifting to get the major crosses moving in favour of the dollar.
The European Central Bank and Bank of Japan will be on hold throughout 2018 while the Bank of England looks to be “one and done”.
Combine that with doubt about the FOMC’s resolve and the USD index is left looking similar to 2002, as shown in the chart below (click to enlarge).
To achieve “escape velocity” and pull away from the support line, the USD will need to be underpinned by higher rates across the curve.
In turn, that means the markets will have to start taking the FOMC seriously when it says three rate hikes are coming up in 2018 and another couple, at least, the following year.
The current Fed Chair Janet Yellen has been unable to get the message across; FOMC projections have been seen as “fake news” by the markets.
Perhaps more credence will be given to President Trump’s new man at the helm, Jerome Powell. The latest inflation update gave him just bit of extra ammunition.
-- Edited by Adam Courtenay
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