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The Kremlinologists turned out to be right, and the Federal Reserve left its "considerable time" language in its statement to assure the markets that it would be around for a while longer with rock bottom rates. It's the divergent (to a point) reaction out of the markets themselves that is interesting to parse, and will be key to watch in coming weeks and months. The action in the stock market was to suggest the entire exercise was a snooze-fest, with stocks ending marginally higher (yes, the Dow at a new record) but not too far from where the major averages were trading just before the news. Which is to say the equity market, always the most optimistic of U.S. markets, has it in mind that low rates stay for now, and until "now" is "then," it's time to party.
Bond markets, inflation-protected securities and the currency markets saw things differently, and it's those markets that may be more instructive to watch as the days and months go on and on. The five-year TIPS note saw its yield break above zero for the first time in ages, a sign that investors are starting to worry more about inflation, or higher Fed rates, which is interesting as consumer price data showed year-over-year inflation fall to a 1.7 percent rate earlier in the day. The dollar put together another strong rally, meanwhile, with the dollar index hitting highs not seen in 14 months and big rises against its main companions, the euro and the yen. And this is where the dot matrix comes in.
The dots, of course, are not an array of Janet Yellen's prowess (or lack thereof) at the firing range, but the expectation from Fed officials on where they see rates in coming years. With 2017's dots all suggesting rates at greater than 3 percent - and closer to 4 percent - the currency market has taken the hawkish outlook here, as Jens Nordvig, strategist at Nomura, said in an email to Reuters. There were two dissenters - the usual suspects, Charles Plosser of Philly and Richard Fisher of Dallas - who were not thrilled to see the statement so dovish, and so Nordvig takes all this and says that this should be "enough to sustain USD uptrend vs G10" currencies, so, against the yen, euro, Swiss franc, pound and all the others.
He does warn, however, that the kind of uncertainty that would drive significant outperformance against the emerging markets currencies is not yet present, given rates are going to be low for some time, so that firm is closing some call options outstanding against the peso and ringgit while sticking with long bets against the yen and euro. "It will also soon be time to ask new questions on the Dollar. What will be the pace of tightening the US economy can cope with? What is the strength of capital flows into the US? Answers to these questions will determine whether the relatively sharp Dollar move in the last 2-3 months can be extrapolated over the next 3-6 months," he wrote in late commentary Wednesday. There's also the possibility, of course, that markets overreacted to the Fed - another soft jobs report would undo a lot of the recent gains in the dollar, or even a couple of other second-tier indicators reinforcing the notion that the outlook from individual Fed members on rates is just that - an outlook - and as a result cannot be trusted insomuch as the data will tell them what to do, dots and dollar strength and models be damned.
It's all over but the dissection of the Fed statement, due later today, which will follow with a Janet Yellen press conference after the U.S. markets get word of whether the Fed did or did not eliminate the "considerable time" bit from its statement that saw markets go into a tizzy all of Tuesday. At this point the market believes that phrase now may *not* be eliminated, which marks the second reversal in about a week on this point. No matter what, somebody is going to be caught leaning in the wrong direction, but if the latest intelligence is that the Fed's statement won't change materially until the October meeting, then the freshest bets are probably in the direction of those betting on that much. So if the statement does cut out that language or modifies it in any way, you could see a selloff in equities, the dollar and bonds.
The meeting also brings with it the update on the Fed's "central tendencies," that is, its sure-to-be-incorrect projections on where the economy is going. Given the rebound in the second quarter that seems to have at least been somewhat sustained in the third quarter, it wouldn't be surprising to see the Fed outlook for GDP bumped up for 2014 (currently 2.1 to 2.3 pct) and 2015 (at 3.0 to 3.2 pct - the Fed will predict 3 percent growth for the year-out period until we're all Morlocks), and the unemployment rate expectations are projected to drop to maybe 5.7 to 5.8 percent from the current 6 to 6.1 percent expected at year-end. Which is all well and good, but it doesn't give us a good sense, really, of what's to happen going past the meeting.
Something has changed in the bond market in some ways - but it's a bit difficult to tease out when you're talking about yields still near very low levels. But there's a sense that the San Francisco Fed's paper on the way in which economists are underestimating the Fed's own view of interest rates is a game-changer, or maybe it's just that people are waking up to the idea that the Fed really does have to raise rates eventually, or even more so, that it's an overreaction to a previous overreaction: backlash to the idea that the August jobs report was so lousy that the Fed was still firmly in "not doing anything ever" mode.
The dynamics of the long-dated market haven’t been altered all that much just yet – or rather, it’s a bit early to declare that. The 10-year is still hovering around 2.50 percent, and the spread between that and 10-year Treasury Inflation Protected Securities stands at about 2.11 percent, and it’s remained in a steady range for the last year-plus as well, actually trending lower in the last few months.
Global ructions are dominating asset flows right now, and we’re not even talking about violent events such as the ongoing Russia-Ukraine conflict, the rise of Islamic State in Iraq and Syria, or the Israel-Palestine situation. Right now smaller events – yet uncertain ones – seem to be affecting the larger markets a bit more, contributing to a decided shift in factors that U.S. assets are reacting to.
The bond market is no longer just about a steady belief in lower-for-forever activity from the Federal Reserve, but about the expectation for more flows from overseas as U.S. assets look more attractive and the U.S. dollar continues to strengthen. The dollar had a banner session against the pound with the threat of Scottish independence growing more and more possible (cue everyone yelling “Freedom!” while being drawn and quartered), as the messy considerations surrounding what happens to oil revenue and the diminution of the U.K. economy is considered. It also threatens to drive more flows toward the dollar as the Bank of England might be expected to hold off on raising interest rates when they had been expected to be the first central bank to act.
The unemployment report occupies a unique position as a bit of a lagging indicator (especially when it comes to wage growth) and yet the most important economic figure that markets look at on a monthly basis. Various indicators point to the likelihood of another strong report come Friday that should accelerate recent trends in markets – more gains in the stock market (with a helping of the “this means the Fed is going to cut us off from the punch bowl blah-blah” stuff) and more strength in the dollar, regardless of whatever incipient gains the euro can muster after the European Central Bank meeting.
Underlying indicators to watch suggest that the U.S. economy has started to move more dramatically higher, whether it’s from the Federal Reserve’s Beige Book or Goldman Sachs’ analyst indicator, a composite of analyst commentary that functions as sort of a “corporate Beige Book.”
It’s ECB day and after Mario Draghi’s recent dramatic utterances, expectation for fresh action has grown, expectations which are likely largely to be dashed.
Draghi told the world’s central banking elite in Jackson Hole last month that market inflation expectations were falling markedly and the European Central Bank would use everything in its power to stabilize them in order to avoid a deflationary spiral. He also ripped up central banking orthodoxy by calling for more fiscal spending by governments at the same time as redoubling economic reform efforts. How to read that?
A frequent refrain among commentators is that this ongoing growth in the stock market has to ‘come to an end’ at some point because of, well, mostly because it’s been going for a while and that it’s gone entirely too far in the last few years.
Given the market’s penchant for 50 percent corrections since the turn of the century, the latter point can’t be discounted entirely, but the former – that essentially, the bull market is endangered because it’s long in the tooth – feels a bit reductive. The day’s figures on car sales due out from the major automakers are likely to support the worries people have about a slowdown that’s just a short drive away from the economy going into a ditch, or something like that (it’s not as if the economy is awesome right now), but the belief in a mid-cycle slowing in some key consumer metrics is probably more the ticket.
Never say the Europeans aren’t cautious. The dollar has been on a roll of late, in part because of the market’s growing expectation for more stimulus from the European Central Bank before long that would include some kind of larger-scale quantitative easing program after a speech last week from Mario Draghi that European markets seem to still be reacting to several days later. Reuters, however, reported that the ECB isn’t quite likely to do move quite so fast (heard this one before) and that took some of the wind out of the dollar’s sails and boosted the euro a bit.
Some of the move in the euro will depend on the trend in European yields, where everything is going down – German Bunds continue to make their way rapidly toward zero, and Bund futures remain in an overwhelming bullish trend, per data from Bank of America-Merrill Lynch. Analysts there also anticipate the dollar is going to experience some kind of medium-term correction – but remains in rally mode otherwise. There’s a headwind there for equities from that – rising greenback makes U.S. goods more expensive, but the gains are still only in earlier stages, and haven’t pushed into territory that would otherwise indicate surprising strength that we haven’t seen in some time.
The markets ease into a traditionally slow period with not much to look forward to other than the Federal Reserve’s Jackson Hole conference due next week, where the highlight, naturally, will be anything Janet Yellen says regarding the state of the labor markets. The chances of the Fed signaling a new shift when it comes to policy are slim – Yellen has proved to be a cautious speaker thus far, interested in furthering Ben Bernanke’s way of telegraphing as much as possible when it comes to policy alterations, and Yellen is more so, her “six months” comment from a few months ago notwithstanding. As Jonathan Spicer and Howard Schneider reported a few days ago, Yellen is much more interested in fighting an inflation war than dealing with a persistent deflationary/lousy economic environment to dominate the headlines, so the expectation should be for lower rates for longer, and not to expect a lot of surprises out of Wyoming next week.
Goldman Sachs economists not that Yellen had sounded a bit more positive on the labor market in July, but even still their belief when it comes to the slack that exists in the jobs market is still too great to bear much more than the end of quantitative easing/bond buying and perhaps a move to a couple of small rate increases around the middle of next year that, well, won’t hurt too much given the Fed’s policy rate still sits between 0 and 25 basis points. The forecasts from Reuters most recently put the first rate hike somewhere in the April to June range, which fluctuates depending on the strength of the economic figures.
By Neil Unmack
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
Banco Espirito Santo’s bail-in has been a nice earner for some bond traders. Anyone who bet that Portuguese authorities would save senior creditors but burn bonds lower down has made a killing. But anyone who tried to follow suit with BES credit default swaps will be feeling much less cheery.