The Fed today surprised financial markets by signalling clearly that were underpricing the likelihood of a December 2015 rate hike, which now seems very much on the table although we will be in a very data dependent world over the next seven weeks. This may provide a fillup for the policy divergence driven USD upside narrative (reinforcing prospective ECB dovisness), although data and market dynamics barriers will have to be overcome (arguing for a cautious approach).
Fed less concerned about global developments, focus on December and more optimistic about domestic demand
The first significant change tooday was to back off the concerns they expressed about China/EM prospects in September, which so surprised markets. The infamous sentence “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” now consigned to history. The second paragraph statement that the Fed is “monitoring developments abroad” is maintained, but that’s hardly surprising. One can certainly question the Fed communication strategy of being quite so upfront about international concerns six weeks ago and apparently back off them so quickly,. But markets also underweighted Yellen’s more hawkish comments in September (recent developments had “not fundamentally altered our outlook”, it was “appropriate to wait for more evidence…to bolster its confidence that inflation will rise to 2 percent”, she strongly rejected the idea that the Fed is approaching being unable to raise rates and her comments revealed that she still believes in the Phillips curve).
The second significant change today was the third paragraph statement that “In determining whether it will be appropriate to raise the target range at its next meeting” it will take into account a wide range of information rather than last month such information would be pivotal “In determining how long to maintain this target range“. A clearer steer that they’re going to be thinking about hiking rates in December, which the market was only attributing a low-30% probability to, would be harder to imagine.
The third change, albeit less significant, was that the Fed seems to have become a little more optimistic on household spending and business fixed investment, which are now described as “increasing at solid rates” rather than the previous “increasing moderately” adjective. They Fed also marginally toned down their concerns about low inflation breakevens – now described as having “moved slightly lower” rather than simply ” moved lower” – which seems sensible given that they contain inflation and liquidity premia and it’s useful to avoid the
Surprised markets are so surprised
I’m not really surprised by this turn of events. My initial reaction to the Fed’s dovishness was that the day of reckoning for the Fed and markets had likely merely only been delayed, my Back to the Future post from couple of weeks ago argued that the reported stabilisation of Chinese data (and growing expectations of further PBOC action, which were realised last Friday) would have the corollory of bringing Fed hikes back to the table (but that dynamic seemed to be being underpriced). Overall it seems that James Bullard’s argument that foreign (China) policymakers’ responses means that the Fed doesn’t also need to react to foreign developments (together with EM countries being as prepared for Fed liftoff as they’re likely to be) is in the ascendency within the Fed. I also argued that while Brainard and Tarullo’s apparent dovishness was notable it was hard to ignore the fact that in September 13 out of 17 FOMC participants thought they’d be raising rates in 2015 (even if I personally think that a short delay is worthwhile for risk management purposes and to avoid end-year illiquidity issues). And yesterday I suggested that there was a good chance of the Fed trying to steer expectations back towards a possible December rate hike, while also trying not to undermine the nascent risk appetite recovery (although I’ve also argued that the prospect of a “Yellen put” epithet probably wouldn’t entice for the Fed Chair).
Welcome back data dependency
The Fed’s aim seems to have been to remind the market that December remains a live month for a potential rate hike, and shift back expectations from Summer/Fall 2016 hikes, rather than promising (threatening!) anything. That’s consistent with Stanley Fischer’s comment that a 2015 rate hike represents “an expectation, not a committment“. So the Fed’s apparent change of tack has put us back in a highly data-dependent world. And some recent US data have disappointed (beyond last months’ weak payrolls print) reinforcing that a December rate hike is far from a done deal with considerable hurdles to overcome, particularly on the inflation side of the dual mandate. In the near term tomorrow’s Q3 GDP release will be examined carefully (e.g. on the extent of export weakness) while Friday’s ECI and core PCE deflator data can help set the tone on the inflation debate (I’m not holding my breath for a sharp uptick given the apparent flatness of the Phillips curve). And of course we get another payrolls print on 6 November, which will be the penultimate release before the Fed has to decide so a swift rebound from last months’ weakness would seem important.
USD bulls will cheer policy divergence fillup, but barriers remain
The Fed’s surprise comes just as USD bulls seemed to be throwing in the towel – with positions unwound after the USD rally stalled, even against EM FX (see here). And many participants were viewing any USD strengthening impetus as coming more from foreign central bank dovishness e.g. the ECB’s opening of the door to deposit rate cuts in December last week (see here, and its notable that EA 2 year swap rates have turned negative for the first time ever) or macro/political weaknesses abroad.
So the policy divergence theme, supporting USD, could experience some renewed focus in the coming weeks. And its notable that USD movements have continued to be well-correlated with US-foreign short rate movements (although as always the relationship can be two-way and indeed USD strength has been associated with US rate hike expectations being pushed out, given the the adverse impacts on exports and inflation). And there has been initial limited general USD strength following the Fed e.g. with EURUSD down 1.2% to around 1.09 but with USDJPY up only around 0.6% to around 121.2. As an aside, I stick with my view that the BoJ probably won’t ease further on Friday (see here), which runs counter the policy divergence theme. That said, that’s not my highest conviction view and my motivation was anyway more a relative one of BoJ seeming likely to underachieve ECB on the dovisness front (reflecting political as well as economic factors). Hence the likely attraction of short EURJPY positions (which usefully also abstract from Fed and risk aversion influences).
But there’s several further reasons for being cautious about the policy divergence USD strength theme: (i) it’s no means a given that US data will perform, given the recent downdraft; (ii) market participants may dust themselves off after today’s Fed surprise and either decide to go back to ignoring what Yellen and Co. have to say(“they’re just sending a shot across the bows, they’ll still end up delaying until earlty 2016) or more likely will be “once bitten twice shy” about establishing fresh USD positions; (iii) relatedly, participants may also have swallowed the rhetoric that it tends to be “buy the rumour sell the fact” around Fed hikes, although I demonstrate here that that’s an inaccurate summary of history which misses important nuances; (iv) an early Fed rate hike may hit market risk appetite (even if the Fed tries to avoid this at the margins) and hence support important risk-off/funding currencies like EUR and JPY (see here).