Yellen to cautiously leave door open to June hike

Financial markets remain sceptical about further US rates rises heading into the tomorrow’s FOMC announcement. Less than one Fed rate increase in 2016 is fully priced, although the current 80% probability contrasts with only 10% a few weeks ago, whereas in December the Fed signalled four rate hikes in 2016. While a rate increase this week is off the table, the combination of recent positive US activity and inflation surprises plus looser financial conditions (helped by Chinese signalling further monetary and fiscal easing and a commodity price bounce) mean that the Fed will likely take a cautiously-optimistic view of macro-financial prospects.  So I’m only expecting the median “dot plots” to be revised down by 25bp as the Fed effectively marks its’ policy to market and therby signals three rate hikes in 2016.  Although my own view is for only two 2016 rate hikes it’s probably too early for the Fed to unnecessarily commit to fewer hikes, although the mean dots could fall more given apparent intra-Fed dissent on inflation. Moroever, the Fed’s forecasts will likely only be tweaked a little. Indeed, the near-term inflation forecast might well be revised up given recent upside inflation surprises: January’s 1.7% y/y core PCE deflator exceeded the median Fed projection of 1.6% for Q4 2016. That said, any Fed reintroduction of the balance of risks around the forecasts would likely be mildly downside, in line with Dudley’s views. And stalling wage growth (despite strong payrolls), disagreements about inflation prospects, concerns about inflation expectations, adverse impacts of the earlier tightening of financial conditions and awareness of the continued fragility of the international macro-financial situation means that Yellen will want to tread cautiously in her comments. She will want to avoid reversing recent improved market conditions, but could struggle given her likely wish to signal that June meeting is “live”.  Conversely, no-one will be surprised by a continued stress on data dependence, including monitoring global risks, and a reiteration that rate rises will be gradual. So the market probability of a June hike will consequently likely edge up from the current 54%. The sceptical market could neverthlesss conceivably conclude that “they’ll eventually come round to our viewpoint” thereby limiting the initial market impact, which would indeed suit Yellen’s likely aversion to a sharp dollar spike or Treasury sell-off. Indeed, the dollar faces the continuing headwinds. But my bias is for the FOMC be mildly dollar-supportive, most likely versus riskier currencies like GBP, NZD and EM FX.  Progress against risk-off currencies (JPY and EUR) will be tougher until we get closer to actual Fed hikes, although USDJPY is notable weaker than implied by both rate differentials and equities. But that’s more likely to be a H2 phenomena, given my continued expectation that the Fed will eventually hike twice in 2016, conceivably starting in June but more likely September, as risk-management considerations and the need to obtain broad agreement in inflation (expectations) eventually come to the fore. And should the Fed dot plots tomorrow surprisingly shift straight to signalling only two 2016 rate hikes that would support risk assets, reduce US rate hike expectations and be broadly dollar-negative.

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Fed likely cautiously-optimistic on macro-financial prospects

Considering the adverse macro backdrop to their January meeting, FOMC members will likely take some reassurance from subsequent US macro-financial developments. Specifically, US macro data have generally surprised positively (see the Chart on the Citi economic surprise index) including industrial production and durable goods orders, while non-US data have been less upbeat. And the abatement of the previously-worrying weakness of the ISM surveys has helped support the incrsase in Fedc rate hike expectations, although the forward-looking (export) orders components argue for caution.

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And the expenditure details underneath the marginal upward revision to the Q4 GDP (still a weak 1.0% saar) continue to be uninspiring.  Household consumption the sole growth driver, but fixed investment was weak and net exports continued to drag (even if both were better than initially-reported).  Today’s weaker than expected retail sales release, including substantial back revisions, also argues for caution. But continued strong employment growth (averaging around 230k over the past three and six months) and the effective tax cut from lower oil prices should support continued household income growth (personal income was up 4.3% y/y in January).  It’s also interesting that US labour market “churn” looks to be picking up – increasing openings, hires and separations – which could translate into greater upward wage pressure (after the disappointing recent stalling, see below).  But overall the Fed will likely judge that it’s coming close to achieving the full-employment side of its dual mandate, although there’s still room for the wider U6 unemployment measure to fall, and so should be signalling that further rate rises are on the cards.

Easing financial conditions, but previous tightening will work through economy

Financial market stresses have also calmed a little, helped by a near-term commodity price bounce as China has promised further monetary and fiscal easing. Last week’s dovish ECB innovations also seem to have supported risk markets after the initial volatility (see here) even if the euro and EA inflation breakevens reactions have continued to disappoint. So US financial conditions have continued to ease (see Chart), also helped by the dollar’s continued weakness in the wake of global uncertainties and risk aversion. That said, the previous tightening of financial conditions, equivalent to several Fed rate hikes, will be working it’s way through the US economy – as highlighted last week by Fed Governor Brainard. But the hope is that the temporary nature of the earlier tightening will limit the damage.

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And, of course, concerns about the international economy remain highly-pertinent, although the previously-discussed Chinese and ECB easings should provide some support if concerns about policy ineffectiveness aren’t completely vindicated (concerns persist about the effectiveness of BoJ easing, with Kuroda this morning apparenely downplaying further rate cuts).  That said, the relatively-closed nature of the US economy mean that the Fed will likely be more concerned about the feedback onto US asset prices and financial conditions than the impact on exports (although as discussed above, weak prospects are hurting GDP).

But Fed divisions on inflation, worries about inflation expectations

On the surface, those better macro-financial conditions have been accompanied by a continued improvement in the inflation picture.  Specifically, both the core PCE deflator and core CPI inflation susprised positively, with the latter’s rise to 1.7% y/y in January exceeding the Fed expectations for Q4 ’16 inflation of 1.6%.  And that suggests that the Fed’s near-term inflation forecasts may well be revised up this week.

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But nevertheless Fed disagreements on inflation have become more apparent in recent weeks.  The list of different Fed views on inflation is too long to detail fully (but see here). But Lael Brainard has been amongst the most dovish, arguing that the recent rise in core PCE inflation was driven by base effects and consequently  “it is possible that 12-month core PCE inflation will move lower in coming months” (see here).  The chart above illustrates her concerns, but importantly also shows that January’s m/m rise in inflation was the strongest in four years.  At the other end of the spectrum, vice-Chair Stanley Fischer argued that “we may at present be seeing the first stirrings of an increase in the inflation rate” and pushed back against worries about the Phillips curve relationship weakening  (this has been a key reason why I’ve consistently advocated slower Fed rate hikes, see e.g. my post from last August).

Moreover, there’s been increasing concern about US inflation expectations (a concern echoed in much of the G10). The January FOMC statement noted the further decline in market-based measures of inflation compensation, but took comfort from the relative stability of survey-based measures.  Subsequent developments have been concerning.  In particular, market inflation breakevens, both Swap-based and TIPS-based, have remained low and fragile (see Chart) – while they have tentatively bounced alongside the oil price rally, their relatively-strong correlation with EA breakevens is provocative. Of course, inflation breakevens can be driven by risk and liquidity premia as well as underlying inflation expectations and Yellen has consequentlt previously been sceptical.  But the apparent volte face of the previously-hawkish Bullard in light of breakevens’ weakness, which have fallen “too far for comfort” and are consequently starting to erode Fed credibility, is quite striking.  Brainard has also worried about the impact on future inflation i.e. second round effects which finds support in the recent earnings growth fallback (see Chart above).

Meanwhile survey-based inflation expectations have also disappointed.  Specifically, the 5-10 year measure in the University of Michigan survey fell to 2.5% in February, representing a (joint) mult-year low even if the rate is not particularly low relative to Fed’s objective (although consumers tend to over-estimate inflation).  Alongside that, the New York Fed’s 3-year ahead inflation expectations series also remains low, although the rebound to 2.62% in February reported yesterday from the record low of 2.45% in January should calm the concerns raised by Governor Brainard.  Such low survey-based inflation expectations provide more evidence that the low inflation breakevens are picking up something genuine rather than risk/liquidity premia (statistical models of underlying inflation tend to use surveys to anchor the estimates).

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So overall the FOMC will be less convinced that they’ve yet met the inflation side of their dual mandate, and has been associated with Fed views of the desirability of seeing further actual inflation rises. That said, Yellen has previously argued that policy needs to be forward-looking, plus she and Fisher (at least) still seem to believe in the Phillips cure.  But it’s hard to see the Fed hiking again before such disagreements are ironed out: consensus will be preferred given the importance of the decision.  This, together with the lagged impact of previous tighter financial conditions and the benefits of operating risk-management monetary policy, underpin my view that the next Fed hike is more likely to come in September rather than June (although I don’t completely rule the latter out) and that in the end there will be two 25bp rate rises in 2016 even if they tomorrow signal three.

Market impacts likely to be limited, risks skewed to limited USD strength against risky FX

Given the above cross-currents it’s not impossible that markets could react with a shrug, concluding that “they’ll eventually move further towards our viewpoint about rate hikes”. Market impacts would be consequently limited in that scenario. But the risks seem skewed to the market interpreting the 25bp downward shift in the dotplot and little-changed Fed forecasts as mildly hawkish (depending on how well Yellen manages to balance the competing factors and not over-egg maintaiing the June rate hike option), which would normally suggest a further repricing of rate hike expectations (probability of a June hike edging up from the current 54%) and limited dollar upside. The important caveats are that dollar strength faces the headwinds of beign adversely impacted by risk aversion and the dollar not having recently benefitted from the repricing of Fed rate hike expectations.

The chart above illustrated that the USD TWI has been substantially weaker than implied by  US-foreign rate differentials.  And that’s particularly the case for USDJPY (see Chart), which once again fell, to around 113, after this morning’s BoJ announcement of lesser focus on rate cuts.  By contrast, both 2-year and 10-year rate differentials imply USDJPY above 120.  That’s a testament to the recent impact of market risk aversion. But it’s interesting that USDJPY has remained weak despite the recent equity price rebound: the 6% rise in the Topix from it’s mid-February low imply USDJPY around 116 (see Chart).  Both facts suggest that USDJPY could bounce on a slightly more hawkish than expected FOMC.  While certainly possible, I’m reluctant to advocate that given: (i) expectations of further BoJ easing may well fade further given polictical-economic constraints (see here); (ii) Yellen may struggle in her attempt to maintain recent positive risk appetite, with greater risk aversion outweighing the interest rate support for USDJPY; (iii) market dynamics seem more favourable to USDJPY downside than upside, although JPY long positions’ rise to an 8-year high suggests vulnerabilities.

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For similar reasons I’m reluctant to advocate EURUSD short positions around the Fed.  The action after the ECB announcement (see here) suggests that the FX market may pay more attention to the potential EUR support from narrowing EA credit spreads than rate differentials in the wake of Draghi’s (somewhat puzzling) signal that further rate cuts are likely.  The EUR has also, in the wake of the ECB’s negative rates policy, become a risk-off currency (albeit signifucantly less than JPY, consistent with the EA’s less impressive net international investment income position).

Rather limited USD upside may be more likely against riskier currencies like GBP, NZD and emerging market currencies, given that likely further repricing of Fed rate hike expectations will be reinforced by any risk-off tendencies from Yellen being interpreted as mildly hawkish. GBPUSD has recently received limited support from boomaker Brexit odds falling back (see here). But the latest referendum poll putting “leave” marginally ahead has seen bokmaker Brexit odds rise back, and the risks seem skewed to further tight polls given the continuing EU migrant crisis and the Boris factor (CBI campaigning for “remain” may take time to offset press support for Brexit). Moreover, GBPUSD is now trading in-line with 2-year rate differentials, which seem likely to fall further with the BoE probably on hold at least until Brexit uncertainties are resolved and the Fed turning (slightly) move hawkish. Indeed, it’s not out of the question that Thursday’s MPC minutes could reveal some initial hints of rate cut discussions (from Vlieghe and/or Haldane).  So the current 16% probability of a 2016 MPC rate cut could grow. Wednesday’s Budget may also further raise market awareness of the UK’s fiscal headwinds, while the labour market release could feature further disappointing wage growth (judging by the BoE Agents survey, reports of continued subdued pay settlements and likely low City bonuses).

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The RBNZ’s surprise 25bp rate cut on 9 March reflected concerns about falling NZ inflation expectations, NZD strength as well as international weakness.  And, unlike Draghi, Governor Wheeler again signalled that “Further policy easing may be required“.  So rate differentials seem likely to move further against NZDUSD: the 80% chance of a further RBNZ rate cut in 2016 seems like an underestimate, with perhaps more than 1 rate cut occurring.  NZD’s exposure to procylical dairy prices underlies it’s risk-on nature. AUD and CAD would traditionally also fall into a similar bucket, but in contrast to the RBNZ the RBA and (especially) BoC have both signalled that they are in no real rush to ease further. AUD and CAD have also been supported by the recent commodity price bounce and more evidence of their domestic economies transitioning (although there remains a long way to go). All three obviously remain exposed to a potential China slowdown, although the recently-announced fiscal and monetary stimulus plans suggest that’s less likely near term (but the furter Chinese debt build-up may well be ampliflying longer-term problems). Markets have consequently been less impacted by recent adverse Chinese data.

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But EM FX has been also supported by the mini equity price recovery, and commodity price bounce, since mid-February (see Chart). Again the corollary is that their risk-on nature will likely count against EM FX as Fed rate hikes approach.  Of course, the situation will vary across EM’s according to their vulnerabilities (weak growth, low inflation, FX reserves, high USD-denominated debt).  But, to take a prominent example of recent EM FX strength (see chart), it’s interesting that the market seems to be revising the view that bad economics/politics is good for BRL, given that a change of government now seems less likely (I discussed Brazil’s macro travails here).  The final chart contains some cross-country metrics on vulnerabilities.

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