June Hike - Weeding Out The Noise
by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
• Since Wednesday’s FOMC meeting, the odds of a June hike have risen. Everyone dissected every adjective, nuance, cat in the hat dot in the plot, and economic projection in order to determine the exact timing of the first interest rate hike. The irony is that the FOMC itself does not know for certain what they will be doing three months from now. There are 3 long months before the June 17th FOMC meeting arrives (with an April meeting in between). Much can happen over this period.
• There are several things that the FOMC knows today, or is highly confident of. FOMC members have stated that they would like to move off of the zero lower bound as soon as possible. Several members have stated that doing so would be welcomed, become it implies that the Fed has achieved its objectives. Of course, this would not be the case if the Fed decided to hike due to the determination that the risks of financial stability have simply gotten too big to ignore. Nonetheless, they have given themselves the flexibility to hike by removing patience. Mission #1 accomplished.
• The FOMC has also likely determined that the pace of the appreciation of the US dollar (USD) was becoming problematic. They probably realized, that should the USD continue to appreciate at the 2015 pace, the impact would affect conditions enough to make a June hike more difficult. Since the FOMC logically expects that a hike would lift the USD further, the FOMC did not want the USD to continue rallying for the next three months before the FOMC even raised rates for the first time. Hence, the primary accomplishment of Wednesday’s FOMC meeting was arresting the dollar’s rise. Mission #2 accomplished.
– The fact that the FOMC acknowledged the downward pressure on import prices and exports supports the argument above. Speculative dollar longs grew to the highest level in history earlier this week. Given economic, and anticipated central bank policy divergences, there were not many fundamental reasons to fight this trend. So far, Yellen was able to halt the upward trend in USD.
• Everything else in the meeting was noise; after all, Yellen’s Fed changed the message in January, again at the February testimony, and then again in March. Much can change between now and June. In the meantime, the FOMC instilled some market doubts and eradicated ‘guidance’, while increasing its optionality and disrupting aggressive speculative dollar longs.
– I addressed the change in the dot plot in Wednesday’s note, but will add that those changes affect the pace and extent of the hiking cycle, and not the timing of the first rate hike.
• The Fed acknowledged some softening of the economy. This helps its USD objective outlined above. There is likely some uncertainty as to how much of the recent (modestly) weak economic data was due to weather, the port strikes, or some ‘regression to the mean’ after two very strong growth quarters. It was probably transitory, but at this point, there is no reason for the Fed to guess.
• Most economists believe that the employment situation in the US is improving and that Q1 is merely a temporary soft patch. To make sure, the Fed says it is ‘data dependent’, while simultaneously trying to be forward-looking to prevent mistakes. (Was this enigma explained by Greenspan Yellen by saying that “removal of patient does not mean we’re going to be impatient”?) Over the past 20 years, FOMC members have said on numerous occasions that ‘current inflation is not something to worry about”. The focus is on inflation expectations two to three years in the future which they believe will be at their 2% objective.
• Since the meeting two days ago, the dollar index is 2% lower, Treasury rates are lower, and the equity market is higher and near record levels. Therefore, should the economy merely plod along, the odds of a June hike are much higher than the market levels indicate.
• Despite very low yields, I believe the long end of the Treasury market remains attractive. Traders and Portfolio Managers typically have time frames shorter than 6 months (often much shorter). Yet, the 2.5% yield on the 30-year bonds scares them away because they think about it as if they will have to hold it to maturity. The security was one of the best-performing in 2014 with a 30%+ return and low volatility.
• As I have been arguing for a while, the 30-year Treasury may be in a win-win environment. If the economy deteriorates and the Fed is on hold, then the entire Treasury complex should remain strong. If the Fed continues to have the conditions to hike in mid-2015, then risk assets will be surprised, and long Treasuries will see inflows. The dot plot will prevent the front end from getting hit too hard which will support the back end. Global growth and inflation expectations should fall further; thus also boosting the backend. Furthermore, long Treasuries will continue to be supported by the push toward corporate pension LDI, particularly if rates rise.
• The USD will likely retrace a bit further and then trade sideways until ‘lift-off’, or at least a higher certainty of such.
• Equity levels have gotten silly and are back in ‘melt-up’ mode, due to a behind-the-curve Fed. This market behavior will only serve to elevate the FOMC’s concerns about the risks to financial instability.
• A few quotes express the situation well. Ex-President of the Dallas Fed said today on TV, “what worries me is that investors have gotten lazy and are totally dependent on central banks”. Three weeks ago Stan Fischer said, “there are numerous cases of people doing un-smart things, and the Fed can’t stop that.” Renown economist Ed Yardeni said yesterday that “this is not investing- it’s all about central bankers -markets are all rigged”
• “In order to attain the impossible, one must attempt the absurd.” Miguel de Cervantes
Regards,
Guy
Guy Haselmann | Director, Capital Markets Strategy
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Scotiabank | Global Banking and Markets
250 Vesey Street | New York, NY 10281
T-212.225.6686 | C-917-325-5816
guy.haselmann@scotiabank.com
Scotiabank is a business name used by The Bank of Nova Scotia
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