While most will still be expecting a continuation of their bond purchases and an extension of the program, which ends in March 2017, one questions if we could actually see this program being unwound somewhat or tapered in coming meetings! If we bring it back to markets, Mario Draghi has lost control in fully influencing the EUR, but his objective was always to lower borrowing rates for corporate and sovereigns, and place more emphasis on promoting fiscal policy – from that perspective the ECB have done a great job. It’s just a shame that there is a lack of demand in Europe for credit and it’s hard to agree with Mario Draghi in that the ‘monetary policy transmission has never worked better’.
ECB inaction increases the chance of US Federal Reserve (Fed) action
It’s interesting that there has been a slight tick higher in the implied probability around hikes from the Fed, with the prospect of a September rate hike increasing to 28% (from 22%) and December at 59% (from 51%). While the implied probability has increased somewhat, it’s still worth remembering that the Fed tends to like markets to have priced in at least a 60% probability before moving to keep market volatility to a minimum.
If they do hike it won’t be down to being data dependent as they keep detailing, but a reverting back to a similar mindset as December 2015 – raising to save face. Either way, the market is gearing up to a speech on Tuesday morning (03:15 AEST) from Fed member Lael Brainard. Her view could hold many clues for traders on how Janet Yellen and the core see the world. Expect markets to be very sensitive to her rhetoric as she is very influential.
Importantly, the Federal Reserve themselves have detailed time and time again that they are data dependant, but the data of late clearly suggests staying on hold for some time to come. We saw a fairly benign payrolls report, but the Fed have a broader labour measure called the Labor Market Index and this has actually turned negative. Marry this with a service ISM report which is the lowest since 2010, manufacturing in contraction and a sizeable drop in August auto sales and there are some question marks around just how strong the US economy is.
To put US growth into perspective, we saw GDP at 0.8% in Q1, 1.1% in Q2 and it wouldn’t be a surprise to see a snapback in growth, taking the Q3 rate above 3%. So for the Fed’s estimate of 2% annualised growth for 2016, we would need to see Q4 growth close to 2.5%. One suspects that may a tough ask, especially if the USD rallies, which would happen if the Fed pulled out a surprise hike in September.
Importantly, inflation expectations have actually started to rise, although remains at fairly subdued levels. Core inflation has been stuck at 1.6% for five months and this will ensure that if the Fed do hike this year, it will accompanied with calming rhetoric that suggests the pace of future moves will be very gradual.
So why does a hike matter?
In many minds, the biggest risk to financial markets is a policy mistake from the Fed that causes a sharp sell-off in the bond market, in turn causing a wave of buying in the USD. USD strength is important not just for the direction of key commodities that feeds directly into inflationary forces, but will also pose a strong headwind for wider economics and corporate earnings. It has a far reaching impact in global economics given the level of USD borrowing, notably in emerging market Asian countries. So as the USD rises so does the risk premium for holding emerging market assets increases. One can be assured that a sharp pick-up in emerging markets will hold sharply negative ramifications for the AUD.
So in conclusion the Fed may use the September meeting to lay a frame work out for hikes in December, while offsetting this by saying and hikes will be super gradual. I feel this remains a mistake and they should allow inflation expectations to push higher before raising.
USD basket – On the daily chart we can see a fairly defined triangle consolidation, with trend support seen at 9447. A closing break of this level and importantly the 18 August low of 9,404 would suggest short positions, potentially testing the May low. It’s tough to be excited about the upside until we see a break of 9600.