It certainly looks to have been the right call, although many will look through the fastest pace of wage growth in six years (+2.5% year-on-year) as predominately calendar effects. Still, the market and the sell-side economists, who recently pushed out their calls for a March hike, have mostly pulled back their view for a December hike. The Fed funds future (December contract) is pricing a near 70% probability of a move, so there could be some further juice in shorts positions if it is adamant they will move on December 16.
I would throw caution to the wind about getting too bullish on the US though as the debate on the desks has somewhat shifted. Three quite poignant questions worth highlighting are:
- With the US dollar index (DXY) breaking out and the Fed’s preferred trade-weighted USD testing 12 year highs, how does the Fed control the USD and specifically the impact that the rate of appreciation has on financial conditions?
- Will a hike lessen the need for other central banks (such as the European Central Bank, the Reserve Bank of Australia and Bank of Japan) to be aggressive with future easing?
- Perhaps most importantly, and something Janet Yellen touched on in her recent Congressional Testimony, what is the path or extent of future hikes in 2016 and 2017?
The first question seems to be a matter of the Fed’s ability to communicate to markets. In theory we are likely to see what is potentially the most dovish monetary policy tightening event in history! However, and as seen very clearly in the bond market, as long as the US bond market underperforms and the yield premium moves in favour of USD longs, then the Fed will be powerless to curb the USD inflows without another strong bout of verbal intervention. This has been seen specifically in EUR/USD, where it seems Mario Draghi has gone after increasing the US treasury/German bund spread with a view to lower the EUR/USD exchange rate. As long as US yields are going up (and underperforming), then the USD will find buyers on any dip.
As always, it the rate of change in exchange rates that central banks will be keen to watch as it is really only speculators who like to see one-way, aggressive price action that ultimately causes strong trends with minimal pullbacks. Reserve managers, exporters and real money accounts want to see decreased volatility and limited range expansion – specifically for hedging reasons. It’s for this reason I would be taking some profits on short EUR/USD trades, although I still expect the European Central Bank (ECB) to ease again in December despite a 5% deprecation since the recent ECB meeting. So selling EUR’s at slightly higher levels makes a lot of sense to me.
The USD is going higher though, and the speculative community clearly expressed this last week by increasing their USD exposure in a big way. This strength will have implications on the S&P 500. It has been thoroughly pleasing to see good news (strong job creation and better wage growth) result in buying of equities after the initial sell-off on the data print. Asia has even seen a fairly logical pattern emerge today, with selling of emerging market currencies, while the Nikkei has continued to push higher. This is the momentum play in Asian equities at present, specifically for those who haven’t found the confidence to wade back into the Chinese markets. The Nikkei continues to break key levels and the trend is your friend here as traders use the Nikkei as a quasi-hedging vehicle against Fed hiking. S&P futures have held firm and are not giving a view that US and Europe should be overly concerned about the open.
Chinese equities have been fairly subdued despite news they are allowing firms to once again tap the primary market for capital and worrying trade data. As someone pointed out to me, the Chinese market has seen a bull market, bear market and a second bull market all in one year with seven weeks still until the end of the year. Although, if you’re looking for real volatility then Bitcoin takes first prize every day, with price falling 28% in a 24 hour period last week!
The ASX 200 has been the big underperformer in the region today, trading below last week’s low, although volumes are not particular high. I would certainly put this down to domestic factors, rather than genuine concern about the Fed starting to normalise policy. There have been many questions asked about domestic companies with BHP as a key one and the impact on top line growth, as well as the progressive dividend policy in the wake of the tragedy in Brazil. While there really seems to be growing concerns around capital city house prices, notably in the wake of another drop in the Sydney and Melbourne auction clearance rates. Real estate investment trusts and banks have found good sellers.
It’s worth highlighting that the ASX financial sector/health care sector ratio and the ASX material sector/health care sector are both at all-time lows and showing strong trends. In this market, being long in the health care sector, especially with a falling AUD and short mining or financials makes a lot of sense on multiple time frames.