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Trader thoughts - the long and short of it

It’s been an interesting session and the market is still trying to price markets accordingly. The event risk started with US CPI (ex-food) coming in at below par 1.7% and this really started the ball rolling, with a keen focus on inflationary trends in the FOMC statement and through Janet Yellen’s press conference.

Market data
Source: Bloomberg

Ultimately, we have seen the Federal Reserve revise down both its 2017 headline and core inflation forecasts by a touch. However, Janet Yellen has faith that the last three soft inflation reads were attributed to ‘off-off reductions in certain categories’ and that these factors would bring down inflation just through the ‘matter of arithmetic’. Certainly, the core of the Fed have a glass half-full approach to inflation, but there is no doubt that if the future inflation reads don’t turn around, like they expect, then the market is going to pile into US treasuries and continue offering USD’s, notably against emerging market currencies like the MXN and BRL.

There has been a predictably sizeable focus on the Fed’s $4.46 billion balance sheet, where the statement around the balance sheet did change enough to provide strategists with a belief normalisation is set to start from the September or October meeting. We understand that once it starts the balance sheet will be reduced by $10 billion per month ($6 billion in treasuries, $4 billion in mortgage-backed securities), with the cap on these reductions rising every three months. The size and scope doesn’t feel like it should shock too greatly, but with inflation trends the way they are, it doesn’t seem thematic of a central bank needing to aggressively hike rates, concurrently with the balance sheet being reduced, which in itself would act as a tightening of monetary policy through reduced liquidity.

In terms of the projections around future interest rate moves, we have seen the so-called ‘dots’ being left largely unchanged, although the 2019 estimate was revised down by 0.125%. These projections of where the future Fed funds rate could have largely been left unchanged, but there has been a pretty strong reaction in the rates and fixed income market. The financial markets reaction has to suggest a dovish shift from the Fed, but I disagree and think at the margin the statement and Yellen’s vision were hawkish, certainly relative to pricing. But we have seen strong selling in the fed funds future January 2019 and 2020 contract, so traders pricing out the prospect of tightening through the next couple of years. To put some perceptive here, interest rate markets are pricing in one hike in 2018 and a 70% chance of another in 2019. The Feds still see three hikes in each year.

The US treasury curve (the difference between two and ten-year treasuries) has flattened five basis points (bp) and at 79bp is eyeing the levels we saw in July 2016. We have also seen inflation expectations fall, but less than nominal yields and this has seen a decent pop in real yields. One suspects this is why gold has found sellers on the session. The USD was initially sold aggressively, with the strong buying in fixed income, with USD/JPY trading from ¥110.31 to ¥108.83, but buying has emerged and I would not be surprised to see this back about ¥110.00 soon.

Interestingly, despite this move higher in ‘real’ yields, we have seen equities hold in well, with only modest selling seen at an index level on the S&P 500, Dow Jones and NASDAQ 100. Equities will have found some confidence that the Fed seem to believe all will be ok in the months to come, with credit spreads didn’t rally move in any great capacity.

The wash-up is that we are expecting a weaker open with our ASX 200 call sitting at 5810, with SPI futures lower by 30 points. Energy stocks will have a tough day at the office, with oil getting smashed 3.5% on higher gasoline inventory (stockpiles +2.09 million) and we see US crude trading into the May lows now. Will OPEC jawboning ramp up from here? It’s certainly a risk if short the barrel.

Iron ore has seen a better session, with spot closing up 2%, while stability has been seen in Dalian futures. Vale’s US-listing closed -0.6%, but BHP looks set to be impacted far greater by its exposure to crude, with its American Depository Receipt closing down 2.5%. Aussie banks will drive the outright performance of the market and we may see some modest weakness in this space on open, but it will be interesting to see if the buyers step in given the recent momentum. Health care is the trade du jour, with the ASX 200 healthcare index breaking out to new all-time high yesterday. Any weakness here should be short lived.

All eyes on the AUD today though, with May employment data due at 11:30am AEST and markets expecting 10,000 net jobs to be created and the unemployment rate to remain at 5.7%. AUD/USD has traded to $0.7636 on the initial Fed induced move but has fallen back below the 76c level. The daily chart looks bullish, but of course, the unemployment is highly unpredictable so the AUD/USD could be at $0.7650 or $0.7525 by the end of the Asia trade.  

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