A hawkish hold, with long-term dovish bias

Does the investment community have the necessary foresight to invest again after we have heard from the Bank of Japan’s ‘comprehensive assessment’ and the Federal Open Market Committee (FOMC) meeting?

  • There has been clear guiding of expectations for a December hike, although the Federal Reserve (Fed) are certainly not committing and the committee looks as confused as ever. Three members voted (Mester, Rosengren and George) for a hike at this meeting, which is quite rare to see this level of dissent.
  • One interesting development was the lowering of the median longer-term ‘terminal rate’ to a range of 2.75% to 3%. This was expected to stay at 3%, and this rate is what many businesses will use to calculate the Net Present Value (NPV) of a future investment. A lower rate therefore increases the prospect of business investing in future projects.
  • The median estimate of future hikes (the so-called ‘dot plots’) signal one hike this year, followed by two in 2017, and three going forward. The market, however, gives this pace a low probability.
  • The implied probability of a hike in the December meeting moves modestly higher to 60%. This is below the 70% level that the Fed would ideally like to see and shows the market is yet to be fully convinced of a December hike.
  • The S&P 500 tells a positive story, with the index closing up 1.1%. 94% of stocks rose with energy, utilities and materials working well. Volumes were 13% above the 30-day average.
  • Volatility has been crushed, with the VIX down 17% to 13.2. Emerging markets are flying with EEM (EM ETF) +2.5%, and good gains also seen in the high yield bond market.
  • The US dollar has fallen 0.5% on the session. AUD/USD hit a session high of $0.7630 and looks set to test the August highs of $0.7750.
  • USD/JPY is eyeing a break of ¥100.00 and while the USD has been sold since the FOMC meeting, USD/JPY actually started falling during early European trade. Expect the Nikkei to find sellers on open.
  • Commodities have been well bid on the news, with gold up $18 at the time of writing.
  • The ASX 200 looks set to open 5376 +0.6%. Expect energy and mining stocks to outperform.

If we assess price action it does seem that many are now happy to invest in Japanese banks, and while the Fed has given as strong a signal of a hike in the December meeting, US stocks still soared.

The Fed are certainly not committing to a December hike, but when you see three members dissent in favour of a hike at this meeting, you know it's close. Importantly, at the same time, you hear that the risks are now ‘roughly balanced’, while they talked about being ‘on hold for the time being’. They want to hike in December, but if something adverse happens in the next month or two that impacts the already flagging market-based inflation expectations, they won’t hesitate to push this call back. The market knows this, hence the interest rate market is reluctant to price in a higher chance of a hike.

On the point of inflation expectations, they have detailed that they will continue to ‘closely monitor’ developments here.

So all-in-all, for a central bank that has given the green light for a December hike, Janet Yellen would certainly be feeling pretty good about the fact that the USD has fallen, US treasury yields have also fallen, the S&P 500 has rallied fairly strongly and eyeing a test of the all-time high and implied volatility has been smashed. Emerging markets have certainly appreciated the reaction, however one has to feel for the Bank of Japan (BoJ) who moved away from a quantitative policy (ie. targeting an explicit level of base money expansion) and onto an interest rate policy. They even committed to allowing inflation to overshoot, providing them flexibility to ease policy further. However, USD/JPY is perilously eyeing a break of ¥100.00 and the Nikkei looks set to open 1.2% lower, presumably not helped by a shift towards supporting the TOPIX (Tokyo stock exchange) and away from purchases of ETFs that track the Nikkei.

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