Trader thoughts - The long and short of it

The initial reaction to the Federal Reserve’s (Fed) statement was largely an expression that a number of funds were expecting a more hawkish tilt and we can clearly see that some market positions have become quite stretched.

US Flag
Source: Bloomberg
We were never in doubt that the Fed would hike by 25 basis points (bp) to a range of 75-100bp. In order to match the expectations and push the USD and US Treasury yields higher, we were going to need to see an increase in the ‘dot plot’ projections and the median projected path for the US Fed funds rate to four hikes for 2017 and 2018. That certainly didn’t happen, although the median estimate for rates in 2019 has been increased by nine basis points. There have also only been very modest tweaks to its growth and inflation forecasts.
 
We can also see Minneapolis Fed President Kashkari dissented, with a view to keeping policy unchanged. He is now the outlier dove on the board (with James Bullard), so traders and strategists will know exactly what to expect at future scheduled speeches.

We have seen a slight upgrade to its view on business investment, which seems fair. Although the Fed see inflation ‘moving’ to target, they stipulated that the committee will carefully monitor actual inflation developments relative to its ‘symmetric inflation goal’. One could argue this seems even a touch dovish, as it effectively signals that the Fed feel there are risks of inflation moving above its target of 2%. They are indirectly urging market participants to focus far more heavily on core inflation or personable consumption expenditure (PCE), given the volatility and unpredictability of energy and food prices.

One can look at the interest rate markets and see that the Fed funds future is not fully pricing in a second hike this year until September, with June a 50/50 proposition. It really does suggest the Fed hurried this hike through to take advantage of favourable equity and credit market pricing. If we see a hike in June will be due to how credit and equity perform, but of course, whether the economic data stays firm or rolls over from here is uncertain.

Aside from interest rate pricing, there has been a strong reaction through the US fixed income curve. However, we should consider that net short positions on five-year treasuries hit the second highest level of all-time at -411,576 contracts. It’s this point that partially backs my argument that some traders wanted four hikes in 2017 and 2018 as the Fed’s expected base case. So one can assume that we have seen some strong short covering today, with the five-year treasury falling ten basis points to 2.00% and in its wake, the USD has been sold fairly hard. USD/JPY has dropped over 1% and that will clearly be a headwind for the Nikkei on open later today.

Perhaps the big beneficiaries of this meeting have been all things emerging markets. The EEM ETF (iShares MSCI emerging market ETF) is up 2.6%, while in the FX market, the South African rand and Mexican peso are flying. AUD/USD is pushed up 1.7% and the pair is eyeing a move back into the $0.7700, largely helped by the fact many consider it to be the proxy of emerging markets in the G10 currency bloc.

On the commodity front, gold is where much of the buying has been centred in commodity land, although oil is up nicely on the session too. The S&P 500 energy sector is up 2.1%, so one can also expect a similar move in the ASX 200 on open. In fact, more broadly our call for the ASX 200 sits at 5815 (+42 points or 0.7%) and will be eyeing a re-test this week of the recent double top of 5830.
 
The S&P 500 and Dow Jones have set a positive tone, backed by a reasonable contraction in credit spreads. For equities, this Fed meeting was about as favourable as we could have hoped for – risk appetite should be supported, although the European political scene and the Organization of the Petroleum Exporting Countries (OPEC) meeting on 25 May pose genuine risks to that view. We even have iron ore up over 3% and BHP’s ADR (American Depository Receipt) is up 1.8%.

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