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US data will be key

On March 18 Janet Yellen pulled off a masterstroke by altering Fed guidance on monetary policy from calendar-based guidance, to a pure data dependant model.

Federal Reserve
Source: Bloomberg

She did so while managing to halt the USD rally, in turn supporting the S&P 500 and many emerging markets.

Enough doubt was injected into what was (and still is) a very crowded trade that investment banks such as HSBC revised its 2016 and 2017 forecasts in EUR/USD to $1.1000 and $1.2000 respectively.

From now on, every piece of US economic data and some key international data points will be micro-analysed to shape views on when the Federal Reserve will target a higher fed funds range. The first hike is likely to start in September, although could in theory happen at any meeting from April after the removal of the bank’s ‘patient’ stance. For June to come into play, we are going to need to see something fairly remarkable from wage growth in the March payrolls report on 3 April and that seems a low possibility.

The cautious stance shown in the March FOMC meeting seems absolutely warranted given Q1 is shaping up to be a repeat of 2014, whereby poor weather and a strong decline in energy exploration has caused a collapse in growth estimates by economists ‘tracking’ models. We don’t get the Q1 GDP read until 29 April, but I would say that is looking like we could see annualised growth of 1% to 1.5%, down from 2.2% in Q4. However, just like 2014, economists are expecting a snap back in Q2 to around 3% and higher. This should also coincide with a basing in core PCE (personable consumption expenditure) and subsequently pushing into the Fed’s own central tendency of 1.35% by year-end and 1.7% (range of 1.5% to 1.9%) in 2016.

Recall the Fed need to be ‘reasonably confident’ that inflation will move back to its 2% objective before they lift the federal funds target range. On the other side of the Fed’s mandate is full-employment and if the current monthly average (over the last 12 months) continues and as long as there isn’t a deterioration in the participation rate (currently at 62.8%) then  the US employment rate should be easily below 5% by year-end.

Personally, I feel the US central bank are most cognicent of potential moves in the US bond market, which have a natural knock-on effect on the USD and volatility in general. The so-called ‘taper tantrum’ in mid-2013 would still be fresh in the Fed’s mind. Recall, this is where the market panicked at the idea of the US economy was not ready for an end to quantitative easing causing the US ten-year treasury to move aggressively from 1.61% to 3% in around 90 trading sessions. The Fed, along with the other high income countries and emerging markets will be keen to avoid a repeat.

With this in mind the Fed’s own projections for where they see the federal funds rate at a specific date (the so-called ‘dots plot’), are showing massive divergence between the Fed’s median forecast for the funds rate and current market pricing. However, this has been the case for some time and the Fed actually brought their forecasts closer to the market in the March meeting.

Most in the market see the ‘dots’ as somewhat of a failed experiment in its communication policy, but it seems logical that if you believe US growth will recover, then at some stage this divergence will close and should put upside in the USD, with bond yields likely to rise. The speed and aggression by which they do will determine if stocks find better sellers.

To put things into perspective, the median projection for the fed funds rate in 2015, 2016 and 2017 is 0.625%, 1.87% and 3.12% respectively. However, at the time of writing the fed funds future (an interest rate instrument) is priced at 0.38%, 1.05% and 1.57% basis points respectively.

The other question traders and investors alike should be asking is ‘how will the Fed actually raise rates’ when the time comes?

This question is the subject of much debate and widely misunderstood by many in the market. There seems to be growing consensus that the Fed will dictate short-term money market rates, or the fed funds effective rate, by using a targeted range. For example, say in September, they suggest targeting a range of 25 to 50 basis points. By utilising and increasing the rate of interest paid on excess reserves (IOER) as the ceiling and the rate paid on overnight repo rate (O/N RRP) as the floor, they can move both up asymmetrically and short-term money market products (like US T-bills, repo’s and commercial papers) can fluctuate within this range.

This is a complicated issue and one that will get much more attention as it has a huge impact on the demand for reserves. In turn, US financial conditions will tighten, however this should be largely be offset by the strengthening economy. Bear in mind that the US will be the only developed market economy tightening rates when the time comes, while the likes of the Bank of Japan and European Central Bank continue to target radical balance sheet expansion. Higher US bond yields should also attract capital to the US as investors seek out yield, but as we have heard quite clearly from the March meeting, the Fed are happy with a rising USD, but will not tolerate a USD that is appreciating at such a rate.

The USD is still the best house on a fairly bad neighbourhood, but traders are going to have to work harder to achieve gains going forward as it won’t be so one-sided. Looking at the crosses, taking the USD out of the equation, can be very beneficial in this environment.

 

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