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Much discussion has centred on whether the 1.3% move on the S&P 500 (with 91% of stocks gaining) was the result of markets being comfortable with a September hike.
Firstly, US data clearly didn’t promote a hike in the fed funds rate this week and, if anything, should delay one. This fits with the predictions I made yesterday in my FOMC playbook.
Yes, August retail sales were fairly upbeat and should support Q3 growth numbers when released (29 October). However, Industrial production fell 0.4% and the NY manufacturing collapsed to -14.67. Bill Dudley (the NY Fed president) has recently talked about a September hike being ‘less compelling’. Clearly, he will not be enthused with the NY data and could push for a December move.
Still, the story of the night has to be the moves in US fixed income. Two days before the Fed meeting and we’ve seen the 2-year treasury spike seven basis points and five-year move 10bp on what was effectively positive news for the bond market! The 2-year treasury has broken out to the highest level since 2011, which is crazy considering the implied probability derived from the fed funds future increased a modest 2ppt to 30%.
The moves look like pure pre-positioning ahead what is perhaps the most anticipated macro event for many years. While pricing is low, it wouldn’t be a massive surprise if the Fed hikes this week. Still, you don’t want to get caught long treasuries.
On the point of market pricing, there have been discussions about how the Fed held off in the last two rate hike cycles (1999 and 2004) until the implied probability (priced into markets) moved well above 50%. In both cases, it was above 70% when they came to raising. Could this be a factor this time around?
The VIX fell 7% to 22.5% as a result of the ‘risk on’ move and traders reducing hedges, with implied volatility in the bond market increasing a mere 2% - hardly a market concerned about a near-term hike. The Bloomberg US financial conditions index (monitors credit spreads, money market pricing, treasures, implied vol, S&P) improved from -19bp to -0.06bp. This is significant as I know the Fed are looking at financial conditions as a key catalyst for raising rates and we are now almost back to expansionary financial conditions.
When the level of reserve liquidations outweighs that of the excess liquidity generated by central banks (the levels currently produced from the ECB and BoJ equates to around USD135 billion), you get a tightening of financial conditions in markets. It’s for this very reason I feel we have seen massive volatility in global markets.
Asian markets are generally bid today and it’s not often you see the Chinese markets being the least volatile market in Asia trade, although I suspect that will change on Friday. The ASX 200 is reflecting the strong US lead, despite the fact we have seen a strong bias to be long (67% of all open positions are held on the long side). Also, if you look at the correlation between the SPI futures and S&P 500, they are moving in lockstep – expect this to continue until next week.
The USD has gained 0.4% against the basket of currencies overnight but we have seen very light ranges during Asia – USD/JPY is epitomising this with a 25-point range in the last 10 hours. AUD/USD continues to respect the May downtrend (currently seen at $0.7170). A 0.7% decline in iron ore futures is helping curb the upside. Short GBP/AUD has been getting attention too after closing below the May uptrend and I would specifically be looking at shorts on a close below the 28 August low of AUD2.1400 for a move into A$2.0800.
All in all, the moves in markets suggest significant pre-positioning from traders, with a general view that Janet Yellen will appease risk assets no matter what happens. At the end of the day, the Fed now have an unofficial third mandate to promote stability and I get the sense traders feel they can raise the fed funds rate and Yellen & Co will do whatever it takes to sell the idea that this is not a negative for markets.