Trader thoughts - the long and short of it

The Federal Reserve has given us a clear message that, barring some sort of collapse in sentiment in the next few weeks, March is good to go to hike the Fed funds rate.

Market data
Source: Bloomberg

The narrative perhaps even throws weight to the camp that we could see hikes in August, September and December too.

We can see in the lead up to the FOMC statement (at 6:00am AEDT) that other US economic data points had been trickling in, with a solid print in Employee Compensation Index (0.6%), the Chicago manufacturing PMI (65.7) and ADP private payrolls report (234,000). Pending home sales coming in as expected at 0.5% M/M in December. All good numbers and should go some way to help mitigate poor reads in both tonight’s (2:00am AEDT) US ISM manufacturing report and the non-farm payrolls (Saturday 3:00am AEDT).

However, it was Janet Yellen’s last meeting at the helm of the Fed which is what the market was most interested in and the wash-up of the statement is that the market is now fully discounting a hike in the March meeting. US rates and bonds actually saw a reasonable move going into the FOMC statement, with some focus on the US Treasury Department having to increasing borrowing of long-term debt this quarter to $66 billion and some focus on increased supply coming in next week’s auctions.

However, the change in Fed’s language went some way to validate the sell-down and we can look out the interest curve we can now see Eurodollar futures pricing in 83 basis points (bp) of tightening from March 2018 through to March 2020, although this yield spread had initially widened some 5bp on the day to 86bp - a decent move by any standards. We can look into the future and see that the market has increased its expectations specifically for hikes in 2019 by 3bp to 31bp and this change in rates pricing has helped support the USD.

Moves in the US Treasury market have also been widely noted, with most of the selling taking place in the 5 and 7-year part of the curve. Naturally, the US 10-year Treasury has caught the attention of most, with yields pushing into 2.75% (+4bp on the day) and the highest since April 2014, although the bulls have waded in and yields are back to 2.71%. So signs of sell the rumour, buy the fact here. It is certainly worthy of note that the yield advantage to hold Aussie 10-year Treasury’s over US 10-year Treasury traded down to 6bp, which was the lowest spread differential since mid-2000, and we find this spread currently sitting at 8bp and its not surprise to see AUD 0.5% lower at $0.8055, although one could argue this is still too high.

Perhaps the key take away from the statement is that the Fed have altered the language that inflation is remain “somewhat” below 2%, and we can now see that they see economic activity as “solid” and importantly that “Inflation on a 12‑month basis is expected to move up this year and to stabilize around the Committee's 2 percent objective over the medium term.” This is in-line with the markets own view, where we can see inflation expectations moving higher of late, although one could argue this has a lot to do with moves in energy. We also saw slight upgrade to the Fed’s views on business investment and the overall statement seems to have been well suited to mark-to-market their views to the underlying dynamics in both the economy, as well as extremely loose financial conditions.

US equities found sellers on the statement, moving inversely to the initial move higher in bond yields, although it could have been worse if we had seen ‘real’ yields moving higher. However, as it is, the 10-year ‘real’ (or inflation-adjusted) yield is actually slightly lower on the day. We can ultimately see the S&P 500 sitting unchanged at 2823, with Aussie SPI futures actually some 6 points higher in the night session. Our ASX 200 opening call therefore currently suggests an open at 6041, and we can see both CBA and BHP ADR (American Depository Receipt) pretty much unchanged in US trade. Looking at the various sectors in the S&P 500, by way of a guide, and aside from a decent move higher in REITs, there is no clear guide for us today and understanding where the ASX 200 goes after the unwind is anyone’s guess. One could argue the positive flow seen yesterday could spill over today, but there is little conviction here.

I had suggested yesterday that there was little in the lead to inspire buying and that view was clearly incorrect. That said, the move higher in the ASX 200 was partially technical, with the bulls happy to defend the 6000 level, which has become a floor in the local market this year. The fundamental catalyst being the slightly below consensus Q4 inflation print and we really have to look at the interest market here to understand the logic, as the market had clearly gone into the inflation data feeling that an above consensus print would be significant and enough for the RBA to alter its stance to a more hawkish bias. We can see rate hike pricing for the May meeting dropping from 5.5bp (or a 20% probability) of hikes priced to 2.5bp (or 10%) and for December we now have 21bp of hikes priced, down from 28bp. A decent re-pricing for a modest miss, and it’s no surprise therefore to see the ASX 200 stage a reasonable relief rally. It’s clear the equity market has voted and said Australia is not quite ready for rate hikes.

Looking around the markets we can also see a largely unchanged read in commodities, with US crude sitting up 0.2%, while gold looks interesting, having traded to $1332 after the Fed statement and with traders buying back into US bonds we have seen the metal rally 1% up $1346. Copper is trading flat at $3.20 p/lb, with spot Iron ore also largely unchanged.

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