It all seems so simple, doesn’t it. The Fed is on track to hike rates; the ECB, if anything, is gearing up to print more aggressively. It’s with that in mind that the market’s reaction to the latest FOMC decision is quite remarkable.
Expectations had been building for the Fed to send a stronger signal that a rate hike was imminent. Instead, Fed chair Janet Yellen did no such thing. She reiterated that rates would likely remain low for a long time after quantitative easing ends, likely next month.
In fact, she offered the market nothing in terms of the timing for the first hike. Even so, the US 10-year yield spiked six basis points or so to 2.62 per cent and the dollar index rose another 2/3 of 1 per cent.
That move appears to be in response to the rate forecasts of the FOMC participants widely assumed to be slightly more hawkish. For what it’s worth, I don’t necessarily think that’s right. Sure, more now think that the Fed funds rate target will end 2015 higher than 1.5 per cent. Yet at the same time, more also think the target will end 2015 below 1 per cent. Let’s face it: it’s the doves that are in control of the Fed.
In any case, none of that says anything about timing. The way I see it, the Fed is being stubborn about things and digging its heels in. Jobs growth is surging, the unemployment rate has plummeted and the ISM index, which is the best lead indicator of the US economy, is around its 30-year highs. The strong data flow is the reason why many in the market rightly thought the Fed would hawk it up. They should. That they didn’t is a message in itself.
Two sentences are important in that regard. Firstly, the Fed, instead of highlighting all of this strong data, noted that “a range of labour market indicators suggests that there remains significant underutilisation of labour resources”.
Secondly, the FOMC suggested that “inflation has been running below the Committee's longer-run objective. Longer-term inflation expectations have remained stable.” Adding to that, the Fed funds rate will remain in its current range “if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored”.
Now consider that over the past couple of months, we’ve seen a 6 per cent appreciation of the US dollar index to its highest level in about a year. The euro has slumped about 8 cents, the dollar-yen is at a six-year high and the little Aussie battler has followed suit, slumping below 90 cents for the first time in about 6 months. These are material events. If that trajectory is sustained, the world the market thinks exists now is going to change markedly.
Exchange rates matter for inflation, even if just for a time. Across the Atlantic, the European Central Bank attributes a good chunk of the sharp fall in European inflation, to exchange rate moves -- perhaps 0.5 per cent or more -- and that could well be an underestimate.
Remember it was only a year ago that that inflation was well over 1 per cent. A few months prior to that, inflation was at the top of the band. Cue a 9 per cent appreciation of the euro, and CPI slumps. Back to the US, and at the same time euro is rising and inflation falling; the dollar index is falling and inflation rising. The CPI hit a high over 2 per cent in June, while the Fed’s preferred and slower moving measure was at 1.5 per cent (from a low of 0.85 per cent). An upward trajectory either way.
But then the USD surged 6 per cent in the space of two months. We’ve already seen the dramatic influence of that move on US CPI inflation, which fell 0.2 per cent in August -- coincidentally, the first fall in about a year.
This brings the annual rate down to 1.7 per cent from 2 per cent. If the US dollar continues to lift or even stays where it is, that annual rate will continue to come down.
If I’m right, then the Fed are going to have all the ammo they need to keep the target funds rate unchanged for a lot longer than the market now expects. I doubt that they will be quick to signal any change to the market; I suspect the Fed and US policymakers are quite happy with a stronger US dollar doing some of the heavy lifting for a time. So I don’t think they’d want to say anything to the market that would change this.
Conversely, for the ECB, the slumping euro has the opposite effect. It will stimulate growth, lift inflation and alleviate the need for the ECB to deliver more stimulus. We may even see the Bank of Japan ease off a bit on the printing presses.
There are a lot of ifs and buts here. This latest USD spike is relatively new and based on expectations of a Fed tightening. I’m not seeing too much that will change these expectations in the near-term, so there’s a good chance things will play out as I’ve outlined above.
Eventually that will lead to a shift in central bank rhetoric and a seismic shift in market pricing: bunds to sell off, Treasury bonds to rally, US dollar down, Australian dollar up, equities up etc. The swings could be wild.
At this point, I’m not looking for that to occur until later this year/early next, so as to allow plenty of time for exchange rate moves to do their thing and inflation rates to change (lags could be lengthy). As I outlined in in my piece (Global rates to rise in 2015? Not likely, August 19), I don’t think we’re going to see much action until late 2015 -- recent market moves and Fed rhetoric would appear to support that view.