by Marc Chandler
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Surveys show that around 90% of primary dealers and economists expect the Fed to raise interest rates in the middle of December. Over the past month, the two-year US note yield has risen by nearly 37 bp to 91 bp. The implied yield of the December Fed funds futures contract has risen by 4.5 bp to 21.5 bp at the close before the weekend. It is the highest yielding close in more than a month. It fully discounts a 25 bp rate hike, IF one assumes that the effective Fed funds rate will average 30 bp (instead of the midpoint of the new range).
To drive home the point that the cycle will be limited and proceed gradually, the Fed may provide sufficient liquidity to keep the Fed funds rate below the midpoint. In addition, given the importance of the IOER tool (interest on excess reserves) in post-lift-off environment, preserving the widest reasonable gap between IOER, which is set at the top of the Fed funds range, and the effective Fed funds rate would maximize the Fed's control. No one, of course, knows with confidence where the effective Fed funds rate will trade within the new range. We have not experienced this before.
Many observers suggest that the data to be released in the holiday-shortened week ahead could solidify expectations of a Fed hike. We wonder if that assessment is valid. First, expectations in the surveys cannot solidify more, and it is not clear that the December Fed funds contract must. Second, and more importantly, it seems to mistake the shift in the burden of proof revealed in the October FOMC statement. Rather than the economy having to do this or that to convince the Fed to hike rates, it is more that the Fed is ready to go barring an unexpected shock.
Such a shock will not be evident in the data that are being released in the coming days. Due to a more recent data, the estimate for Q3 GDP will likely be revised from 1.5% to at least 2.0% and perhaps a little more. With slower labor force and productivity growth, trend growth in the US is estimated to be close to 2.0%. Growth in the current quarter is tracking a little better than this.
For the past several quarters, household consumption has been fairly stable. This is set to continue into Q4. October personal consumption expenditures are expected to have risen by 0.4%, which matches the six-month average. The PCE core deflator, which the Fed targets, is expected to rise to 1.4% from 1.3%. If so, this would be the quickest pace since last November. Rising shelter and medical costs seen in the CPI data may also be evident with the core deflator. Separately, durable goods orders are expected to snap a two-month decline. The internals is also likely to have improved.
There is no data from the eurozone that could offset the powerfully dovish signals by ECB President Draghi ahead of the weekend. That it will "do what it must" will go down in the Draghi lexicon. There were two elements for investors. First, the staff forecasts are important. They inform officials where it stands relative to its target. The forecast for inflation will likely show that the ECB medium term inflation target is unlikely to be reached. What follows from this is that the ECB has to do more to satisfy its mandate.
Second, Draghi emphasized that all of its tools will be used to achieved its goals. There are four relevant ones: the length of the program, the pace of purchases, the composition of those purchases, and the deposit rate. Draghi suggested that a lower deposit rate could facilitate the efficiency of the asset purchase program.
The September 2016 end-date was never very hard, so its movement would be a small concession. The ECB could increase its purchases by around 20 bln euros to 80 bln a month. Increasing the number of agencies that qualify for QE are already gradually been taking place, but to buy sub-sovereign debt would be a new step. In particular, given the relative market developments, free up more German assets that could be purchased. Initially talk centered on a 10 bp cut in the deposit rate, but to get ahead of the curve, a larger move may be necessary. There is increasing talk now of a 20 bp cut.
The flash November PMI, money supply and lending figures, and Spanish preliminary CPI do not have the heft to alter the ECB's assessment. The region's composite PMI and GDP have been remarkably steady recently. Lending growth pay has picked up modestly, but it remains anemic. Spain has been experiencing deflation, but the economy's strength has been among the best in the region. Deflation pressures may have eased. It will likely have little consequence. Focus is on Catalonia's push for independence and next month's elections.
One should be forgiven for thinking that new inflation information could spur the BOJ into more action. However, we continue to advise to look past the core rate, which excludes fresh food. This is the formal target, but to help guide policy in such a difficult time, it is clear that top BOJ officials are more nuanced than many analysts and media appear to appreciate. Excluding food and energy, Japan's CPI is a little more than 1%.
Moreover, some officials argue that rent deflation is not a cyclical phenomenon and may need to be excluded, which would raise underlying inflation toward 1.4%. While this is below target, it is not the kind of level that fosters a sense of urgency.
Moreover, despite the often repeated claims, Japanese officials do not regard the two consecutive contracting quarters as a "technical recession" (whatever that really means). If they thought it was a recession, they would respond. The small, inventory-led decline in Q3 is largely seen as an unfortunate statistical quick and a poor optic around such low trend growth.
The Autumn Statement is the highlight from the UK. It is not expected to have market impact. The 0.5% first estimate for Q3 GDP is subject to revision though we do not expect it to be changed. If it is, we would be over rather than under. Sterling's decline from the year's high near $1.60 at the start of H2 has coincided with a push back in interest rate expectations. The December 2016 short-sterling futures contract has seen a decline in the implied yields from 150 bp to 83 bp at the start of November. It finished last week near 90 bp. While we expect sterling to fare better than the euro, the gap between Fed and BOE appears to be considerably longer than many have been anticipating. This means that the forces of divergence will be a weight on cable.
The Australian dollar rose a little more than 1.5% last week. Copper prices fell to new six-year lows. The price of gold was at fresh five-year lows. Iron ore prices were also at multi-year lows. Still, technical and fundamental considerations fueled the Aussie's recovery. Technically, we think a short-squeeze succeeded in pushing the currency above a downtrend that triggered ascending stops. Fundamentally, there is increased speculation that the RBA's easing cycle is complete. The two-year yield was up three bp, to 2.0% the biggest increase among the high income countries on the week, and the highest nominal yield among them, outside of New Zealand.
The Australian dollar's strength is begetting talk of new carry trades. This is possible. The market is too big and strategies too diverse to rule it out, but remember that under current conditions, being long Australian dollars against the euro, yen, or sterling for that matter, can be a driven by momentum considerations. One is indeed paid a little to be so positioned, but many short-term traders and even professionals may find that volatility is high enough that it still may overwhelm the carry. Most positions foreign exchange traders (as opposed to investors) do not appear to be kept long enough to earn an attractive amount of interest income.
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.
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