Central Banks Deliver Hawkish Surprises – What Will The Fed Do?

Following a series of more hawkish central bank action recently, 50 basis points (bp) hikes have become the new 25bp.  Several central banks surprised last week including a 100bp hike in Canada, 75bp hike in the Philippines and an inter-meeting tightening in Singapore. 

Meanwhile, while the upward surprise in US June CPI inflation (1.3% m/m) increased the chance of a 100bp hike from the Fed this month the University of Michigan sentiment survey revealed a decline in inflation expectations, with consumer sentiment languishing near all-time lows, dampening expectations of a larger move. 

While a 100bp hike at the 26/27 July FOMC meeting is quite possible after the Fed raised rates by 75bp last month, some Fed officials have dampened expectations of such a large move.  Officials such as Atlanta Fed President Bostic and Kansas City President George, have highlighted the risks that more aggressive rate increases would hurt the economy at a time when recessions risks have intensified. 

As we go into the Fed blackout period, with no Fed speakers ahead of the FOMC meeting and with the key June CPI print out of the way, there will be limited new news for markets to chew on.  Markets have fully priced in a little more than 75bp of Fed tightening this month, which seems reasonable, with a 75bp hike the most likely outcome.

This week has kicked off with another outsize increase in CPI inflation, this time in New Zealand where the Q2 CPI reading came in at 7.3% y/y (consensus. 7.1%, last 6.9%) reinforcing expectations of a 50bp hike by the RBNZ at its August meeting. 

There are several central bank decisions on tap in the euro area, Japan, China, Turkey, South Africa, Indonesia, and Russia.  The outcomes will differ.  The European Central Bank is primed to hike by a tepid 25bp, with focus on the likely announcement of an anti-fragmentation tool.  Not surprises are expected in Japan (Thu), China (Wed), Indonesia (Thu) and Russia (Fri), with policy likely on hold in all four cases. 

In contrast a 50bp rate hike from the SARB in South Africa (Thu) is likely while Russia is expected to cut policy rates by as much 100bp.   Aside from central bank decisions earnings releases gain momentum this week while Italian politics will remain in focus.  

The US dollar has kicked off this week on a weak footing after ending last week on a softer note. USD positioning remains heavily long though its notable that speculative positioning in the USD index (DXY) has slipped over recent weeks (according to the CFTC IMM data). 

Still stretched positioning and lower yields as markets pull back from aggressive Fed tightening expectations will likely cap the USD in the short term.   However, it’s hard to see the currency losing much ground, with EURUSD parity continuing to act as a magnet.  

Fed, ECB, BoJ In Focus This Week

Three major central banks meet to decide on monetary policy this week, but after massive and unprecedented actions over past weeks, there is likely to be little new in terms of additional policy measures announced by the US Federal Reserve (Fed), European Central Bank (ECB) and Bank of Japan (BoJ) in the days ahead.  Key data this week include US Q1 GDP, the April US ISM manufacturing survey and China’s April purchasing manager’s index (PMI).

The Fed has thrown everything but the kitchen sink at Covid-19 to combat the severe economic and market impact emanating from the virus.  This included aggressive rate cuts, unlimited asset purchases (Treasuries, MBS), purchases of commercial paper, loans to small businesses, easing rules for banks and provision of US dollar swap lines with other central banks to help ease global USD demand pressures.  Aside from some fine tuning, there may not be much else the Fed will do at its meeting on Wednesday. Meanwhile the US ISM survey (Fri) is likely to post a sharp decline (consensus 37.0).

Markets have reacted well to the measures announced and implemented so far, but as noted there is a growing disconnect between the rally in equity markets over recent weeks and rapidly worsening economic data.  US Q1 GDP data (Wed) this week will likely reveal some of the damage, with a 4% q/q annualised fall in GDP forecast by the consensus. Q2 GDP will be even weaker however, as most of the weakness in activity will have taken place in April and will have likely continued into May and June.

The ECB continues to face pressure to do more as Eurozone activity continues to plunge.  So far the main thrust of the ECB’s measures are EUR 750bn of bond purchases and loosening of restrictions on such purchases.  However, sovereign spreads, especially in the periphery (especially Italy) are under pressure and the ECB may need to act again soon though perhaps not as early as the meeting this Thursday.  The ECB will also likely shift the onus of further easing to fiscal, especially the proposed “recovery fund”, which continues to fuel major divisions between European countries.

Last but not least the BoJ meeting on Monday will probably be the most active in terms of new measures, but on balance they will probably do little to move markets.   At the last meeting the BoJ significantly increased the amount of ETFs they would purchase, which to some extent has helped the Nikkei 225 rally over recent weeks.  At this meeting the BoJ is unlikely to alter its negative interest rate policy, but is likely to remove its JPY 80 trillion cap on JGB purchases and announce an increase in corporate bond purchases along with other measures to ease credit.

On the data front China’s official manufacturing PMI is likely to remain around or just above the expansionary threshold of 50 as much of China’s supply side of the economy opens up.  However, the ability to retain expansion at a time when global demand and therefore China’s export markets are collapsing, will prove difficult.  China’s authorities appear to be increasingly realising this and have stepped up support both on the fiscal (via special bond issuance) and monetary side (targeted cuts in various rates), but so far the scale of easing has been limited and Q1 growth was especially weak.

Confidence Dives, Markets Shattered

COVID-19 fears have proliferated to such a large extent that confidence is being shaken to the core.   Confidence in markets, policy makers and the system itself is being damaged.  Today’s moves in markets have been dramatic, continuing days and weeks of turmoil, as panic liquidation of risk assets and conversely buying of safe assets, is leading to intense asset market volatility.  Economic fears are running rampant, with the failure of OPEC to agree a deal to prop up oil prices over the weekend adding further fuel to the fire.  Consequently, oil prices dropped a massive 30%, leading to a further dumping of stocks.

When does it end?  Confidence needs to return, but this will not be easy.  Policy makers in some countries seems to have got it right, for example Singapore, where containment is still feasible.  In Italy the government has attempted to put around 16 million people in quarantine given the rapid spread of the virus in the country. However, in many countries the main aim has to be effective mitigation rather than containment.  I am by no means an expert, but some experts predict that as much as 70% of the world’s population could be infected.  Washing hands properly, using hand sanitizers, social distancing and avoiding large gathering, appears to the main advice of specialist at least until a cure is found, which could be some months away.

In the meantime, markets look increasingly shattered and expectations of more aggressive central bank and governmental action is growing.  Indeed, there is already significantly further easing priced into expectations for the Federal Reserve and other major central banks.  This week, the European Central Bank is likely to join the fray, with some form of liquidity support/lending measures likely to be implemented.  Similarly, the Bank of England is set to cut interest rates and implement other measures to support lending and help provide some stability.  The UK government meanwhile, is set to announce a budget that will contain several measures to help support the economy as the virus spreads.

It is also likely that the US government announces more measures this week to help shore up confidence, including a temporary expansion of paid sick leave and help for companies facing disruption.  What will also be focused on is whether there will an increase in number of virus tests being done, given the limited number of tests carried out so far.  These steps will likely be undertaken in addition to the $7.8bn emergency spending bill signed into law at the end of last week.

All of this will be welcome, but whether it will be sufficient to combat the panic and fear spreading globally is by no means clear.  Markets are in free fall and investors are looking for guidance.  Until fear and panic lessen whatever governments and central banks do will be insufficient, but they may eventually help to ease the pain.  In the meantime, at a time of heightened volatility investors will need to batten down the hatches and hope that the sell off abates, but at the least should steer clear of catching falling knives.

Bracing for the worst

There was little progress over the weekend during discussions between US politicians attempting to agree on a budget deal and thus avoiding a partial government shutdown by the end of today. The US Senate is now set to reject a House of Representatives plan to delay President Obama’s Affordable Health Care Act while renewing funding for the government until December 15, leaving an ongoing stalemate in discussions.

Markets are bracing for the worst, with risk aversion rising, US equities and the USD falling. Meanwhile US Treasury yields remain capped having dropped sharply since early September. Political shenanigans in the US threaten to overshadow the US September jobs report at the end of the week. Nonetheless, the data will provide major clues to the timing of Fed tapering regardless of the budget/debt discussions.

It’s not just in the US where politics is fuelling market tensions. In Italy former Prime Minister Berlusconi withdrew his party’s support from the coalition government, leaving current Prime Minister Letta scrambling to form a new parliamentary majority in order to avoid snap elections. The impact will likely be felt on Italian and peripheral bond yields over coming days.

Meanwhile following elections in Germany last week coalition discussions to form a new government are ongoing although no deal is in sight yet and talks could go on for some time yet. Political uncertainties are unlikely to alter the European Central Bank’s (ECB) course this week, with an unchanged policy decision expected although benign inflation and weak credit growth will reinforce the need for an easing bias and forward guidance. Political issues are set to dominate markets over coming days, leaving risk aversion elevated and risk assets under generalised pressure.

The USD index lurched lower in the wake of the uncertainties in the US, extending its drop from early September. The near term prospects for the currency are bleak, with limited potential for any upside unless a budget deal is reached. Safe haven currencies in particular the JPY will be buoyed in this environment. The EUR will not fully be able to take advantage of USD weakness however, given the political tensions within the Eurozone.

In terms of high beta emerging market currencies including Asian currencies, any positive impact from the fact that US yields are capped, with 10 year treasury yields dropping sharply recently (higher US yields have been negative for EM currencies over past weeks so a drop will be positive for them) will be outweighed by rising risk aversion, leaving most Asian currencies vulnerable.

Dollar undermined by lower yield

Risk assets in general appear to have gained traction on the basis that central banks will maintain or expand highly accommodative monetary policies via further asset purchases and balance sheet expansion. The Federal Reserve and European Central Bank will likely provide more fuel to the fire this week, with the former set to maintain its policy settings including USD 85 billion in asset purchases while the latter is set to cut its policy refi rate by 25bps to 0.50%.

Weaker data into Q2 in the US (and the softer than expected reading for Q1 GDP annualised 2.5% QoQ pace revealed last Friday) effectively seals the case for maintaining ultra easy policy at least until later in the year when the Fed is set to taper off asset purchases. As for the ECB are mere rate cut may not be sufficient with attention on any prospects for non conventional easing and rebuilding the monetary transmission mechanism.

Weekend news in the Eurozone was positive, with Italy finally forming a government following two months of deadlock but the week should begin quietly with holiday in Japan and China. In any case market activity is set to be limited ahead of central bank policy decisions and the US April jobs report at the end of the week where a 150k increase in payrolls.

As the US Q1 GDP report revealed the impact of the Sequester via massive spending cuts is increasingly biting into growth and while expectations of ongoing monetary accommodation is helping to buoy markets, growth recovery will need to strengthen to justify the current optimism built into markets. At least there is some realisation, finally in the Eurozone, that recovery may need to be reinforced with less austerity.

FX market activity will remain hesitant ahead the key events this week but overall it appears the USD will lose further wind out of its sails especially as US bond yields continue to drop. The US 10 year Treasury yield dropped to is lowest level this year, a factor that has particularly undermined the USD against the JPY where a failure to test the 100 level has also contributed to a drop in the currency pair. A test of USD/JPY 100 is off the cards unless and until US yields rise again. Lower US yields are helping EUR/USD to stay above the 1.3000 level although this is being mitigated by the fact that German 10 year bund yields are also declining.

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