Two little words from Fed Chair Jerome Powell set the markets on fire this week. He said, “Interest rates…remain just below the broad range of estimates of the level that would be neutral for the economy…” The phrase “just below” is a huge change from last month, when he said rates were “a long way” from neutral, and that “we may go past neutral.” He also noted yesterday that the impacts of policy “may take a year or more to be fully realized.” Powell could be setting the stage for a pause in the Fed’s rate hiking cycle after the December hike while they assess the impact of the hikes so far.
You can see here how the market’s expectations of how much further rates are likely to rise have been drifting lower ever since the last FOMC meeting, and how expectations lurched lower still after Powell spoke. The market is now pricing in only two more rate hikes, even though the FOMC is forecasting four or five more.
This change is likely to have a substantial impact on the dollar. The graph below shows that for the last several years, the dollar has basically tracked the expected rise in Fed funds. But with the market now expecting either a slower pace of hikes or even a pause, the dollar is likely to come under some pressure.
Personally, I must admit I was surprised by his comments and still am. The real Fed funds rate is currently around 0.2%. Meanwhile, the economy is growing by 3.5% qoq SAAR. Since when does an economy growing at that pace need virtually free money to sustain its growth?
This raises the awkward question of what happened over the last month to cause him to change his tune. Was it Trump’s bleating about the Fed being his biggest problem? Was it the stock market’s wobble – not that much really considering the market hasn’t had a serious correction in a long time. Perhaps the recent signs of weakness in the housing market?
There are only two things I can think that reflect well on the Fed. The first is if they think growth may not be as robust as they previously believed.
The other possibility is that they expected Thursday’s slightly lower-than-expected personal consumption expenditure (PCE) deflators. The core PCE deflator slipped to 1.8% yoy from 2.0% yoy (1.9% expected), while the headline figure was unchanged at 2.0% (2.1% expected). While this may still qualify as being “near 2%,” as they said, it’s moving in the wrong direction. Together with weaker-than-expected German inflation and the downturn in oil prices, it suggests maybe they won’t be exceeding their 2% inflation target any time soon. This downturn in inflation could be why they think after the December rate hike, they should become more data-dependent. In any event, more data-dependency = more uncertainty = weaker dollar.
Seperately, the Bank of England published a study of “EU withdrawal scenarios and monetary and financial stability.” It basically set out what it saw as the four possible results of the Brexit negotiations. They were: bad, worse, terrible, and disastrous.
It’s significant that according to the Bank, even the best outcome economically, a “close relationship,” would result in lower growth for Britain than under the current set-up. The worst outcome, a disorderly Brexit, would apparently be a disaster, with output plunging by nearly 8% and not recovering to current levels four four years at least. (Note that during the 2008 Global Financial Crisis, output fell 6.5%.)
The report was compiled at the request of the Treasury Select Committee of Parliament. BoE Gov. Carney and some other colleagues will testify to the panel on Tuesday morning. Treasury officials and Chancellor of the Exchequer Hammond will also be testifying sometime during the week about their analysis, which is somewhat less bleak but negative nonetheless (it wasn’t based on the current proposal, but rather those agreed by the Cabinet back in July).
This is why I’m basically negative on sterling almost regardless of the results of the negotiations – I think they portend a return to the low-growth, high-inflation Britain of years gone by that will force the Bank to choose between supporting a flagging economy and supressing pass-through inflation from a weakening currency.
The upcoming week: RBA, Bank of Canada, NFP
The coming week has two central bank meetings and the monthly panic over the US nonfarm payrolls, plus the purchasing managers’ indices (PMIs) for every place that hasn’t announced them yet.
Really, there’s little to discuss about Tuesday’s Reserve Bank of Australia (RBA) meeting. Although the RBA meets more than most other central banks (11 times a year), these meetings aren’t particularly illuminating. The market doesn’t even see a 50% probability of a rate hike until December of next year. Once again, this meeting is likely to be pretty much a non-event for the markets.
The Bank of Canada is more in play. While nobody expects a hike at Wednesday’s meeting (the odds are 1.8%), something is expected early next year – the odds for a hike at the January meeting are 65%, rising to 82% for the April meeting. So the market thinks a hike is coming, just not now.
In that case, it will be important to hear their assessment of the economy, particularly as growth slows. They too may decide to pause in their rate hiking cycle if they think the Fed is going to do so, lest they lose competitiveness vis-à-vis their most important trading partner.
Outside of that, of course as usual in the first week of the month, attention will focus on the nonfarm payrolls (NFP). As I say every month, I don’t think the focus should be on payrolls – employment has already surpassed the Fed’s target, so moving further into full employment isn’t going to affect their policy. Rather, attention should be on the rate of change in average hourly earnings. That’s a harbinger of inflation, which is the key variable nowadays for the FOMC.
In any case, the NFP figure is expected to be up 203k, which is about par for the course – the six-month moving average of the initial figure is 196k, so this would be quite in line with the recent trend.
The average hourly earnings on the other hand are forecast to rise at a faster mom pace than in the previous month, with the yoy rate remaining the same – above 3%. Now, once could be just a fluke, but twice in a row is the start of a trend. I think this might get people to rethink the conclusions they drew from Powell’s speech and put a bid under the dollar.
Speaking of Powell, he’ll be testifying before the Joint Economic Committee of Congress on Wednesday. That’s bound to be a highlight of the week. We may get some clarification of his comments and the reasoning behind them – how much is he worried about the economy slowing? Also, Atlanta Fed President Bostic speaks on Thursday and Gov. Brainard speaks on Friday. They’re both voting members and so well worth listening to.
Other US events worth watching include the ISM indices, out on Monday and Wednesday.
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