Fed sees rates on hold; UK election, ECB meeting, Japan tankan

Rates as of 06:15 GMT

Market Recap

The FOMC meeting can be summed up in two words: no change. No change in rates, no change in the Committee’s estimate of future rates, and no change in the outlook for growth and inflation.

The vote to keep rates unchanged was unanimous, the first unanimous vote since May. With everyone on board at this point, rates are likely to remain unchanged until there’s a “material” change in the economic outlook.

The Fed’s dot plot, with the FOMC members’ estimates (aka guesses) for where rates would be at the end of each year, was little changed from September. In fact the median estimates didn’t change at all, once you take into account the fact that they cut rates by 25 bps in October. Crucially, the Committee still sees rates on hold next year and rising in 2021 and 2022.

The most notable change in the dots was that now only four people see rates moving higher in 2020, and even those people are only looking for one hike. The seven people who were looking for higher rates back in September, circled in red, have thrown in the towel. There’s a pretty strong consensus for keeping rates unchanged. This explains why USD fell yesterday.

This is a contrast with the market, which sees rates falling next year and then staying steady in 2021 and 2022.

In fact, the meeting doesn’t seem to have convinced the market at all. The odds of a rate cut in the future are now deemed slightly higher than they were shortly before the meeting.

There is an increasing consensus on the Committee about the long-term outlook for rates. Each quarter the Committee members forecast what they think the long-term neutral rate of the Fed funds rate is. You can see from the graph how the “central tendency” is converging on a narrow range near the median – that is, fewer and fewer people think that the long-term Fed funds rate is likely to be higher than 2.5%.

Economic assessment:  The Fed’s assessment that “the labor market remains strong and that economic activity has been rising at a moderate rate” remained unchanged. They did however express more confidence in the future by removing a comment from the previous statement that “uncertainties about this outlook remain.”

To me, the Fed’s forecasts as laid out in the Summary of Economic Projections (SEP) contains one glaring contradiction. On the one hand, as I mentioned, the “dot plot” shows the next move in interest rates to be up, albeit in 2021. However, the median forecasts for inflation in 2021 and 2022 is 2.0%, which is right on the Fed’s target. But Fed Chair Powell had said that would take a “significant move up in inflation that is also persistent” to get them to hike rates. That may be “persistent” but is it “significant,” given that they’re looking for 1.9% next year? I had the impression that they would have to see a significant and sustained overshoot of the 2% inflation target before they contemplated raising rates. Given their economic forecasts, I don’t see why they’re pencilling in a rate rise at all, except if we’re back to the old story of “normalizing” rates, something that I haven’t heard in ages from anyone. This makes me think that while further cuts are unlikely, the hikes that they’ve pencilled in are unlikely too at this point.

By the way, if you’re confused about what’s likely to happen in the US economy, you’re in good company. “None of us have much of a sense of what the economy will be like in 2021,” Powell said. And these are mostly people with PhDs in economics and a huge research department to call upon.

Trade update: Reuters reported that Trump is likeli to meet with his trade advisors today to discuss the increase in tariffs on Chinese goods that’s scheduled to go into effect on Sunday. US markets seem to be assuming that these tariffs will be delayed. But according to the Global Times, a Chinese government mouthpiece newspaper, US officials have offered to cancel the tariff increases, but China insists that existing tariffs, not just planned ones, must be removed as well. Chinese traders seem to believe what they’re reading, because 1-week vol in USD/CNY options has skyrocketed.

If they do delay the increase tariffs, there would probably be little reaction in US markets, as that’s the assumption. But if they decide to go ahead and hike tariffs, I would assume that stock markets would fall sharply and the markets would go into “risk off” mode, with AUD/JPY falling sharply.

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Today’s market

Huge day today!

First and foremost, the UK General Election. As I’ve written before, the likely results are binary: either the Conservatives win a majority or they don’t win a majority. Either a Conservative majority or a hung parliament. A Labour majority is thought to be a statistical impossibility, and I doubt whether even an Act of God could deliver a Liberal Democrat government. As a result, the implications for Britain are binary too: if the Conservatives win a majority, we (assume we) get Brexit as advertised on 31 January next year. If a hung parliament, we perhaps get some renegotiations around the edges, if possible, and then another referendum.

The polls are suggesting that the Conservatives win a majority, but the polls – notoriously unreliable in Britain in the last few years – are even more unreliable this time, as many people will vote Brexit, not their party.

Here’s the schedule of events:

  •  Polls open at 7 AM local time (0700 GMT) and close at 10 PM (2200 GMT)
  •  The first exit poll should be released shortly thereafter. Historically, the exit polls are accurate to within 15 seats for the winning party, but given the uncertainties, we may not have confidence in the result at that time. Any result that shows the Conservatives with fewer than 341 seats (the 326 majority + 15 margin of error) would be taken as questionable.
  •  The first results are typically reported between 11 PM and midnight (2300 GMT and 0000 GMT), with most of the results coming in after 2 AM (0200 GMT). By 4 AM local time (0400 GMT) about half the votes should be in. Usually the race is determined by 6 AM (0600 GMT).

One small point to watch is will PM Johnson get re-elected? It is possible that the Conservatives win but Johnson himself loses, as he had only a tiny majority at the last election in 2017. If he loses, it would the first time ever for such a situation in Britain. No one knows whether someone who isn’t a member of Parliament or the House of Lords can become PM.

I discussed the Swiss National Bank (SNB) meeting in yesterday’s comment, so no need to go over that again, especially as it’s probably going to be concluded by the time you read this.

Then we come to the European Central Bank (ECB) meeting. The ECB meeting is likely to be pro-forma insofar as policy is concerned, but it will attract a lot of scrutiny as it’s the first one under the leadership of ECB President Lagarde. This will be her first time to give the post-meeting press conference and so to hear her views in detail.

Lagarde hasn’t made many comments about monetary policy up to now. The most she said was in her hearing before the European Parliament’s Committee on Economic and Monetary Affairs on Monday. Her comments then could’ve been taken from the statement following the ECB’s last meeting, suggesting that we can expect continuity from her rather than a new change of strategy. This is only natural as Lagarde isn’t an economist by training. She’s therefore likely to start her tenure by reflecting the views of the Governing Council more than by trying to shape them in a new direction. I expect more of the same this week as she starts to find her way in this new role. Perhaps her most important job at first will be to try to heal the divisions on the Governing Council between the doves and the hawks.

At the last ECB press conference, in October, then-President Draghi said the market had understood the ECB reaction function when it largely priced out any further cuts, and added that Lagarde has time to come to her own conclusions on monetary policy. What this means is that as far as the ECB is concerned, policy is basically on hold right now. Nothing has happened since then to change that view. Eurozone Q3 GDP was +0.2% qoq, 0.1 percentage point above the ECB’s forecast. Crucially, Germany avoided falling into recession. The manufacturing purchasing managers’ index, while still below the 50 “boom or bust” line, has turned upwards.

Private sector credit is gradually increasing, while lending rates are falling.

Core inflation rose to 1.3% in November, still well below the ECB’s target but nonetheless the fastest rate in four years.

This meeting will also produce new staff forecasts for GDP growth and inflation. They’re likely to be unchanged from the previous set three months ago, and so won’t require any policy response. This allows Lagarde the luxury of reviewing policy without any pressure to change it immediately.

As a result, I expect the important parts of her statement to be pretty much the same as in October. She’s likely to acknowledge some improvement in the global outlook, as other central banks have done, but continue with the assessment that “the risks surrounding the euro area growth outlook remain on the downside.” One possible change we can glean from her comments to the EU Parliament may be that she tempers the ECB’s willingness to change policy (“the Governing Council continues to stand ready to adjust all of its instruments, as appropriate…”) to be conditional on an assessment of the possible side effects of policy. That would be a fairly small change however without much market significance.

That’s enough excitement for one day. Nonetheless, there are a few other indicators.

The US producer price index (PPI) is expected to show an upturn in upstream inflation. Following yesterday’s US consumer price index, which showed inflation running at over 2% on both a headline and core basis, this could help cement the idea that prices are headed higher – or at least that inflation isn’t slowing. USD positive

Then overnight we get the Bank of Japan’s quarterly Short-Term Economic Survey of Enterprises in Japan, known universally by its Japanese acronym tankan. The tankan is a huge survey of some 11,500 companies in Japan designed to be representative of the Japanese economy. This is the most important indicator out of Japan every quarter.

Like the Ifo or other such surveys, it’s presented as a diffusion index (DI) of the percentage of firms saying things are “improving” minus the percentage saying things are “worsening.” It’s troubling that this quarter, the DIs for both large manufacturers and non-manufacturers are expected to decline notably, although the expectations index for large manufacturers (what they expect the index to be when the survey is taken in Q1 next year) is forecast to rise a bit.

One problem with the tankan is that its effect on USD/JPY is not consistent. You might think that a rise in the DIs would foreshadow a better economy and therefore cause the yen to strengthen, while a fall should have the opposite effect. However, the tankan’s most direct link is to the stock market, since it reflects the views of companies. A weak tankan can send Japanese stocks lower. And as we all know, the yen often strengthens on a “risk off” mood when Japanese stocks fall. So even if you can forecast the results of the survey correctly, it’s hard to predict how the currency will move as a result. Nonetheless, just straight economics would suggest that a further decline in sentiment among companies could eventually elicit a response from the somnolent Bank of Japan, if we listen to what Gov. Kuroda has to say. The tankan may therefore be negative for the yen.

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DISCLAIMER

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The information and opinions in this report were prepared by Marshall Gittler and do not represent Fairmarkets’ views or opinions. Though the information herein is believed to be reliable and has been obtained from public sources believed to be reliable, the author makes no representation as to its accuracy or completeness. This report is provided is General Financial Advice and does not take into account the particular investment objectives, financial situations, or needs of individual traders. It is not an offer or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy.

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The author is not acting as a financial adviser, consultant or fiduciary to you or any of your agents (collectively, “You” or “Your”) with respect to any information provided in this report. Information contained herein is being provided solely on the basis that the recipient will make an independent assessment of the merits of any investment decision, and it does not constitute a recommendation of, or express an opinion on, any product or service or any trading strategy. The information presented is general in nature and is not directed to retirement accounts or any specific person or account type, and is therefore provided to You on the express basis that it is not advice, and You may not rely upon it in making Your decision.

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‘The key is not to predict the future, but to prepare for it.’ Pericles, 500 BCE

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