The Fed wants to get the monkey off its back

Fed Vice Chairman Fischer appeared to leave the door open to proceed with a hike on 17 September.   If markets are relatively calm and the US payrolls data not surprisingly weak, then it seems the Fed is ready to take the first step.

The Fed messaging of this move has been persistent and not easily swayed by weaker commodity prices, a strong dollar or sluggish growth outcomes in emerging markets.  The Fed has instead responded to these risks to growth and inflation by highlighting that the pace of policy tightening is likely to be gradual and responsive to data and market conditions.

It may be the case that the Fed wants to be predictable in its actions and not easily spooked by what many think is inevitable volatility as the Fed enacts its first rate hike in the post 2008 crisis era.

Some commentators, including from some other central bankers interviewed last week, are encouraging the Fed to proceed with the hike in September, believing this will help generate more certainty and reduce the constant speculation about when the Fed raises rates.

Of course after the first hike attention will turn to the next one, but the market may respond as if it has a monkey off its back, and be comforted if the Fed calibrate further policy action more closely to economic and market direction.

At the end of the day one or two rate hikes in the USA should have little discernible impact on the US economy.  It might lead to further gains in the USD, which would contribute to tightening in financial conditions in the USA, but the gains in the USD should be contained if the Fed subsequently responds by switching quickly back to a wait and see policy stance after only two hikes.

The market is reverting back to risk aversion on Monday with strength in EUR and JPY and weakness in commodity and Asia EM currencies.  But we think it is better now to swing back to a bullish stance in USD vs EUR and JPY.

The volatility in asset markets over the last week has already served to clear out a lot of the existing short positions in EUR and JPY.  Both spiked up early last week breaching key levels and triggering panic stop loss related purchases.  The fact that both currencies are now weaker than where many investors and traders have cut short positions in these currencies will irk many and they will consider where they might re-enter these short positions, tending to provide a capping influence on both currencies.

The IMM futures speculator positioning data confirm that net shorts in both these funding currencies is now much lower.

We also think the market is significantly under-pricing the risk that the Fed proceed with its first hike in a few weeks. Those odds are priced at around 30 to 40% according to Fed fund futures.  Our sense is that the odds should be more like 60 to 70% at this time, with the Fed needing to be deterred from tightening by significant market upheaval or a weaker set of payrolls data on Friday.

The rebound in EUR and JPY over recent weeks in part was predicated on the expectation that the Fed would decide to delay policy tightening in the face of global market upheaval.  The message from the Fed is that it is prepared to accept a fair degree of market turmoil before delaying its much discussed and heralded policy hike.  September 17 still appears to be the best time to raise rates, accompanied by the FOMC’s economic projections and Chair’s press conference, with October 28 a short press statement only meeting and December 16 a riskier time to hike so close to thinner year end markets.

As such, with the market under-pricing a Fed hike in September, and positioning cleaner in EUR and JPY, we see less risk of market volatility and risk aversion boosting these currencies.

Furthermore, the demand for dollars may come increasingly from EM and Mideast central banks.  Global FX reserves have been falling as EM central banks spend USD reserves to shore up their weaker domestic currencies and Mideast oil producers fill the funding gap left by weaker oil revenues.  These reserve managers may decide to sell alternative reserve currencies to rebuild USD holdings, thus tending the support the USD against alternative reserve currencies.

Condition in China will remain of much market concern.  On Monday morning the Chinese mainland equity market is weaker but the Chinese currency is stronger.  However, other Asian currencies are weaker, suggesting that the market believes the gains in CNY are artificial and generated by policy intervention. How the stock market performs this week is anyone’s guess, but falls this morning may test the mettle of policy makers that would like calmer conditions.

The big events coming up for China include trade data this coming weekend, following by the full suite of activity, inflation and credit growth data next week.  Ahead of that the market will also be wary of the Government sponsored PMI data due tomorrow for both the manufacturing and services sectors.  Both these indicators will be important for sentiment.  The Markit flash manufacturing PMI for August out two weeks ago fell further to a low in data available since 2012, so expectations for the Government PMI tomorrow are already low.

The service sector PMI has improved in recent months to July, so it will perhaps be more interesting to see how it has fared in August.  It is possible that it has weakened given the stock market correction and surprise CNY deval on 11 August.

Chinese economic data was much weaker than expected in July, and some put this down in part to the weak Chinese stock market from mid-June causing credit markets to tighten up in July.  Expectations for economic data in the coming week are likely to be subdued, providing a low bar for the market to be positively surprised.

It may be the case that calmer equities and policy easing in late July and early-August helped stabilise economic activity before the most recent Chinese market turmoil.  If so the economic reports to be released next week may not be as bad as expected.  However, confidence over Chinese growth and financial conditions are unlikely to improve much for at least a couple of months.  Economic activity seems unlikely to improve now until at least the fourth quarter.

The lack of confidence in Chinese macro-conditions, combined with a high probability that the Fed forges ahead with policy tightening in a few weeks appears likely to keep the USD in a rising trend vs Asian and commodity currencies.

I am travelling for the rest of this week and into next.  I wish you the best of luck navigating these very interesting markets.

Please feel free to spread the word to your colleagues and contacts that they can register on my website to receive my AmpGFX reports that will begin from mid-October, and get the occasional blog in the meantime as I stay in touch with the markets.