Today’s market focus is all about the Federal Reserve and how aggressive it is likely to be. The fixed-income market in particular has been pricing in a more forceful showing by U.S. policymakers later this afternoon (U.S. 10’s backed up +5bp to +2.645%), most notably on the back of yesterday’s somewhat surprising American inflation report, but will they be disappointed with the Fed outcome?
The May U.S. consumer-price index (CPI) headline came in stronger-than-expected (+0.4%, month-over-month, and +2.1%, year-over-year), even the less volatile core beat forecasts (+0.3%, month-over-month, and +2.0%, year-over-year), confirming the fastest one-month gain in nearly two years. This unexpectedly large increase will obviously provide fodder for the Federal Open Market Committee ‘hawks’. Despite much evidence of wage pressures, the CPI data implies demand-pull inflation is leading to an earlier arrival at the Fed’s policy objectives. As being the case for much of the U.S. recovery and expansion, services prices are leading the increases in the CPI.
Services prices represent nearly +60% of the consumer basket, and they rose +0.4%, month-over-month, and a hearty +2.8%, year-over-year. What will not be lost on the hawks is the fact that core prices have accelerated in the past three months and are up to +2.8%, the highest level since January, 2008. This may be the evidence that the policymakers have been waiting for to begin the conversation on “removing” policy accommodation within the next two to three quarters – much sooner than the four to six quarters that the fixed-income market has been pricing in. Since yesterday, fixed-income traders are bracing themselves for an assertive Fed and have been flattening the U.S. curve aggressively – by selling U.S. short paper and pushing their yields higher.
Traders Await Fed Guidance
Nonetheless, the Fed will not be looking to abruptly adjust market expectations in the manner that the Bank of England’s (BoE) Governor Mark Carney did last week, which saw the sterling soar (£1.6834-£1.7004) following his comments about a possible rate hike much sooner than the market had been pricing. There is risk of a subtle change at Fed Chair Janet Yellen’s post-meet press conference (2:30 p.m. ET) – the market will be looking for any indication that the debate will be shifting from reducing to removing policy accommodation. In reality, a pre-emptive Fed cannot afford to wait to achieve its goals before changing tact to removing accommodation. Yellen and company will not want to be caught behind the curve and force a Carney-style shift in policy – market transparency is important; it’s there so as not to provide any antagonistic knock-on effect to the U.S. economy. To date, market consensus believes that unless American economic data — especially employment and inflation — sharply surprises to the upside, the Fed will stick to the comfortable script on tapering, ending quantitative easing, and begin tightening sometime in the second half of 2015. Any changes by Yellen and her rate-setting team should be accurately telegraphed.
Albeit fleeting, the forex market requires volatility, and it certainly was in attendance with GBP when the Monetary Policy Committee (MPC) vote results were released earlier this morning. The BoE minutes from its June meeting were the highlight in an otherwise quiet market. The minutes were again unanimous (9-0) in keeping both interest rates and the Asset Purchase Target (APT) steady. The GBP/USD briefly tested above £1.70 as the BoE noted that the low probability markets placed on 2014 rate hike was somewhat ‘surprising,’ but it has since given back the initial gains and then some (£1.6945), as the comments were in-line with Carney’s Mansion House address from last week (he was clearly speaking on behalf of the MPC). The members also agreed upon the “considerable costs” in terms of lost output of a premature hike, as well as the difficulty of reversing such a move.
The exact timing of the BoE’s first-rate hike will depend will depend on how much spare capacity (operating below the maximum sustainable production) the MPC members believe still exists in the economy. The more slack has been reduced the more sustainable growth will generate ‘inflationary’ pressures that have to be countered by a rate move. But the MPC sees “considerable uncertainty” over its estimate of spare capacity of +1% to +1.5% of gross domestic product. All members agreed that the bank rate should not be raised until there is ‘more evidence’ of slack being absorbed – it seems that with the lack of consensus that this will be reached at different times. While the minutes were overall supportive for sterling, the lack of hawkish surprises should begin to squeeze GBP/USD longs to book some profit, and even provide some support for the EUR on the cross (€0.8003 and €1.3558 outright).
FOMC Could Trigger Gold Rush
Higher U.S. short-term yields are having an obvious impact on commodities, especially gold ($1,268 an ounce). In recent days, the yellow metal has advanced as spiraling violence in Iraq, and ongoing tension in Ukraine has investors requiring a hedge against an uptick in geopolitical instability. However, the lack of follow through in the yellow metals prices will surely disappoint the market bulls – currently, strong resistance remains intact at $1,275 an ounce. Higher U.S. prices are signaling investors to take some profit off the table ahead of today’s FOMC announcement. The longer-term prospects for the commodity look disconcerting, especially since it has fallen -8% since last March’s highs, mostly on the back of stronger U.S. data.
Euro Edges Up
The 18-member single currency, the EUR, remains well contained within recent ranges, but it did manage to hit a one-week high on Monday at €1.3580. The pair has bounced off this week’s lows after reports circulated that the European Central Bank would refrain from undertaking additional easing policies over the next several months after the combination of measures announced back on June 5. Currently, the single unit continues to be battered about mostly on cross-related interest because of a lack of direct fundamental releases. Interest rate differentials have EUR/GBP shorts dominating, however, this morning’s June MPC vote is pressuring both majority positions – long GBP and short EURs. Short covering after the MPC minutes is boosting EUR/GBP, and by default, dragging EUR outright higher. Through yesterday’s high with momentum (€0.8009) technically brings the €0.8033 area into play. The market should expect further squaring of some vulnerable positions as we head stateside to focus on the FOMC.