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Fed on hold

The Federal Open Market Committee (FOMC) conclude their policy meeting today and it is expected that this will be the fifth consecutive meeting where monetary policy is left on hold following last December’s rate hike. Market expectations about the FOMC’s intentions have been volatile through the course of this year as the FOMC’s ‘policy guidance’ itself has been volatile, often depending on what is happening in financial markets rather than necessarily in terms of its economic mandate. Being asset price dependent rather than data dependent creates the risk of a feedback loop in which the markets believe the FOMC becomes more hawkish when equity markets are moving higher and becoming dovish when equity markets are moving lower. This is a recipe for an increase in financial instability.

Hence, at the start of this year, the FOMC’s own interest rate projections (the so-called ‘dots’ looked for four quarter-point rate hikes this year. This was quickly revised to just two in reaction to the market slide earlier in the year and escalation in international economic and financial uncertainty (China FX policy, an elevated US dollar and a weak oil price). Although, the Chinese currency has depreciated both against the US dollar and in terms of the currency basket, the proposed inclusion of the RMB into the SDR in October implies that devaluation risks for the financial markets will be limited. The US dollar is fairly flat but the oil price is weakening again though much of the oil industry’s adjustment of investment plans has probably already taken place.

Now the markets are pricing in just one rate hike this year with ‘Fed-watchers’ looking at the 21 September and 14 December FOMC meetings as being the timing of the next move. A rate hike at the 2 November FOMC meeting is unlikely given the proximity to the US Presidential election. Janet Yellen’s next public pronouncement will be at the Kansas City Fed’s annual economic symposium on 26 August where the programme this year will be on the design of monetary policy frameworks (see previous years’ programmes here). Brexit uncertainties seem to be dissipating and the consensus view that Brexit would cause a long-standing economic and financial shock seems to have been mistaken.

The FOMC has never tightened monetary policy in the month preceding a Presidential Election though: since 1964 the FOMC has raised interest rates eight times in the year of the election. The path of US bond yields during an election year does not depart much from the average pattern which indicates a seasonal bias to rise in early February before drifting higher through mid-May and slowly decreasing into the year-end. This is more or less what has happened so far with the US 10-year Treasury yield this year. As an aside, the upward pressure on libor interest rates reflects a recent increase in the demand for US dollars as a result of funding pressures, especially with Eurozone banks and also the impact of regulatory changes for US prime money market funds that come into effect on 14 October.

Equity markets have enjoyed a strong rally on the basis that the major central banks remain accommodative and this reflationary theme is bolstered by the re-iteration of using fiscal policy as a demand-management tool at the G20 meeting at the weekend. The S&P500 index is at a new high though valuations are historically very stretched. The US economic data surprise index has been rising (i.e. the data has tended to be better than expected, though yesterday’s US PMI service index at a five-month low pointed to sluggish growth).

Separately, Japan is expected to implement a fiscal stimulus soon with about JPY 6tn in new funding and the BoJ might announce fresh monetary measures at its policy meeting later this week. The Japanese two-year bond yield fell to a record low of minus 0.37% and the USDJPY exchange rate moved back towards the 106 level. The exception to the advance in EM equity markets, which are at an 11-month high, is China where the regulator is said to be considering tightening curbs on the USD 3.6tn market for wealth management products.

As far as equity markets are concerned, the main threat to sustaining the rally is upcoming political risk in the form of the Italian constitutional referendum scheduled to be held in October. The popularity of the anti-euro Five Star Movement has fanned ‘Quitaly’ concerns. The under-capitalisation of the Italian banking system will be revealed in the publication of the banks ‘stress tests’ this Friday. In time-honoured fashion, there will likely be a ‘last-minute’ deal to allow some state recapitalisation of the Italian banking system that mitigates the cost to bank bondholders of being ‘bailed-in’ (see Italy’s bail-in headache by Silvia Merler of Breugel). The next key political risk is the US Presidential election in November. Recent opinion polls have given Donald Trump a slight lead over Hillary Clinton. The financial markets’ preferred candidate for the White House is Hillary Clinton as she represents the status quo and is seen as friendly towards Wall Street. A Trump Presidency, on the other hand, would augur a change in economic policy that is a lot more protectionist (‘America First’). Janet Yellen would probably lose her job though Donald Trump said he favours a low interest rate policy.

Elsewhere, a week tomorrow, the BoE’s Monetary Policy Committee meet and the BoE will also publish its Inflation Report and update its economic forecasts post-Brexit. The BoE has been part of the consensus view that Brexit is bad, though the effects so far seem to be on published measures of business and consumer confidence. This is not surprising given the ‘Project Fear’ campaign in the run-up to the referendum. The BoE’s own agents’ summary of business conditions suggested little economic impact and this week’s CBI industrial trends survey was surprisingly upbeat on both output expectations and export orders.

International investors are taking advantage of the fall in the sterling exchange rate to purchase UK companies (Softbank-ARM) and buy commercial property. GlaxoSmithKline this morning announced plans to invest GBP 275mn at manufacturing sites in the UK. Note that net speculative short positions are now at an extreme and suggest that the exchange rate might be subject to potential short-covering. Brexit fears of a UK recession are clearly exaggerated and a case can be made for the BoE not to carry out further monetary easing. Indeed, press reports that some UK banks are preparing for negative interest rates might be counter-productive as both the ECB and BoJ have found. With gilt yields at record lows, will more QE make much difference?

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