In the realm of physics, absolute zero is the temperature at which every element freezes and molecules are no longer in motion. The FED and other global central banks seem to be mimicking their scientific betters by keeping rates at a low enough level to prevent the movement of capital from their balance sheets and into the real economy. Yes, the ECB, Riksbank, Swiss National Bank are at negative interest rates but it is the velocity that measures absolute zero rather than the relative level of interest rates. This brief analysis is based on the CONTINUED FRUSTRATION of trying to understand the basis of FED communication and signalling to the markets.
The ubiquitous speeches from Fed governors and presidents reverberate with the need to get off the ZERO BOUND as the U.S. economy recovers and unemployment continues to recede, thus providing the impetus to remove the emergency unconventional tools of monetary policy. The Fed has continued to stress that the employment conditions are strong but the inflation numbers are too tepid to insure the success of meeting its DUAL MANDATE. When it seemed that September would be the month for the Fed to finally move off the zero bound, Chair Yellen and the FOMC invoked a third prong to its mandate by injecting into the statement, “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.”
In today’s FOMC statement, the FED removed this sentence and added in, “… whether it will be appropriate to raise the target range at its next meeting” (of course dependent on fulfilling its dual mandate). This change in language, coupled with the removal of the dour outlook about the global financial system led traders and investors to believe a December rate rise was CERTAINLY IN PLAY,ESPECIALLY AS THE PROBABILITY OF A HIKE REACHED ALMOST 50%. The concept of the next meeting is not new for the markets have been advised since the spring that every meeting going forward was LIVE for a Fed rate HIKE.
Yet, the FED is stuck at zero and the ECB, PBOC, Riksbank and BOJ all remain vigilante to the need for more QE as the IMF continues to warn of a continued slowing global growth. The FED seems to see the world with rose-colored glasses compared to the IMF and Ms. Lagarde. One wonders what happened to the fears of the headwinds to growth from an overly strong dollar. The U.S. dollar has strengthened 4 percent since the last week’s Draghi statements and the Fed’s “hawkish” predilections today.
In the third quarter, U.S. corporate earning shortfalls were all the result of an overly strong dollar. What would happen to corporate profits if the U.S. dollar strengthened and wages increased enough for the FED to feel it achieved its dual mandate and interest rates needed to be raised? It seems in an absolute zero world all money is frozen into the stock market for any chance of a positive return on capital.
Corollary outcomes to the FOMC statement:
1. SPOOS initially broke but after further thought turned and rallied to make two-month highs and retraced all the losses for the second half of August. It seems that the FED raising rates in December will be deemed good news as it will reflect less stress in the world economy.
2. The GOLD and SILVER markets had strong rallies before the FOMC release but had erased gains. The GOLD broke $28 off the high to close $10 lower on the day. The market accepted that the December rate increase is probable so time to sell the precious metals and other haven asset classes.
3. The U.S. dollar had a strong rally post-FOMC as good U.S. economic data will become a repository for foreign investors. Therefore, an equity market rally suggests all is good in the U.S.A. If the dollar continues higher than the ECB and BOJ will not have to do more QE for the dollar will be performing on its own strength. This view most likely helped to push the GOLD and SILVER lower as the strong dollar with a possible 25 basis points is deemed a quality asset in realm of financial assets. How strong of a dollar rally will it take before the FED speakers all revive the strong currency headwind discussion?
4. The yield curves reversed the previous two days of trade and flattened in dramatic fashion as the short-end of the curve was sold while the 30-year bond held up very well. The 5/30 curve closed at 141 basis points from a pre-FOMC 150 basis points, a very robust moved in response to the mere Fed rhetoric. Certainly, these are words we have heard before.
While trapped at the ZERO BOUND the markets’ reaction function is ABSOLUTELY UNKNOWABLE so trade accordingly.
***The Reserve Bank of New Zealand (RBNZ) released its official cash rate announcement two hours after the FED. The RBNZ held rates steady at 2.75 percent, as expected, but in its statement, Governor Graeme Wheeler said: “However, the exchange rate has been moving higher since September, which could, if sustained, dampen tradables sector activity and medium-term inflation. This would require a lower interest rate path than would otherwise be the case.” Governor Wheeler remained very concerned about an overvalued currency and slowing growth in China and East Asia. The Aussie/kiwi cross will be an indicator of continued concerns about an overly strong currency–presently the cross is trading at 1.0625.
Last night after weak inflation data from Australia the Aussie/kiwi traded to a five-month low of 1.0535, which should be a low risk point if wanting to trade on a possible rate cut by New Zealand. In an example of the topsy-turvy world of central bank zero interest rates, last night the Aussie dollar dropped 100 pips following a lower CPI number. In a “normal” world, lower inflation would be deemed a strong fundamental as it would be a signal that a central bank was maintaining stable prices resulting in an INCREASED REAL YIELD. Yet in today’s world, lower inflation infers a coming cut in interest rates and thus a reason to sell a currency. The markets are dynamic and as traders we can not afford to be frozen in thinking while at ABSOLUTE ZERO.
Tags: 5/30 Yield Curve, BOJ, ECB, Fed, FOMC, Gold, Janet Yellen, PBOC, rate hike, silver, U.S. Dollar