By Dean Popplewell
Today's market focus is all about the Fed and how aggressive they are likely to be. The fixed income market, in particular, has been pricing in a more forceful showing by US policy makers later this afternoon, most notably on the back of yesterday's somewhat surprising US inflation report, but will they be disappointed with the Fed outcome?
The May US CPI headline came in stronger than anticipated (+0.4%, m/m and +2.1%, y/y), even the less volatile core beat forecasts (+0.3%, m/m and +2.0%, y/y), confirming the fastest one-month gain in nearly two years. This unexpectedly large increase will obviously provide fodder for the FOMC "hawks". Despite much evidence of wage pressures, the CPI data implies some demand "pull" inflation is leading to perhaps an earlier arrival at the Fed's policy objectives. As being the case for much of the US recovery and expansion, services prices are leading the increases in the CPI.
Services prices, which represent nearly +60% of the consumer basket, rose +0.4%, m/m and a hearty +2.8%, y/y. 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 policy makers have been waiting for to begin the conversation on "removing" policy accommodation within the next 2-3 quarters – much sooner than the 4-6 quarters that the fixed income market has been pricing in. Since yesterday, FI traders are bracing themselves for an assertive Fed and have been flattening the US curve aggressively – by selling US short paper and pushing their yields higher.
Nonetheless, the Fed will "not" be looking to abruptly adjust market expectations in the manner that the BoE's Governor Carney did last week, which saw the sterling soar (£1.6834-£1.7004) following comments about a possible rate hike much sooner than the market had been pricing. There is risk of a subtle change at Ms. Yellen's post-meet press conference (2:30pm EST) – 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 tack 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 US economy. To date, market consensus believes that unless US economic data, especially employment and inflation, sharply surprise to the upside the Fed will stick to the comfortable script on tapering, ending QE and begin tightening sometime in H2 2015. Any changes by Yellen and company should be accurately telegraphed.
Albeit brief, forex markets require volatility, and it certainly was in attendance with GBP when the June MPC vote results were released earlier this morning. The BoE minutes from June were the highlight in an otherwise quiet FX market. The minutes were again unanimous (9-0) in keeping both interest rates and 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 Governor Carney's Mansion House address from last week (he was clearly speaking on behalf of the MPC). The members were 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 that 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 GDP. 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) as we head into the FOMC decision.
Higher US short-term yields are having an obvious impact on commodities, especially gold ($1,268oz). 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 metal's prices will surely disappoint the market bulls – currently, strong resistance remains intact at $1,275oz. Higher US 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 somewhat disconcerting, especially since it has fallen -8% since last March's highs, mostly on the back of stronger US data.
The 18-member single currency, the EUR, remains well contained within recent ranges, but 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 ECB would refrain from undertaking additional easing policies over the next several months after the combination of measures announced back on Jun 5th. Currently, the single unit continues to be battered about mostly on cross-related interest due to the lack of direct fundamental releases. Interest rate differentials have EUR/GBP shorts dominating; however, this morning's June MPC vote report 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 release.