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The FOMC has thrown cold water into the notion that the Fed will be as dovish as previously thought. Yes, the Central Bank cut its interest rate by 25bp and formalized the end of QT (Quantitative Tightening), which was merely the ‘anti-harakiri’ move to content a market that had fully priced in this outcome.
What really mattered was. What hand Fed’s Chair Powell would play during the press conference? Powell deployed its fair share of ambiguity and conditionality to future rate policy, even contradicting in his view, but the end result is that the bar had been set, as emphasized during yesterday’s note, too high for the Fed to meet.
A key lesson to take away from the most recent policy ‘showdowns’ at the helm of the ECB and the Fed, both now behind us, is that the market, as a discounting mechanism, tends to price into an asset a future perceived valuations, based on assumptions built up on the lead-up to these events.
When the actual event comes due, the delivery of the outcome (reality) must meet these preconceived assumptions to keep the ball rolling and dynamics undeterred.
For instance, to keep selling the Euro, given how much the currency had depreciated ahead of the ECB, the Central Bank should have really thrown all it had to fortify the dovish expectations. By failing to deliver a rate cut, even if pre-announced for Sept, and also not fleshing out details with regards to the composition and quantities to be purchased as part of its upcoming QE II, that’s where they could not meet the bar set by the market.
In the case of the Fed, the playbook for the USD to stay bid had to be a Fed that under-delivers based on what the market had priced in. Heading into the meeting, participants held the belief that a 22% chance of a 50bp rate cut was still possible, a 25bp rate baked in the cake, while a total of 66bp of rate cuts was still the central case by year-end. After all said and done, the market was left with the impression of a ‘hawkish cut’, hence the disconnect with the current Fed’s view was further adjusted via a stronger USD.
The policy statement got off to the expected start with a 25bp rate cut citing “global developments” and “muted inflation pressures” and the announcement of the formal end to its balance sheet normalization program (QT), even if Fed’s voting members George and Rosengren ended up being dissenters.
But it wasn’t until Powell took the stage at the press conference that the markets had a real chance to filter out the wheat from the chaff by deciphering whether this ‘insurance cut’ was part of a longer rate-cutting cycle or a ‘one and done’.
This time, the headline that grabbed the market’s attention came as Powell referred of today’s 25bp rate cut as being part of a “mid-cycle adjustment to policy”, and just like that, the market’s perception immediately switched to price out its implied ambitious easing notion.
This led to a swift transition into ‘true risk-off’ in financial markets, with capital flows seeking out a shelter away from the risk curve back into long-dated US bonds, while keeping the front-end of the Treasury yield on a solid bid as the implied dovish policy was re-assessed.
We also saw investors scrambling to the exits in the equity market as the accommodative path set by the Fed didn’t cut it to keep the bid tone. It also resulted in a clean breakout in the VIX (vol index). The ‘true risk-off’ dynamics then went full circle as the market amassed Yen longs in a classic move to safety.
As Powell’s presser continued, some conflicting signals started to feed through the markets, as he seemed to somehow walk back some of the ‘hawkish cut’ notions by denying that this is meant to be just one rate cut. The literal words he used “I didn’t say just one rate cut.”
This helped to somehow re-calibrate the idea that a Sept rate cut might still be on the table, with the market now assigning a 50/50 chance according to the CME Fedwatch tool, conditional to how the US economic data, global growth, and trade dispute evolve in the next month.
That ambiguity in Powell’s communication, with some logically thinking it was outright conflictive, poses a risk in the form of loss of confidence by market forces. This was reflected in the diminutive reprieve in equities, not buying into Powell’s attempt to sneak in some ambiguity, while the USD index vs G8 FX barely budged either, ending NY business hours at the very end of the day, which communicates acceptance to keep the party going.
Today’s FOMC leaves a foggy backdrop to take by heart as the ambivalence that I feared Powell would resort to has played out to a certain extent. Yesterday’s note read: “Powell must seek out leverage by leaving the door open to act near-term if needed, but the market aims for meat in the bone (read reassurance), which is why they want enough explicit acknowledgment that the Fed aims to bring the interest rate lower by at least 50bp before reassessing.”
The market didn’t get to hear what it wanted and by Powell resorting to a somehow conditional stance with flexibility to adjust on the go to new developments was not sufficiently committal rhetoric to satisfy the market, which for now has fallen victim of its own high-bar setting dynamics. However, make no mistake, in a long enough time horizon, this easing bias by the Fed will be determined by the rhythm played in the market whether the Fed likes it or not.
The USD remains king of FX en-route for its 10th straight day of gains in a row, a milestone that we’d have to refer back to April ‘18 to witness such a run. But fancy stats aside, what really matters here is that the USD index (against an equally-weighted basket of G8 FX) has found equilibrium at the highs of the day on Wednesday. I expect this close to lead to momentum strategies to pile into the currency for further follow-through, which appears to be a playbook in resonance with the current market’s view as Asian trading gets underway.
The indices show the performance of a particular currency vs G8 FX. An educational article about how to build your own currency meter can be found in the Global Prime’s Research section.
In terms of the currencies that look most vulnerable for USD bulls to capitalize on, the usual suspects (AUD, NZD, GBP) are firm contenders to see further losses on a momentum play day. One could also consider the EUR as part of the group to depreciate against the USD. It’s a more tricky situation against the JPY, CHF due to the risk-averse conditions, while the CAD is also finding a fair share of buying interest after Canada’s May GDP beat estimates by a small margin.