Fed holds, pound breaks $1.27 ahead of BoE

Forex
Morning Note

Stocks firmed and the dollar fell, whilst gold rallied to a 5-year high as the Fed opened the door to cutting rates.

It’s like 2010 all over: the race to the bottom is on. Only this time the global economy is coming off a period of remarkable synchronised expansion, not a terrible recession and the worst financial crisis in a generation or more. So what gives!? Must Powell acquiesce to the whims of his president? Must Draghi end his tenure not normalising, but actually cutting rates even deeper?

Draghi to be fair has little option. In the absence of structural and fiscal reform – blame Germany – he can but tinker around the edges of the zero lower bound, hoping to weaken the currency to get some competitiveness back. Powell is in a different position, although really it looks like central banks are spitting in the wind in trying to shift inflation expectations. They should try to focus on boosting oil prices instead.

FOMC holds

So yesterday the FOMC nudged towards a cut. Nearly half the 17 members of the FOMC think cuts will be warranted this year. The median dot plot suggests 50bps in cuts through 2020. The dots evinced a shift from a tightening bias to an easing bias. The patient mantra was dropped, whilst the economy is now only expanding at a ‘moderate’, not ‘solid’, rate. The market took this as a sign the Fed’s listening to their demands – a cut in July is now fully priced in.

But there’s yet optionality for Powell and co. The Fed refrained from explicit references to cuts. The median dot plot shows no cuts this year still. The market is ahead of itself again. If we believe the dots, rate cuts will come slower than the market wants them to.

In some ways the Fed thread the needle here – keeping the market and the president happy without actually committing to cuts. The dots suggest the Fed is saying: “Of course we will cut, just not yet-good enough?”. For now it is. But the tail seems to be wagging the dog, forcing the Fed to follow sooner or later.

Certainly revising inflation expectations lower points to concerns that tame price growth cannot simply be attributed to transient factors. Yet at the same time the Fed thinks unemployment will be lower and growth stronger than it thought in March.

The problem we have is that Fed looks like it is flip-flopping; changes its mind based not on economic data but on the caprice of financial markets; appears in thrall to the White House; and is therefore at a very serious risk of losing its credibility.

Markets

Yields hit the deck. US 10yr bond yields slipped beneath 2% again for the first time since 2016. Bunds heading deeper into negative territory.

Gold rallied on the outcome as yields sank, breaking north of $1385. It’s now cleared a tonne of important multi-year resistance, paving the way for a return to $1400 and beyond. This is a big move, but if the Fed doesn’t deliver the cuts the bulls could be caught out.

Stocks liked it – the S&P 500 notched gains of about 0.3%, Limited upside as the Fed was not as dovish as the market wanted and because a lot of this was already priced in. Asian markets rallied across the board.

Futures show European stocks are on the front foot, catching a tailwind from Wall Street and the Fed. The FTSE 100 may underperform though as the pound is finding bid.

Oil has climbed as US inventories feel three times more than expected. Brent was up at $63.50, threatening to break free from its recent range – look for $63.80. WTI at $55.50 also close to breaking out of its trough.

FX

The dollar kicked lower after the Fed decision – but with the ECB looking super easy the gains versus the euro are limited. Likewise the yen with the Bank of Japan also ready to step up stimulus. Likewise the Australian dollar, with RBA governor Lowe talking up a further, imminent, cut. The race to the bottom is on. Is it too soon to talk about currency wars?

The exception here is the Bank of England, which is heading towards raising rates. We get to learn more about the BoE’s position later today. The difference here is the inflation expectations, which are moving up, not down like they are elsewhere. Britain’s also enjoying strong wage growth and a super-tight labour market. All of this is dependent on a smooth Brexit – this is not a given by any means.

Indeed, Brexit is keeping the lid on sterling’s gains – the prospect of Boris Johnson taking Britain out of the EU come October 31st is a risk. There’s now talk of a possible general election if he gets in – risky, we know what happened to May. The prospect of a general election would not do anything to remove uncertainty around UK assets. Zero clarity still.

EURUSD moved through 1.12 and was last at 1.1280, but failing to gain enough momentum to rally above 1.13 and scrub out the Draghi-inspired losses.

GBPUSD has reclaimed 1.27. Quite a chunky move here, blasting through a couple of big figures in under a day. Maybe the prospect of a more hawkish BoE is helping the pound, albeit the market is actually pricing in cuts, not hikes. At least Mark Carney doesn’t have to deal with a political leader on his case…

USDJPY lost the 108 handle to trade at 107.50, now breaking free into new 2019 lows (ex the Jan flash crash).”