One of the most amazing things about markets, at least to me, is the speed and efficiency at which it is able to incorporate new into its asset pricing.
Perception vs. Reality
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Andrew Kositkun Foreign Exchange Head Trader
One of the most amazing things about markets, at least to me, is the speed and efficiency at which they are able to incorporate news into asset pricing. For example, in December 2018, the markets were pricing in a ~96% chance of a rate hike in 2019. However, after the Fed's dovish pivot in January, market pricing turned on a dime. At one point in March, the markets were pricing an ~80% chance of a rate cut in 2019.
While we think the markets are overly bearish on the Fed, what are the reasons to prompt a Fed cut? Broadly, they are to fight recessions, support inflation, and counter market stress. Using history as an example, here is how these three scenarios have played out in the past.
In 1989, 2000 and 2007, the Fed faced recession fears as employment and other economic measures showed deceleration. In all three cases, the yield curve also inverted. The Fed cut rates aggressively back then, and if faced with heightened recession risks again, the Fed would likely quickly cut rates down to the zero lower bound.
In 1995, the Fed faced signs of a weakening economy (but not recessionary) and soft inflation. Additionally, the Fed noted the soft inflation was likely due to monetary tightening earlier in the year, i.e. the Fed overshot. Ultimately, the Fed did cut rates to support the economy.
In 1998, the Fed faced market stress events with the collapse of Long-Term Capital Management and the Russian default. As a result, the Fed cut rates to provide support for the markets, creating the "Greenspan put." Once the markets stabilized, the Fed then resumed its hiking cycle. If the Fed were to be faced with a market stress event, it is likely to follow this same playbook.
Should the Fed cut this year, it will most likely be under the 1995 scenario with the Fed using the narrative that the neutral rate is lower than previously estimated. However, there are risks to cutting rates in hopes of boosting inflation expectations. In 1995, the Fed cut rates but inflation didn't pick up. Luckily for the Fed, there was a productivity boom which extended the business cycle. Clearly there are no guarantees that happens this time around, making the prospect of cutting rates to boost inflation a risky proposition especially with rates already close to zero.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 1.50%
Expectations for a rate cut of 25 bps to 6.00%
Expectations for rates to remain unchanged at 1.50%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
Expectations for a gain of 0.3% after a 0.2% gain
Expectations for a small gain from 54.2 to 54.5
Expectations for a decline of 1.8% after a 0.3% gain
Expectations for a gain of 175k after a 183k gain
Expectations for a gain of 180k; UR remains at 3.8%
Expectations for a loss of 10k jobs; UR remains at 5.8%
EZ Jobs Report
Expectations for the UR to remain at 7.8%
EZ Composite PMI
Expectations for a final print of 51.3
German Manuf. PMI
Expectations for a final print of 44.7
German Factory Ords.
Expectations for a gain of 0.3% following a -2.6% print
German Indust. Prod.
Expectations for a gain of 0.5% after a -0.8% print
U.K. Manufact. PMI
Expectations for a decline from 52.0 to 51.2
Asia/China and Australia
China Caixin PMI
Expectations for a small gain
Expectations for a smaller trade surplus
The EUR has continued to consolidate largely between $1.1300 and $1.1500 since the middle of November. Short term trends continue to alternate between a bullish and bearish bias lasting a few days to a week or so; most recently, the euro has been weakening on the back of very weak PMI and manufacturing data. Continue to expect more range bound markets with a slight bias toward euro weakness; much of the euros movements will still depend on how the GBP will react to the ongoing Brexit, U.K. Parliament, and EU negotiations.
It is hard to put into words the complexity and nuances of the Brexit negotiations and the impact on the GBP as the official March 29 deadline approaches. The ebbs and flows of the parliamentary maneuvers and votes are taking their toll on the psyche of the market. Markets continue to remain modestly constructive and optimistic for a deal as the deadline or a short term extension seems to be in the offing. The GBP will continue to reflect the continued optimism/pessimism of the most recent headline.
While the correlation with the JPY and "risk-on" or "risk-off" strategies is not as strong as in 2018, the correlation remains workable and bears monitoring. The JPY rose sharply during December as equities and interest rates cratered; as stocks have rebounded along with interest rates in the New Year, the JPY has weakened. This past week, U.S. interest rates collapsed and the JPY has appreciated again. Continue to expect more of the same bipolar responses.
RBC, our mothership, had forecast a range for the CAD for Q1 of 1.3600/$ to 1.3100/$; at the time they made that forecast in December, the CAD was very weak and had been on a sharp downtrend. Since the beginning of the New Year, the CAD has rebounded but settled into a tighter range of 1.3450 – 1.3250/$ over the past three months reflective of the directional changes in equities and commodity prices. Continue to expect more consolidative and range bound markets this week.
The CNY has been benefiting from a number of fronts since the beginning of the year. The Chinese government and central bank have been using all monetary and fiscal means possible to keep the economy liquid and afloat. Continued positive expectations surrounding a successful conclusion to the U.S. – China trade deal also spurred demand for CNY. Over the past weeks, the CNY has consolidated its gains as the trade negotiations drag on; expect more sideways trading until more news is known about the trade negotiations.
The AUD reflects the recent bipolar nature of global equities, interest rates, and commodities prices and trends. December was a "risk-off" month and the Aussie weakened sharply reflecting all that pessimism. January and February saw global equities rebound and the Aussie has followed suit; over the past month, equities have been consolidating and so has the AUD. Expect more sideways trading this week with the market paying close attention to the Reserve Bank of Australia's monetary policy meeting.
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