Morning Commentary: Anchors Aweigh

Foreign Exchange - Morning Commentary

Anchors Aweigh

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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
At the Fed’s May meeting, the Fed delivered a dovish statement which was followed up by a less hawkish press conference.  This then puts extra emphasis on the meeting minutes, which will be released today, as it will give hints as to whether the statement or the press conference more accurately reflects the FOMC’s view.  Specifically, inflation expectations will be of particular concern with Powell describing factors depressing inflation as transitory.    
A building narrative in the markets has been the Fed’s concern over unanchored inflation expectations.  In other words, the Fed has become increasingly concerned over the credibility of its inflation 2% target.  Given that future inflation expectations are primarily driven by past inflation results and that PCE inflation has averaged 1.6% since the Great Recession despite the Fed’s extraordinary measures, this is a valid concern. 
Case in point, Fed member Bullard recently said that “…a quarter point [cut] in an environment where the U.S. economy is surprising to the upside…would probably send a signal that we are serious about hitting the 2% inflation target…”
Historically, the Fed has done a midcourse correction three times—in 1987, 1995 and 1998.  However there are key differences between those three situations and the US economy’s current position. In 1995, the best analogy to today, there were two key differences.  The labor market and economy slowed materially.  Additionally, the hiking cycle was much more aggressive with the Fed raising rates 3% (in 5-.75% increments) in one year versus 2.25% (in steady and predictable .25% increments) over three years in the current cycle. 
Ultimately I believe the bar remains high for an insurance cut. Beyond the three prior examples of mid-cycle cuts being imperfect analogies to the current situation, there is no guarantee that a rate cut would spur inflation.  This is significant given the Fed’s proximity to the zero lower bound and resulting limitation on the number of rate cuts at the Fed’s disposal in the event of an economic downturn.  However, the Fed’s research conference this June does represent an opportunity for the Fed to address its inflation reaction function and possibly lay the groundwork towards a new framework such as price level targeting.  
  • Tensions between the US and China are in focus again with the WH considering adding 5 additional Chinese companies that produce surveillance equipment to the list of companies blacklisted from using US components and software.
  • Hong Kong appears to be fast tracking the controversial extradition plan that would allow extradition to the Mainland.  This would, in essence, eliminate the distinction between the two court systems and throw in question the region’s autonomy.  
  • Yesterday PM May’s proposal to allow a second referendum caused the GBP to spike higher, however the currency quickly gave back those gains and now finds itself lower than where it originally started as May’s proposal seems dead on arrival.  As we highlighted in past commentaries, PM May’s premiership appears over and markets are now focused on who the next leader will be and the increased probability of tail outcomes.
  • Canadian retail sales ex autos came in much stronger than expected at 1.7% versus expectations for a 0.9% gain.  UK CPI came in softer than expected 
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