Thursday, September 19, 2019

Fed sends mixed message to the market; Bank of England unlikely to make changes on monetary policy

  • China
  • Dollar
  • Gold
  • Euro
  • Stocks

Market recap: Safe havens pull back after Jerome Powell’s speech, two-year yields rise

The US Federal Reserve announced yesterday it will cut rates for the second time this year by 25bps. Fed chairman Jerome Powell stated that inflation is likely to return to its 2% target, as the outlook for the domestic economy remains strong. Household income, he added, is supported by a strong job market, rising income and solid consumer confidence. But investor sentiment was still mixed on Wednesday, as Powell reiterated the ongoing trade war dispute between the US and China is still causing economic uncertainty and slowing global growth.

Powell also announced the Fed will be adopting a more data-dependent strategy, and will make decisions on a meeting-by-meeting basis. Yesterday’s dot plot chart may not be a strong indicator of future cuts as it includes non-voting members, but does suggest Fed officials are forecasting a stronger economy in the following years.

Meanwhile on Wall Street, equities sharply declined after the Fed’s mixed signals but pushed back later in the day. The DJIA ended 0.13% higher and the S&P 500 remained flat, gaining only 0.03% on the day, while the Nasdaq closed 0.11% down. The Dollar Index remained mostly flat, gaining 0.04%.

Safe haven assets pulled back after Powell’s speech. Gold declined 1.14% while the yen fell against the dollar, dropping as much as 0.3% during the speech.

In the bond markets, US treasury two-year yields rose 2.9 bps to 1.75%, while 10-year yields remained flat at 1.79%, narrowing the 2s10s curve.

Today’s analysis: BoE unlikely to change interest rates before Brexit negotiations conclude

The Bank of England (BoE) will announce its decision on interest rates at 3pm (GMT +4). Analysts are expecting it to hold rates at their current level of 0.75% (CME Group report investors believe there’s a 99% probability of unchanged rates), and it’s the most likely scenario, especial when you factor in recent Brexit developments, plus the current global and domestic economic outlook.

With the Brexit deadline only six weeks away, you can expect more uncertainly regarding trade agreements and other economic factors. The BoE will need to wait for the details of a deal or no-deal with the EU before deciding on what measures are needed to meet its target inflationary rate of 2%.

Recent economic figures have shown what affect the ongoing Brexit saga, combined with the global economic slowdown, is having on the UK’s domestic economy. Its GDP fell 0.2% in Q2, which was below the BoE’s flat forecast. This is due to the businesses stockpiling before the Brexit deadline of October 31st. Both manufacturing and services PMI (Markit) also slowed, with the manufacturing PMI hitting a seven-year low of 47.4 (down from 48 in July) and services PMI slowing to 50.6 in August from 51.4 in July. But there was also indications of a strong domestic economy - the unemployment rate remained low at 3.80%, while the ILO average wage growth sat at 4% in July (it was previously at 3.8%). The data suggests businesses are holding back on investments plans as they wait for an announcement from the UK and the EU.

So the BoE is unlikely to change rates at the moment while it waits for an outcome to Brexit. Sterling may remain flat after the BoE announces its decision. But if it delivers a negative warning regarding the UK economy and the implications of a no-deal Brexit, sterling may fall to 1.24’s level.

The FOMC meeting is set to disappoint the market this year

Yesterday’s Fed meeting proved it is much more hawkish than the market anticipated, and there are several pieces of evidence that support our theory:

  1. The dot plot suggests there will be no more rate cuts by the end of 2019 and 2020.
  2. The FOMC statement was largely unchanged from July, and the rate cut was designed, “to provide insurance against ongoing risks”.
  3. The rate cut was again declared a “mid-cycle adjustment” at the meeting. If the economy does turn downwards, a more extensive sequence of rate cuts would be appropriate.
  4. Powell said future decisions to be highly data-dependent, without a pre-set course.
  5. Powell described the outlook for the US economy as, “favourable”.
  6. Powell shut down the idea that the Fed would use negative rates as a tool in the future.
  7. The FOMC forecasts the 2019 Q4 GDP at 2.2%, which is stronger than previously estimated.

Dot Plot of September FOMC meeting

Economic forecast comparison between Jun and Sept FOMC meeting

Economic forecast comparison between Jun and Sept FOMC meeting

Target Rate Probabilities for 11 Dec 2019 Fed Meeting

Despite the fact the Fed has claimed there may not be any more rate cuts by the end of this year or even 2020, the majority of the traders still believe that there should still be at least one more in December. The dot plot indicated very divisive opinions from the Fed policymakers, meaning investors still feel there could be another rate cut this year.

While the Fed’s economic outlook projection is still positive, the market always projects a more dovish tone than the Fed can and will deliver. With Powell’s declaration of a data-dependent approach to future cuts, the judgement for another rate cut this year will depend on the forecast of economic figures versus the actual figures.

Throughout July and August, economic figures remained upbeat, although market consensus was that the ongoing trade war and shrinking economic growth would start to damage the economy. But the reality is the news actually hasn’t been that depressing, and the market has been more stable than expected.

In this case, the outcomes of October and December’s policy decisions are likely to continue this year’s trend – the market will be disappointed and the dollar will be strong and supported. It is expected the overall trend of the dollar against the euro, Aussie and Kiwi could remain unchanged by the end of the year.