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Marshall Gittler’s weekly comment: Happy Holidays!

August 3, 2020

August 3, 2020

Marshall Gittler’s weekly comment: Happy Holidays!Marshall Gittler

Market Recap: is the Fed making a mistake?

The Fed raised rates to 2.50% as was widely expected, but surprised the market (although not me!) by forecasting more rate hikes ahead. True, they are now forecasting fewer hikes than before: two next year instead of three, and still one in 2020, meaning three more in total instead of four. However that was a big surprise to those who had expected them to signal even fewer or perhaps even a pause for now. The stock market reaction tells the story: the S&P 500 ws up a bit more than 1% before the announcement came out, but ended the day -1.54%. A lot of the market’s fall came during Fed Chair Powell’s press conference, when he appeared to rule out a change in the Fed’s policy of gradually reducing its balance sheet.

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The Committee’s forecast for the possible range of the eventual neutral rate remained the same at 2.5%-3.5%, but their median estimate of that figure moved down to 2.75% from 3.0%. That means not only is the actual Fed funds rate now at the bottom of the range of what they think might be the long-term neutral rate, but also the median estimate for the Fed funds rate for the next three years is above their estimate of the long- term neutral rate.

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They also modestly downgraded their estimates for 2019 GDP growth and inflation (both headline and core PCE deflators).

What surprised me about the results was the modest move in the dollar relative to the large move in stocks and bonds. EUR/USD was virtually unchanged on the day.

I think reason for this modest move is that the market believes the Fed is making a policy mistake and will have to reverse course later on. The three-month Eurodollar futures show that the market expects no change in rates next year and a reduction of 19 bps – i.e., the reversal of one rate hike – in 2020. That would explain why the stock market fell but the dollar didn’t rise.

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Personally I disagree. I think the higher rate expectations for the US should support USD going forward. I expect that the Committee will indeed deliver on the tightening – or more accurately, normalization – that it has foretold, and that it won’t send the US economy into recession.

 The real Fed funds rate is still near zero anyway; I don’t think an economy where there are more job offers than unemployed persons needs such super-stimulus.

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Meanwhile, financial conditions are barely changed from when the Fed started this rate-hiking cycle back in late 2015. Nine rate hikes and no substantial change in financial conditions suggests that there’s plenty of room for the Fed to hike rates further without sending the economy into recession.

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That’s why I remain bullish on the dollar.

One thing is for sure, though: past performance is no guarantee of future performance. If we compare last year’s total return on the major currencies (X axis) with this year’s return (Y axis), we can see that almost across the board, the worst performing currencies in 2017 were the best performers in 2018, and vice-versa. It also amazes me to see the euro (-4.97%) did almost as badly as the pound (-5.64%) this year and that the Australian dollar (-7.03%) did worse than both of them.

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Volatility coming soon

The last two weeks of the year tend to see approximately normal volatility. The unusually thin market means that there could be high volatility, but the reduced news flow means that there isn’t too much to get volatile about. With the ECB and FOMC meetings out of the way, Italy capitulating to the European Commission, and even Trump apparently giving in about shutting down the US government (although there’s still time for him to change his mind!), perhaps we can expect a quiet couple of weeks. (No guarantees, though.)

Note though that January tends to be the most volatile time of the year in the FX market. That’s probably because investors who’ve wound down their activity ahead of the year-end book closing rush in to take new positions. Many hedge funds traders for example basically step back from the markets in early December so as not to jeopardize their bonuses for the year. Then in January they start up with a vengeance, taking positions that they hope will net them profits over the year.

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About this graph: Currency volatility for each week is ranked from most volatile (100) to least volatile (0) of the year. We then take the average for 2008-2017. If volatility were distributed randomly, over time each week should have an average ranking around 50. The graph shows the divergence from 50. Weeks with positive bars have been more volatile than average, those with negative bars are less volatile.

Schedule of events: not much up for now

Next week of course will be dominated by the Christmas holiday. Given that Christmas is on Tuesday, most professionals will probably be out of the market on Monday. And Wednesday is Boxing Day in the UK, the major center for FX trading in Europe. That basically leaves Thursday and Friday to trade.

Japan and China of course don’t take the Christmas holidays off (I remember being interviewed by CNBC on Christmas Day in Tokyo many years ago, since I was the only English-speaking economist at work that day) so we will get some indicators from them during this time. The Tokyo CPI comes out on Friday morning in Tokyo and later that day, the German CPI comes out. (The EU CPI usually comes out the day after the German CPI, but this time it’s delayed until the end of the next week.) Both headline figures are expected to show a slowing of inflation, in line with other inflation data that we saw last week from the UK and Canada, among others.

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Falling headline inflation globally is the natural result of falling oil prices. We’re likely to see further declines in the months ahead as oil falls further and the impact feeds through to the wider economy. While most central banks target core inflation, which isn’t immediately affected by falling oil prices, as the effects permeate the economy, it should restrain inflation generally. That might make it difficult for some central banks, particularly the ECB and Canada, to hike rates in the future and cause those currencies to weaken.

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We will also get the advance US trade figures on that day. The trade deficit is forecast to narrow slightly – that could be encouraging for the dollar and cause it to strengthen slightly.

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The following Monday it’s the day before New Years – why bother coming into the office for one day? Followed by New Year’s Day, the biggest holiday of the year in Japan. So it will be Wednesday before the market really gets under way again. The ADP report will be delayed until Thursday because of the holiday, but on Friday – the first Friday of the month – we get the US nonfarm payrolls again, as usual. So far, it’s expected to be business as usual, although of course more firms may contribute forecasts closer to the date. Right now, the market is expecting yet another trend NFP (180k vs the six-month average of 185k) with the unemployment rate forecast to remain at the decades-low 3.7%.

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Average hourly earnings, arguably the more important figure, is expected to rise by 0.3% mom. Although that would bring the annual rate of increase down a bit, the acceleration in the month-on-month rate of growth would probably be taken as positive for the dollar.

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The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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