FX Daily: Markets Dangerously Underprice Risk of Central Bank Tightening

19th June 2014 By: Eimear Daly

  • Fed’s Yellen put the recent higher inflation print down to “noise” in the data and confirmed that inflation continued to run well-below the FOMC’s 2% objective. (MNI)
  • Fed’s Yellen said there is uncertainty about monetary policy and a range of disagreement among FOMC regarding the path of short-term rates. (MNI)
  • BoJ’s Morimoto said the Bank must watch upside and downside risks to exports though maintained that exports would gradually recover on global growth. Morimoto believed Japan’s core CPI would rise accelerate gradually and the 2% target can be hit around fiscal 2015.
  • Bank of Japan officials now estimate that the domestic output gap has moved into positive territory but a pullback in demand after April sales tax hike is keeping them cautious about the public’s inflation expectations.(MNI)
  • China’s Ministry of Finance is to cut the VAT rate for some small companies as part of ongoing tax reform. Companies paying tax rates of 4% or 6% will pay just 3% from July 1st. The government has been slowly expanding a scheme to replace the business tax with a VAT for the services sector in order to reduce their tax burden and nurture their development over traditional manufacturing industries. (China Securites Journal)
  • Profits of state-owned Chinese enterprises rose 6.9% y/y to CNY942.6 billion in the first five months, versus 6.5% in the first four months.
  • China’s Current Account Balance came out at +$7.0 billion versus a preliminary $7.2 billion. The Capital and financial account was significantly lower at $94.0B versus expectations of $118.3B.
  • New Zealand’s quarterly GDP came in marginally below expectations at 1.0% versus forecasts of 1.1%. The quarterly growth rate exactly match output growth in Q4. Annual output growth however marginally exceeded expectations of 3.75 at 3.8%.

Events yesterday were clear examples of market expectations overshooting the outlook for monetary policy. Thursday’s US CPI shot higher to 2.1%, above target and was the third consecutive gain for the index. This whiff of inflation meant many market participants went into the Fed meeting with a clear hawkish bias. The Fed effectively reissued their statement word for word, maintaining their forward guidance for ultra low interest rates based on inflation running continuously below target. The Fed even kept the warning tag line that inflation persistently below its 2 percent target “could pose risks to economic performance”. The FOMC was obviously comfortable overlooking inflation that was now above target. As for the heavily anticipated economic projections, they were mixed. GDP growth was sharply downgraded, unemployment target range downgraded and inflation range slightly upgraded. Even the controversial dot plot was less than clear cut. While members brought forward the timing for the first rate hike, rate hikes would now be slower to come and the long run interest rate lower. Considering the hawkish bias the market held going into the meeting, the sharp downgrade in GDP outlook and the appearance that inflation was obviously not a risk to the Fed’s outlook meant that the meeting was taken as moderately dovish by the markets.

However markets may have slightly downplayed how hawkish this Fed meeting actually was. Yellen admitted in the Q&A that the US’s potential growth rate may be lower for some time. This is certainly backed up by the downgrade in the Fed’s view of the long-term interest rate and although the Fed saw the economy as rebounding after the slow winter, the housing market was an exception to this and was viewed as remaining slow. The slack in the US economy isn’t as great as previously though meaning the point at which inflation will begin to emerge is a lot closer. There are trillions of excess reserves in the US system, courtesy of the Fed’s aggressive QE policy and as soon as we get some return of money velocity, inflation will be back. The subtle shift forward in the dot plot for sooner rate hikes may have been members recognising this risk. Yellen may have tried to downplay the recent spike in US inflation as “noise” but the pressure on energy inventories after the cold winter was long over by May, meaning the excuse of temporary factors is looking less and less credible. We got the first whiff of inflation in corresponding surges in the PCE deflator, PPI reading and core CPI and now with less slack in the US economy that first whiff of inflation is about to stink.

The trade weighted US dollar initially popped higher on the release as the markets scrambled to decipher the dot plot but gradually settled lower and reached a monthly low in the morning’s session. The US 10 year yield was pressed further lower to below 2.6% and the US 2 year fell to just 0.43%. Right now the US yields are pricing in less than 2 hikes in the next 2 years and we express concern that the US money market and US dollar are now underpricing the risk of policy tightening in the US especially if inflation picks up. We maintain our view for the first increase in the Fed funds rate in mid-2015. This comes with a clause however that further US rate increases will, as the Fed persistently repeated be slow and gradual with a lower termination rate.

The euro has begun to unceremoniously crawl higher against a range of currencies. The biggest driver appears to be a reversal in the carry trade crosses, which saw sharp declines after speculation the euro could be used as a carry trade currency. EURCAD and EURAUD reached lows of C$1.46720 and A$1.43600 respectively on June 12th before the carry trade began to reverse. I would argue that the euro was never a funding currency as internal carry is still available within the Eurozone itself. Now with escalating tensions in Iraq and the ongoing Ukrainian crisis, the argument for even entering a carry trade is less certain, not with Brent and natural gas prices at these elevated levels. It also appears that the brunt of the initial reaction to Eurozone negative deposit rates has passed. The use of deposit facilities at the ECB has jumped over the last few days and Eonia even ticked higher in the last two sessions. The euro has the habit of front running ECB policy decisions and then retracing the currency impact in their immediate aftermath. This is now what is evolving, albeit with a slight detail. We can expect euro-dollar to continue its slow crawl higher, reaffirming our call for $1.37 level in one month’s time.