Sent: 09 June 2020 09:24
Subject: FED THOUGHTS – Great Expectations and the dollar’s influence.

 

In a nutshell, with the recent moves into risk, powered in part by the longest slump in the dollar in a decade, the bar for disappointment tomorrow is set pretty low at a time risk appetite is tightly wound with high leverage (see Margin Debt increases and retail options appetite). A delay of fresh good news from the FOMC could see some sharper unwinds in near term risk … ready for a fresh explosion in July when the realisation of a slow return of jobs (even with reopening, it is going to take a long time to recoup the lost ground with partial reopening).

All eyes shift to the FOMC meeting tomorrow – and despite no change expected at the headline level for rates, there are growing expectations for fireworks potential in the commentary. Negative rates have been swiftly dismissed by many of the Fed Presidents, not least Powell who in May said the committee’s view on negative rates had not changed. Even with the persistent barrage from Trump, “this is not something we are looking at”, the Fed Chair has consistently reiterated. As such, the outlook for negative rates on Fed Funds futures has diminished, where middle of the covid crisis the markets had been pricing NIRP from as early as May next year. Markets are clearly pricing in more policy support expectations given there is still a big disconnect between the V recovery in equities and other risk assets vs the slower recovery outlook for the broader economy – albeit data has been improving from a low base, particularly the high frequency data (car sales, flight bookings, gasoline consumption, hotel occupancy etc). M2 Money supply and Fed Balance sheet are already accelerating at the fastest rate in history, which has provided the legs for the risk V-recovery:

Recent significant pressure on the dollar, the DXY had been down for 9 consecutive days for its longest losing streak in a decade, highlights not only some pain trade in crowded positioning in many asset classes, but also an expectation for more from the Fed. The messaging has been consistent, inflation can overshoot and the long term economic outlook is a concern, most officials continue to give cautious tones even as State and other countries reopen their economies. Uncertainty prevails still.

The immediate question for risk assets is what will be delivered from the FOMC tomorrow vs what the street is apparently expecting:
 – No move in rates is the base case across the board, with Fed Funds @ 0-0.25% there is very little wiggle room in any case without reigniting talk of NIRP and putting Trump in a position of looking like he controls the Fed.
– Forward guidance could be used to steer the conversation, but with the Fed’s current stimulus programmes in their infancy and the MLP (mainstream lending programme) coming online it seems premature to expect a great deal other than pledges to support price stability and jobs growth going forward.
 – Jobs outlook is improving with the reopening of economy, witnessed in the Manpower monthly recruitment report in which the 3Q outlook for hiring hits 10yr low (not unexpected) but 60% of employers surveyed anticipate hiring levels returning to pre-pandemic levels by the end of 2020 – with many expecting a return before the end of summer.
– inflation breakevens (5yr as proxy) are well off the lows but still have a significant way to go before getting close to pre-covid levels, let alone target rate. Though University of Michigan 1yr inflation expectations are surging… but again, Fed is willing to look past near term inflation risks at this point (probably welcomes them).

  

 – talk of more fringe policy discussions, the main one being Yield Curve Control. Uber-dove Brainard has been the most vocal proponent of using QE to target specific yields to prevent borrowing costs rising too much too quickly, although Clarida and Williams have also been open to using this policy and it has the backing of the likes of Bernanke and Yellen. So it has some big supporters. This would almost certainly lead to further dollar weakness, a ballooning of the Fed Balance Sheet and an even heavier flow of debt issuance – risking further Japanification of the economy. But look to what happened to the JPY and Nikkei when Abenomics was launched!

 

 The Dollar Index, before this morning’s uptick, was sitting with an RSI of 23! The most oversold by that metric since early 2018. Matched by Euro RSI at 70, Cable 69, and EM FX basket 79.5 coming into today.
 

The US stock market has recovered all of the lost ground, and now 34% of the stocks in the S&P 500 have an RSI reading above 70, compared with 0% below 30. The difference between overbought and oversold stocks is the highest since early 2018. Perhaps more importantly, given what has been driving the market and sentiment, is that the Russell1000 Value index now has an RSI of 75 and is up 49% from March nadir. Shorts have been capitulating aggressively, the GSCBMSAL index has outperformed by 7% since the start of March.

 

Where are we with the Value vs Rotation/Momentum which has been a key driver for both sentiment and the pain trade? Still a way to go for the real mean reversion but a some significant moves now been made for the short term.

 

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