The FOMC came and went, and as expected the Federal Reserve’s pledge to be “patient” before raising rates has been removed. However the central bank has also signalled it will probably be cautious about actual rate hikes. This is no surprise, and I’ve made this point in recent blogs, the strengthening of the US dollar is a de facto hike in interest rates as monetary conditions tighten as a currency appreciates. The fact that the FOMC specifically mentions dollar strength is very important, at least in terms of noting the impact of import prices on inflation, but as I’ve said many times before, if employment conditions continue to improve at the current pace, the hand of the Federal Reserve will still be forced. There is no greater sign of incompetence in central banking than getting behind the curve. Ms Yellen is extremely competent, I think it is very unlikely that could happen to the United States. I also believe, that rates at 0% represent an unwelcome problem for the Federal Reserve and any chance that they can get away with interest rate rises will be gladly taken. So, with all due respect, to financial journalists holding on to the hope that rates will continue to remain unchanged for months to come… I think the Federal Reserve will hike as soon as they can. If they could get away with 2 hikes of 25bps in 2015, taking the Fed funds rate to 0.5% I think they would jump at it. After all, what happens when the next recession comes and you have no ammunition to play with? I’m sure you see the point…
The reaction in the currency markets was not altogether surprising. After all for months investors and traders alike have been betting on the Federal Reserve’s actions yesterday. The declaration that rate hikes are coming, has been the motivation for the dollar buying trade, and when the central bank confirms the market view, the smart guys move to take profits, it happens every time… “buy the rumour, sell the fact”. While I had expected to see a dollar selloff, the extent of the move caught me by surprise. It is clear that liquidity isn’t what it used to be, and policy makers (one would hope) should take note. The financial markets are NOT safer than they used to be, far from it. But already today we can see signs of dollar strengthening again as the positions have reduced somewhat and dollars have been re-purchased at vastly superior levels. I am not certain if the correction is over, it will take another few days to increase my confidence level, but it is very likely that 1.1045, the overnight high for EUR/USD and 1.5165 for GBP/USD are hugely significant levels. It is probable, these currency pairs will not exceed those highs so long as the dollar bull trend persists. I will be able to make that statement with a bit more confidence after further study, but it is looks likely to be the case.
US equity markets reacted very positively to yesterday’s announcement, but as I have inferred, US dollar strength is likely to continue. It is therefore probable that stocks which are more sensitive to dollar strength will continue to underperform relative to the more dollar insensitive component of the US equity markets. Whether the S&P rises in a dollar strengthening paradigm will depend on where we are in the re-allocation of investment funds away from exporters and other dollar sensitives to more domestically focussed corporates which are either indifferent to dollar strength or indeed benefit from it. But it is important to note that we have seen these situations before and dollar strength is no barrier to further US equity index gains.
Finally, we saw a fighting budget from the UK government yesterday. It was a good budget, a smart one, only time will tell whether it’s enough to get the Conservative Party over the line. But incumbency is an advantage of sorts, and with both larger parties – Labour and Conservative – neck and neck, I still think the question will be asked by enough in the polling booths in 49 days time… is a change justified? I’m not sure it is, but maybe I’m biased!
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