We’ve had a full day for the markets to adjust to the new reality after Wednesday’s FOMC announcement. First of all some quotes from the FOMC press release in bullet points:
- pace of job gains picked up while the unemployment rate remained steady
- a range of labor market indicators suggests that underutilization of labor resources diminished
- business fixed investment and net exports stayed soft
- energy prices appear to have stabilized
- Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.
- Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate
- Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term
Reading between the lines of FOMC press releases is art as much as science, but I can tell you that the consensus is that a September hike is considered very likely, providing any Greek catastrophe is not deemed to have an adverse global market impact. It’s worth pointing out though, that Goldman Sachs has now pushed back their expectation of the first hike to December, the rationale being that no clear signal was given for September which was a pre-condition as far as they are concerned. No one expects this rate hiking cycle to take interest rates substantially higher. Historically US rate hiking cycles have tended to raise the level of interest rates anything from 3 – 5%, but this time around the expectation is for no more than 1 – 2%, leaving an end rate of about 2% which is no great shakes. Furthermore, given the job the ECB has done over the last few years to reduce, if not, eliminate the risk of contagion, I consider it very unlikely that the goings on in Greece will delay any action on the other side of the pond.
You really wouldn’t know it from the price action in the currency markets. Over the last week, the US dollar is significantly weaker against its major peers. There have been a range of explanations for why this is so, and I will expand on that shortly. But I thought it worth illustrating the one asset class where the reality on the ground is impacting prices in the way one would expect. Below are charts of the main US equity index, the S&P 500, and the European index, the Eurostoxx 50. The divergent price action since the start of April is clear for all to see…
But back to the seemingly anomalous dollar price action in recent days. If you were observing from Mars, and you were told that the Federal Reserve is about to hike interest rates, and Greek debt default is imminent, you would expect – assuming of course financial matters are conducted in the same way across the solar system and by all intelligent species – the US dollar to rally strongly while the euro collapses. But that’s not what we’ve seen, in fact we’ve seen the exact opposite. The two most intriguing explanations I’ve heard, quite apart from my stock answer to this conundrum (which is that the market still owns too many US dollars, and has sold too many euros already) are the following:
- Investors who had been buying European stocks had been hedging their exposures. The Greek crisis has resulted in a reversal of that trade (quite apparent from the chart above illustrating the fall in European share prices of the last few weeks), and as a result the hedges are being unwound as well. If you close out the hedge, it means you are buying euros.
- Greece should not have a material impact on the euro anymore as the risk of contagion has been eliminated. Thus what we are seeing has more to do with a correction in the US dollar following fairly soft Q1 data.
I invite you to choose the narrative that best fits reality as you see it. Personally I think there is something to be taken from each of those explanations.
Back to reality… The UK economy, as highlighted by both employment and consumption data in recent days is one of the rock stars amongst the advanced economies, and is amply justifying the incumbent Tory party’s recent election victory. GBP/USD broke the 1.5816 level I have discussed repeatedly, and as a consequence I have thrown out my view that the dollar bull-trend is back in play. If the facts don’t support a theory, dump it and don’t look back. As far as I’m concerned, it is irrelevant that EUR/USD has not currently confirmed this by breaking to a new high as well. That may well happen in the next few days or weeks, but I am happy to view the period since the mid-March EUR/USD lows until now as part of a huge corrective complex within the bigger picture US dollar bull trend that has been in force for over a year. In the context of similar dollar bull-trends that have occurred in the last 40 years, this is an entirely reasonable view to maintain. At the end of the day, it all comes back to the bigger macro picture. Strong solid growth in the US and UK, versus more sluggish signs of recovery in the Eurozone tells me that the USD and GBP will continue to outperform EUR in the months ahead, interspersed with periods like now where corrections are necessary because the market has got ahead of itself.
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