Hawks Rule the Roost at the Fed These Days

The opposite of a “dovish hike” leads market commentary.

Inverted yield curve, anyone?

Photographer: Andrew Harrer/Bloomberg

Going into Wednesday's interest-rate decision by the Federal Reserve, market sentiment was leaning toward a dovish hike, meaning that the U.S. central bank would raise rates but acknowledge some headwinds such as turmoil in emerging markets. What they got was the opposite, as policy makers said they still expect the economy to evolve in way that warrants “further gradual” rate increases.  

In other words, the Fed expects to raise rates a total of four times this year, up from the three bumps central bankers had signaled back in March. If it wasn't evident before, it should be now that this Fed under new Chairman Jerome Powell intends to keep tightening monetary policy until, as East West Investment Management Co. market strategist Kevin Muir put it in a pre-decision blog post, something breaks. The question is, when will that happen? It's impossible to know, of course, but the bond market seems to suggest that such an event is getting closer. That can be seen in the yield curve, or difference between two- and 10-year Treasury yields, which shrank to less than 40 basis points following the rate announcement. The gap is the narrowest since 2007, and a growing number of strategists say it's likely to invert before much longer, an event that typically precedes a recession.

Inversion Ahead?

The gap between 2- and 10-year Treasury yields is the narrowest since 2007

Source: Bloomberg

Here's the kicker: in two weeks, the Fed is scheduled to pick up the pace of its unwinding measures. Currently, the central bank is allowing its $4.32 trillion of balance-sheet assets to shrink by $90 billion a quarter; that will ramp up to $120 billion starting next quarter. "The heat is on!" Putri Pascualy, a managing director and partner at Paamco, which manages $9.9 billion, wrote in a research note Wednesday. "The balance sheet reduction is the ($4 trillion) elephant in the room."

It's notable that emerging-market stocks and currencies immediately extended their declines following the Fed's rate decision. Emerging-markets have been under a great deal of stress recently, and officials there largely blame the strong dollar that has resulted from the Fed's efforts to tighten monetary policy. As a result, central banks in developing countries have had to adjust domestic policies in response. The Reserve Bank of India boosted a key interest rate by 25 basis points to 6.25 percent on June 7, its first increase since January 2014. Perry Warjiyo, the new governor of the Bank of Indonesia, complained last week that the Fed was considering only domestic U.S. objectives in setting policy rather than the impact of its measures on foreign economies. The MSCI EM Index of equities fell, extending its decline since peaking on Jan. 26 to 11 percent. The MSCI EM Currency Index dropped to a fresh low for the year, bringing its losses since peaking on April 3 to almost 4 percent. The biggest losers Wednesday were the Argentine peso, Turkish lira and South African rand. Powell said in early May that the Fed’s gradual push toward higher rates shouldn’t be blamed for any roiling of emerging-market economies, which he added were well-placed to navigate the tightening of U.S. monetary policy.

Taking a Hit

Emerging-market equities and stocks suffer from Fed's decision to raise rates

Source: Bloomberg

Speaking of the dollar, the Bloomberg Dollar Spot Index briefly rose to a fresh high for the year, adding to a turnaround that started in April. With yields on two-year Treasury notes yielding some 3.17 percentage points more than similar-maturity German bunds, it's almost impossible for international investors not to own dollar-denominated assets. The gap between U.S. and German yields has expanded from about 2 percentage points this time last year. Also, while the Fed is committed to raising rates, it's unclear when the European Central Bank or Bank of Japan will start removing their extraordinary accommodation. "The dollar (had) been weakening steadily through the session but recovered smartly on what was understood to be a hawkish statement," Marc Chandler, the head of currency strategy at Brown Brothers Harriman & Co, wrote in a research note. But just as quickly as the dollar ran up, it fell back after the Wall Street Journal reported that the U.S. is preparing tariffs on billions of dollars of Chinese goods as early as Friday. The decision awaits President Donald Trump's approval, the paper reported, without saying where it obtained the information. The exact amount of goods subject to tariffs is in the process of being finalized, the WSJ reported. 

Roller Coaster

The dollar soars on Fed rate move only to drop on trade war concerns

Source: Bloomberg

A budding rally in equities abruptly ended because the additional rate hike that's now expected to come this year "suggests restrictive monetary policy sooner rather than later, which could ultimately impact investors in riskier assets, including high-yield bonds and equities," according to John Hollyer, global head of Vanguard’s Fixed Income Group. "Concerns of the Fed being behind the curve and allowing the economy to overheat may be replaced with concerns around the faster pace of tightening in the coming quarters," Bloomberg News reported Hollyer as saying. Even before the Fed's decision, some analysts were looking for a reversal in equities, especially in the shares of faster-growing companies, which are nearing a dot-com era record relative to lower-priced stocks, according to Bloomberg News's David Wilson. The ratio between the S&P 500’s growth and value indexes has expanded as much as 25 percent since December 2016 and last week closed within 3 percent of a record set in March 2000, when an Internet-driven surge in stocks reached its peak. Jonathan Krinsky, chief market technician at Bay Crest Partners LLC, and John Lynch, chief investment strategist at LPL Research, both highlighted the potential for a value-stock rebound in reports this week. 

Gorging on Growth

Near-record S&P 500 ratio spurs speculation on value-stock rebound

Source: Bloomberg

The price of a barrel of oil rose despite Trump taking to Twitter to accuse OPEC of inflating prices. "Oil prices are too high, OPEC is at it again. Not good!" Trump tweeted on Wednesday. In April, he slammed the cartel, which he said was behind artificially high prices after it signaled a willingness to tighten crude markets. At the time, he said the cartel "was at it again" and it "will not be accepted." Nevertheless, traders were more influenced by an Energy Information Administration report that said U.S. stockpiles declined 4.14 million barrels, the most since March and counter to an industry report showing an increase. Trump may still get his wish. Investors are looking for signs of whether OPEC will reach a consensus on boosting production, with the group set for a fractious meeting in Vienna next week, according to Bloomberg News's Grant Smith and Catherine Ngai. The International Energy Agency said Saudi Arabia and other Gulf producers may need to boost supply to offset potential losses from Venezuela and Iran. “While some members appear to be against the idea, we believe that we will see a gradual lifting of cuts,” Warren Patterson, a commodities strategist at ING Bank NV in Amsterdam, told Bloomberg News.

Ignoring Trump

Oil rallies despite Trump's tweet that OPEC is keeping prices too high

Source: Bloomberg

One down, two to go. Now that the Fed's monetary policy meeting has passed, the focus turns to the European Central Bank's gathering Thursday and the Bank of Japan's confab on Friday. Of those two, the ECB is likely to be the most impactful. That's because although no one expects the ECB to raise rates, there's a good chance that ECB President Mario Draghi signals an end to quantitative easing this year, while saving the details for future meetings, according to Bloomberg Intelligence. If so, that would signal a huge vote of confidence in the euro zone's economy, especially since the data has been underwhelming of late. On Wednesday, for example, Eurostat said that euro-area industrial production dropped 0.9 percent in April, exceeding the median 0.7 percent decine forecast in a Bloomberg survey, as production fell in the region’s four biggest economies. The region's economic data has been undershooting estimates to a degree not seen since the crisis days of 2011-2012, according to Citigroup Inc.'s economic surprise indexes.

What If the Fed Just Lets Inflation Run for a While?: Conor Sen
Gundlach Sees 6% Yield in 3 Years. Anyone Else?: Brian Chappatta
Share Buybacks Are Distorting Profit Picture: Stephen Gandel
Why Wall Street Isn’t Freaking About Trump: Barry Ritholtz
ECB Should Seize the Day and Call Time on QE: Marcus Ashworth

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