Of the last 150 years of developed market monetary policy, we suspect nothing will prepare market participants or Fed members for the twisted terms and double-speak the FOMC will try to unleash today as they attempt to ‘end’ the most extreme policy measures ever. Goldman Sachs’ ‘base-case’ for today’s FOMC is a “steady as she goes” message with few substantive changes in language and asset purchases ending on schedule… but Goldman warns, recent macro and market action might bias the Fed dovish.
The last 150 years (as we previously showed)…
And today’s preview…The main event today will be the FOMC statement.
Our US economists expect the FOMC to make only minor adjustments to the statement. They expect the Committee to maintain its “considerable time” guidance and assessment of “significant underutilization” in the labour market while also drawing down their asset purchases to zero. While their base case is that the statement will acknowledge recent developments overseas, they do not expect the FOMC to shift its assessment of the domestic outlook.
In today’s Global Markets Daily, we examine the potential market impact of today’s FOMC.
Our view is that recent market moves, including the drop in oil prices, could cause a dovish shift by the FOMC on inflation. We see this as a risk for the Dollar, which – after a large move in the 2-year rate differential against it – has been held up by risk aversion and safe haven flows into the US. As a result, today’s Global Markets Daily argues that, even with the bounce back in the SPX, stocks offer better risk-reward into the FOMC than the Dollar.
The global growth scare has moved interest rates against the USD
Over the last month, global growth fears have taken over markets. As our most recent FX Views argued, this has weighed on the Dollar, with the 2-year rate differential – the key driver of the Dollar in recent months – falling the most since the “no taper” surprise in 2013. This is notable, given that recent growth fears come from outside the US (as opposed to inside). For example, the IMF’s recent World Economic Outlook lowered the 2015 growth forecasts for the Euro area, Japan and some emerging markets, but kept growth the same for the US. This is consistent with the analysis by Jan Hatzius and team, who find that the effects from a stronger Dollar are roughly offset by lower oil prices, keeping our bullish growth view intact. In short, it is rather puzzling that the 2-year differential has moved so sharply against the Dollar, given that the case for US cyclical outperformance has, if anything, become stronger. We next provide a highly approximate breakdown of what has driven rates markets so sharply against the USD in recent weeks.
Since October 3 (the positive payrolls surprise), the trade-weighted 2-year rate differential of the US vis-à-vis the majors has fallen 15bp, with three factors looking to be the main drivers:
Foreign growth drag: the surprise drop in German industrial production on October 7 (data for the month of August), which coincided with the SPX falling close to 1.5%, moved the 2-year differential nearly 3-4bp against the Dollar.
Dovish Fed speak: The FOMC minutes for September, published on October 8, and comments by Fed Vice Chair Fischer (October 9) at the IMF/World Bank annual meetings highlighted the negative implications for US growth and inflation from a stronger USD and drove the 2-year differential another 7bp against the USD.
Mounting Ebola fears: headlines over the weekend of October 11/12 reported a second Ebola case in Dallas, whereupon the 2-year differential fell another 3-4bp.
Of course, this attribution is highly approximate, but it is interesting for what matters and what does not. In the latter camp is the negative retail sales surprise that sent markets into a tailspin on October 15. After an initial knee-jerk reaction, the 2-year rate differential is essentially unchanged from before that release. Instead, rates markets seem to have put the greatest weight on dovish Fed speak, which accounts for roughly half the Dollar-negative move in 2-year rates, while the foreign growth drag and Ebola fears might make up the remainder.
Risk-reward into the FOMC favours SPX over the Dollar
Two weeks ago, we argued that a rise in risk aversion supported the Dollar even as rates markets moved sharply against it. At the time, we thought that this combination – a Dollar-negative move in rates versus a Dollar-positive rise in risk aversion – made things a bit tricky for the USD. Given that risk appetite was holding up the USD in the face of low US interest rates, a dovish shift from the Fed could leave the Dollar vulnerable in the near term. We now re-examine that view as we head into the FOMC.
Our base case for today could be called “steady as she goes”:
(i) the FOMC ends QE3 with a final taper;
(ii) the “considerable time” forward guidance is adjusted only minimally, dropping the reference to asset purchases; and
(iii) other changes are small, with the “significant underutilization” phrase to describe labour market slack staying on, a possible acknowledgement of weaker growth abroad, but an unchanged risk assessment for the US that keeps the “nearly balanced” wording.
In our view, such a business as usual statement signals that, despite a weaker global growth outlook, the Fed remains optimistic on the US. In our view, this would see front-end rates and SPX rise, while the Dollar could well tread water, as the move in front-end rates is offset by improving risk appetite (as growth worries in the market abate on the Fed’s business as usual message).
On the dovish side, the main risk is an introduction of downside risks to inflation, which could weigh on front-end rates and the Dollar, while sending SPX higher. Even though market pricing has pushed the first Fed hike into Q4 2015, this scenario could see sizeable market moves since it would inevitably re-start a debate over the Fed’s reaction function. We think this scenario is unlikely, given that survey-based measures of inflation expectations remain stable and that the FOMC is more focused on core rather than headline inflation. It is also possible that the Committee downgrades its risk assessment for US growth, but again we see this as unlikely given that we are tracking Q3 above 3%. While an extension of asset purchases beyond this meeting was flagged by St. Louis Fed President Bullard, we think communication just prior to the start of the blackout period has made it clear that this will likely be the final taper.
On the hawkish side, any change in the “significant underutilization” language (for example, to “slack remains elevated”) would see the front-end interest rates and the Dollar move up, while SPX would likely fall, weighed down by rising rates and, potentially, a move up in risk aversion. Given that this language only went into the statement in July, this is unlikely at this stage, in particular since this meeting does not have a press conference. A hawkish surprise would also be no acknowledgement of weaker global growth. Again, given that this was perhaps the main talking point at the recent IMF/World Bank annual meetings, we see this as unlikely.
Goldman’s Exit 101…
Source: Goldman Sachs
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