"Every positive value has its price in negative terms…” Pablo Picasso
While August closed with a clear dominance of political and geopolitical factors dominating sentiment and positioning, September has begun with economic factors (and by extension the implications for monetary and fiscal policy) at the forefront. The first half of September saw a clear rotation into more pro-cyclical assets, suggesting that markets were perhaps rethinking - and repricing - the prospects for global growth. There have been a number of factors that have driven sentiment in this regard, such as more positive rhetoric on US-China trade and hopes for a broad fiscal impulse (not least from Europe). However, the main area of global growth outperformance (at least relative to expectations) over the period has been from the US. Thus, last night’s monetary policy update from the Fed was a key focus.
Earlier in the month, there were a broad array of view on the FOMC’s most likely course of action - ranging from unchanged to a 25bp cut to a more aggressive 50bp cut and even in some extreme corners signals of an imminent return to QE. However, a more positive tone to the global trade concerns and continued strength in the US economic data (critically the acceleration of wage prices in the August employment report and the reacceleration of the service sector ISM activity index) had tempered market expectations back towards the middle ground. Notably, over the start of this week, funding stress in the US repo markets nudged any expecting no change back to the centre ground too.
"I keep my cards in my pocket and my cash in my boots” Jackson Rathbone
The funding concerns that have got a lot of airtime this week are technical in nature, and as Powell referred to in the press conference last night, "have no implications for monetary policy or the economy”. Indeed, while there is a potentially troublesome issue of reserve scarcity in the US financial system if it were to persist indefinitely, the current spike in overnight rates is a result of corporate tax payment dates driving a demand for cash (close to quarter-end cash requirements), at a time of an inverted money market curve and heavy bill issuance as a function of bloated budget deficits. There is the risk that if such stresses and thus high cash rates were to persist, that it could turn from a liquidity issue to a solvency issue for the weakest in the markets. However, for now we would suggest that the Fed liquidity provision (in the form of repo auctions) will suffice.
From our perspective however, the most significant factor of the US monetary policy debate outlined last night is the disparity between the market expectations for the future path of rates and that of the Fed itself. The ‘dots’, or rate path expectations from individual members of the Federal Reserve Board, highlight a median expectation of no further cuts (though several project one more 25bp cut). The market is currently pricing around 30bps of rate cuts this year and another 45bps in 2020.
Immediately after the Fed decision to cut rates 25bps, but prior to the press conference, President Trump tweeted his disquiet with the Fed’s balanced approach to meeting its mandated monetary policy objectives (2 percent inflation and full employment), opining that "Jay Powell and the Federal Reserve Fail Again. No "guts”, no sense, no vision! A terrible communicator!”. Ironically, immediately after this tweet, Powell managed to deliver a statement and Q&A session in which the implied monetary stimulus was significantly below the expectations of the market, calm fears of an imminent repo funding disaster against a backdrop of significant global uncertainty, and did so with a modest positive response from the USD, and US yields and minimal reaction from equities and risk assets. From our perspective, such an outcome required clear, careful and effective communication.
"Flight without feathers is not easy” Plautus
In the eurozone, following the package of easing measures from the ECB (a 10bp rate cut, reopening of the Asset Purchase Facility, extended forward guidance - including reinvestment policy and a tiering of reserve remuneration) have thus far had minimal impact on the EUR; a lower EUR is likely the most efficient, though not explicitly targeted stimulus to the eurozone economy at the current juncture. This is likely a function of two linked factors. The pushback from a number of national central bank heads to the extent of the President Draghi’s latest measures suggests either the view that monetary policy is near (or at) its effective lower bound or that there is reduced desire for further easing. Indeed, if we add this to the increased debate around fiscal easing from those member states who have room (Germany, Netherlands,...) then there is a perhaps understandable near term support for the EUR.
However, we remain of the view that the downside economic risks to the eurozone have not been negated and that the desire for significant fiscal stimulus - particularly from Germany where there is the most space - remains very low. Against this backdrop and our maintained view that the manufacturing recovery in China will be intentionally shallow (as China increasingly focuses on the quality, not quantity of economic growth), it is likely that the growth and yield premium of the US over the eurozone widens rather than narrows. From our perspective, this ultimately continues to favour a weaker EUR.
Lastly, GBP has been relatively well supported over recent days / weeks, despite the well publicised disparity between the views of the government and of Parliament. We retain a positive bias for GBP, and despite the increasing rhetoric from the press and the EU, we are increasingly convinced that there is a clear (or at least clearer) plan behind the scenes. If we are right and there is the prospect for a solution to the backstop issue and thus the passage of a withdrawal agreement, then GBP is significantly undervalued.