The market celebrated yesterday’s dovish shift from the Fed, as the Federal Open Market Committee statement dropped the “gradual increase” language on the intent to raise rates further, replacing it with a commitment to remain “patient” until conditions make it clear what to do next. Then, the FOMC took the odd step of releasing a special one-page statement on its balance sheet reduction policy rather than including language on this in the statement itself.
In this statement, it is clear that the FOMC is now far more sensitive to the possible impact of QT as a policy tool: “Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.”
It’s easy to see why the market has celebrated this meeting outcome, but I am unsure how far the market can extend this reaction in snapping up risky assets (and assuming a weaker USD is the flip-side of further strength in risk appetite). Past cycles show that the majority of the pain in asset markets unfolds as central banks find themselves behind the curve and are swinging into full gear with accommodative policy – for example in 2001-02 and in 2008 into early 2009.
As we discussed on today’s Morning Call, if this cycle is similar to past cycles – are we at a September 2007 moment or a 1998 Asian crisis response moment. In the former, the market very briefly celebrated the then Fed chief Ben Bernanke’s surprise 50 basis point cut at the September 18, 2007 FOMC meeting but the enthusiasm peaked inside a month as it became increasingly clear that the Fed was doing too little too late. In late 1998, the previous Fed chair, Alan Greenspan, chopped rates three times in response to the Asian financial crisis, but the damage never spread into the US economy, and tech stocks blasted higher into the 1999-2000 bubble.
The market response to the FOMC meeting was swift and fairly large in currencies, though still somewhat muted relative to the scale of the dovish surprise in my view, perhaps because the market was already increasingly positioned for a dovish shift from the Fed. The question is how far a new weak USD trend can extend here – a couple of factors are holding me back from a weak USD view beyond the next couple of weeks.
First, the Powell Fed has merely switched into neutral here and provided guidance that will allow it to respond either way from here – but it hasn’t actually eased anything – and it will only actually take the step to ease in the presence of either brutal market pain like we saw back in December or very clearly softening economic data. The logic quickly gets circular. Second, how long before other central banks, particularly the Bank of Japan, European Central Bank and Reserve Bank of Australia, are actively shifting into a new easing cycle as well?
Not long, especially for the BoJ. Beyond the Fed policy angle, we also have the pressing issue of US-China trade talks over the next several weeks which could either support the latest moves further or provide a sudden reality check. Finally, a natural headwind that will develop as long as the Fed is not actively easing is that the huge US treasury issuance will rise and must be absorbed by the market – and those are funds that have to come from somewhere. In other words, we eventually get either higher yields (lower bonds) and higher equities or we get lower yields (higher bond prices) and lower equities.
AUDUSD jumping to attention on the dovish FOMC surprise and manages a close at a new local high and now facing down the 200-day moving average. We have spelled out our longer-term concerns for Australia’s housing market and an unfolding credit crunch, but recent China stimulus noise and a spike in iron ore prices and the Aussie’s traditional role as a G10 barometer of risk appetite are supporting. If the positive mood in global markets is sustained here and the US-China trade negotiations avoid a train-wreck over the next month, the upside could stretch all the way to the key 0.7500 area.