Markets swirling around Jackson Hole

John Hardy

Head of FX Strategy

Today, Fed chair Powell will speak at Jackson Hole, Wyoming on Monetary Policy in a Changing Economy. The title of the speech sounds like an auto-generated speech title, offering few clues, but this market will be searching intensively for new hints as to how Powell currently views the lay of the land, especially in light of the risks to the economy from the ongoing trade confrontation and to globally vulnerable economies from the issue of tightening USD liquidity.

Base case

Our base case for the content of Powell’s speech is that he clearly and frankly states the case for continued gradual hiking of policy, driven by the risk of accelerating inflation as the output gap has disappeared and the obvious evidence that inflation is now at its highest in the post-global financial crisis decade with a policy rate that is still very low by historical standards. 

Of course, it is widely agreed that the neutral rate in a world of heavy debt loads and slower productivity growth is much lower than in years past. As well, we have to remember the prominence of financial stability risks in previous Powell rhetoric, and we’ll likely see a reminder or two of how seriously the Fed chair takes its “third mandate”. 

I suspect Mr. Powell is sympathetic with the specific guidance from the Kansas City Fed president George, who specifically state the case for two more hikes this year. The market is actually leaning for the same scenario, but expectations for further hikes thereafter taper quickly.

Wildcards

The most important wildcard is the degree to which Powell airs his concerns on the various sources of risk for the forward guidance on gradual rate hikes, especially as the market is second guessing the Fed’s policy guidance beyond the end of this year. We would be shocked if Powell makes any mention of the Trump’s complaints on rate hikes, and we also think it is far too early to fret the level of the US dollar. That leaves us with a few other areas of interest that could see possible commentary that offer new information:

Yield curve inversion: This is a constant market obsession and a few Fed members are far more concerned than others about the US yield curve, with the 2-10 spread at a mere 22 basis points. A marked airing of concerns here would be seen as dovish, but something more along the lines of a comment at the July semi-annual testimony before congress may be more likely:
“If you raise short-term rates higher than long-term rates, then maybe your policy is tighter than you think. Or it’s tight, anyway.”
But what would that mean – the only takeaway from such a comment is that it becomes more important to have a look at the guidance again once the next couple of (already priced in) rate hikes are in the bag

Risks from trade policy: Powell will have to mention this, but we suspect conditional rhetoric, i.e., that the Fed would prefer to react after the fact rather than tweak guidance now as it doesn’t know how negotiations and actual tariffs will turn out.

The recent EM mini-tantrum and the degree to which Fed tightening is responsible: Very uncertain whether this issue will be discussed in much depth. If it is aired, it could be done in two ways – possibly to highlight that it isn’t the Fed’s fault and is down to the individual vulnerabilities of the weakest actors in EM (ouch!) or that the Fed is only interested if there is a risk of a blowback into the US economy (still not particularly dovish as it suggests that Powell doesn’t appreciate the fact that he is the world’s central banker as much as the US’ central banker.

Quantitative tightening: We’re not expecting anything, but interesting if it is brought up in any way, especially Powell’s views on where the right ending point is for the Fed’s balance sheet. We suspect Powell doesn’t want to trigger a new risk on rally given current still-easy financial conditions and very elevated equity markets, so not expecting anything dovish here.

Market reaction

If Powell entirely fails to even mention or even if he merely fails to express concern that further Fed policy unwinding threatens global actors with heavy USD-denominated debts on risks from the tighter USD liquidity issue, we could see a rough few sessions for EM ahead. The focus could quickly move to the USDCNY and whether the Powell Fed has lost the plot and risk appetite suffers a very ugly correction sooner rather than later if China allows the CNY to devalue in line with a fresh spike in the US dollar. 

This is the extreme end of outcomes and reactions. We could see a mix of rhetoric on the above outlined talking points that is either modestly USD positive or negative and keeps markets in a range. At the other end of reaction patterns, if the USD is going to sell off heavily from here, I suspect the support for that view will not come from this speech. Powell is not ready to unleash a dovish shock and USD weakness would be driven by a different narrative.

Meanwhile, among the major currencies, sterling sticks out for its weakness as the currency looks at increasing risk of heading into a further tailspin without positive news developments on Brexit (and assuming the Italian populist threat remains sidelined for a time. But the main standout in the weak column is the Japanese yen, which has been in for a broad and profound drubbing over the last few sessions, with the whiplash especially severe in EURJPY. The driver for the yen appears to be risk appetite more than lower bond yields in the US, as the MSCI EM equities index has bounced in sync with JPY crosses. The JPY downside may quickly pivot back to neutral or better if Powell gives EM the cold shoulder and risk appetite shudders again.

Chart: GBPUSD

Among the major currencies, sterling could be in for a rough ride if the Powell speech triggers another round of USD strength, as confidence in sterling continues to wane ahead of the increasingly tight Brexit negotiation schedule, with Brexit supposedly happening in March of next year. A move toward 1.2500 and even lower is a risk on a USD-positive outcome today, while sterling may underperform other majors even if it rises versus the USD if the market sells greenbacks in the wake of today’s Powell speech.

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Source: Saxo Bank

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