Follow The Bouncing Fed

While all eyes and ears will conveniently and expectedly be on the Fed announcement and press conference in a few hours, the real action continues to take place in China, where the liquidity crunch is becoming unbearable for the local banks (and will only get worse the longer Bernanke and Kuroda keep their hot money policies). The CNY benchmark money-market one-week repo rate was 138bp higher overnight to a 2 year high of 8.15%. The 7 day Interest-Rate swap rose for a record 13th day in a row jumping +10 bps to 4.08%, the highest since September 2011. China sold 10 Year bonds at a 3.50% yield, above the 3.47% expected, and at a bid to cover of 1.43 which was the lowest since August 2012. Moody’s commented that local government financing vehicles (LGFVs) pose significant risks to Chinese banks. LGFVs accounted for 14% of loan portfolios at end-2012 according to Moody’s.

Elsewhere, in Japan central printer Kuroda was speaking in parliament promising that Abenomics will return to normal and talking up the market once more, even as the USDJPY finds itself unable to regain the previous upward momentum despite the rhetoric. Japan reported a jump in May exports, which however was offset by imports, leading to a better than expected trade deficit at JPY 993.9 billion on expectations of JPY1.22 trillion. Still, this was the largest ever May deficit for Japan, and the third biggest ever. Good news then?

Little out of Europe, where several Eurozone and German speakers have poured hot water on the Cyprus request for a bailout modification, saying no change in hell. Even though stocks in Europe have recovered from a lower open, which was also marked by a sharp sell-off in stocks in thin  markets, there is a distinct feel of unease, with credit spreads wider as market participants look forward to what is expected to be a crucial FOMC meeting. Wider credit spreads in Europe weighed on financials in Europe. Looking elsewhere, the release of the most recent MPC minutes showed that the MPC voted 6-3 to keep QE unchanged, as expected, with the majority stating that the QE and FLS are still working through economy.

And with all that out of the way: back to your regularly scheduled Fed watching which culminates with a 2pm announcement and a 2:30 pm press conference.

The main bulletin headlines via Bloomberg:

  • Dollar Index trades in a range as markets await clues from FOMC meeting with Bernanke’s press conference the highlight. Most major currencies also sidelined ahead of the U.S. event.
  • Swedish new consumer confidence at 98.2 in June vs 97.7 in May
  • Swedish unemployment rate at 8.2% in May vs est. 8.8%
  • Yen gains for first time in three days versus dollar on bets Bernanke won’t move toward tapering of QE
  • BoE June minutes show King lost his final BoE vote, as majority of committee blocked his bid for more stimulus as they saw economic strength
  • U.K. banker bonuses face decade delays in industry overhaul
  • Bloomberg JPMorgan Asia Dollar Index halts two-day decline before Fed ends two-day meeting today; Thailand’s baht leads gains
  • Korean Won gains on speculation that exporters repatriated income to benefit from currency’s decline to near 2-mo. low

SocGen recaps the layout of the macro and FX considerations on FOMC day:

Market tensions erupted across different asset classes last month and the nature of the Fed's guidance today on the policy of asset purchases will help to decide whether (bond) markets have moved too far in too little time. In truth, the bank's message at the previous FOMC meeting on 1 May was pretty clear: ‘The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes'. We see little incentive for the Fed to draw a different set of conclusions on the economy today (eg payrolls came in below 200k last month, probably insufficient to move the policy needle), but some changes to the statement or clarification in the press conference will have to be made to defuse tensions which have propelled 10y cash yields and mortgages 60bp higher since the last meeting. Bernanke made the observation in his JEC testimony to Congress last month that reducing QE purchases would be possible at the next few meetings. Since that testimony on 22 May, the S&P has lost over 1.5% and USD/Asia has gained 1.3%. Laying out the next steps without committing to a timetable to retain flexibility and data dependency is probably the best one can hope for today as the Fed tries to soothe the bond market. Clarifying the mechanics of an exit from stimulus should help volatility to ease off, at least for a while until the timetable for tapering becomes clearer. This may temporarily revive carry/commodity interest (AUD, ZAR) and support a bounce in EM assets more generally, but we see this relief, if it happens, as an occasion to reduce exposure to EM assets.

Reloading topside USD/JPY strikes and selling volatility are two strategies that could work in FX to benefit from today's FOMC statement, whilst a temporary re-adjustment lower in rates and reduced volatility favours a tightening in spreads (receiving USD 1y2y swap forwards, still high vs USTs). In outright terms, 10y swaps still look set on extending above the 2.42% level above which they narrowly managed to close last week. Vols in USD/JPY have started to drift lower since Friday and the 1mth fell to a low of 15.215 yesterday vs a high of 18.90 last week. Unless AUD/USD slips back towards to 0.9400, vol should be a sell too.

The other focus of the day will be the BoE minutes. The 0.98% bounce yesterday in EUR/GBP was order-driven and does not strictly represent a change of sentiment towards the currency pair. Having been locked in the narrowest of ranges for the best part of the last two weeks, only on a close above 0.8606 is it worth considering raising the short-term target to 0.8650. This scenario would get a lift If it transpires that none of the three doves (including outgoing governor King) backed off from voting for an imminent £25bn QE increase despite the spate of stronger macro data of late.

Finally, DB's Jim Reid with the full recap

The reality is that not much has changed data wise since Bernanke's JEC testimony on May 22nd and therefore he has an opportunity to say that the Fed are still data dependant and leaving no set timetable for tapering. However we have to acknowledge that the minutes to the May 1st meeting were on the hawkish side and there are those in the Fed that want to start to pull back from the current levels of stimulus. Our best guess is that the FOMC statement will actually be pretty similar to the last one but that the Q&A will be where all the fun will start. Bernanke has to address asset purchases and every nuance in his replies will be seized upon by markets.

Our gut feel is that the Fed will err on the side of caution with regards to tapering talk and that no additional signal will be given by the Chairman to accelerate the market's fears. However this view is more based on the fact that it’s a personal view that it would be a policy error to withdraw stimulus today. Indeed the last two quarters have seen the lowest US nominal GDP since Q1 in 2010 - some 13 quarters ago now. This is a weakening nominal recovery and one that even at its peak was still very weak relative to history. With a huge debt load nominal GDP is very important but it gets far less attention than it deserves. Nevertheless, the Fed may think very differently to us and their updated economic forecasts will shape their thinking to some degree. They may see the recent dip in inflation as transitory.

In terms of other things to look out for from meeting, DB’s Peter Hooper noted that if they do hint towards imminent tapering then they will stress that fed funds rate hikes are still a long way off and well into 2015 under the FOMC’s projections. Regarding the Fed’s Summary of Economic Projections (SEP) which are scheduled to be released with today’s policy statement, DB’s Joe Lavorgna thinks that the Fed’s forecast ranges for real GDP growth (2.3%-2.8%) and unemployment (7.3%- 7.5%) remain tenable, and thus are not likely to change meaningfully. Changes may occur in inflation forecasts given recent softening inflation indicators. In the last SEP, the year-end core inflation range was 1.5%-1.6% - currently, the core PCE deflator is running at 1.1%. As a result, our US economists would not be surprised to see the lower end of policymakers’ 2013 core inflation range be reduced by 20-30 basis points. We suspect Bernanke’s thoughts regarding the recent market volatility will also be closely watched and keenly interpreted. Finally, there will probably be some questioning around the Chairman’s plans when his tenure ends in January 2014.

On the topic of EM weakness we are seeing little respite from the price action overnight. Indeed, Asian equities are trading lower led by the Hang Seng (-1.2%) and KOSPI (-0.9%). This comes despite the S&P500 (+0.78%) closing near the highs yesterday. Chinese banks are again under some pressure today with banking shares 1-2% lower and CDS/bonds of some major banks 5-10bp wider in Asian trading amidst further reports of tight onshore interbank liquidity. China's CNY one-week repo rate is 138bp higher overnight to a 2 year high of 8.15%. Moody’s commented that local government financing vehicles (LGFVs) pose significant risks to Chinese banks. LGFVs accounted for 14% of loan portfolios at end-2012 according to Moody’s. Although the risk is hardly news for markets, it’s adding to an increasingly cautious view of the sector. Elsewhere in Asia, Japanese equities are trading higher this morning, coming off a weaker yen (-0.1%) and better than expected export numbers (10.1% yoy vs 6.4% expected). The Nikkei is trading 1.3% higher with only utilities stocks in the red, weighed by TEPCO shares (-6.7%) after the company found high levels of radioactive materials in groundwater near its Fukushima power plant (Bloomberg). The Australian dollar continues to lose ground against the USD (-0.1%) at 94.8, after a 0.6% loss yesterday.

Turning to the day ahead, needless to say the attention will be focused squarely on the FOMC. The policy statement and Summary of Economic Projections are due at 7pm London time and the Chairman will be speaking from 7:30pm onwards. Ahead of that, in the UK the BoE publishes minutes from its MPC and Chancellor Osborne’s annual Mansion House speech is expected to outline a plan to sell down stakes in state-owned banks.


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