Citi's Englander On What Can Go Wrong In The Next 11 Days?

1) Regional Fed presidents are talking hawkish but markets are pricing dovish.

Expectations of fed actions have retraced sharply since March. Consider the path of the October 2014 fed funds futures rate (right now the first fed funds contract that prices in a full hike, Figure 1).  With the exception of a brief period immediately after the January FOMC, fed funds futures now price in the lowest path of Fed policy rates on record.


Now consider the risks that accompany Wednesday’s FOMC. Our economists write: “Fed officials are expected to reaffirm the need for a highly accommodative monetary policy ‘at least through late 2014.’ The Committee has set hurdles for additional QE-type asset purchases and at this meeting is not likely to resolve plans beyond the scheduled completion of Operation Twist.”  If they unexpectedly they shift the timing of the expected Fed hike to earlier in 2014, or even if “at least through late-2014” becomes “through late 2014”, we are likely to see pressure on bond markets, FX risk and very probably all risk correlated assets, -- to a limited degree if “at least” is dropped, and much more strongly if the timing is changed. Very likely they will reiterate the previous timing, as our economists expect. Even for those of us who still think there is a significant chance of additional stimulus, the chance of misunderstood language at this meeting seems very high, when it is very unlikely that additional measures will be announced.


What may be a bigger risk is that some Fed governors and regional Fed presidents shift their expectation of tightening to earlier. When the last FOMC projections were published in January, three FOMC participants saw a need to tighten in 2012 and six in 2013. Six participants saw no need to tighten until 2015 or beyond.  If there is a shift in this distribution to earlier and tighter, investors may interpret the drift in the projections’ center of gravity as an early Fed-warning signal. Given the pricing in the fixed income market, this could easily be viewed as an stealth indication of tightening risk.


The rates effect and the asset market effect in this case would be unambiguously USD positive.


What skews the risk is the degree to which rates have shifted back to pricing in pretty much unalloyed policy dovishness despite Fed governor and regional President hawkishness, better than expected economic data on the whole, and the absence of any smoking-gun indication of weakness.


Figure 1 – October 2014 fed funds contract implied yields



2) The ECB doesn’t announce any measures for Spain and Italy

The next ECB meeting (May 3) is critical for both euro optimists and pessimists.  German yields are at record lows, euro zone bank stocks are at almost-record lows and  sovereign spreads are widening (Figure 2).  European policymakers very likely thought they had a break from crises after the Greek debt package and PSI were rammed through.  The rapid advent of the Spanish crisis, its spread to Italy, new concerns on the Netherlands and  very poor economic data have caught them flat-footed and so far there is no indication that any policy response is thought to be needed.


Figure 2: Euro bank stocks, German yields and Italy-Germany spreads


In the past, the euro has sold off sharply when the ECB does not present a policy response to rapidly deteriorating market conditions.  When conditions are deteriorating the euro trades off tail risk, and whether the policy  is attractive or not, the market focus is whether sovereign debt concerns will intensify or recede. If the ECB does not provide relief and especially if they give a complacent signal on market conditions (which will likely be interpreted by FX investors as  signaling the absence of a consensus), the EUR is likely to break to the downside sharply. By contrast, a week ago even the mention of more SMP buying sent the euro up more than a big figure, so we would not underestimate the upside risk to the EUR, when much of the market is clearly leaning to the downside, if they manage to put together an effective response.


One issue that the ECB may have to address is that monetary policy has effectively tightened for the euro zone (Figure 3). The thick blue line at the top of the figure is the GDP-weighted 10yr yield in the euro zone (this includes German, France, Spain, Italy etc, but excludes Greece, Portugal and Ireland). It is running about 150bps above the G120 countries clustered at or below 2%, and has widened by about 50bps in recent weeks as euro zone GDP-weighted yields have gone up and those elsewhere in  G10 have declined.


Using a common rule of thumb that a 100bp increase in policy rates is equivalent to about a 20-25bp increase in long rates, we have seen the equivalent of an effective short-end tightening of more than 200bps recently. If we consider the full 150bp gap between euro zone long rates and the rest to the G10, it is equivalent to monetary policy being 600bps tighter at the short end.


That this spread is a result of risk premium, rather than monetary policy, and is probably unwelcome to the ECB does not unwind the negative effect that it has on activity.  One reason that tail risk is euro negative is that it reduces any prospect that the euro zone has of growing out of its debt crisis.  Hence, if FX investors perceive that no policy response is forthcoming, the euro is at risk of falling sharply.


Figure 3. 10-yr yields in euro zone and elsewhere


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