ECB may engage QE in January while Fed will keep markets believing for a June hike

Outlook:

Nobody knows how long the 10-year yield will hold up on the vague Fed statement in the face of a worsening crisis in emerging markets and especially Russia. Yesterday we wrote that we do not expect a single puny rate hike some six months or more down the road to offer real yield support and an ever steepening yield curve.

It’s likely that if oil traders had not decided to retreat from the lows over the past two days to test the bears, the Fed statement would not have had the influence it did. If oil had instead gone lower, it’s likely the yield would have followed. A temporary bounce in oil gives the impression that maybe the oil crisis is ending for producers like Russia, but let’s be realistic. The oil price bottom is not likely to be in. Not yet. And so we need to continue to dread a looming sovereign debt crisis among emerging market countries that may entail Venezuelan or Russian default, among other misfortunes. “Contagion” as a financial market phenomenon is not well understood. The models tend to be mechanical, whereas markets are organic. Even the disease model is not a good predictor. We felt a little shiver when Pimco reported a total loss on Russian paper—shades of LTCM.

An air of excitement surrounds the US and Cuba agreeing to re-open diplomatic relations after almost 54 years (encouraged by the Pope). The embargo will remain until Cuba has free elections, among other conditions. The stunning development in US-Cuba relations, whatever objections the Congressional right wing may bring forward, are indeed a “historic breakthrough.” Pres Obama is entirely correct that doing the same thing for over 50 years and expecting a different outcome is stupid.

Analysts are failing to notice that the US has good timing for once and is inserting itself between Cuba and its friends in Venezuela, Russia and North Korea. Consumer product companies (and cruise ships) are salivating and we wonder where oil comes into it. More importantly, it leaves only North Korea as the last player in the old Cold War. We continue to doubt that it was N. Korea behind the Sony hacking, a view upheld by at least some of those who actually know something about hacking (Wired magazine). The opportunities opened up by Cuba are not offset by the looming disaster in Russia and other EM’s, but the change alters the overall global tone. The Castro brothers don’t like the Chinese model of communism plus free markets, but they can’t live forever and that’s probably what’s coming. Cuba has influence far beyond its 11 million people.

Oil, Russia and Cuba are seen as secondary issues in the FX market, with central banks the key drivers. On that front, we have the ECB repeating that QE is coming, probably at the Jan 22 policy meeting, while the Fed affirmed the First Rate Hike as coming in June, maybe, if the creek don’t rise. The Europeans are being cagey about German and other opposition to QE, but the Fed is worse—the statement is so full of conditionality that it is just hogwash. We are very disappointed in Yellen, who was the best straight-shooter among the regional Fed presidents when she was at the San Francisco Fed.

Duelling Central Banks

ECB board member Coeuré gave an interview to the WSJ in which he makes several critical points. First, the ECB will start publishing minutes next year, four weeks after each meeting. Second, he sees “broad consensus” that the ECB needs to do more to fight deflation and boost the economy. “Mr. Coeuré’s comments were noteworthy in that they suggest that the central bank’s threshold for action has now largely been met, and that officials have moved to the design phase of a quantitative-easing program focused on government bonds.”

Coeure said “It’s not that much of a question on whether we should do something, but more a discussion on the best way to do it. If we want to do more, we obviously have to reach out to market segments where there is more liquidity, and that is why the government-bond market is the baseline option, which doesn’t necessarily mean we would only buy government bonds.” Moreover, the euro should fall further as a “logical market outcome.” He said “I don’t want to pass a judgment on how much it can adjust or how much it should adjust.”

In contrast, the Fed tried to have it both ways on “considerable time.” Market News reports “The Treasury market was jolted in several directions immediately after the statement and continued to gap around throughout Yellen's press conference. In one moment the curve was steeeping and in the next moment it was flattening. And this happened several times -- the wildest reaction to the Fed in a very long time. Yields gapped lower and then they gapped higher and so on and so forth.”

The cause of volatility was moving the considerable time phrase from one place in the statement to another and adding the word “patience.” Market News gives us the revised paragraph: "Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. However, if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated."

This is total humbug, to be charitable.

What counts, maybe, is the economic projections. The estimate of the median Fed funds rate is lower at end-2015 at 1.125% from 1.375% projected at end-Sept. The unemployment rate is now seen as 5.2-5.3% from 5.4-5.6%. The “central tendency” of GDP remains the same at 2.6-3%. Moreover, dissent was relatively high, 3 against 7. Kocherlakota wants everything the same until the inflation outlook is 2% (yikes). Then we have a bunch of silly things, like Yellen defining a “couple” of meetings as two. Well, gee. Some folks took this to mean the First Rate Hike could come at the April meeting.

Is there anything real and useful in the Fedspeak? Not much and nothing new. The Fed removed the word “significantly” from the assessment of labor market underutilization. The Fed notices that inflation expectations are stable while market-based indicators of inflation expectations are lower. More humbug. Fed studies years ago showed that market-based indicators such as Fed funds futures do not forecast actual inflation at all well. Yellen repeated that the drop in oil prices is transitory and should be viewed as equivalent to a tax cut.

Bottom line: the ECB will be engaging in QE in late January while the Fed will be encouraging the market to believe in the June rate hike. There’s no way this can’t imply a stronger dollar, right? Wrong. If we get an EM default or other crisis, the US 10-year yield can sink on safe haven flows to well under the last low yield (1.85%), perhaps 1.50% or 1.35%. The dollar will not thrive under such circumstances. So make hay while the sun shines.

Note to Readers: Analysts have been saying for a few days they already see the market thinning out. Next week is Christmas week, with Christmas on Thursday. It’s dangerous to make decisions when the market is thin and flaky, so we are thinking of publishing reports on Monday but then not again until the following Monday. Comments and requests from readers are welcome.