Is good news bad once again as investors look towards Fed tightening?

Macro Outlook

One sure thing learned in the past week is that traders are fearful of the Federal Reserve tightening monetary policy. And when the tightening begins, anyone long of equities or short of the dollar will need to have trade protection. Index options volatility spiked with the VIX around 50% higher on the week as traders rushed to protect long portfolios with put options. Despite a dovish tone to the FOMC statement last week, where the it remained unanimous on all points except one (Charles Plosser and use of the word “considerable” with regards to the length of time that rates would remain low); with the focus seemingly now on wages growth, traders now see this as the key data dependency. When the Employment Cost Index (an economic indicator normally regarded as low importance) unexpectedly increased, this was seized upon as a sign that wages were set to grow. As traders joined the dots to assume this would put pressure on the Fed to raise rates, cue mass selling pressure and a huge dollar rally. July’s average weekly earnings were actually flat and below expectations in the Non-farm Payrolls report which paradoxically allowed for a relief rally on Friday. However it shows that anything that suggests possible tightening will encourage the bears. Is good news bad once again?

Must watch out for: European Central Bank monetary policy

Impact: The recent drop in the flash Eurozone Harmonised Index of Consumer Prices (HICP) to 0.4% from the previous level of 0.5% should help to focus the ECB to the job in hand. The Eurozone is struggling to escape the prospect of deflation and disinflation in Germany just heightens the chances. The market will be looking for the ECB to act. It is highly unlikely that there will be any movement in rates, but Mario Draghi’s press conference will be important to give an update on the prospect of Quantitative Easing measures. Recent meeting have driven euro volatility.

Foreign Exchange

After 3 weeks of solid gains for the dollar the potential for a correction is increasing and after Friday’s disappointing Non-farm Payrolls, this correction looks to be about to set in. Forex traders have become used to strong US data in the past few weeks and the FOMC inadvertently created a sharp gain for the greenback that now could be reversed. Focusing on the “significant underutilization of labor resources” seemingly as an excuse to keep monetary policy ultra loose, when the Employment Cost Index jumped unexpectedly on Thursday traders pounced on this as a sign that wage growth was about to come though and this would help to persuade the hawks on the FOMC flex their muscles. Although Friday’s wage growth in the Non-farm Payrolls report was flat (below the +0.2% exp) it might just be a matter of time now before wages do start to pick up in the US. The correction in the dollar may now be seen but any hawkish US data will now be seen as pulling forward the Federal Reserve’s tightening programme. Although the Dollar Index may see a near term correction, it may just be a matter of time before the hawks are in control which will pull the dollar higher again.

WATCH FOR: The service sector PMI data will be the driver on Tuesday, but with four major central banks (RBA, BOE, ECB and BOJ) announcing monetary policy decisions it is likely to be volatile for the local currencies. The ECB press conference looks set to be the volatile event of the week.

Indices

Having pondered the impact of geopolitics in Russia and the strength of corporate earnings, it appears that the thing that traders fear the most is the end of ultra loose monetary policy. The past week has seen signs that it does not matter that the US is growing again, it does not matter that corporate earnings season has been strong. What matters is when the FOMC begins to tighten monetary policy. Historically, periods of lower US interest rates have been significantly better for equities than performance during a tightening cycle. Therefore, any data that suggests that Janet Yellen and the FOMC might need to bring tightening forward will now be pounced upon by the bears. The Non-farm Payrolls report which showed a lack of earnings growth (apparently a key factor necessary for Fed tightening) caused a rally in global equities. The market now sees Fed policy as data dependant now. Will good news now be bad for equities? Added to the list of concerns is that currently Germany remains at biggest amongst the major markets as Russian sanctions become ever more severe. This is due to its closer ties with Russia in terms of energy imports and trade flows. This became apparent in the outlook statements of some of Europe’s biggest companies (such as Adidas and Continental).

WATCH FOR: US data will be closely scrutinized now for any sign of a lead indicator for Fed tightening. Geopolitics in Russia also remain important. Earnings season continues in the US and Europe and with less economic data from the US this week, the focus should return to corporate results to help drive indices.

Other Assets: Commodities & Bonds

The pressure of a strong dollar has been outweighing the impact of the economic sanctions that have previously provided a “war premium” for the precious metals. Gold and silver have become functions once more of the greenback with the strength of the dollar creating selling pressure for the metals. With little economic data due this week gold and silver bulls will be looking for the technical unwinding of the dollar strength to help drag the prices higher again, however with the economic data in the US improving any bounce could prove to be near term respite.

With traders betting on the Fed tightening rates sooner than already anticipated, bond yields have started to push higher again. Any tightening (increase) of interest rates hurts the price of fixed income assets such as Treasuries. However do not expect it to be a smooth ride. After the weaker Non-farm Payrolls report, it looks like with the sharp correction again on Friday, that the moves will be data dependent.

WATCH FOR: With less key US data released this week the dollar could be less volatile which should be replicated both commodities and bonds, but heightened geopolitical tensions could stoke volatility too.