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Sunrise Market Commentary

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Will the FOMC cut rates when it meets today?

Tue, Sep 16 2008, 08:44 GMT
by KBC Market Research Desk

KBC Bank

Markets: Fixed Income

On Monday, global bonds surged sharply higher as investors were looking for shelter after Lehman Brothers filed for bankruptcy and equities plummeted. The massive safe haven bid primarily favoured the short end of the curve and led to a huge bull steepening of the US and European yield curves. To ease tensions in the money market following the bankruptcy, the Fed, ECB and the Bank of England all injected money in the banking system. Over the weekend, the Fed already widened the collateral it accepts. The measures however failed to calm markets, with equities falling sharply and closing the day below the cycle lows in the US. As a result, bonds closed the day at the session highs and even gained further ground overnight; as AIG and Washington Mutual were downgraded and Asian equity markets plunged lower (most of them were however closed on Monday). In a daily perspective, US 2-year yields dropped 49.7 bps compared to 29.3 in 30-year yields with the latter even falling to new all-time lows at around 4%. In the euro zone, yields also plunged lower between 23.9 bps and 4.6 bps. It shouldn’t surprise that in this context the eco data played no role of importance.

Will the FOMC cut rates when it meets today?

Today, all attention will be on the FOMC meeting and the developments on the financial markets.

Eco data include the August CPI, the September NAHB housing survey and the July TIC flows. Headline CPI is expected to be flat, but following the below expected headline import and producer prices, we also here put the risks on the downside of expectations. The core CPI is expected to rise by 0.2% M/M, an estimate we subscribe. The NAHB headline index stabilized in August at a historical rock bottom 16. For September, a marginal improvement to 17 is expected. While the market usually ignores the release, something which will also be the case today, we closely look for clues whether the situation in the housing market stabilizes, improves or again deteriorates. The NAHB alone won’t change the overall assessment though.

The FOMC kept rates unchanged in August for the second meeting in a row. However, Dallas Fed governor Fisher dissented twice in favour of a more restrictive policy (rate hike). Until recently, the Fed made quite clear that its 325 basis points of rate cuts were enough of easing to steer the economy through the chilly climate, caused by two shocks (commodities- inflation & credit crisis). Inside the Fed, a number of (regional) governors resisted already in spring the aggressive easing policy of chairman Bernanke. They feared that it would push inflation higher and unmoor inflation expectations leading to a situation of stagflation like in the seventies. The Fed warned at the time that it already expected a slowing in economy and thus wouldn’t react anymore in case the eco figures would actual worsen.

We think that also the recent experience of bubbles, for which the easy Fed policy in recent years has been singled out as partly responsible, played a role in the Fed’s attempt to stop the markets from discounting more rate cuts. The August FOMC statement summarized the situation as follows: “Although downside risks to growth remain, the upside risks to inflation are also significant concern to the Committee.” However since, the inflation outlook showed a dramatic improvement. The oil price dropped from a 147 $ high to about 92 $ currently and inflation expectations have dropped sharply too. Q2 GDP as been exceptionally strong (3.3%) but recent data like the August payrolls and especially the August retail sales were very weak, suggesting that H2 GDP will barely grow. At the same time, the turmoil in the financial markets has only intensified with the rescue of Freddie & Fannie last week, the chapter 11 bankruptcy of Lehman & the takeover of Merrill this week-end and the fate of AIG and Washington Mutual still highly uncertain. Will these new developments convince the Fed to cut rates, eventually by 50 basis points? Until yesterday, we thought they wouldn’t. Indeed, it might smell a bit like panic and could weaken the image coming from its firm stance of the weekend, that at last the Fed puts a line under moral hazard, by not bailing out institutions like Lehman. With the monetary and credit transmission mechanism still impaired, a rate cut might not have that much direct effect right now. In this context keeping its powder dry didn’t look to be a bad decision. In the statement, the FOMC might have put less emphasize on inflation risks and more on economic growth risks, pointing out at the same time that financial conditions deteriorated and monitored closely. On top of that Dallas Fed Fisher might vote again with his fellow governors for keeping rates unchanged. This would set the stage for an eventual rate cut later on this year or early next year.

However, in the face of yesterday’s panic on the equity markets and the concomitant plunge in Treasury yields by 30 to 50 basis points, the Fed may choose for a big 50 basis points rate cut, as a confidence building measure. We agree however that whatever the Fed does, nothing or a big move carries a binary risk. The market may ignore a rate cut and push equities further down or in case of an unchanged decision equities may crash, in both cases putting the Fed’s credibility at stake. Currently, the October FF futures trade at an implied 1.78%, suggesting a 25 basis point rate cut today.

No one will dispute the severity of the situation in financial markets and its consequences for the economic situation further out. However, on a day-to-day basis, markets also move according to internal dynamics. The technical analysis tries to capture these. Has the bearishness now reached an extreme? Has the equity market exhausted for now? This is a real possibility. Equities had an awful session, down almost 5% and closing not only at an extreme (S&P: new low at 1192) but also at an intra-day low. In Japanese candlestick analysis, it is called a marubozu, an exhaustion signal, whereby there are temporarily no sellers anymore and a sign of a turnaround. The VIX index of fear reached a high at 31.70, matching/approaching levels that signalled a turnaround in August 2007 (credit crisis), January 2008 (Kerviel/SG), March 2008 (Bear) and July (Freddie & Fannie). Will history repeat itself and give equities some respite? In case, the S&P drops below the 1180/1160 area where a number of key supports are concentrated, it would signal that the market embraces a scenario of financial meltdown/deflation. Investors shouldn’t ignore such a signal. For Treasury markets it would of course be highly favourable. Short term, the Treasuries are priced rich because of the flight to safety and therefore any easing of strains might lead to profit taking in Treasuries. The global context is bond friendly, but as events might affect the market instantly, it is difficult to give concrete advice.

European bonds surge higher as investors look for shelter

Today, all attention will continue to go out to the developments on the financial markets following the bankruptcy of Lehman Brothers and the downgrading of AIG and Washington Mutual. In this context of heightened tensions, the government bond market is likely to remain the place to be. Overnight, US Treasuries gained further ground, which is reflected in the sharply higher opening of the European bond market this morning.

Today, the euro zone calendar contains some interesting data with the euro zone CPI and the German ZEW indicator. The headline inflation is expected to be confirmed at 3.8% Y/Y, although there is a chance for a downward revision following the lower inflation data in France. At the same time, the core CPI is seen slightly higher at 1.8% Y/Y in August compared to 1.7% Y/Y in July.

In today’s FT Deutschland, Luxembourg ECB governor Mersch calls current levels of core inflation incompatible with the objective of price stability. His comments surprise us, as of late there have been some more dovish comments coming from the ECB and given the stability at rather low levels of the core inflation rate over the past year compared to the surge in the headline inflation rate. Yesterday’s lower than expected labour cost growth in Q2 should also ease concerns that second round effects would lead to a wage price spiral. As such, we shouldn’t draw too much conclusions out of Mersch comments, which appear at odds with other comments from the ECB. This morning, ECB’s Nowotny warns that the current crisis in the US may result in slower economic growth in Europe. The rapid deterioration of the economic climate is likely to be highlighted in today’s ZEW (current assessment), although there is a risk that the sentiment indicator will rise on the recent drop in the oil price and the euro. Nevertheless, the eco data won’t be the major driver for the bond markets. This role will be given to the equity markets, which plunged lower and closed below the cycle lows in the US.

Regarding trading, we don’t go against the flow and hold on to a bullish view on the bond markets, especially at the short end of the curve. We feel that current developments in the financial markets and the recent drop in the oil price will dramatically change the outlook for both growth and inflation in the euro zone, which have the potential to bring ECB rate cuts forward in time. This may mean that rate cuts are not the far distant prospect anymore they were even a month ago. As such, we clearly favour the short end of the curve and look for a bullish steepening of the European yield curve. At the same time, risk aversion will increase further, which will mean that the swap spread will become ever wider, as well as the intra-EMU government bond spreads.

In the UK, the CPI will be released and is still expected to move higher from 4.4% in July to 4.6% Y/Y in August, as two of the six major energy suppliers hiked gas and electricity bills in August. The decline in petrol prices won’t be enough to offset the increase. This would result in the third letter of King, which may be important as markets currently expect the Bank to cut rates by November.

Currencies: Global market turmoil puts the yen again in the driver’s seat. Other major cross rates indecisive.

On Monday, the fall-out from the Lehman crisis was also the most important driver for currency trading. However, except for the yen cross rates, the directional moves in a lot of other major cross rates were far less pronounced compared to the one-way price action on the bond markets and on the stock markets. The dollar was sold off in (thinned) Asian trading and EUR/USD spiked higher to the 1.4480 area before the opening of European trading. However, the heavy losses on the European stock markets made (currency) investors drawing the conclusion that the impact of the current crisis will spread far beyond the US and EUR/USD reversed earlier gains and even tested the 1.41 area just before the start of US trading. A new sell-off in the oil price supported this move. During US trading hours, EUR/USD entered calmer waters. At first, the US stock market losses were rather contained, but a late session selling wave also weighed on the dollar and EUR/USD closed the session at 1.4243, after all remarkably close to the 1.4224 on Friday.

Today, the calendar contains a series of eco data that in normal circumstances would be closely monitored (US and EU CPI, ZEW). However, in the current environment, they probably will pass almost unnoticed. Later in the session, all eyes will be on the Fed interest rate decision. Over the previous days, we were not convinced at all that the Fed would cut rates already at today’s meeting. However, after yesterday’s events the pressure is obviously building. A rate cut would be a (moderately) negative factor for the US currency as it could be seen as an indication that the crisis enters a phase that even the Fed didn’t take into account until recently.

Over the previous weeks, EUR/USD was caught in a forceful downtrend. The decline in the oil price and growing signs of deterioration in the European economy (and elsewhere outside the US) caused a sharp re-allocation in favour of the dollar. The dollar even became favoured over the euro in case of global investor uncertainty. However, this trading paradigm has changed last Friday. After the developments over the weekend and yesterday, the markets speculate on additional US interest rate cuts. Recently, interest rate differentials were not the most important driver for EUR/USD trading, but a ‘surprise’ Fed rate cut would at least overthrow the scenario that the dollar could over time get support from a ‘normalization’ of US interest rates. Of course, the chances for ECB rate cuts are also growing, but the idea that the dollar would gain interest rate support anytime soon at this stage probably should be delayed sine die. We hold on the conclusion that overall impact of the recent developments should be more balanced for EUR/USD short term. The oil price will continue to play a role but we still tend to think that its impact on EUR/USD could become less compared to what it was some time ago.

From a technical point of view, Friday’s reversal signal that the downtrend was losing momentum was confirmed yesterday. The pair currently trades above the STMA (1.4146) and tests the MTMA (1.4292). The picture is still far from cleared out and one should expect more wild swings in the days to come. However, for now we assume EUR/USD to have entered a consolidation pattern between 1.3882 (reaction low) and the 1.4575/80 breakdown area. A re-break above the latter would indicate a further loss of momentum in the dollar. While this is not our preferred scenario, in the current environment of elevated market stress, stop-loss protection on EUR/USD shorts is warranted.

As one could expect in an environment of global market stress and with a lot of Asian markets closed, USD/JPY yesterday was highly correlated to swings on the stock markets. The sell-off in Europe hammered USD/JPY to test the 104.50 area, the ‘decent’ open on the US stock markets brought some temporary relief but this was undone by the late session sell-off in the US with the pair closed the session near the intraday lows at 104.66 (compared to 107.94 on Friday).

Overnight, the Japanese stock markets (and some other Asian markets) still have some catching up to do as markets were closed yesterday. USD/JPY remains under pressure and trades at around 104.35 at the moment of writing.

On the technical charts, USD/JPY staged a gradual rebound from the mid-July reaction low to set a new reaction high at 110.68 on August 15. Since then, the pair entered a consolidation pattern and gradually slipped through a series of support levels and this move accelerated as this weekend’s developments put the yen again in the driver’s seat. USD/JPY fell below the 105.55 reaction low and is now coming close the key 103.77 support (16 July low). The yen will remain favoured as long as global pressure persists (e.g. in case of a ‘panic’ fed rate cut) and for now there are no triggers available that his yen favourable environment will change anytime soon. However, as soon as the global tensions ease the first unwinding of yen longs is often very violent.

On Monday, EUR/GBP trading developed remarkable calm. In line with EUR/USD, EUR/GBP set an intraday high in the 0.80 area before the start of European trading but quickly returned to the 0.7925 area and settled in a tight sideways trading range for the remainder of the session EUR/USD finished the session at 0.7916, not that far away from the 0.7932 close on Friday. So, at least for now, rising global market tensions have no additional negative impact on the sterling versus the single currency. This is a bit remarkable given the poor state of the UK economy and the strain on the activity of in the City

Today, the UK eco calendar contains the UK CPI data. The consensus expected the Y/Y figure to tick up to 4.6% from 4.4%; but the risk might be slightly to the downside and this might full market speculation on BOE rate cuts. In theory, this should be a sterling negative. However, at the current juncture, we wouldn’t be surprised that markets/sterling would react (slightly) positive in case the data open the way for the BoE to support the ailing UK economy. Markets will also keep an eye on BoE’s King explanatory letter to the government (as inflation exceeds the 2 % inflation target by more than one percent).

Two weeks ago, EUR/GBP tried to break out of the longstanding sideways 0.7760/0.8098 trading range, but the test was rejected and this triggered a correction sending again in the previous range. In line with EUR/USD, we indicated on Friday that the EUR/GBP correction could lose momentum. We hold on to that view, even if the losses for sterling/rebound in EUR/GBP over the weekend were far from spectacular. We hold on to our view that it is too early for a major/sustained comeback of the sterling. For now we stay neutral on EUR/GBP.

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Published on  Tue, Sep 16 2008, 09:03 GMT