May's Italian job as Yellen fires the starting gun

The pound is drifting into tomorrow’s crucial Brexit speech from Theresa May. Her set piece in Florence will determine whether the pound finishes the week at 1.37 or back towards 1.32. The range-bound GBP/USD rate this week belies the importance of May’s speech as it will set out the next policy steps for the Brexit process. The outcome of this speech is also seen as binary, it will either deliver a soft or hard Brexit, with a softer Brexit being the favoured outcome for pound bulls.

Fed puts the balance sheet on a mildly hot wash

The market is starting to fade some of the post Fed moves from last night. The dollar is backing away from last night’s highs and US futures are pointing to a lower open later today. Yellen is shrinking the balance sheet by gradually phasing out the reinvestments, they will do this by using a set of steadily increasing caps, so payments received by the Fed from the securities that they own will only be reinvested once they exceed these caps. The initial level of the caps are $6bn for Treasuries and $4bn for MBS, every three months they will be lifted until they peak at $30bn for Treasuries and $20bn for MBS. Considering the Fed’s balance sheet is more than $4.5 trillion, it will take a long time to shrink it back to its pre-financial crisis size, however, the pace of increasing the cap every three months is quite punchy, and may be more aggressive than some in the market had expected. This should be good news for the dollar and bad news for Treasury prices (good news for yields).

It’s not about the data anymore…

Although the balance sheet announcement was the set piece of yesterday’s Fed meeting, the most important part was the Fed’s dot plot and its inflation forecast. The Fed lowered its inflation forecast for this year and does not expect prices to reach its target rate until 2019, however, it maintained its dot plot, which has 4 members expecting to hike rates in December and 4 members remaining on hold. This signals a profound shift at the Fed: it’s not about the economic data anymore.

Investors should remember this shift, data may not be the most important driver of asset prices anymore. The Fed is on a set path to normalise rates and shrink its balance sheet, and it thinks that the economy can handle that even if inflation is below target. The FOMC has weighed up the low unemployment vs, low inflation debate and decided to side with low unemployment, assuming that inflation will catch up at some stage. The Fed Funds Futures market reacted to this and has already priced in a near 60% chance of a rate hike in December, we expect this probability to rise over the coming weeks, and the driver of rising Fed expectations is likely to be Fed speakers, who could overtake the economic data as a key driver of US assets for the rest of the year.

All I want for Christmas is…. A rate hike, or two

Or two, if the BOE moves in November for similar reasons to the Fed (a willingness to look through high inflation in favour of a tight labour market) then we could see the world’s major central banks all take a hawkish stance in union (bar the BOJ), which is a new phenomenon nearly 10 years on from the financial crisis. All of them (the ECB is likely to announce an end to its APP programme in the coming months) seem to have decided to the time has come to reduce the extremely accommodative stance adopted in recent years and start bringing some normality to financial conditions, and potentially to financial markets. What is remarkable is that the markets seem to agree that now is the time too. Whereas the taper tantrum in 2013 suggested that markets needed the life support, the reaction to this shift in central bank policy suggests that markets now crave yield more than stimulus, which is why markets haven’t fallen off a cliff. What is also interesting is that the MSCI Emerging Markets index has virtually retraced all of last night’s losses, this does not mean that EM investors are dismissing the Fed’s intensions to tighten policy, but rather that at this stage its doesn’t see coordinated central bank action triggering a spike in volatility. Even though US index futures point to a weaker open, we believe that the lack of volatility caused by the Fed move (the Vix is currently below 10) will sustain stock market gains for some time.

May’s Italian job

Now, back to May. The timing of tomorrow’s speech is as yet unconfirmed, although I heard through the grapevine that we should expect it around 2pm tomorrow. We will write in more detail today about what to expect from May, however, as mentioned above, expectations are for a binary outcome, which is likely to lead to a big move in sterling either way tomorrow.

Volatility in the 1-week at-the-money option for GBP/USD has risen sharply in September as the pound has surged and as we lead up to May’s speech, however it has backed away from recent highs although it remains at its highest level since June. We would expect the pound to remain range bound until tomorrow, even though UK public borrowing figures showed a weaker than expected borrowing rate for August.

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