Today is Fed Minutes: Keep your fingers crossed

Outlook:

Today we get the Fed minutes, with everyone hoping against hope there will be some juicy tidbits. We say two things count: first, any talk of the virtues of normalization. We have not heard nearly enough about that. It seems to have obvious advantages, some of them not readily measurable but some of undoubted importance, like goosing home-buyers to the table before rates go up much.

The second nugget we want concerns inflation. Yesterday CPI was up 0.2% in Oct (following two months of decline), with the core CPI also up 0.2% for 1.9% y/y. High Frequency Economics notes that the year-over-year at 1.9% is still higher than 1.6% at year-end last year. And the year-to-date pace of core CPI is 2.1%. BBH’s Chandler is the only one to point out that “the 3-month annualized pace of core PCE is 2% compared with 1.7% previously.” JP Morgan economists say the next three months will show “a much more rapid adjustment.” So, are the smart research economists at the Fed advising the governors that inflation is due for lift-off (and do the governors believe it)?

Most analysts are concerned with the pace of hikes once the first one is done. Will there be one--or four—next year? The Fed has been anxious to persuade the market that it won’t be “one and done” but the pace will be gradual. Nobody knows what “gradual” means, of course, and now the true data-dependency begins. Well, logically, if oil and other commodity prices, and import prices, keep falling because of the slowing world economy and the rising dollar, we get an automatic drop in inflation. This should slow the process. But it’s the job of the Fed to see beyond “temporary” factors like oil and import prices. We need to assume that once those temporary factors reverse, we might see a massive rise in inflation. Somewhere in the bowels of the Fed are some economists slaving over the alternative inflation scenarios given a range of oil and import prices. That’s what we wish the Fed would disclose.

As we wrote last week, it looks like Vice Chairman Fischer thinks the biggest portion of the dollar rally has already occurred. That makes conditions safe for the First Hike—we won’t get an overreaction because the process has been so slow that the hike is priced in by now. We are not so sure, nor are some big-name analysts. Morgan Stanley forecasts parity by year-end, which is (which is less than seven weeks away). Goldman is even more bullish, seeing 0.8500 (and 135 in dollar/yen), although the WSJ doesn’t name a date for the Goldman forecast.

Where Fischer is probably right is assuming that panic in commodities will not accompany a new dollar rally. And maybe it’s true that the upcoming rally will be less than 10%, with 15-20% already behind us. But let’s not forget that FX markets always overshoot. FX probably overshoots more than other sectors.

Fischer may also be underestimating European issues. The ECB policy meeting is closer than the Fed meeting, a week from next Thursday (Dec 3). We must expect some last-minute changes as traders in various markets prepare their positions. Today the FT Notes that the while the 10-year Bund yield is slipping down 3 bp to 0.50% today, the 2-year is -0.38% and Berlin sold a new 2-year €5 billion issue this morning at that yield for the first time.

We are still having a hard time wrapping our head around any investor choosing to pay a government 0.38% to store its capital stake—for any length of time. We can appreciate that some fund managers--insurance companies, for example--are required to hold domestic assets. We have the same rule in the US. But surely demand for a lousy investment must be limited. Meanwhile, the US 2-year is yielding 0.87%, up 2 bp today and likely to keep going. This is more than a bump in the road for the euro’s lasting allure—it’s a concrete roadblock.

As an aside, Reuters has a story on how negative rates and excess bank reserves are threatening to kill off the repo market, already shrinking 2.9% over the past year and facing more contraction. Repos are the critical link in short-term funding. “ECB policy combined with new regulations have squeezed profits in Europe's 5.6 trillion euro ($6 trillion) repo market. The study found that most banks offering repo facilities had restructured their business models and that many were now taking losses on deals with some clients.” The repo market may not be able to come back, or at least not easily and quickly, reducing liquidity semi-permanently. This was Dudley’s worry and the reason behind the invention of special long-term repos at the NY Fed.

Finally, we don’t know to what extent the terrorism factor will cut into European economic activity. We know the drag effect is not zero and we also know the effect in Europe is likely to be bigger than the effect would be in the US, not because Americans have different responses to disaster but because the continent is so big. Houston and Seattle keep on trucking even as Washington DC goes into lockdown.

Hold your breath and cross your fingers. The next big number we are likely to see is 1.0500.