The Fed doesn't like surprising the market

Outlook:

So-called inter market analysis is a snare and a delusion, and we dislike having to try to escape the trap. The most pernicious of the inter market themes is “oil is down because the dollar is up,” implying demand for oil instantly and automatically sinks when it becomes more expensive in dollar terms. And yet demand for energy is set contractually long in advance of any single day’s price action and we have an impenetrable tangle trying to see how expected lower demand that cuts prices today in fact affects later demand.

It may well be true that the higher dollar gets oil traders to have a less rosy view of oil prices, but it’s hardly based on verifiable demand factors. So, it’s true because people believe it to be true and force it to be true in a self-fulfilling prophecy even when it’s complete bunk.

As for falling oil prices being the driver of equity indices, this is factually demonstrable only in the FTSE 100, which has a high proportion of mining and energy-related companies. For the DAX or other index to track the FTSE is a matter of sentiment contagion. In the US, the BoA/Merrill Lynch survey of global investors last week showed a serious underweighting in US equities (in part because of the too-strong dollar), and yet until yesterday, the S&P had risen 13% off the Feb low. So maybe it’s just profit-taking.

The IMF is as befuddled as everyone else by inter market behaviors. The FT reports the IMF sees the increasing correlation of oil and equity markets—see the chart—when falling oil prices “should” be promoting growth and thus earnings and thus rising equity prices. The correlation should be an inverse one. “Slowing demand, rather than just excess supply, is part of the answer, [the IMF] says. But it adds that oil is making life tricky for central banks, many of which can’t cut interest rates further, leaving expectations of rock-bottom (or negative) inflation baked in.

“Persistently low oil prices complicate the conduct of monetary policy, risking further inroads by unanchored inflation expectations. What is more, the current episode of historically low oil prices could ignite a variety of dislocations including corporate and sovereign defaults, dislocations that can feed back into already jittery financial markets.”

We have another disconnect—not only the Fed vs. the bond market, but the Fed vs. the Fed. The Fed sees two hikes this year while the market sees one (at best) and that one a long way down the road. But we now have no fewer than five regional Fed presidents calling for a hike and PDQ, maybe even April, in contrast to the Yellen statements about delay until global conditions are more stable. We worry that means the Fed thinks it can’t hike until the end of negative rates in Europe are in its viewfinder.

But the regional Feds are looking at domestic US conditions and finding cause. Yesterday it was St. Louis Fed Bullard, who told Bloomberg that given jobs and inflation data, “… you could probably make a case for moving in April…. I think we are going to end up overshooting on inflation” and the natural rate of unemployment. Bullard dislikes the dot-plots as misleading and wants every meeting to have a press conference—the alternate meeting press conference schedule also misleads and no-body believes every meeting is “live.”

The day before, Chicago Fed Pres Evans said two rate hikes this year are “not at all unreasonable” and Philadelphia Fed Harker said he would like to “get on with it” a little faster. San Francisco’s Williams and Atlanta’s Lockhart also said an April move should be considered. Kansas City’s George had already voted for an increase in March.

Not all of these Feds are voters, but never mind. Five regional Fed presidents would be willing to raise rates in April! And yet Fed fund futures “imply almost zero chance of a move in April and a rate of just 61.5 basis points by year end,” according to Reuters. The FT reports futures are pricing in a 6% chance.

Wow, what a disconnect. Here’s a couple of points: it was always silly for reporters and analysts to view the Fed as dovish by cutting the number of hikes from four to two. The prospect of two rate hikes is hardly dovish,. What made it seem that way was the cut from four, which was always unrealistic in the sense that the bond market was thinking zero. The real question is why the Fed projected four in the first place. The dot-plot is supposedly each member voting his own view without seeking a consensus first.

We need to assume each member was being truthful. Therefore it should be no surprise if those who voted for four hikes are now coming forward to say it may be two, but it had better be sooner. In other words, not everyone has changed his mind. But many, including Yellen, must be worried about the Fed’s reputation risk. To say four in December and two in March is really lousy for both credibility and ability to communicate.

To retreat from four to two was to acknowledge the bond market was sneering at the Fed disrespectfully. That might not have been such a good idea—it makes the bond boys even more arrogant than they were before. BBH analyst Chandler says the Fed may have switched from over-promising and under-delivering to under-promising and over-delivering. Good data next week may make an April hike not so far-fetched an idea.

But the Fed doesn’t like surprising the market, unlike the days of yore under Greenspan when the Fed “spoke with one voice and freedom of speech was not encouraged,” as the Market News fixed income analyst puts it. In other words, the Fed is botching “communications” and continuing to harm its credibility. Besides, no sooner did the count of Fed wanting a hike in April rise to five than the 10-year yield retreated, from nearly 2% earlier this week to 1.869% this morning—another disconnect.

An interesting outcome of all this is that one party believes the five Feds—China. As the FT reports, the PBOC fixed the midpoint weaker at Rmb 6.515/S for “the biggest one-day decline since early January and continues a fortnight of depreciation.” One analyst (Commerzbank) says the PBOC is acting ahead of the curve and pricing in a higher probability of an April hike by the Fed.

Well, that’s food for thought. What does all this mean for the dollar? The next few days are going to be confusing because so many markets are closed for the Easter holiday and if they are not closed, staffed with juniors. Every year the Easter holiday gets bigger in terms of stifling market activity. The wise course of action is to retreat along with everyone else. We will produce reports tomorrow and Monday but when London is closed, FX gets impossibly thin. The dollar might come out of this tangle of contradictions next Tuesday or it may not. But it’s just guessing now and you shouldn’t have a position.