GSFM’s Stephen Miller comments on the Federal Reserve June statement

From

Stephen Miller

Fed forecasts no increase in rates until at least the end of 2022

  • The Federal Reserve projected interest rates will remain near zero through 2022 with the Fed’s ‘dot plot’ revealing a flat profile out to end 2022.
  • The Fed also pledged to maintain at least the current pace of asset purchases at approximately $80b per month
  • As part of a commitment ‘to using its full range of tools to support the U.S. economy in this challenging time’ the Fed Chair indicated the Fed would continue to review the asset purchase forward guidance and that they have been studying the international evidence on yield curve control
  • Longer end bond yields earlier in the week hit 3 month highs and yield curves had been steepening.
  • Officials forecast the U.S. unemployment rate would fall to 9.3% in the final three months of the year from 13.3% in May, according to median estimates, and to decline to 6.5% in 2021. U.S. GDP was projected to contract by 6.5% this year before rebounding 5% next year. Core inflation would be 1% this year before rising to 1.5% next year and 1.7% in 2022, still short of the 2% ‘sweet spot’ – indicating that inflation is not a problem in any way on the Fed’s radar
  • The Fed Statement assuages any nascent fears that rising long-term bond yields may at some stage lead to a ‘tipping point’ for the prices of risky assets.
  • Steeper yield curves generally indicate confidence in the economic outlook.
  • Higher long-end yields and steeper curves had reflected:
    • Abating deflation fears (with some medium-term inflation risk)
    • Confidence that the policy authorities have the economic challenges of the COVID-19 crisis in hand whether through monetary or fiscal measures (although I think that this may be optimistic but not implausible)
  • The key difference between now and the December quarter 2018 is that then the Fed was on a tightening tack. Today’s Statement suggests the FOMC is not only of a mind to keep rates lower but use other tools such as QE and yield curve control to potentially run the economy hot given benign inflation. At his press conference,
  • Chairman Powell referenced that the US expansion had lasted 128 months and yet inflation was still not back to target.
  • The Fed’s actions should keep bond market yields well contained at least in the near-term.
  • In the medium term there may be challenges of the exit from easy policy. In particular ‘moral hazard’ issues and (as unlikely as it may look now) the return of inflation. However, those issues are for the time being of secondary or no concern to the Fed.

Would the RBA be concerned at the appreciating $A?

  • The RBA may be casting a nervous eye at the $A. It is, however, difficult to see what trigger it could efficiently pull to arrest any further significant appreciation. In the past the RBA has implemented ‘smoothing and testing’ which in this instance would involve the purchase of foreign currency denominated assets (such as US Treasury Bonds) and in so doing sell $A and buy foreign currencies (the RBNZ has flagged doing precisely that through its Large Scale Asset Purchase  – LSAP – program so as to drive the NZD lower). I doubt that the RBA would go down the RBNZ path but it might try some short-term intervention such as ‘smoothing and testing’ were it to see the appreciation of the $A as being too much too soon.
  • There are some arguments too that the RBA may have a little bit more tolerance for a higher exchange rate, at least in the short-term:
    • The $A has risen from its daily closing low around 0.57c in late March to close to 0.70c currently, pretty much back to where it started the year.
    • That is in line with risk markets – such as the S&P500 – returning to close to where they started the year. The $A generally does well when risk sentiment is positive.  But bear in mind at the start of the year the AUD was close to 0.70c so we have to view it in that context.  Also what has happened recently has reflected weakness in the USD with both the EURO and CAD and others showing greater strength against the USD. The USD has weakened recently with positive risk sentiment and did so further in the wake of the Fed’s Statement overnight.
    • Globally the data has been a little better (US and Canadian employment, Chinese manufacturing), lockdowns are ending, vaccine expectations are elevated.
    • Australia’s economy has weathered the virus storm better than many others and the currency may reflect investors’ view that the Australian economy is in a much better position those others.
    • Currently closed borders means perhaps that activity is not as responsive to currency levels.
    • Australia’s commodity exports are doing well. Problems in Brazil has seen Australian iron ore prices climb sharply
  • Nevertheless an aggressive march above 0.70c may see a little more hand-wringing in Martin Place.

Risk markets in general have exhibited arguably surprising ebullience and the strong recent appreciation of the $A has reflected this

This reflects extraordinary faith in the ability of policymakers and central banks.

But there are worries: even putting the uncertainties associated with the COVID-19 crisis and potential ‘second waves’ to one side for a moment are there other elements that might suggest risks are asymmetrically weighted to the downside:

  • The big one is the heightened tension between China and the US (and the West more broadly). Of course we’ve had trade tensions elevated for the past year or two, and the Huawei issue, but relations between China and the West have ratcheted up further in the wake of COVID-19. Unrest in Hong Kong just adds fuel to the fire.
  • Global politics were already dysfunctional: the US was characterised by “gridlock” and a polarising Presidential campaign before the current period of extraordinary civil unrest; in Germany, Angela Merkel was in government but not power; and, as mentioned, China had a Hong Kong problem.
  • Cyber ‘cold war’ tensions are escalating
  • Governments were wrestling with deep-seated structural issues such as climate change, inequality and “oligopolisation”.
  • Additionally, Investors also need to contemplate potential longer-term pitfalls relating to exit strategies from extraordinary stimulus. The “moral hazard” issues attaching to those measures loom large.

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