Surprise, surprise.
Minutes from the Fed’s April meeting are out and the message is overwhelmingly hawkish. June is “live” after all.
Equity markets immediately dipped into the red although after yesterday’s commentary from Williams and Lockhart, investors probably should have expected this. In hindsight, it looks like the San Francisco and Atlanta Fed chiefs were looking to telegraph what was coming.
The FOMC emphasized a commitment to data-dependence (which has been in question since last September, when global market turmoil ignited by China’s transition to a new FX regime caused the Fed to change its reaction function). This was the operative passage from the release:
“Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.”
Considered in the context of that excerpt, this week’s solid CPI print now looks especially important. While the minutes contain the obligatory nod to “downside risks emanating from developments abroad,” they paint a picture of a Fed that is increasingly worried about falling behind the curve when it comes to normalizing policy. Some members, the FOMC said, “expressed concern that the likelihood implied by market pricing that the Committee would increase the target range for the federal funds rate at the June meeting might be unduly low.” In other words, the Fed thinks the market may be ill-prepared for the possibility that the FOMC pulls the trigger next month. Goldman called it going into Wednesday:
“Considering how low is the market pricing of a hike in June/July today, with the release of the Minutes, US rates might end the day higher and the Dollar stronger.”
To be sure, the minutes didn’t betray a complete lack of concern for global developments. That is, it certainly isn’t clear that the FOMC has made some kind of dramatic U-turn and is now focused squarely on US economic data as opposed to events that have the potential to create exogenous shocks. Here’s another notable passage:
“Some participants noted that global financial markets could be sensitive to the upcoming British referendum on membership in the European Union or to unanticipated developments associated with China’s management of its exchange rate.”
That reminds me of something Citi’s Brent Donnelly said earlier today:
“Hiking a week before the UK vote seems like a totally unnecessary risk that this extremely risk-averse Fed would never take.”
And here’s what Steve Englander (the bank’s head of G10 FX strategy) had to say on Tuesday:
“The argument against opening the door to a June hike now is that it would mean a fast, extensive repricing of rate hike expectations. Raising the June meeting from the dead would be a major shocker even if done gradually over four weeks.”
Well Mr. Englander, count everyone “shocked.” The market is now pricing a 28% chance of a June hike versus 14% going into the release of the minutes. Meanwhile, the dollar rose to session highs against the yen and the euro and predictably, EM stocks sold off, as the MSCI Emerging Markets Index fell nearly 1.5%.
There’s a certain extent to which markets would probably be relieved if a June hike actually materialized. The uncertainty surrounding if and when the Fed will move again isn’t healthy and feeds into fears that normalization is now impossible, setting up a scenario wherein the Fed will have no more counter cyclical maneuverability in a downturn.
Still, as CNBC’s Rick Santelli put it, there’s no way to embark on even a modest tightening cycle without upsetting equity markets at this point. The notion that ultra loose monetary policy is key to supporting stock prices is simply too ingrained.
The question now, of course, is what happens next. If the hawkish minutes are followed by equally hawkish commentary from Yellen and Bill Dudley - who will both speak in the coming days, Dudley tomorrow and Yellen on June 6 - we could be in for a rather tumultuous ride. “This clearly reasserts strong-dollar view,” Macquarie’s Thierry Wizman told Bloomberg over the phone. That’s great for the ECB and particularly for the BoJ, but not so good for EM. It’s also bearish for crude, which reversed gains after the minutes were released. As we saw in January, when EM (and particularly China) come under fire and when crude slides, things can go south in a hurry.
Watch oil, the USD, and China between now and the June meeting. If oil falls, the dollar soars, and China starts behaving badly, we’ll get perhaps the best test yet of the Fed’s supposed “data-dependence.” As for rates, I’ll close with an excerpt from BofAML on how to play a “policy mistake”:
“Recent Fed speak and a slew of important speakers lined up to talk before the June meeting (Dudley, Yellen, Fischer) has shifted attention back to the front end of the rates curve. Eurodollar bears that were forced into hibernation since March have woken up, revisiting similar arguments of dots vs. the Fed, rates vs. US data surprises etc. To us, there is one worrying sign in the reaction of the bond market to the better data and hawkish Fed speak unlike 2013: instead of the optimistic signal the yield curve sent during the taper tantrum, long end rates now suggests a re-ignition of the policy mistake trade. Raising June/July probabilities is a small victory that is coming at the cost of dealing with higher probability of inverted yield curves 2-years forward, in our view.”
