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US$ Rebounds from -10% Slide, as Odds of Fed rate hike by year’s End, rises to 90%

Oct 08, 2017

     The horse race over who will become the next chairman of the Federal Reserve, has seen four contenders for the position move briefly into the lead in the betting markets, but only to see their odds of winning, plummet. Two falling stars – Fed chief Janet Yellen and Goldman Sach’s #2 insider, Gary Cohn, have seen their odds for getting the nod for the position of Fed chief, peak in the mid-30’s and then quickly plunge to as low as 10%.

     President Donald Trump has a golden opportunity to reshape the Fed, with five picks for the governing Board, including the #1 and #2 slots, and selections for three other Board members. Yet Trump relishes in generating as much drama as possible, and keeping his audience on edge, and guessing about his mood swings, and who or what will become the next target of his Twitter storms.

     Fed chief Janet Yellen’s term expires on February 3, 2018. Yellen and her deputy, Stanley Fisher are the architects of the Fed’s tepid march back to monetary normalization. The Yellen Fed has approved four rate hikes and started to reduce the size of its $4.5 trillion balance sheet in October. The Fed said the balance-sheet runoff would follow the framework released in June: $6 billion in Treasuries and $4 billion in mortgage-backed securities per month, rising every three months until the amounts reach $30 billion and $20 billion per month, respectively. The Fed doesn’t have a specific date for ending the runoff.

     On Sept 28, outgoing Fed deputy Fischer said it was important to reverse its massive bond buying program, given that it was a temporary measure. The Fed has given investors plenty of notice that they would begin to unwind their balance sheet and so the actual event will be like “watching paint dry.”  Traders will be watching closely to see whether President Trump selects people to run the Fed that will continue with the path of normalization, or instead, stop the march towards “Quantitative Tightening” <QT> in its tracks.

     The US’s federal government ran a $668 billion budget deficit for the just-completed 2017 fiscal year. That’s $82 billion more red ink than the previous year.Washington isn’t focusing much on the deficit these days, following the lead of President Donald Trump. The president has ruled out cuts to big benefit programs that drive the deficit’s growth, and Congress has rejected most of Trump’s other spending cuts. The national debt is $20 trillion and CBO projects it would grow to about $30 trillion within 10 years.

       In the sweep stakes for the Fed chair, Former Fed Governor and Morgan Stanley executive Kevin Warsh zoomed up the probability charts, at least if chatter from Fed observers and online prediction site PredictIt is correct. However, Warsh is viewed as a hawk, who would continue with QT, and allow interest rates to climb higher. His odds of winning the #1 job at the Fed, peaked at just above 50%, but has since dropped to around 35% today.

     Instead, Jerome Powell has moved into the lead for the first time in the betting markets, surging to a 40% probability today. Powell is seen as a moderate, and someone who would take orders from the president, and more likely to stop QT and more willing to monetize the federal government’s debts.  Trump also wants somebody who agrees with his preference for a cheaper US$.

     Meanwhile, traders in the futures markets have raised their bets on the Fed hiking rates in December after data showed faster wage growth and the jobless rate hitting its lowest level in more than 16 years in September. Average hourly earnings grew +0.5% last month, bringing their annual increase to +2.9%, which was the largest gain since December 2016. The jobless rate fell to 4.2%, the lowest level since February 2001.

     On October 6th, Boston Fed chief Eric Rosengren stepped up his argument to stay on track for additional gradual interest-rate increases, “We’re definitely seeing that tighter labor markets are causing wages and salaries to gradually go up. “Failing to respond to very tight labor markets with rates remaining negative in real terms could potentially risk unnecessarily shortening the economic recovery.” Rosengren’s call for higher rates is remarkeble, coming from someone who had built a reputation as a super dove.

     Also on October 6th, New York Fed chief, William Dudley should the Fed continue to gradually raise interest rates – since the ongoing improvement in the job market ought to lift wages and bring inflation back up to the Fed’s +2% target. “Even though inflation is currently somewhat below our longer-run objective, I judge that it is still appropriate to continue to remove monetary policy accommodation gradually,” Dudley said.

     Philadelphia Fed President Patrick Harker, who is also a 2017 voter, said on October 5th, he has “penciled in” a rate hike for December. Esther George, head of the Kansas City Fed and possibly the most hawkish Fed policy maker, urged her colleagues to continue tightening policy to avoid the threat of financial instability from asset-price bubbles.

     As such, federal funds futures are priced for a 90% chance that the Fed would hike interest rates at its Dec 12-13 policy meeting by +25-bps to 1.375%. The latest jobs report also increased expectations for two additional interest rate increases, the first in mid-2018, and a second to 1.625% by the end of 2018.

     The US$ rose for its fourth consecutive week of gains on October 6th; as traders trimmed some short bets on growing views that interest rate markets are under pricing the extent of future Fed rate hikes over the coming months. Solid US economic data, along with the prospect of US tax cuts and the 35% chance of the hawkish Kevin Warsh getting the nod as Fed chief – all combined to given a lift to the US$ in recent weeks.  The last time the US$ enjoyed a four week rising streak was back in February-March when expectations of significant US-tax reforms were at a fever pitch but the US$ tanked more than -10% in the subsequent months as those expectations faded.

     Much of the US$’s losses were also related to speculation that the European Central Bank <ECB> would soon begin to wind down <Taper> its QE printing scheme. The growing recognition that the ECB was moving towards Tapering was the main impetus, that helped to lift the Euro from as low as $1.0400 in January ’17 and to as high as $1.2050 in Sept ’17. 

     The US$’s retreat was widespread. The Bloomberg Dollar Spot Index – which includes five major reserve currencies and 5 Emerging currencies, also fell -10.6% from its highs this year. The Euro accounts for 32% of the index, while the Japanese yen equals 18% of the index’s weighting. Major emerging market currencies such as Korean won, Mexican peso and Chinese yuan equal 18% of the weighting. The Aussie $ equals 6%. However, the Euro is still the chief alternative to the US$, and it has lots of influence over the direction of the Swiss franc, which has a 4% weighting in the Bloomberg Dollar Spot Index.

     The ECB bought fewer German bonds than it should have for a sixth straight month in September, a sign that it will announce on Oct 26 that it will reduce its monthly purchases, currently at €60-billion per month, in light of stronger economic growth in the Euro zone. On October 4th, Austria’s central bank chief Ewald Nowotny said the ECB should taper QE gently, and avoid abrupt changes. “We are aiming for the prospect of a cautious normalization. Caution means not hitting the brakes abruptly, but slowly taking your foot off the pedal,” Nowotny said, lending support to the move toward Tapering QE.

      On Sept 28th, Bank of France chief Francois Villeroy de Galhau said there was no doubt that the current economic and job market recovery would lead to higher inflation. “We are facing today a simple requirement linked to our mandate of maintaining price stability and the progress towards our inflation target. We must reduce the intensity of our net asset purchases while also keeping overall our monetary policy significantly accommodating,” Villeroy added.

     On Sept 26 – Bank of Portugal chief Carlos Costa acknowledged that exiting quantitative easing will “likely be even more challenging” than the adoption of the policy at the height of the Euro zone debt crisis. “We are looking at new territories in terms of new economic and financial landscape. QE exit will likely be even more challenging than (QE) adoption.”

      Looking forward, there are many moving parts to the dynamics of the foreign currency markets. The wildcard is the unpredictable nature of US President Trump and his picks to run the Fed. Hawk or Chicken hawk, or more doves are the key question marks. Trump’s ability to pass tax cuts through Congress are also uncertain, given the amount of bad blood between himself and several Senators in the Republican party.

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