Summary: The FOMC meeting triggered a fresh downdraft in market sentiment late yesterday, as they made it explicitly clear in its economic and policy forecasts, that it will continue to hike the policy rate even if the economy begins slowing and labor market conditions materially worsen. The US dollar spiked higher in response across the board, although new highs in USDJPY were tamed by fresh intervention threats from officials in Japan overnight. The US 2-year yield rose above the 4-handle for the first time since 2007.
US equities were not double thinking the signal from the Fed as Powell said the current level was at the absolute lower level of what is seen as necessary to get inflation under control. The US 2-year yield is trading 4.12% this morning adding renewed pressure on S&P 500 futures trading around the 3,788 level after touching the big 3,800 level in yesterday’s session. A soft landing scenario is increasingly getting difficult in the Fed’s assessment of the economy and the dot-plot also showed that the Fed’s intention of tightening further in 2023 despite the economy cooling. The next big level to watch on the downside in S&P 500 futures is the 3,740 level.
As noted below in the comments on the FOMC wrap, the Fed’s hawkish surprise took the US dollar sharply higher across the board, with even EURUSD touching new lows for the cycle towards 0.9800 and USDJPY trying above the former cycle high near 145.00, though some push-back from Japanese officials overnight tamed that move partially. Still, if the move is linked directly to the latest rise in US yields, it may be difficult for short yields to continue rising at anything resembling the pace they have achieved over the last few weeks, with the 2-year rising from below 3% to above 4% since early August. Stronger US data from here suggests a more resilient US economy than expected (potentially lifting the entire US yield curve, importantly at the long end as well as the short end) is one way that the USD bull can continue rampaging.
EURUSD broke lower to fresh 20-year lows of 0.9809 amid Putin’s partial mobilization and the strength of the dollar from the hawkish Fed signals. While the ECB stays hawkish as well, the relative hawkishness still tilts in favor of the Fed due to the harsh winter coming up especially for Europe as Russia has cut gas supplies. The stronger case of a recession also continues to bode for more downside in EURUSD in the near-term.
Japan's intervention warnings continue, without much effect on the yen
As the Bank of Japan held its policy rates unchanged at ultra-low levels today in-line with expectations, there was a spike in yen volatility with a new 24-year low printed at 145.405 but that was soon reversed and USDJPY corrected back sharply lower to 143.55. The pair has since traded back higher towards 145 again, despite some stark FX warnings including top currency official Masato Kanda saying that the government could conduct stealth FX intervention and will remain on standby. To be fair, pressure on the yen should ease with long-end US yields reacting to recession concerns arising out of the more aggressive near-term rate hike plans of the Fed as was firmly communicated by the latest FOMC dot plot. Governor Kuroda will be on the wires at 3:30pm local time, and more yen volatility can be expected.
Gold (XAUUSD) focus alternates between Powell and Putin
Gold trades softer following another hawkish FOMC rate hike that helped send the dollar sharply higher. By continuing to raise interest rates while also raising expectations for lower growth and rising unemployment the FOMC is signaling a recession is a price worth paying for getting inflation under control. Putin’s increasingly desperate measures and threats regarding his war in Ukraine helped support gold and shield it from losses as the dollar and yields rose. Geopolitical support aside, the yellow metal may struggle as long yields continue to rise and the market continues to price inflation sub 3% in a year from now. Resistance was confirmed above $1680 while below $1654, last week's low, the market may target the 50% retracement of the 2018 to 2020 rally at $1618.
Crude oil (CLX2 & LCOX2)
Crude oil prices received a boost on Wednesday after Putin’s speech, but gains faded later in the day amid a hawkish Fed boosting the US dollar and strengthening the case for a deeper economic slowdown, not only in the US but around the world. EIA’s weekly stock report had a softening impact with crude and fuel stocks all rising while the four-week averaged demand for gasoline slumped to the lowest level since 1997 on a seasonal basis, and a measure of diesel demand fell to its lowest since 2009. Geopolitical worries and the EU embargo on Russian imports remain the main source of support for a market that is increasingly worried about an economic slowdown and with that lower demand for crude oil.
US Treasuries (IEF, TLT)
The more hawkish than expected Fed (more below) inverted the US yield curve further, as the 2-10 inversion fell well below -50 basis points and therefore to its most inverted level since the early 1980’s as the market figures that the Fed’s continue pace of rate tightening will eventually lead to a recession. While the 3.50% yield level was broken ahead of the FOMC meeting, all of the action was at the short-end of the curve yesterday as the Fed made clear it will hike even if economic conditions and the economy deteriorate. So, the surprise at the longer end of the yield curve would be a resilient economy. Either way, longer treasuries will trade nervously around inflation- and growth-related data releases from here.
Fed surprises hawkish as 2-year yield leaps over 4%
The Fed managed to surprise on the hawkish side of expectation at yesterday’s FOMC meeting with the message embedded in the combination of the new set of staff economic projections and policy forecasts for this year and next. The surprise was less about the modestly higher median projections for the Fed policy rate by the end of this year and the end of next year relative to market expectations, and more that the Fed made those forecasts despite a significant lowering of the GDP forecast for this year and next and a sharp rise in the unemployment rate forecast. In other words, the clear message that the Fed is willing to continue hiking even if the economy deteriorates to get ahead of inflation made an impression, taking market expectations for Fed policy some 20 basis points higher by mid next year and spiking the US dollar higher and US yields to new cycle highs – mostly at the front end of the curve.
Russia’s partial mobilization spurs risk off
Russian President Putin, in his televised speech to the nation Wednesday morning, announced partial mobilization, calling up 300k reserves, whilst threatening the west with “All means of destruction, including nuclear ones”. Referendums in Donetsk, Luhansk, Kherson and Zaporozhye (15% of Ukraine territory) are scheduled September 23-27, and any fighting in these regions will be considered as attacks on “Russian territory” and thus pave the way for a potential military escalation, justifying the use of mass destruction weapons.
US earnings recap
General Mills rose 5% yesterday on better-than-expected earnings in its fiscal year Q1 on top of raising its outlook on organic revenue growth to 6-7% from 4-5% reflecting higher prices. The US homebuilder Lennar was down 2% on Q3 revenue and earnings in line with estimates and Q4 estimates on deliveries in line with analysts' expectations. But purchase contracts were down 12% from a year ago missing estimates highlighting the pressure from higher interest rates.
Temporary measures to shield EU consumers from high energy prices are becoming permanent
According to the calculations of the Brussels-based think tank Bruegel, European governments have allocated about €500bn to protect consumers since September 2021 (see the report). The exact figure is higher because Bruegel has not yet counted the most recent packages from the United Kingdom, Germany and Denmark. We would not be surprised if the total amount will reach at some point next year €1tr. But there is more. European governments have also allocated more to support utilities facing risk of liquidity crisis (several instruments are used including loans, bailouts and fully fledged nationalisation). This represents a total amount of €450bn (this is actually above half of the NexGenerationEU funding which was agreed after the Covid crisis).
Dreadful growth forecasts for the eurozone
We all know forecasting is a tricky task, even more so in the current macroeconomic environment (the impact of the energy crisis is tough to assess). Yesterday, Deutsche Bank revised downward its 2023 growth forecast for the eurozone, from minus 0.3 % to minus 2.2 %. This is a massive drop in GDP if it happens. It would be the third lowest euro area GDP growth since WW2 (behind 2009 and 2020, of course). This shows how low expectations are for the eurozone next year.
Bank of England may tilt to hawkish despite recession concerns
The BoE meets on Thursday after last week’s meeting was delayed by a week for Queen Elizabeth II’s funeral. Policymakers are expected to hike rates by another 50bps, which would bring the Bank Rate to 2.25%, although a 75bps hike is still on the table. Beyond September, analysts forecast a 50bps increase in November and 25bps in December, taking the Bank Rate to 3%, where it is expected to stay until October 2023. Also worth highlighting is the “fiscal event” delivered by new Chancellor of the Exchequer Kwasi Kwarteng on Friday. This will be his first statement on how he plans to deliver new Prime Minister Liz Truss' pledge to make the UK a low tax economy, which risks stoking inflation in the medium-term. However, short-term plans on energy support package suggest lower inflation to end this year, but that would not be enough for the BoE to go easy on its inflation fight.
What are we watching next?
Today’s earnings focus is Costco and Darden Restaurants as both companies are exposed to the US consumer. Analysts expect Costco to show 15% y/y revenue growth as the US retailer gains market share on a strong competitive position amid the ongoing cost-of-living crisis. Darden Restaurants is expected to post a growth slowdown as the pent-up demand driven quarters following the reopening after the pandemic are over. Revenue growth is expected to slow to 7% y/y in FY23 Q1 (ending 31 August).
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