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Central bankers generally fall into two camps; doves and hawks, while I would add the flock down the years has been graced by some owls. This week has already shown the ascendancy of the doves via Mario Draghi, and on Wednesday the Federal Open Market Committee and its squadron leader, Jay Powell, affirmed that easier monetary policy beckons.

Market expectations for Wednesday were for no interest rate cut until July, lower inflation forecasts by the FOMC and a dovish tone from Mr Powell during his press conference.

On that score the FOMC and Mr Powell largely delivered. 

The bottom line from Wednesday’s meeting is that the Fed has bought itself time to wait for what the upcoming G20 meeting reveals about the outlook for US and China trade negotiations and also before employment and inflation data arrives ahead of the central bank’s late-July meeting. If trade talks hit the wall and economic data fall short of forecasts, a 50 basis point rate cut looms next month. 

David Riley at BlueBay Asset Management notes:

”The FOMC statement sets up a July rate cut unless data and especially inflation data surprises to the upside and there is unequivocally good news from Trump/Xi later this month.”

David also makes an important point: 

”Today’s meeting was the opportunity for the Fed to push back on market expectations of near-term rate cuts — they did not take it despite their confidence in the performance of the US economy.”

The main market reaction has seen Treasury yields decline, led by the policy sensitive two-year note, dropping 12 basis points towards 1.75 per cent, a fresh low for 2019. The dollar retreated, with the euro holding above $1.12, while inflation expectations bounced a little higher. 

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The dollar-yen exchange rate has moved fairly closely with the recent shifts in long-dated US Treasury yields. As the 10-year note yield fell from 2.60 per cent in April, the yen appreciated from Y112 towards Y108. On Wednesday we saw the yen appreciate beyond Y108 as the 10-year benchmark fell towards 2.03 per cent after the statement was published and that highlights the dovish FOMC statement and leaves the Bank of Japan in a tight corner.

While repeating the view of ”sustained expansion of economic activity, strong labour market conditions, and inflation near the Committee’s symmetric 2 per cent objective as the most likely outcomes” the latest FOMC statement added this kicker: ”But uncertainties about this outlook have increased.” Also of note, the growth assessment shifted from ”solid” to a ”moderate rate”. Among the FOMC voters, James Bullard, the St Louis Fed president, dissented as he sought an immediate 25bp rate cut.

Wednesday’s meeting provided an update of economic and interest rate projections and here we can see the oil tanker of forward projections turning. The median interest rate forecast of Fed officials now shows a 25bp reduction next year, compared with their previous projection of a 25bp increase in 2020. 

But, eight members of the 17 strong FOMC expect a cut of 0.5 per cent next year and that nudges the FOMC more in tune with the bond market’s call of the funds rate falling to 1.65 per cent by the end of the year (based on the January Fed funds futures contract, which on Wednesday set a new high in price for 2019) versus the current midpoint of 2.375 per cent for the overnight rate set by the US central bank. The 2020 dot estimate dropped to 2.1 per cent from 2.6 per cent, while the long-run neutral fed funds rate was lowered to 2.5 per cent from 2.8 per cent.

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The FOMC also reduced the outlook for inflation this year with the median estimate for the personal consumption expenditures index slipping to 1.5 per cent growth from 1.8 per cent. PCE is seen rising to 1.9 per cent next year, still below the central bank’s target of 2 per cent. 

That only affirms the bond market’s aggressive call for rate cuts this year and in that regard, the Fed and ECB have this week signalled they will follow the path being set by falling government bond yields. 

Quick Hits — What’s on the markets radar

Negative yielding debt at a record — Yet another unwelcome record tally for traditional fixed-income investors, the ranks of insurers, pension funds and asset managers, who rely on long-term streams of income. The universe of negative-yielding bonds now tallies a record $12.5tn, taking out the prior peak from 2016 as shown here.

Eurozone inflation expectations climb — The power of Mario Draghi’s dovish remarks at Sintra on Tuesday still resonate. The eurozone inflation swap for five years, starting with a five-year lag, (known as the 5yr/5yr break-even) climbed towards 1.30 per cent on Wednesday, up from an intraday low of 1.08 per cent on Tuesday. A sustained climb above 1.32 per cent, the low from late-March would certainly please Mr Draghi and his colleagues at the ECB.

Fading the EM F/X bounce — Carry trade favourites, led by the Turkish lira, South African rand and Brazilian real are all up sharply since mid-May, highlighting the hunt for yield as developed world bond markets have rallied hard. 

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Brown Brothers Harriman caution that dovish central banks, led by the Fed, only work up to a point. 

”We need a good global growth story much more and we’re not there yet. Yes, US and China are talking again but with Trump complaining about the euro, we suspect trade tensions will remain high into the autumn. We’d look to fade this EM FX bounce.”

Buying the dip — Long-dated Treasury paper has its fans and there’s scope to think higher yields will find buyers. Oxford Economics highlight recent positioning in the futures market, that shows a net short among non-commercial traders (those that use futures to speculate on prices, rather than hedge an underlying exposure) to the tune of 6.5 per cent of market open interest. Such bearish positioning may well limit the extent of a back-up in yields and this was the backdrop last November. 

Oxford Economics note:

”History shows that the Fed has always delivered easing when markets have moved to price it over a 12-month horizon.”

Given the current macro headwinds, they add: ”We think any near-term dip in long-end Treasuries is one to buy.”

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I’d love to hear from you. You can email me on michael.mackenzie@ft.com and follow me on Twitter at @michaellachlan.



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