From Deutsche Bank’s macro strategist Alan Ruskin
When a new Sheriff comes to town what does he do? If things have been unruly, he asserts himself and shows who is boss. If the old regime was largely peaceful/ successful, he follows the old sheriff’s protocols.
What has this got to do with markets/anything? The incentive for new Fed Chair Powell to come in and be disruptive to markets is extremely limited, in our view. Any changes are going to be about nuance. It is very unlikely the market is going to get guidance that the Fed is shifting its thinking from 3 to 4 hikes this year. After all, what is Powell’s incentive to pre-signal far ahead, and risk his credibility for so little gain, and when the Fed has yet to build a strong shift in consensus?
Is the central Fed view (that Powell likely represents) probably thinking the risks allied to fiscal expansion are in the direction of doing more than 3 hikes rather than less this year? Probably yes. Will this be made even vaguely explicit? Probably not, unless it is squeezed out of him with some deft questioning.
In the end, we’ll get the semi-annual text before Powell’s talk, but the market may well wait for the Q&A to respond to the body language and how much confidence Powell inspires. (In most spaghetti Westerns how the Sheriff carries himself is critical).
This ‘comportment factor’ is currently assuming additional importance, because testy times lie ahead. Firstly, it is possible Powell may have already inherited a policy mistake. The decision to put the shrinkage of the Fed balance sheet on auto pilot, at the same time as a huge increase in the supply of Treasury paper is coming on stream, has contributed to some loss of control at the back-end, that could become acute if inflation accelerates even modestly. More obvious, fiscal policy has now almost certainly added substantially to the amplitude of the US business cycle – strong growth in 2018/19, but hold onto your cowboy/girl hat in 2020.
It’s worth noting that markets are thinking similarly. The Tuesday morning when we receive Powell’s testimony text, FX vols are up slightly, but vols are up even more for the Wednesday vol that captures Powell’s Q&A performance. Forward vols for Mon – Tues – Wed are indicated at 8.75 – 9.2 – 10.8 for EUR/USD and, 9.35 – 10.4 – 11.3 for USD/JPY. Vols for the event look mostly consistent with ‘the Sheriff’ analogy above. As for the dollar directional reaction, it will be influenced by the positioning going into the event, for the more the market is positioned in one direction, the more the market is prone to reverse after the testimony.
What we have seen of late is that because the next FOMC meeting is close to a a done deal on a rate hike, data and events are not shaking up the immediate expected Fed policy response by much. This is reducing the FX response to Fed rhetoric. In addition, as Figure 1 shows, even as the Fed raises rates, the market persistently thinks in terms of being nearer the end of the cycle. As an example, it is likely that after the March Fed 25bp rate hike, the market will be pricing in less than 100bp of additional tightening.
This is at the low end of the range since 2010. What is clear from recent price action, is that for the USD to be more favorably responsive, either the data has to inspire market thinking that the Fed is i) not as advanced in the tightening cycle as is priced, and/or ii) that the Fed is ready to accelerate tightening. Powell is not even close to giving these signals. Instead, we may need to look to the FOMC 2019/20 dots for the market to change a view that a hike today, means fewer hikes tomorrow.