Whilst the language from the Fed was on the dovish side last week, the projected path for the Fed Funds rate was significantly more hawkish compared to the FOMC’s previous forecasts from just a quarter ago. Furthermore, with Yellen watering down her forward guidance at the ensuing press conference, replacing it with a “data dependent” approach, the bulls were given a green light to buy the US Dollar across the board.
That said, there are is still some confusion over Fed policy (despite their best efforts at being more transparent!) and this is reflected in market prices some way out of line with the FOMC interest rate projections. With the market derived curve for Fed funds some way below the FOMC’s projections, either the market is mis-priced, or it simply does not believe the Fed’s economic and interest rate projections – possibly because the Fed has an awful track record in economic forecasting!
We have to say that we are slightly surprised by the muted reaction in the US rates and bond markets last week. The 5 year US Treasury yield looked like it was breaking out above well defined resistance, yet by week’s end, yield held the range as can be seen in the chart below.
In a world fixated by deflationary concerns (Europe and Japan for example) and where yields have been melting because of central bank policies, any G10 country that has rising yields on the back of a hawkish central bank that appears to be behind the curve will surely see a very strong currency. If yields remain stuck in the range, we suspect that US Dollar gains will be a little bit more muted, but the main point here is that the Dollar is in a bull market and we are simply trying to assess the strength of the move in the months ahead when we look at US bond yields. The higher the yield, the stronger the Dollar will be.
Having been bullish on the Dollar against the Euro and Aussie Dollar of late, we are casting our net slightly wider. In particular, we view the post Scottish referendum price action in Sterling as bearish. In theory, the NO vote was supposed to be bullish for Sterling as it would remove uncertainty for the market. In practice, the UK political systems now has to work out how to devolve power to all the different regions, not just in Scotland. We also have a general election in 8 months that may increase uncertainty again. So, political uncertainty has shifted rather than being removed and may very well become a negative for Sterling in the months ahead. Furthermore, the UK’s largest trading partner remains stuck in the slow lane and we have large current account and budget deficits that need to be controlled at some point. It is certainly not inconceivable that UK growth has peaked and we see a slowdown in the quarters ahead.
The weekly chart below shows the upside rejection in cable. We believe that Sterling will go lower in the period ahead and have sold with a stop above last week’s high of 1.6525.
Last week had been viewed as an important week with a potentially important FOMC meeting, Scottish independence vote and liquidity operations from the ECB (weren’t they a disappointment!). The events of last week confirm our bullish view on the US Dollar, we continue to expect yield curves to flatten modestly over time, and equity markets to lose momentum. Overall, we believe that investors are underestimating the headwinds that should become apparent in a post Fed QE world, and we expect volatility to increase in the months ahead.