Six Talking Points

1.  Many are arguing that the dollar's rally reflects a shift in expectations of Fed policy.  There seems to be little evidence for this.  A shift in expectations would be most directly reflected in market pricing of the Fed funds futures and Eurodollar futures contracts.  Since the end of August, the implied yield of the March 2015 Fed funds futures contract rose a single basis point to 15.5 bp.  The implied yield of the June 2015 Fed funds futures contract rose by 3.5 bp to 30.5 bp.  We suspect that many observers are getting ahead of themselves by placing too much importance on comments from a few regional Fed presidents.  The recent JOLTS report gives little reason to expect a dramatic reassessment of the conditions of the labor market.  While the FOMC statement will evolve, it seems that there is still no urgency from the Fed's leadership to change the forward guidance. 

2.  Economists and investors will agree that there are many considerations that influence long-term interest rates, and Fed policy is only one of them.   The US 10-year yield rose from 2.34% at the end of August to nearly 2.55% yesterday.  The (generic) yield has risen every session this month.    One of the factors underpinning the yield may be the improved prospects for growth.   Barring the non-farm payrolls and some consumption data, nearly every other major economic report has surprised the consensus to the upside.    That said, the 10-year yield has been held back by the 100-day moving average for the past five months.  Yesterday was the first day it finished above this average since April 3.   It is found today just below 2.53%.

3.   The widespread assumption is that the unorthodox easing by central banks has depressed volatility throughout the capital markets.  Some observers are trying to link the increase in volatility to a change in this, and specifically the Federal Reserve that will wind down QE next month.  There are two problems with this narrative.  First,  it does not align with the rise in currency volatility that bottomed in mid-July.  The volatility of the S&P 500 (VIX) put in a recent peak in the first half of August, and currently sits on its 50-day moving average, below 13%.  Bond market volatility (MOVE) has risen.  It bottomed in early August.  Second, and more importantly, the global measures of liquidity are unlikely to change very much.  The liquidity that was emanating from the Federal Reserve will likely be replaced by the ECB beginning with next week's TLTRO, and later supplemented by the ABS/covered bond purchase scheme. 

4.  Be wary of simple economic determinist explanations and predictions.  Investors may know about assessing net present value, but many seem to under-appreciate non-economic sources of motivation.  In the face of conventional opinion we argued against the likelihood of the disintegration of the EMU, or even a country dropping out, precisely because we had understood the issues to be more about politics than economics.  It also allowed us to anticipate a tightening of the sanctions against Russia by Europe, despite the immediate economic interests.   Many observers expect Scotland to reject independence because of their economic self-interest.  We also see a "no" vote as most likely, but not simply because of economic benefit.   Ironically, an independent Scotland might an oxymoron in the sense that its independence by prove to be more chimera than real, and Scotland itself might cease to exist if Shetland and Orkney opt-out of an independent Scotland (to either form their own country or stay with the England and Wales).  When monitoring the results next week, how these areas vote could be important to the overall reaction, ie a substantial "no" vote could limit the impact of an overall small "yes" vote.  

5.  Here in September, the Japanese yen is the weakest of the major currencies, falling about 2.6% against the US dollar and 1.1% against the euro.  The dollar was in a JPY101-JPY103 trading range from April through most of August.    When the dollar broke above JPY103, the 10-year Treasury yield was below 2.45%.  On August 29, when the dollar closed above JPY104 for the first time since the start of the year, the US 10-year yield was below 2.35%.  Frustratingly, it appears that the foreign exchange market led the rate move.  Japanese investors have stepped up the export of their savings (they have purchased $12 bln of foreign bonds over the past two weeks), and at the same time, speculators have grown a substantial short yen position.   The gross short speculative yen position in the futures market has grown by almost 50% to 133k contracts in the last four weeks through September 2.    

6.  While there appears to be more talk about rising price pressures, the evidence remains elusive at best.  Over the past month, the yield curve measured by the 2-10-yields has flattened marginally.  Wage growth continues to be subdued.  Commodity prices are slumping.  Since peaking in late June, the CRB index has fallen over 10%.  Oil prices are off 16%.   Copper prices are off 7%.  At the Bank of England, two members of the MPC voted for an immediate rate hike last month even though CPI, wages and commodity prices were falling, for fear of inflation around the corner.  We do not think those hawks (Weale and McCafferty) represent the MPC any more than Plosser, Fischer and Bullard represent the majority of the Federal Reserve.