Fed Disappoints, but Global Investors Happy

The Fed clearly disappointed expectations with its decision not to slow its asset purchases, but the Financial Times may go a bit too far with its headline suggestion that the Fed blinked.   The Fed did no such thing.  It had never pre-committed to a September tapering.  And surveys suggested around a third did not in fact expect the Fed to taper now.  

A fairer criticism may be that the Fed did not push back harder against market expectations.  However, in past, the Fed has been accused of being a slave to market expectations.  The Fed has argued its course is data dependent and, surely we are not the only ones who recognized that the economy, broadly understood showing the momentum the Fed had expected.  Moreover, outside of some short-term speculators, it is not clear who has been hurt by the Fed's decision. Asset markets, equities, bonds, emerging markets, commodities rallied.  Investors and policy makers around the world are richer by the Fed's decision not poorer.    No harm no foul.  

We suspect that no matter what the Fed did, its credibility would be questioned.  Damned if they do and damned it they don't, put the Fed behind the proverbial 8-ball and this is not simply hindsight, but we had highlighted the Fed's credibility dilemma.  

The Fed's concerns about the economy, outlined by Bernanke at the press conference, means, we think, that an tapering in October is unlikely.  Several of the issues cited may not be fully resolved, like the fiscal issues, or could be exacerbated, if a compromise on the debt ceiling entails new spending cuts.   Moreover, tapering in October would give too much credence to high frequency data, which typically is noisy.  

We continue to believe that the Fed should wait for the new chairman (and new configuration, given the planned and anticipated departures, including Yellen if she does not get the chairmanship).    Waiting until then to taper will have little real economic impact and improves the credibility of the forward guidance (in the sense that the Fed that offers the forward guidance will be there to enact it).  

The market is finding it difficult to extend yesterday's gains (of the catch-up move in Asia and Europe, given the rally in US afternoon yesterday).   This lends credence to our thinking that 1) the market overreacted, after all the dollar had been trending lower against the euro, sterling and Australian dollar, for example, in recent weeks when something on the magnitude of 2/3 of the market expected the Fed to announce a tapering.  

We suspect that with the Fed behind us for at least several weeks, the market's focus can shift back to Europe.  As is well appreciated, German elections are this weekend.  German policy toward the euro area is unlikely to change as it was largely a function of a faction of Merkel's CDU and the opposition Greens and SPD.  

The German election is important because with the passing of that event, European issues can return to the fore.    These include, the German Constitutional Court ruling, the fragility of the Italian government, the Greek funding gap, next year's planned exit from aid packages by Portugal and Ireland, Slovenia's potential need for assistance to address it fragile banks.   Recall that Portugal's request to relax next year's austerity measures was rejected by the euro area finance ministers.  

There is also seems to be increased speculation that the ECB will offer another LTRO early next year. Roughly a third of the borrowings have been returned, those that need it still of course want it.  Many are concerned about the LTRO-cliff approaching.  Offering a two year LTRO would in effect extend the current one for another year.

While the PMIs in the euro area have improved, there seems to be a gap between such survey data and the real sector data.  The real sector appears to be lagging behind.  The unexpected and large drop in UK retail sales (-0.9% vs consensus of a 0.4% rise; the largest decline since last October) illustrates underlying vulnerability of the currencies to poor data.  Sterling, like the Australian dollar, has not been able to push through yesterday's highs even though the euro has.  

We often find that sterling leads the euro. Consider that sterling's H1 high was set on Jan 2, while the euro's peak took place a month later, or that sterling recent low was set on August 26, while the euro's recent low was set on September 6.   

Consistent with this, we note that some of the actively traded emerging market currencies, like Turkish lira, the South African rand and the Brazilian real are also seeing some profit-taking after yesterday's out-sized advance.  The question many portfolio managers are asking is whether they should take advantage of the bounce in the emerging market currencies/assets to further lighten up as the Fed will taper in the foreseeable future, even if not immediately.