FOMC Minutes: Centrists Remain In Control

The FOMC minutes were not very surprising.  The FOMC is not in any hurry to raise interest rates before the middle of next year at the earliest.   The FOMC statement did not drop the "considerable period" phraseology to describe the time between the end of QE and the first rate hike.  However, the minutes show it was a point of discussion and a compromise was achieved to emphasis the data dependency of the Fed's actions.  

In speeches by many Fed officials it is evident that the decline in inflation expectations is a issue of concern.  The minutes revealed that some officials were more concerned about a further breakdown in long-term inflation expectations than they were about growth faltering.  

The recent University of Michigan's survey showed the long-term (5-10 year) inflation expectation has slipped to 2.6% from 2.8%.  This is the lowest since March 2009.    Breakeven rates, which compare the inflation-protected securities to the conventional bond yields have deteriorated more than the survey results.  The 10-year breakeven was near 2.3% at the start of H2, and is now near 1.84%, just above the mid-October spike low (1.83%).  The 5-year breakeven was near 2.1% in early July and fell to 1.4% in the mid-October swoon.  It is now 1.50%.  

Another market-based measure of inflation expectations is the 5-year/5-year forward.   It as near 2.60% at the end of H1 and is now near 2.17%, which represents a new low for the year.  Both last year and in 2011, there were spikes to 2.0%.  

The different metrics produce different results, but they are all moving in the same direction. The drop in energy prices, including gasoline, is significant for households and businesses.   Inflation expectations are about the headline rate.  For policy purposes, the Fed gives a privileged place to core price, which excludes food and energy.  The reason is not that the officials are trying to be deceptive, but because for the last half century or so, headline inflation converges to core inflation, not the other way around.  That is to say, the core rate offers a stronger signal than the volatile headline rate, which is important for other matters, like cost-of-living adjustments.  The inflation-protected securities are linked to headline CPI.  

The October PPI was released earlier this week and it surprised on the upside.  The core rate rose 1.8% year-over-year.  The consensus had expected a small decline.  On Thursday, the October CPI will be reported.  The market expects a softer headline reading and a firmer core.    The core rate has been equal or below the headline rate since March.  This may have changed in October.  

The minutes did report a discussion of the headwind from the poor developments abroad, and this, of course, was before the unexpected contraction in Japan's economy in Q3.  There seemed to have been some effort not to emphasize this very much on the grounds that US exports are a relatively modest share of US GDP (~15%).  Because US companies service foreign demand primarily by building locally and selling locally (a direct investment expansion strategy rather than the classic export-oriented approach) weaker foreign demand is addressed primarily by reducing local production.   

The euro spent most of the session at the upper end of the recent range.  It spiked to $1.2600, a new high for the month, but beat a quick retreat.  It was trading just above the 20-day moving average  ($1.2535) after US stock market closed.  Note that the five-day moving average can cross above the 20-day average before the week is out, which may suggest some model accounts may reduce short or go long.   In addition, there is a down trend line drawn off the Oct 15, Oct 21 and Oct 29 highs that comes in today just above $1.26.  A convincing violation of the trend line may also encourage a bout of short-covering.  

We also note that the 50% retracment of the euro's decline since Oct 15 comes in near $1.2620 and the 61.8% retracement is found near $1.2685.  For all but the shortest-term traders and the nimble ones at that, it may be preferable to not play the correction, but view the upticks as a new opportunity to get with the underlying trend. 

Part of the demand for the euro may have been related to cross plays against the yen.  The dollar poked through JPY118.  It hit a lot near JPY115.50 on Monday.  The next obvious target is JPY120.  We would expect to see some official jawboning from Japanese officials ahead of this level. 

Sterling made a marginal new low today of $1.5590, according to Bloomberg.  However, it staged a reversal, though at pixel time, it is not clear whether it will finish above Tuesday's high of $1.5679 to signal a potential key reversal.  In addition, sterling may have carved out a double bottom, having taken out last Friday's low by 3 ticks (3/100 of a penny).  A move above $1.5735 could spur a move toward $1.5880, the measuring objective of the double bottom.