High Noise to Signal Drives Markets

The capital markets are particularly difficult to navigate at the moment.  The news stream is noisy.  There are three issues that are confusing:  the Fed, Greece and Australia.  

How to think about the FOMC minutes?  The market clearly saw the minutes as dovish and reducing the chances of a June lift-off.  The debt market rallied, with the December 2015 Fed funds implied rate slipping below 50 bp, and the dollar came off.  However, we think that 1) the market is exaggerating the dovishness and 2) events since last month's meeting have to be taken on board.  

We have argued that the real signal from the Federal Reserve comes from its leadership, Yellen, Fisher, and Dudley.  Their signal is most clear in the FOMC statement.  If someone disagreed with the statement, they would dissent.  The minutes have a high noise to signal ratio.    The minutes read as if there may have been a push from the hawks to hike rates in March.  The dovish tint to the minutes, we suspect, was a push back against them. 

Since the FOMC meeting, several Fed officials have indicated that a June hike was still on the table.  The international headwinds have slackened since the FOMC meeting.  For one, Fed officials, like all of us, have learned that the German and Japanese economy appear to have grown faster than the US in Q4 14.  A resolution to the existential issue posed by Greece will be resolved by the time the Fed meets next month.   Also, since the Fed met in January, they have seen the continued improvement in the labor market, including a recovery in average hourly earnings.  

Some are concerned about the slowing of the US economy in Q4 and so far in Q1.  However, this too should be kept in context of 1) well above trend growth in April-September and 2) the combination of labor force growth and productivity, suggests trend growth is in the 2.00-2.50% area rather than above 3% as it was understood prior to the crisis.  Yellen's testimony before Congress next week is the next important event for insight into Fed-think.  In the mean time, we still expect the Fed to modify its forward guidance and to shift away from the date-specific "patience" that will keep the door open to a mid-year hike. 

Another issue that seems noisy is the ongoing Greek negotiations.  There was a report in FAZ that suggested there was official interest in Greek adopting capital controls.  The German paper is often seen as a favorite outlet for some Bundesbank officials.  Earlier this week, IFO's Sinn, who is hostile to the EMU project, called for Greece to introduce capital controls, but this is hardly policy.   

Capital controls in EMU are not and cannot be policy.  They are the expression of the failure of policy, as was and continues to be the case in Cyprus.  It is possible that capital controls are introduced in Greece, but this still seems quite a ways off  and would be a result of the breakdown in negotiations.  As it stands now, the Eurogroup will reconvene to consider Greece's proposal that is reportedly framed around the Juncker-Moscovici initiative earlier this week.  In effect, Greece appears to be requesting a four-month extension of the existing loan program with modified conditionality. In particular, it wants to avoid means like a cut in pensions or an increase in the VAT that would weaken growth.  

The ECB did grant a small increase in the ELA yesterday, but less than Greece requested, according to reports.  Part of the problem is the concern that the ELA funds would be used by the banks to buy government T-bills.  This is objectionable on grounds that it is agreed that ELA funds should not be used as an indirect way to finance the government.

We have identified the set of maneuvers in Europe as brinkmanship.  By definition, this means going to the very brink, which could even carry into very early March.  That is the only way each side can be sure they are getting the very best possible deal.   That said, we continue to expect that Greece stays within the monetary union. 

The Australian dollar is the weakest of the majors, losing a little more than 0.5%.  The main trigger was S&P warning the country’s triple-A rating is at risk due to the deterioration of its fiscal situation.  However, this is a reiteration of what it has said before.  With government debt around 20% of GDP, this is not an imminent threat.  This is not to say we are bullish on the Australian dollar.  On medium term view, we expect the central bank’s downside objective $0.7500 objective to be surpassed.    We have not been keen on a March cut after the February move.  However, a Q2 rate cut still seems the most likely scenario.   

  

There are two other developments to note.  First, Japan’s January trade deficit was smaller than expected at JPY1.177 trillion.  The consensus had expected a JPY1.681 trillion shortfall.  Japanese exports rose 17.0% year-over-year.  This follows a 12.8% increase in December and expectations of a 13.5% increase.  This is the strongest growth since late-2013 and comes on the heels of the BOJ upgrading its assessment of exports yesterday.  Exports to Asia are booming.  They are up more than 22% from a year ago, compared with 11% in December.  Exports to China are up 20.8% after a 4.3% increase previously.  Exports to the US slowed to 16.5% from nearly 24%.  Imports fell 9%.  This reflects the decline in commodity prices.  The consensus expected a 4.9% decline after a 1.9% increase in December. 

Second, today’s Department of Energy oil inventory figures will be closely watched.  Yesterday API reported a 14.3 mln barrel increase in US crude stocks.  This is a huge build.  It is equivalent to about a day and half of US production.  The refinery strikes may be flattering the inventory growth.  It is a major weigh on oil prices today, extending yesterday’s losses.  The DOE’s estimate was expected to show a more mild 3 mln barrel build.