Weekly Outlook

By David Morrison  |  16/03/2018 15:41

This article looks ahead to the Fed’s monetary policy meeting and considers recent market movements in stock indices, FX and crude oil

FOMC look-ahead

There are several significant events due in the coming week. These include updates on UK inflation, unemployment, Retail Sales and the latest monetary policy statement from the Bank of England, where no change to the Bank Rate is anticipated. But the main event by far is the two-day Federal Reserve monetary policy meeting which concludes on Wednesday. This will be Jerome Powell’s first meeting as Chairman, made more important in that the Federal Open Market Committee (FOMC) will update their quarterly Summary of Economic Projections.

Three or four hikes in 2018?

The CME’s FedWatch tool (which uses the fed funds futures to calculate odds on forthcoming rate hikes) puts the probability of a 25 basis-point rate rise at around 90%, which is pretty much as close to a dead cert as it could get.  As the rate hike is fully priced in to markets, investors will be paying far more attention to the FOMC’s quarterly summary. This is where all members of the Committee contribute their forecasts for inflation, GDP growth, unemployment and the fed funds rate for the next three years and beyond. Perhaps the most important element within the summary is the “dot plot” which gives a pictorial representation of each member’s (anonymous) forecast for future fed funds. Back in December most members anticipated three 25 basis-point rate hikes in 2018. The question now is if this will be raised to four. Going into the meeting, the market is still pricing in three hikes, although there has been a slight upward shift recently. This quarter’s “dot plot” will help to solidify the FOMC’s thinking. So, we’re likely to see a repricing of risk depending on whether the Committee sticks with three or shifts further towards a total of 100 basis points-worth of hikes this year. 

Inflation outlook

Analysts will also want to know if projections for inflation (as measured by Core PCE) get nudged up. Last quarter the expectation was that Core PCE would come in at 1.9% in 2018, before hitting the Fed’s 2.0% target next year. Any upward tweak would be additional evidence that the Fed is becoming more hawkish. In the current environment where the Fed is the only developed-world central bank actively engaged in tightening monetary policy, such a shift may lift the dollar – particularly given recent dovishness from both the European Central Bank (ECB) and Bank of Japan (BOJ). However, there’s still a feeling that the Trump administration favours dollar weakness (despite protestations to the contrary from Larry Kudlow – Trump’s new chief economic advisor). Investors are also wary of bidding up the greenback given Trump’s unfunded tax cuts and spending plans which are adding to the budget deficit and national debt.

Trade war?

Higher borrowing costs are rarely good for equity markets. Bear in mind the Fed is also engaged in “quantitative tightening” – removing stimulus as it reduces its balance sheet. All this weighs on bond prices which puts upside pressure on Treasury yields. This comes against a background of a fresh wave of market angst over the possibility of the US opening a trade war with China. It was always likely that Trump’s tariffs on steel and aluminium were little more than a first sortie as he pushes back against the Chinese government’s alleged theft of intellectual property. This was made more explicit after Trump directly addressed China’s trade surplus with the US. The president said he wants China to reduce it by $100 billion (roughly 26%) or face tariffs of $60 billion.

Market reaction

The bottom line: if the FOMC sounds dovish and continues to forecast three 25 basis point rate hikes this year, then expect the immediate reaction to be a weaker dollar and a rally in equities. A push towards four hikes should see the opposite. This should also lead to a spike in bond yields and volatility – something that could unsettle investors in the current environment.
 
Stock indices

Global stock indices have struggled recently as investors worry about Trump’s imposition of tariffs escalating into an all-out trade war. There are also concerns after Trump made further changes at the White House, getting rid of key personnel.

A pattern has recently emerged whereby early rallies in US stock indices have petered out, ending in a series of weaker closes. This trading behaviour points to dwindling risk appetite amongst traders. Earlier in the week the S&P 500 pushed above the highs hit at the end of February when the US stock market underwent a corrective bounce. However, the index failed to break above 2,800 and subsequently fell back towards its 50-day moving average just below 2,750. Investors are concerned that Trump’s imposition of steel and aluminium tariffs is looking more like a targeted attack on China. The odds on an all-out trade war have shortened as Trump has been particularly outspoken about China’s alleged theft of intellectual property. Midweek the president said he wanted China to reduce its trade surplus with the US by $100 billion (roughly 26%) or face tariffs of $60 billion.

Recent US economic data has been mixed. Headline and Core CPI both rose 0.2% in February as expected, and this helped to calm nerves following January’s jump in consumer prices. At the beginning of February US stock indices experienced their largest and most protracted sell-off since early 2016 after a jump in Average Hourly Earnings triggered inflationary fears which led to a spike in bond yields and volatility. This was compounded a fortnight later by an unexpected surge in CPI when the headline number rose 0.5% in January – well above the +0.1% rise from the previous month. But Wednesday saw the release of disappointing Retail Sales numbers. Once these were plugged into the Atlanta Fed’s GDPNow forecast, the tracker predicted first quarter GDP growth of just 1.9% - down from 4% just four weeks ago.

Nevertheless, while there’s been a bias to sell rallies, the major indices failed to break out in either direction while bond yields remain rangebound. The yield on the US 10-year Treasury continues to trade above 2.80% but is down sharply from 2.90% which followed the release of the “Goldilocks” non-Farm Payroll and Average Hourly Earnings from a week ago.

FX

The main feature of last week’s trade was that the dollar remained in a relatively narrow range. Looking at the Dollar Index, the area around 90.00 continued to act as resistance while support held around 88.00, although this has narrowed in to 89.00 from the third week of February. As far as the EURUSD is concerned, we’ve seen resistance kick in around 1.2400 over the past three weeks, although this widens out to 1.2500 going back to the beginning of this year. Support comes in around 1.2200.

On Wednesday, Larry Kudlow (who replaced Gary Cohn as President Trump’s key economic advisor) said the time was right to buy the dollar and sell gold. His comments triggered a modest rally in the greenback and an offsetting fall in gold. However, the moves were short-lived as the overwhelming view is that Trump’s plan to “Make America Great Again” requires a strong US export market, which benefits from dollar weakness. In addition, there’s little doubt that the Trump administration’s unfunded tax cuts and proposed spending plans will add to the budget deficit and national debt. This in turn is helping to keep a lid on the dollar, as is general uncertainty surrounding the Trump presidency, whether this be to do with the prospect of tariffs leading to trade wars or unease at the constant turnover in White House staff. US Treasury yields have pulled back from levels hit straight after the release of last week’s payroll and earnings data. Nevertheless, they remain elevated with the 10-year yield holding above 2.80%.

Sterling has had a decent run since the beginning of this month. The GBPUSD pair remains in an uptrend which began in October 2016. However, it’s currently running into some resistance around 1.4000. Support comes in around 1.3600 which marks the lower end of the upward-sloping trendline. Meanwhile the EURGBP looks rangebound. Support comes in around 0.8750 and resistance around 0.8950 or so. This looks likely to continue until we have some clearer news on Brexit negotiations which could take some time.
Investors appear to be cautious of taking on additional FX exposure until we hear from the Federal Reserve on Wednesday. If the FOMC’s “dot plot” indicates additional hawkishness with a shift towards four 25 basis point rate hikes this year, then the dollar should benefit, at least in the short-term. But if the FOMC’s rate forecast remains broadly unchanged from December, then the greenback could come under further selling pressure.
 
Crude oil

On Thursday the International Energy Agency (IEA) reported that global oil demand was forecast to pick up this year. In the normal course of events, this should keep a floor under prices and perhaps see first Brent, and then WTI, head back above $70 per barrel. However, the IEA also expects stockpiles to grow, and at a faster pace than the pick-up in demand. There is a feeling that the oil market is quite fragile with confidence in the underlying bullish fundamentals fading somewhat.

We’ve just seen some contradictory US inventory numbers with the American Petroleum Institute (API) recording lower-than-anticipated crude stockpiles while the official data from the Energy Information Administration (EIA) showed a larger-than-expected build in inventories. But there’s also the issue of US production which just hit a fresh record high of 10.38 million barrels per day. This represents an increase of 23% compared to mid-2016, and US output continues to undermine efforts by OPEC and a group of non-OPEC producers to keep a bid under prices through an agreed 1.8 million barrels per day output cut. This agreement has been in place since November 2016 and is due to continue until the end of this year. However, there’s a danger that it may fall apart before then. OPEC members Saudi Arabia and Iran are squaring off with each other over their optimal oil price target. Saudi is aiming for $70 while Iran calculates that $60 works best, arguing that all a higher price will do is encourage further US shale production. This is already forecast to top 11 million barrels per day by year-end. In addition, Russia has previously agitated for bringing the output cut agreement to an end once global inventories fall back towards their five-year average. Putting this all together suggests that this summer’s OPEC meeting could be the venue for a breakdown of the output cut agreement which should weigh on prices.

Looking at a monthly chart we can see that crude has made steady upward progress since early 2016 when both WTI and Brent were trading below $30 per barrel. Prices hit three-year highs back in January in a move which saw Brent top $70. However, both contracts have since pulled back a touch and have been rangebound for the past fortnight with WTI hovering between $62 and $60. Brent is currently stuck between $66 and $64.
 
Key events
Monday -             EUR Italian Industrial Production, Italian Trade Balance, Euro zone Trade Balance, German Bundesbank Monthly Report

Tuesday -             AUD Reserve Bank of Australia Monetary Policy Meeting minutes; GBP CPI, RPI, PPI and HPI; EUR German and Euro zone ZEW Economic Sentiment surveys

Wednesday -     GBP Claimant Count Change, Unemployment Rate, Average Earnings Index; USD Existing Home Sales, Crude Oil Inventories, FOMC Fed Funds Rate, Monetary Policy statement, Economic Projections, Press Conference

Thursday -           AUD Unemployment Rate; JPY Flash Manufacturing PMI; EUR French, German, Euro zone Flash Services and Manufacturing PMIs, German Ifo Business Climate survey, ECB Economic Bulletin; GBP Retail Sales, BoE Rate Decision, Monetary Policy Summary; USD Weekly Jobless Claims, Flash Manufacturing and Services PMIs

Friday -                 GBP BoE Quarterly Bulletin; CAD CPI, Retail Sales; USD Durable Goods Orders.

 
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