The Trade Week Ahead – Trading the Fed

Come 04:00 AEST Thursday the Federal Reserve will increase the Federal Funds rate for the eighth time in 2 ½ years, the third time in 2018 and will have a further 5 rate hikes to December 2019 meaning it will have reached its neutral cash rate and its median dot plot projection.

Discounting ever-the-perma-dove in Neel Kashkari Minneapolis Fed President the board is, in essences, aligned with one another. All are advocating for the FOMC to pursue ‘gradual hikes towards the neutral rate’.

Clearly there are those that would prefer to increase rates at a faster pace (Esther George, Charles Evans) or would prefer to reach the neutral rate over a longer period of time (John Williams). But the conclusion is the same – in the next 18 months the Federal Funds rate will be at 3% to 3.25%; the speed at which it reaches this is the only unknown.

The best member to watch is Governor Lael Brainard Chair massive dove turn neutral her comments from September 12th perfectly summarise the Fed’s thinking:

‘Over the next year or two, barring unexpected developments, continued gradual increases in the federal funds rate are likely to be appropriate to sustain full employment and inflation near its objective.’

The stage is set for a rather interesting period in the USD and US equities, both in my opinion are heading higher, however that statement in itself is interesting.

The trade perspective here is that markets continue to under-price the Federal Funds rate. Some repricing has begun show as seen by the purple versus green lines in the chart above which show the pricing leading into the June meeting versus the latest reading (late last week). However, even with the steepening of the futures market, the discount to FOMC forecasts is large. The markets clearly aren’t pricing in material inflation.

I am, as I have suggested before, U6 employment (underutilisation), wage prices, the wealth effect (S&P and DOW made new record all-time highs last week) and a President adding more stimulus to the economy – inflation is coming fast, I therefore, am on the side of the Fed not the market currently.   

The next instrument to watch is the US 10 year which has held steady for most of the year for a whole manner of reasons. One that is taking centre stage currently is a tax-deduction trade for US corporate. US investors had until September 14 before the new tax changes from last year came into full effect; meaning corporate would have been buying bonds to get set in the tax-deduction trade suppressing the yield in the US 10 year. This loop-hole is now closed leaving the US 10 year to follow the US 2 year suggesting there will be a uptick in 10 year yields.

This bring into focus the effect on the AUD – currently the spread between the Aussie-US 10 years is at the lowest level it’s been since June 1981 – if we factor in the forecasted rate hikes in the Federal Funds rate that spread could be as wide as 150 basis points by the end of next year.

This should put sustained downward pressure on the AUD; as the return premium that has seen foreign investment into Australia for decades is now being squeezed by low yields and a massive FX headwind, the longer term AUD view is one way – down.

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