Global markets started the week on a down note from US political dysfunction and rallied in hopes of tax reform. In global affairs the markets seem to be discounting (or have priced in) the official invoking of article 50. Given the dramatic shifts in US politics, it is easy to understand why there is less emphasis on an event that will take 2 years to sort out. This is why it will be important to understand what could be over the horizon and find opportunities or risks while others worry in the near term.
The Pound remains at a post-brexit low and seems to have a lot of bad news baked into it. It would make sense from a longer term point of view to look for opportunities in certain asset classes (such as Gilts) that will provide some upside potential and favorable exchange rate movement. With elections in France and Germany this year there will be plenty of volatility and headlines to create some buying opportunities in the UK market and being prepared for those opportunities will be important. It should be good to have a base case scenario and list out what is expected bad news vs unexpected. Below is a good start to this list.
The Fed will speak in a few hours and the almost no one is expecting rates to remain the same. As discussed earlier the markets seem to be taking this rate hike in stride because the Fed seems to have waited to the very last minute to leave make sure there was nothing that could support a delay in rate hiking. What will be important to look for is the language at the conference. How the conference manages the expectations of the Fed going forward will play a large role in the markets going forward.
Should the Fed get more aggressive in their language, and appear to want to head off inflation, the markets could take a pause and revalue equities on that assumption. If the Fed instead keeps the appearance of only raising rates in the absence of any data giving a reason to hold, then markets will feel the economy can expand without much interference from higher borrowing costs.
It will be important watch the Fed futures for June, which is slightly to the advantage of another rate hike, and the end of year overall projections. Should these tick towards more rate increases because of an aggressive fed it will no doubt introduce volatility and readjustment in the equity and currency market.
With nonfarm payrolls coming in at 235K, they beat most expectations. This leaves very little in the way of a rate increase this month by the Fed. What will be important to look out for is how aggressive the Fed seems to look in terms of future rate hikes. Like the ECB coming out stronger than expected in their remarks, a similar tone could spark rallies in yields and currencies here in the US. A quick drop in the dollar is now being reverse (with the exception to the Canadian dollar due to their strong job numbers) as people digest the news. This also led to a rally in the US market futures.
This mixed signal of wall streets whisper number seeming to be higher means very little in the face of the Fed who was looking for bad numbers as the only hindrance to a March rate hike. So should these trends in the dollar and the markets keep in this direction all day, it could just be a traders opportunity to bet on the reversal, but nothing more.
An interesting correlation was seen in the markets yesterday. With the Federal Reserve coming out with hawkish sentiment for a rate increase this month (now over 80% likely), the markets rallied. In the past this was a good reason for the markets to sell off, re-valuing equities to higher discount rates. Now the opposite has occurred and it is tough to understand what to think of rate increases going forward. The best way to make sense of this seemingly reversed trend is to look at where the markets feel the Fed is in terms of combating inflation.
In the past the Fed has been reluctant to increase rates at the cost of the fragile recovery. This caused one rate increase per year over the last two because of concerns with brexit, elections and a lack of inflation. This put the market in the mindset that the Fed would like to see a very strong sign on recovery before taking action on inflation alone. During the end of last year inflation creeped up and now the Fed is changing it tune to raising rates despite Trumps tax and regulation plans. In the near term this expresses that the Fed seems to be a bit behind the curve, due to their caution, and have pushed up their rate hike to this month. This gives the market a signal that the Fed feels things are better than their previous expectations. If the Fed looks to try and correct this mistake with taking action with less external factors in consideration, the market could perceive future rate hikes differently in the future.
Should the Fed start to look at inflation rates alone and not worry as much about political and market turbulence in their decisions, the pace of rate increases could become less accommodating to markets. This drive to get ahead of inflation could lead to rate increases while the markets stagnate and bond becoming more attractive with an introduction of volatility.
That isn't to say that a rate hike is going to reverse the post-election rally, but it will certainly start to move independently of market expectations and could travel a path not aligned with high stock valuations. At a minimum it will make alternatives to stocks a more attractive prospect in the future.