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Boy the food at this place is really terrible – and such small portions! France’s suggestion it could sue AstraZeneca over a lack of vaccine deliveries rather smacks of not wanting a cake and not eat it. Cases across France and Germany are rising fast and with the vaccine rollout so shambolic across the Eurozone, it creates worry about the pace of economic recovery in the bloc. That has not massively dented the mood in the markets yet – stocks are not the real economy etc, plus rebounding car sales are a boost (see BMW, VW) and plans for a vaccine passport should spur travel this summer – but it could be a problem for the currency.

A cautious mood prevails in global stock markets this morning ahead of the Federal Reserve meeting. Stocks are hugging the flatline in early trade, whilst US futures are flat as really nothing matters today except the Fed, its dots and what Jay Powell says in the presser after.

Uber shares are lower in the pre-mkt after it announced some measures to comply with the UK Supreme Court by offering drivers employee-like status. I say some measures since it looks like drivers won’t be entitled to a minimum wage whilst logged on waiting for a client, but only when they have a fare or are going to pick them up. I don’t think this complies fully with the court’s ruling and Uber could face fresh action. Sticking with cars and it is very interesting to see VW and BMW come back strong and this poses very clear challenges to a certain Tesla stock, which fell another 4%.

Yesterday the FTSE 100 managed to close above 6,800 for the first time since mid-January. The Dow Jones industrial average declined 130pts, or 0.4%, from its record high. The S&P 500 was 0.16% lower, ending a 5-day win streak. The Russell 2000 small cap index fell 1.7% and the Nasdaq rose. US 10-year rates nudged up above 1.63% despite strong demand at a 20-year auction. The Vix – the ‘fear gauge’ – declined to its lowest in a year.

Fed preview: Join the dots

The market will be watching this very closely indeed. This is going to be a tough one for the Federal Reserve and its chair as it’s going to be a hard sell to contain yields and inflation expectations. The problem is that the market is already pricing in a big recovery but the Fed is trying to say ‘not yet’, we’ve still got some way to go. This dichotomy exists largely because employment has become the Fed’s go-to measure of monetary policy outcomes, which is new, and not really what markets are looking at (earnings, GDP). Doublespeak is a risky game – the ECB has been tying itself in knots over its communication. Jerome Powell has been much clearer and has been sticking to his guns ahead of this meeting, despite the greatly improved economic outlook, the rapid rollout of vaccines in the US and – crucially – a spike in bond yields. Coming into the meeting we note 10-year Treasury inflation-protected securities breakeven inflation rate hit 2.303%, the highest since July 2014. 5-year breakevens are at the highest since 2008.

Overall, the Fed is still in very much in accommodation mode – keeping the punchbowl filled up and will want to not let the market think it is bringing forward its rate hike expectations or tapering bond purchases. The Fed has made it clear that its goal is maximum employment and will keep the punchbowl filled up until it gets there. Powell will stick to the script but the market will make up its own mind about what this means for the path of rates and inflation – and the US dollar.

Key questions for the Fed today

Do enough members move their dots to a point where the market sits up and reacts? It seems unlikely that enough members will bring their dots forward to move the median plot much nearer than the first hike of 25bps occurring before the end of 2023, which is still short of the current market positioning which indicates a hike in 2022. An additional 5 members of the total 18 would need to pencil in a hike 2023 to move the median dot. So really this ought not to have much impact on the market – a signal that more than 6 policymakers – say around half or even a majority – are thinking early 2023 would be noteworthy.

Table: Current dots from December

Current dots from December

Is the Fed more likely to lean on long yields (eg a Twist operation) or appear happy to let then run higher and then chase with hikes? The economic fundamentals and cyclical upswing in growth and inflation suggest the latter – the Fed has been talking more about yields being a function of recovery than worrying about inflation. But it won’t want to signal that it’s really bringing forward hike expectations too rapidly, either.

Does it extend supplementary Leverage Ratio (SLR) relief for banks beyond the March 31st deadline. I think it’s unlikely but there may be some action to try and prevent dumping on Treasuries onto the market and the volatility this could generate. I should note that the excellent Zoltan Pozsar of Credit Suisse argues that it won’t be a problem anyway since the vast bulk of Treasuries which are currently exempt from SLR are booked at bank operating subsidiaries, not broker-dealer subsidiaries. “The market assumes that the SLR exemption is what has ‘glued’ the rates market together since 2020, and that the end of exemption means that large US banks will have to sell Treasuries. That view is wrong.” We will find out.

What does transitory really look like in an inflation context? How much above 2% and for how long would warrant action? I think on this we will find out more come June when the prints start shooting higher.

Stick: On March 4th, Powell said the Fed would need to see a broader increase across the rate spectrum before considering any action and stressed that the current policy stance is appropriate. He didn’t signal the Fed was in any rush to do anything about rising yields – there was not the slightest hint the Fed was looking to control the yield curve or carry out a twist operation. The closest hint of concern was this: “We monitor a broad range of financial conditions and we think that we are a long way from our goals,” Powell said, adding: “I would be concerned by disorderly conditions in markets or persistent tightening in financial conditions that threatens the achievement of our goals.” Powell stressed that the Fed is a long way from achieving its goals of full employment and averaging 2% inflation over time.

GDP and inflation expectations have risen since the last dot plot in Dec, and this should be reflected in the forecasts. The OECD raised its growth outlook for the US this year, as have some investment banks. Goldman Sachs raised its forecast to 8% this year, while Deutsche Bank raised its forecast to 6.6% growth, up from 4% seen in November. The 4.2% projection for 2021 GDP growth projection looks outdated for sure.

The OECD raised its growth outlook for the US this year.

But a much stronger economic outlook is not going to stop the Fed from holding fire for now. Powell has spoken enough times about the ‘real’ unemployment rate being closer to 10%. And the Fed is no longer looking at the inflation dynamics and Philip’s Curve – it’s on a mission to right wrongs and get employment back. The Fed will not move on rates and will continue to purchase $80bn of Treasuries and $40bn of mortgage-backed securities each month. Any significant move is unlikely to occur before June, when we might start to see the Fed respond to rising employment levels by voicing a more optimistic economic outlook that warrants a tapering of asset purchases.

Does the Fed signal that inflation will be more than just transitory? If not, can it convince us it will be temporary? Inflation remains the elephant in the room – does it materialise in force and how long does that last. Things could get uncomfortable for the Fed from a market perspective over the coming months as base effects lead to a pickup in inflation readings, which will undoubtedly create upwards pressure on yields whatever amount of rationalising about the data. The Fed will want to use this meeting to reiterate that it is happy with this – indeed AIT implies running a hot economy/inflation to counterattacks years of systematic undershooting of its target.

The other big elephant in the room is issuance – if the Fed really is eyeing a tapering of asset purchases this year (not to be signalled today), then where does that leave long-end yields as Biden – fresh from his $1.9tn Covid relief- swivels his attention to a potential $3tn green/infrastructure bill. How is the market going to absorb all this extra issuance if the Fed is not there to hold the bag? As I suggested yesterday, I think this implies structurally higher bond yields and inflation.

So, it’s interesting to come to the latest BoA Fund manager survey, which reports that the biggest risk seen by investors is inflation or a taper tantrum. This is the first time the pandemic has not been the chief risk for markets in over a year. We have turned a corner for sure – but shouldn’t investors be welcoming economic growth? The consensus from the survey seems to be that 10s hitting 2% would spark a 10% correction in equities and that a 2.5% yield makes bonds more attractive than stocks.

Oil – WTI futures dipped under $64 for a week low yesterday as the nearest months flipped into contango, indicating a slightly looser market than we have been discussing. That seems in large part down to inventory builds in the US as the effects of the weather event in Texas etc refiners were shut in. It may also reflect some worry about tax hikes and global demand worries in light of the European situation. On the whole, the market remains pretty tight this year and should be reflected in higher prices after this period of consolidation. Futures recovered the $65 handle though as the API reported a draw in crude oil inventories of 1 million barrels for the week ending March 12th. Draws on gasoline and distillates were also reported, though much smaller than in previous weeks. This could indicate the US situation is stabilized and we return to a period of healthy draws on inventories as the market tightens.

Ahead of the Fed, gold will be one to watch – continues to trade in a narrow range and failing to break the upside resistance at $1,740. The Fed is likely to deliver action here.

Ahead of the Fed, gold will be one to watch

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