Yesterday, the U.S. Federal Reserve brought its three-year drive to tighten monetary policy to an abrupt end, abandoning projections for any interest rate hikes this year and said it would halt the steady decline of its balance sheet in September.
The decision made public after the regular two-day monthly meeting came after the FED Chairman met with President Donald Trump on Monday to discuss the US economy and the Monetary policy.
Fed Chairman Jerome Powell and Vice Chairman Richard Clarida dined at the White House with President Donald Trump and Treasury Secretary Steven Mnuchin on Monday night, the Fed confirmed in a statement.
The dinner, the first session between Trump and Powell since the new Fed chairman took over a year ago, was held “to discuss recent economic developments and the outlook for growth, employment and inflation,” but did not delve into “expectations for monetary policy” going forward the Fed statement said.
The president has been sharply critical of the Fed and of its President last November and blamed him repeatedly for the sharp fall in equity markets, drawing wide criticism for his interference in monetary policy management.
Donald Trump is keen on having buoyant equity markets and the FED is probably keen to ensure that Donald Trump’s tweets do not create additional havoc in the markets.
Form a pure macro-economic standpoint, the prudent stance of the FED – more prudent than the market consensus which expected at least one hike in 2019 – is coherent with the sharp slowdown in economic activity and leading indicators at the beginning of 2019.
The US Economy is expected to slow down to below 2 % in the second quarter of 2019 with a market consensus of 1.8 % and our own expectations of 1.5 %. The World economy is also slowing down sharply and will probably record its lowest growth rate since 2011 in the second quarter of 2019.
At the same time, US core inflation is falling towards 2.1 %, a significant cooling off when compared to the sharp acceleration of the middle of 2018.
Maybe more telling, the US Consumer Price Index is falling sharply. The CPI increased only 1.5 percent year-on-year in February of 2019, following a 1.6 percent rise in January and below market expectations of 1.6 percent. It is the lowest inflation rate since September of 2016, mainly due to a fall in cost of gasoline and clothing while prices of electricity stalled.
The FED is therefore perfectly right to stop raising rates for the time being, taking into consideration the deflationary effects of Donald Trump’s Trade Wars.
It will probably have to wait until a resolution of the conflict with China and an improvement in economic data to re-consider its neutral policy stance.
At the current level of inters=est rates of 2.25 %, and considering a core inflation rate of 2.1 %, monetary policy is marginally restrictive and considering a falling CPI at 1.5 % it is becoming resolutely restrictive.
Impact on the US Dollar
Yesterday’s announcement caused a sharp move in the US dollar as traders and speculators sold the Greenback sharply. The Japanese Yen rose a full figure from 111.50 to 110.60 in a matter of minutes while the EUR shot up from 1.1349 to 1.1440 in the same time frame.
As we highlighted many times over the past few weeks, the market was far too long US Dollars and some leveraged positions have certainly been closed yesterday, re-balancing the market.
It may sound counter-intuitive but we see this as a confirmation that the US dollar should be bought.
AND AS A RESULT WE CLOSE OUR LONG EUR RECOMMENDATION AND GO LONG THE US DOLLAR.
The reasoning behind this strategic shift that we had already hinted at for a few weeks ago in our weekly review is that the current economic slowdown and deflation scare will FREEZE the interest rate situation for several months.
As a result, the US currency will benefit for a significant positive carry trade, particularly against the Japanese Yen, the Swiss Franc and the EURO.
At the short end of the curve, the interest rate differential will remain a 2 % or more for several months while at the long end of the curve it reaches 3 % plus, an attractive proposition indeed.
The US Yield Curve shows returns ranging from 2.47 % on 3 Months to 3.40 % on 30 years Treasuries.
The German returns range from -0.53 on 3 months to 1.1 % on 10 years, giving a yield advantage of almost 3 % to the US Greenback.
The Japanese Yield Curve is in negative territory up to 7 years and yields barely 0.5 % on 10 years offering a spread on 2.8 % in favor of the US currency
But the most interesting by far is the Swiss Currency which offers a spread of 3.5 % in favor of the US Dollar on ONE YEAR while the 20 Year offers also close to 3 %
Even if in the short run it is possible to see the EUROZONE economy improving faster than the US economy, the improvement will not be such that the ECB will suddenly raise rates or stop its quantitative easing.
If anything, the ECB will want to ensure that the European economy is on an extremely strong footing before thinking of tightening again.
In fact most Central banks will err on the side of too easy monetary policies after this new and unexpected bout of global weakness.
As a result, the structure of interest rates will remain unchanged for a while and tis will favor the US dollar.
Yesterday sharp move did not dent the positive undertook e of the US currency and the FED’s decision in fact paves the way for an exit from the neutral technical position we have been in for weeks in the foreign-exchange markets.
In fact, volatility has been at its lowest level since 2014 in the forex markets and we are probably about to have a sharp move soon.
When looking at the major charts, yesterday’s sharp move was quickly reversed and the picture is becoming constrictive for the US dollar.
The US dollar Index tested its long term moving average but rebounded sharply on it. It should now re-test the upper band it challenged at the beginning of the month. A break above 97.5 will open the way for 100.
The EURUSD pair tried to break its downtrend and succession of lower highs yesterday but the quick reversal today will probably bring t back below the trend line and below the moving averages.
Looking at it from a longer term perspective, we may well be starting what we have always expected to be the final leg of the US dollar secular bull market that we called in 2008 and 2014 with targets at 1.05 and then below 1. before a secular bear market in the US dollar starts.
CHF – Swiss francs
Our best bet and strongest conviction by far is SHORTING THE SWISS FRANC
The case is both fundamental – INTEREST RATE DIFFERENTIALS – and TECHNICAL
The CHFUSD Pair is in a very clear long term triangle that will propel the US dollar much higher once broken and the most likely is that it will break in the coming weeks.
Surely, the Swiss National Bank will want to control the move, but if the move is global move, oil will be very difficult for intervention to be successful.
The long term chart of the Swiss franc also calls for a sharp move, probably down.
Volatility has been suppressed for the best part fo the past 5 years while interest rate differentials have increased significantly over the period.
Switzerland has the most negative interest rates of all countries in the world but the economy is sputtering, inflation remans extremely low and unemployment has been rising.
It is only a matter of time before the Swiss National Bank decides to let the Swiss currency depreciate.
The Swiss GDP is extremely weak with Q4 2018 in contraction
Swiss core inflation is very low at 0.4 %
Unemployment has been rising again.
In a nutshell, the Decision of the FED to pause its tightening cycle marks the beginning of an extended period of stable interest rates
Interest rate differentials are at the highest they have ever been in 5 years in favor of the US Dollar and the carry trade will push the Greenback higher
Our favorite Trade is SHORT Swiss francs at 0.998 to the US Dollar