THE BLOG

Are We Nearly There?

05/08/2014 12:41 BST | Updated 04/10/2014 10:59 BST

The familiar plaintiff refrain often heard from bored children on a long car journey. It could also be very reasonably applied to the journey which markets and investors have made since we stood in the depths of despair in March 2009. The relevant destination to which the question refers today could be thought of as that place at which stock markets finally realise that the last dance is in progress and the time has come to don one's coat and leave.

As I write, on Aug. 1st, S. & P. futures are flat on the day, pre-open, having been down 0.6%, after a 2% decline yesterday, as they digest this week's climb in Treasury yields, the 4.0% first estimate for Q2 2014 U.S. growth, and an FOMC statement that may be read to suggest the supertanker is finally turning onto a more hawkish course. Bad, or preferably so-so news, like today's set of labour market metrics, is once again good news for equity markets, if it staves off Fed tightening.

Firstly, the GDP figures and revisions. In addition to the barnstorming Q2 2014 estimate, the dreadful Q1 was revised up to -2.1% from -2.9%, and 2013 growth was revised up by 0.3ppt to 2.2%. However 2012 and 2011 readings were lowered, leaving the aggregate post-recession period broadly unchanged. As ever, markets will focus more on the present day, rather than on history, and will therefore adopt a more positive set of Q3 expectations.

As for the FOMC, the post-meeting statement's relatively hawkish comments on inflation surprised, and sent Treasuries tumbling. To quote; "Inflation has moved somewhat closer to the committee's longer-run objective", perhaps reflecting the fact that its preferred inflation gauge, the personal consumption expenditure, (PCE), price index, rose 1.8% in May Y.o.Y., having plumbed a low of 0.8% in February, and presumably choosing to ignore the slightly benign June core CPI reading as an aberration. Much more importantly the Committee felt "The likelihood of inflation running persistently below 2 percent has diminished somewhat."

Rushing to balance this apparently hawkish shift, with respect to labour markets the FOMC opined that, "A range of labor-market indicators suggests that there remains significant underutilization of labor resources".

Finally, we learned that arch-hawk Plosser dissented, feeling that the guidance on interest rates, i.e. "The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends", wasn't appropriate, given "considerable economic progress". Recent comments might have led one to expect that Fisher might also dissent, and in all probability this has to happen soon. They both depart as part of next year's regular rotation, but that leaves 3 meetings this year, and they could be joined as dissenters by new Vice-Chair Stanley Fischer who, as yet, one has to view as something of an unpredictable pragmatist. We will see if the minutes, to be released on 20th Aug., reveal any more surprises.

Although the FOMC's composition is substantially more hawkish than it was in 2013, the powerfully persuasive role of Chair has since passed to Yellen; if anything a dove compared to the more centrist Bernanke. One still suspects that this is a Fed that will be true to its word; only really becoming concerned when higher wage growth suggests that both inflation and employment metrics are entering a danger zone.

The employment report was a tad on the anaemic side, with the only pleasing metrics, from the Fed's point of view, being a tick up in the participation rate and a slightly above expectations Y.o.Y. Core PCE.

Given the FOMC's inherent dovish inertia, it will take series of strong figures to accelerate any change in stance; a necessary and sufficient set of conditions for this could comprise, at a minimum, a strong employment report on 5th Sept., (including encouraging 2nd tier metrics, such as average weekly earnings), and unexpectedly robust PCE inflation figures on 29th August, as well as a strong series of forward-looking indicators, such as durable goods expenditure and ISM surveys, leaving the next meeting, on September 16th/17th, in possession of enough information to make significant changes to its statement.

This meeting will also be accompanied by a post-meeting news conference and the release of a new Summary of Economic Projections, (SEP), along with the famous Fed 'dot' chart showing members' future Fed Funds Rate expectations, so there is the possibility for a real market inflexion point. All the moreso, as the dots will probably also reveal expectations for 2017 for the first time. I would expect these to be way above the market's current pricing and also to contradict the current vogue for marking down the so-called Terminal Fed Funds Rate-that could give bond markets as nasty jolt, as this has been one of the factors under-pinning this year's unexpected rally.

Markets expect the first rate hike in roughly twelve months time, and a move to shorten the wait, accompanied by a longer-end bond sell-off, will certainly lead to a rise in volatility, as the valium that is QE simultaneously comes to an end in the U.S.

Perhaps last Wednesday's US equities price action is a taste of things to come; the S. & P. initially fell to a low of -0.4% shortly after the strong GDP release, but ended unchanged on the day. The next six months will see a schizophrenic equity market, unsure whether to fret about higher rates or to be reassured that higher growth will buoy profits. Ultimately, I see this as a 'wash' for markets, as they have already discounted rate rises and a start that comes slightly early, with a slightly higher final rate destination will not necessarily lead to a bear market in stocks, however I predict a change is coming-a wild ride, given complacency's propensity to encourage carry trades and other 'nickel-in-front-of-steamroller' strategies, coupled with poor liquidity-the no doubt unintended, but in fact inevitable, consequence of reduced bank risk-taking as a result of Dodd-Frank.

Buckle up children!

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