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The Real Impact of Rising Rates

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What’s in Today’s Report:

  • What’s the Real Impact of Rising Rates?
  • Chart: 5-Year Inflation Expectations Hit New Highs

Stock futures are modestly lower with EU shares this morning as traders digest the strong post-Fed rally amid hawkish Fed speak and still elevated tensions surrounding Ukraine.

Geopolitically, talks of new sanctions on Russia by the West, including on the energy sector, are acting as a mild headwind on risk assets today.

Economically, the latest U.K. inflation data ran hot with CPI jumping to 6.2% vs. (E) 5.9% in February, a fresh 30-year high.

Today, there is one economic report due out: New Home Sales (E: 810K) but it shouldn’t move markets leaving focus on the Fed as Chair Powell is scheduled to speak at 8:00 a.m. ET. Loretta Mester and Mary Daly will also speak at 10:00 a.m. ET and 11:45 a.m. ET, respectively.

Finally, there is a 20-Year Bond auction at 1:00 p.m. ET that could move Treasury yields.

Bottom line, stocks are showing some signs of exhaustion after a strong one-week rally in the wake of the March Fed meeting, and any additionally hawkish Fed speak or negative news flow surrounding the Ukraine war could see the selling pressure pick up as near term traders book profits on recent gains.

Early Earnings Season Takeaways

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What’s in Today’s Report:

  • Early Earnings Season Takeaways

Futures are modestly higher as China made two surprise interest rate cuts overnight, helping stocks bounce from Wednesday’s late-day declines.

China’s central bank made two small surprise interest rate cuts overnight which helped Asian stocks rally (Hang Seng up 3%) and that’s pushing U.S. futures higher.

Today focus will be on economic data and earnings, and for stocks to extend the early morning rebound we need to see stable data and solid earnings (meaning no extreme cost pressures).  Economically, the key report today is the  Philly Fed Manufacturing Index (E: 19.1).  If it suddenly plunges as Empire did on Tuesday, that will slightly increase anxiety about the economy.  We’ll also be watching Jobless Claims (E: 207K) and Existing Home Sales (E: 6.40M).

On the earnings front, the key report today is NFLX ($0.82) after the close, but we’ll also be watching:  AAL (-$1.54), TRV ($3.86), UNP ($2.60), CSX ($0.41) and PPG ($1.19).  If margins are much weaker than expected, look for more earnings-related volatility.

FOMC Preview (Will the Fed Confirm the Rally?)

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What’s in Today’s Report:

  • FOMC Preview – Will the Fed Confirm the Rally?

Futures are modestly higher as stocks rally off dovish comments by ECB President Draghi and again ignore more ugly economic data.

In a speech Draghi said the APP (the EU QE program) had a lot more “room” implying it could be re-started, and that helped global equities rally modestly.

Economic data, meanwhile, was again ugly.  German ZEW Business Expectations collapsed to –21.1 vs. (E) -9.3 while Euro Zone exports missed estimates at –2.5% vs. (E) -1.2%.

Today will likely be dominated by pre-Fed positioning and trading should be quiet, although there’s always the chance we get a U.S. – China trade update as the G-20 draws closer.  Economically there is just one report, Housing Starts (E: 1.240M), and it shouldn’t move markets.

ECB Announcement Takeaways, July 21, 2017

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ECB Announcement Takeaways

  • The ECB left key interest rates unchanged.
  • The monthly QE program remains 60B euros
  • Forward guidance was left unchanged from the June statement.

Takeaway

As expected, the ECB left all major policy decisions as they were at the July meeting, including interest rates, QE and a lack of any material new forward guidance. The initial reaction to the statement was dovish, as policymakers appeared to simple “kick the can” toward the September meeting.

But, Draghi’s press conference following the statement offered more mixed signals. First, the ECB President reiterated his upbeat view of the European economy, which is slightly hawkish, but did mention that he and other policymakers remain cautious about the lack of inflation. To that point, Draghi repeated his pledge to increase QE in both size and duration should the economy falter or financial conditions worsen. This was largely expected, but it offered a dovish reminder. At this point in the press conference, the release was still a wash.

The catalyst for the surge in the euro, which gained well over 1% in intraday trade, was actually due to the lack of attention Draghi gave to the recent strength in the currency. He had several opportunities to address the recent gains in the euro, which hit multi-year highs earlier this week.

Yet the failure to do so was enough for currency traders to chase the shared currency up to new highs.

Bottom line, the ECB effectively “kicked the taper can” to the September meeting, which means unless Draghi verbally suggests otherwise between now and then, any changes will likely be very subtle (i.e. modest taper to QE but extended duration). That was underscored by the fact that the 10-year bund was essentially unchanged yesterday. Looking ahead, the ECB still is a long way off from actually tightening policy (as they are technically still actively easing with their QE program) and as such, the rally in the euro is getting a bit extended. Nonetheless, the trend remains bullish for the euro, and until there is a catalyst such as blunt, less-dovish commentary from Draghi or a spike in EU inflation, then the path of least resistance will remain higher for the euro.

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Market Implications of Fed Vice Chair Dudley’s Optimistic Statements

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What are the market implications the optimistic statements from Fed Vice Chair (and President of the Federal Reserve Bank of New York) William Dudley’s optimistic statements this week?

Fed Vice Chair Dudley reiterated and bolstered Fed Chair Yellen’s “steady as she goes” message on rate increases last week, again dismissing low inflation as not a big enough problem to stop the Fed from continuing to hike.

Additionally, Dudley was optimistic about economic growth, saying he was “confident” the current economic expansion had plenty left in the tank.

Bottom line, Dudley reiterated that the Fed is committed to raising interest rates and removing accommodation, and that caused a mildly “hawkish” reaction across currencies and bonds.

It also helped push stocks higher (although stocks were already in rally mode). So, our general Fed outlook remains the same: Balance sheet reduction starting in September, and a rate hike in December.

However, in order for the hawkish tone from the Fed to get the Dollar Index and yields moving higher, we’ll have to see actual improvement in the economic data, and that remains elusive. As such, the market remains skeptical about future rate hikes, despite the Fed’s warnings (Fed fund futures are pricing in just a 20% chance of a September hike, and 40% chance of a December hike). So, the Fed has some work left to do on reestablishing its hawkish credibility after years of ultra-dovishness.

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Fed Takeaways: What the Hike Means for Markets, June 15, 2017

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FOMC Decision: The Fed increased the Fed Funds rate 25 basis points, as expected.

Wednesday’s Fed decision was not the dovish hike the market was expecting, although it wasn’t exactly a hawkish decision, either (even considering Yellen’s balance sheet surprise). Looking at the statement, the Fed wasn’t as dovish in its language as the consensus expected. The economic growth language remained good, and actually improved a bit from the May statement.

The inflation language, as expected, was downgraded, but the Fed refrained from changing the characterization of risks, and left them “roughly balanced.” That’s Fed speak for “any meeting is live for a rate hike.”

However, the Fed did note the undershooting of inflation recently, and explicitly said they are monitoring inflation, meaning if it continues to underperform they will react with easier policy. For now, the best way to characterize the statement is “steady as she goes,” with regard to the Fed’s current outlook.

Wildcard to Watch: Balance Sheet Reduction

We were right to make this our wildcard to watch, as the topic of the balance sheet provided the only real surprise in yesterday’s Fed meeting.

Importantly, the Fed gave guidance on all three major balance sheet related questions: When will it reduce the balance sheet? How will it reduce the balance sheet? What holdings will it reduce?

What will it reduce: The Fed revealed that it will simultaneously reduce holdings of both Treasuries and Mortgage Backed Securities, which was generally expected.

How will it reduce its balance sheet: The Fed will implement a rising monthly “cap” on principal reinvestments. What that means, practically, is the Fed will not reinvest the first $6 billion of Treasury principal and the first $4 billion of MBS principal, making it a total of $10 billion that it won’t reinvest each month, at least initially. That cap will rise by $10B every three months, so one year from the start date (which will likely be September), the Fed will no longer be reinvesting $50B worth of bond principal payments per month. That number and this escalation is not surprising, and was close to in line with most forecasts (i.e. this wasn’t “hawkish.”)

When will the Fed start Reducing the balance sheet: This was the surprise, as Fed Chair Yellen said balance sheet reduction could start “relatively soon.” That is sooner than expected, as the consensus was the Fed would hike rates again in September, and start to reduce the balance sheet in December. Now, that may be flipped.

Since reduction of the balance sheet is like the Fed hiking rates, this was taken as mildly hawkish, and the dollar bounced along with bond yields. However, this surprise is not a hawkish gamechanger, and won’t alter anyone’s outlook on Fed policy going forward.

Bottom line, for all the noise and production yesterday, the Fed outlook remains broadly the same: One more rate hike and balance sheet reduction in 2017, unless inflation metrics get much worse.

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This Week’s Fed Decision Takeaway and Rate Hikes To Come, May 4, 2017

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The Fed made no changes to interest rates this week, as expected.

Fed Decision Takeaway

The Fed statement almost perfectly met our “Meets Expectations If” scenario, as the Fed acknowledged the slight loss of economic momentum since March, but stated it viewed the slowing as only temporary, and left the door firmly open for a rate hike in June.

Looking specifically at the statement, the Fed said yesterday that economic activity had “slowed” compared to “expanded at a moderate pace” in March. But, in the second paragraph, the Fed said the loss of economic momentum appears to be “transitory,” and signaled the recent underwhelming data won’t make the Fed deviate from future rate hikes.

Underscoring that point was the fact that the Fed said risks to the near-term economic outlook continue to be “roughly balanced,” which is Fed speak for “we can hike rates at any meeting going forward.” Bottom line, the Fed was not spooked by the recent soft data and it is not deterring them from any future rate hikes… yet.

From a market standpoint, there was a mild “hawkish” reaction, not so much because the statement was hawkish, but instead because there was nothing dovish in the statement. That’s what markets have become conditioned to expect. The Dollar Index drifted to the highs of the day 30 minutes after the statement while the 30-year Treasury erased small gains and closed fractionally lower. Stocks drifted slightly lower, but selling was mild. Overall, the Fed statement was not a market mover.

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FOMC Preview and the Next Rate Hike, May 2, 2017

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There is virtually no chance the Fed will hike rates at tomorrow’s meeting, as the chances were slim before the recently disappointing economic data. Now, those chances have declined to near zero. The key question tomorrow is: Just how forcefully will the Fed telegraph the next rate hike?

The answer to that question, taken in the important context of the recent slowing of economic momentum, will decide whether the FOMC decision pushes stocks higher, or whether we see a retracement of the recent gains.

May FOMC Meeting Preview + Next Rate Hikes

Hawkish If: The Fed clearly signals a rate hike is coming in June. Right now, Fed fund futures are pricing in about a 70% chance the Fed does hike rates, but that’s not a consensus expectation, yet. If the Fed specifically points to the “next” meeting in tomorrow’s statement (as it did in the fall of 2015 and 2016) as the likely date of the next rate increase, you will see markets react hawkishly as a June rate hike is not a foregone conclusion. Additionally, if the Fed is still intent on hiking rates in June despite recent economic data disappointments, that might imply a Fed that is more hawkish than previously expected.

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Meets Expectations If: The Fed slightly downgrades the assessment of the economy in paragraphs one and two, but also says any slowing of activity is likely only temporary (it’s the temporary part that is the key). Markets expect the Fed to acknowledge the modest loss of economic momentum, but not to make too big a deal out of it.

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Dovish If: The Fed materially downgrades economic commentary in paragraph one and downgrades the outlook on inflation, and in doing so materially reduces the chances for a June rate hike. Specifically, to be dovish we would need to see 1) A downgrade of both the growth and inflation language in paragraph one, plus no mention of it being temporary. The net effect would be to remove the expectation for a June rate hike.

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Wildcard to Watch

Fed Balance Sheet. As we have covered, the reduction of the Fed’s balance sheet is an important but under reported topic that could result in a more-hawkish-than-anticipated Fed. Specifically, the major questions facing the Fed regarding the balance sheet are:

1) When will the Fed begin to reduce the balance sheet (2017 or 2018)?

2) What securities will the Fed stop buying (just Treasuries or Mortgage Backed Securities, too)?

3) How will the Fed stop reinvesting proceeds (all at once, or gradually)?

How these questions are answered will determine whether the Fed balance sheet is a hawkish influence on markets (yields up, stocks potentially down).

I (and almost everyone else) do not expect the Fed to touch on this in this week’s meeting. However, if the Fed does address this topic, it will come in paragraph five of the statement. Any change there will likely have hawkish implications on markets tomorrow, but again any changes are unlikely.

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Last Week and This Week in Economics, March 27, 2017

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For all of 2017, better-than-expected economic data has helped to offset the decreased likelihood of pro-growth policies from Washington, and that continued last week as what little economic data we did receive was generally supportive for stocks.

The Sevens Report, March 27, 2017Looking at Durable Goods, longer-term readers know we ignore the headline and look straight for New Orders for Non-Defense Capital Goods ex-Aircraft (NDCGXA). That is the better measure of business spending, as the headline Durable Goods order is massively skewed by the timing of aircraft orders.

NDCGXA missed estimates in the Feb. report (-0.1% vs. (E) 0.5%), but the January data was revised higher (from -0.4% to 0.1%). So, that largely offsets the miss in February.

The March flash manufacturing PMI was a disappointment, as it missed estimates and hit a surprise six-month low at 53.2 vs. (E) 54.3. But while disappointing, the flash PMI forecasted weakness in February that didn’t appear in other national manufacturing PMIs, and even at 53.2, that’s still a decent absolute number (remember, anything above 50 shows activity accelerating). Point being, that one number doesn’t suggest a loss of momentum.

Looking at other data, February Existing Home Sales slightly missed estimates but February New Home Sales beat estimates. But, with housing it’s helpful to step back from the monthly data and observe the overarching trend, and that trend is stability. All the housing data confirms that so far. Higher mortgage rates are now causing a noticeable slowdown in the housing recovery, and that remains key un-sung support for the economy.

Turning to the Fed, there were multiple speakers last week, but the headliner was Fed Chair Yellen, who made no comments about the economy or policy during her speech. Other Fed members were on balance slightly hawkish, as many of them referenced hiking three or four times this year, but none of it was impactful enough to reverse the dollar or Treasury yield decline we’ve seen since the Fed’s dovish hike in March. Markets still have a June rate hike at about a 50/50 proposition, unchanged from last week.

Bottom line, all the focus was on politics last week, but economic data remains the unsung hero of 2017, and it continues to help offset growing policy headwinds via Washington.

This Week

This week will be another relatively quiet week from an economic standpoint, and once again the most important number won’t come until Friday.

That number is the Core PCE Price Index contained in the Personal Income and Outlays report. That’s important because it’s the Fed’s preferred measure of inflation, and if the headline PCE Price Index breaks through 2.0% yoy (last 1.9%), and the Core PCE Price Index moves further towards 2.0% (last 1.7%), that may elicit a slightly hawkish reaction in markets.

Internationally, there are two notable reports to watch. First, Chinese Manufacturing PMI hits Thursday night, and while China remains on the back burner from a macro standpoint, any signs of economic slowing will surprise markets. Second, EMU Flash HICP (their CPI) comes Friday. The best outcome for European stocks is a Goldilocks number, where core inflation doesn’t rise much from the current 0.9% yoy pace, and as such doesn’t make the ECB think about ending QE prematurely. A Goldilocks number will be positive for European ETFs (HEDJ, VGK, EZU).

Bottom line, this will be another quiet week from a data standpoint, but the numbers need to confirm the acceleration of growth to continue to support stocks. From a risk standpoint, too-strong HICP or Core PCE numbers are the events to watch (they might make the Fed and ECB lean more hawkish).

Politically, there will be a lot of analysis on the shift towards tax cuts (we’ll do a primer this week), but nothing truly important is scheduled. Finally, on the international front, British PM May will formally trigger Article 50 to begin the Brexit process (although that shouldn’t cause much volatility).

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Economics, This Week and Last Week, March 20, 2017

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Sevens Report - Last Week and This WeekLast week was generally “Goldilocks” from an economic data and Fed standpoint, as economic data continued to be buoyant while the Fed successfully executed a dovish hike (at least in the short term).

Starting with the Fed, the FOMC hiked interest rates 25 bps, as expected, but left the dot projections for 2017 and 2018 unchanged at three hikes each. Given market expectations for an increase in the dots, the reaction was immediately dovish (stocks up, bonds up, gold up, dollar down).

As we said last week, it’s important to see the forest for the trees. Regardless of the Fed’s projections, the first hike of 2017 came three months earlier than expected, and the question going forward isn’t whether the Fed hikes again, but “when” and “how often.”

If inflation data keeps rising and economic activity accelerates (or we actually get corporate tax cuts) the answers to those rate hike questions will be “soon,” and “more than three times.” Point being, don’t confuse the short-term dovish reaction with a reduction in risk from a hawkish Fed throughout 2017. The risk hasn’t changed.

Looking at the economic data last week, it showed an ongoing “reflation trade,” as inflation and growth data beat estimates. Both February PPI and CPI ran a touch “hot,” and showed either bigger-than-expected monthly increases (PPI) or year-over-year price increases that were the biggest in several years (headline CPI rising by 2.7%).

Meanwhile, the first economic data points from March, Empire Manufacturing and Philly Fed, also both beat expectations. Philly was 32.8 vs. (E) 30.0 and New Orders, the leading indicator of the report, rose to 38.6, which is the highest since 1983!

Actual “hard” economic data last week was a touch disappointing on the headline as Retail Sales met expectations and the “Control” group (the best measure of discretionary consumer spending) rose just 0.1% vs. (E) 0.3%. Revisions to the January data were positive and offset the disappointment, though (January control retail sales were revised to 0.8% from 0.4%).

It was a similar result with February Industrial Production being flat vs. (E) 0.2%. However, January data was revised slightly better to -0.1% vs. -0.3%. Meanwhile, the manufacturing sub-index was more positive (up 0.5% vs. (E) 0.4% and January was revised to 0.5% from 0.2%).

Bottom line, the “hard” economic data continues to lag the “soft” sentiment data (i.e. Philly/Empire Surveys) and the running estimate for Q1 GDP (the Atlanta Fed’s GDP Now) is just 0.9%, the lowest in nearly a year.

Again, it’s not an indictment of the rally just yet, but at some point, that GDP number needs to start to rise to meet the surging survey data, otherwise we’ve got a problem.

This Week: Economically speaking this will be a generally quiet week, as the notable data doesn’t come until Friday via the global flash PMIs and February Durable Goods report.

Yet despite the small number of reports, the data is still important, because it has got to continue to help support stocks in the face of ever-dimming policy prospects. So, those numbers (especially durable goods) need to continue to imply economic acceleration.

Other data to watch this week includes housing data (New Homes Sales Wednesday and Existing Home Sales Thursday), but generally housing continues to hold up well in the face of generally higher rates.

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