Blotter: A fully priced Fed is no threat to EM
I decided to get up early and watch France play Australia at the World Cup. France is really good at football and Australians are not. As I type, the score is 1-1, giving me a degree of false hope that the inevitable, a sizable French victory won’t occur, but the odds and logic favor the consensus coming true. While another result could happen and shock the football world, it would be foolish to bet otherwise, and logic tells you to go with the consensus. This is a timely analogy regarding the Federal Reserve. The bond market is expecting the Fed to raise rates two more times in 2018 and then a couple more times in 2019. If this outcome plays out, how can interest rates shock the world for the balance of the year?
Unless something extraordinary happens, interest rate fears will diminish because we know what we are going to get. This doesn’t just apply for cash rates but given that the yield curve shouldn’t steepen significantly at this part of the cycle, long dated yields are also unlikely to move higher. Now, if inflation risks escalate, the curve will respond, but Fed Chairman Powell has given us a framework of tightening every three months, a path that would need a dramatic shift in the economic outlook to alter. US growth’s fiscally induced sugar high should last for a little longer, but if inflation remains benign, Interest rates will cease to be a threat to risk assets for the balance of the year.
If US 10’s have a range of 2.70% - 3.00% for the summer months, emerging market assets will rally off depressed levels. I appreciate we have several idiosyncratic risks in the guise of the Mexican and Turkish elections but again, these outcomes appear set in stone. EM currencies will rebound because stable interest rates imply the USD grinds lower. I have believed in a 90-95 range for the DXY and, despite the Euros weakness post Thursday’s ECB meeting, I do believe that clarity on the Fed will lead to risk asset strength. EM equities are poised to bounce, especially in China with the Shanghai composite at long term support. The thematic model portfolio added another 15% to China stocks on Friday.
You just don’t want to be short carry or risk assets when interest rate volatility and the risks of a policy adjustment appear off the table. Rates can grind a little lower over the summer months as shorts are covered, EM spreads will come in a bit and EM equity under performance will finally come to an end.
Macro noise is nothing but that; noise. The NK summit was a yawn for financial assets and while US / China trade escalations were an intraday hiccup, the end result was negligible. China will ease policy if tariffs threaten growth, so China investors should focus on this. More Brexit noise this week and it wont matter. USD weakens a bit from resistance and the GBP goes up regardless. Italy isn’t going to be a problem until later in the year and spreads should come in over the next few weeks.
The BOE and SNB meet this week, as do the CBs of Mexico and Brazil. An OPEC meeting in Vienna starts Tuesday. The ECB has its annual forum in Sintra this week, where Draghi, Kuroda, and Powell will all speak. On Tuesday, US Housing Starts. The BoJ will publish its minutes on Wednesday. On Thursday New Zealand GDP. On Friday, Japanese Industrial Activity, Canadian CPI, and Japan, Germany, the EU, and the US print Manufacturing PMI’s.
Despite considerable over analysis, France beat Australia 2-1. Even with some short-term volatility, consensus was correct, and the World Cup wasn’t shocked.