Brainard Rains On USD Bulls’ Parade
Fed’s Lael Brainard departed from the sentiments expressed by the majority of Fed members in comments made yesterday. Coming just days after the usually Dovish Rosengren argued in favour of a rate hike, noting that with US employment at full capacity and low rates risking an overheating of the economy, Brainard instead urged caution.
Brainard was the last Fed member scheduled to speak before the Fed meet next week for their September rate decision. As such, her speech was closely watched by traders keen to see whether the speech would see an extension of recent Fed Hawkishness. USD Bulls were left disappointed however as Brainard highlighted risks to the US economy, specifically from China and emerging markets.
Subdued inflation and uncertainty, both domestic and global, were noted as factors warranting caution in “the removal of policy accommodation.” Brainard’s comments fuelled an instant unwinding in US September rate hike expectations which fell from highs of 30% on Friday to around 15% after her comments were made.
Fed Turning Hawkish Despite Data
Recently it seems the Fed has been seeking to guide markets in the direction of a rate hike this year despite recent data weakness and various global concerns such as Brexit and the upcoming US election. Traders now await key US data on Friday with August CPI due after Industrial and Manufacturing Production data on Thursday. Inflation data will be closely watched given recent weakness with May, June and July readings all falling short of expectations.
Pre-Mature Rate Move Poses Risks
The prospect of a Fed rate rise in the near term is challenging as many emerging market economies are still at risk. A rate rise would lead to a decline in the nominal GDP outlook alongside an increase in real US rates which would weigh on risk assets. The pace of deleveraging in economies with USD denominated debt is determined by the ratio of capital costs to return expectations. As global overcapacity has led to a weakening of return expectations, low funding costs are needed to upkeep a minimum expansion rate of fixed assets.
Given the current environment on high debt and weakened global investment returns due to overcapacity, it seems reasonable to expect that central banks will only look to start raising rates once inflation is increasing as raising real rates, whilst investment returns are subdued, is counter-productive. If the Fed is looking to take a pre-emptive monetary policy approach by raising rates ahead of the curve, then corporate profitability will suffer.
One scenario which might see the Fed take this dynamic into consideration would be a “Dovish hike” whereby the Fed moved only a small 15 – 25bps and signalled that a long pause would be held before moving again. This would effectively keep the neutral real rate at a depressed level, keeping long term yields down and risk supported. This would also be in keeping with the backdrop of weak US data recently.
UK CPI in August was shown to remain unchanged from the prior month at 0.6% on the headline reading (vs. 0.7% expected) and 1.3% on the core reading (vs. 1.4% expected). Whilst both readings fell slightly below expectations, the Bank of England will likely overlook the weakness as neither reading fell back below the prior print.
At 0.6% on the headline reading, inflation remains at the highest level since 2014 and continues to highlight an absence of economic weakness in the wake of Brexit. Despite some initial weakening as the data was released, GBPUSD has since recovered as traders judge the data to be unlikely to weigh on the BOE ahead of Thursday’s meeting.