Last week’s speech by Chair Yellen laid out a clear narrative for the Fed’s dovish shift. The narrative goes that market turmoil in Q1, in part because of anxiety over RMB devaluation, caused markets to scale back their expectations for rate hikes, which helped insulate the US economy from adverse repercussions.
The Fed thus needed to shift dovish, in order to validate the shift in market expectations. That is certainly a reasonable narrative; it just isn’t what happened.
The SPX and front-end rates have been positively correlated since August, as both have been buffeted by the ebb and flow of RMB devaluation fears. In the run-up to the last FOMC, those fears were abating, causing risk to rally and the front-end to price back hikes. The Fed shift was thus a genuine dovish impulse, causing the Dollar to fall and US equities to outperform.
We review key elements of the Fed narrative and argue that the dovish shift is: (i) unlikely to last long, given that the narrative behind the shift does not mesh well with how markets traded, i.e., is arguably quite weak; and (ii) is not obviously risk positive, given that it boosts US growth at the expense of the Euro zone and Japan, i.e., tilts growth away from where it is needed most.
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... We think there are two paths from here.
One is what the market is pricing, a world where the Dollar is kept in check by a dovish Fed and restraint from those central banks (the BoJ and ECB) facing genuinely low inflation. We think this scenario is difficult for risk assets outside of the US, because underlying imbalances in the G10 are still heavily monetary in origin, i.e., too little monetary accommodation in Europe and Japan and, arguably, too much in the US.
The second is for monetary policy in the G10 to finish the job, which will mean a stronger Dollar, though obviously not in a straight line. After all, the past year has shown that Dollar strength is a deflationary shock, which periodically causes the Fed to shift in a dovish direction. We see this scenario as more risk positive, because additional monetary impulses from Europe and Japan will buffer less accommodation out of the US. Such a scenario would also allow the fix for $/CNY to move higher in order for the RMB to be roughly stable in trade weighted terms, i.e., would not necessarily be negative for EM. Our view is still that policy makers will converge to the second scenario, which is what our forecasts reflect.
...In line with our Fed view, we hold to our Dollar bullish call