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Fed Turns Dovish Again

Published 17/07/2017, 10:53 am
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Originally published by BetaShares

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Global Markets Review & Outlook

Whether she meant to or not, Federal Reserve chair Janet Yellen struck a dovish tone in testimony last week, with markets particularly salivating over her comment that “the federal funds rate would not have to rise all that much further to get to a neutral policy stance.” Stocks rallied and bond yields and the US dollar fell. The Australian dollar surged higher, much to the likely annoyance of the RBA.

So, are we almost done with US rate hikes?

Reading Yellen’s speech in full places the comment in a broader context. While she does suggest that the neutral rate is “currently low” - due to temporary factors – she goes on to concede it is likely to rise over time, suggesting “additional gradual rate hikes are likely to be appropriate over the next few years.” Such nuances, however, were lost on the market.

That said, Yellen also conceded that the Fed may revise its interest rate outlook if inflation fails to rise as much as it anticipates over the next few months or so. While US CPI inflation again surprising (a little) on the downside on Friday, markets are counting on low persistent inflation keeping the Fed largely sidelined – indeed, a December rate hike remains only a 50% risk, and only one rate hike is priced in for the whole of 2018.

Of course, if the Fed is right and inflation does rebound (annual core inflation has eased to 1.7% in June from 2.3% back in February), markets will face a reckoning. But the bigger challenge for the Fed is what it will do if inflation fails to lift to 2% or more, and equity valuations continued to push ever upward into potentially dangerously overvalued territory.

Indeed, history suggests the Fed’s inflation target is overly ambitious and unlikely to be realised – after all, annual core CPI inflation has rarely been above 2% since the late 1990s. Sadly, Yellen’s formal speech last week made no mention of financial stability risks – even though she has sporadically referred to these in the past. All up, to my mind, until such time as the Fed takes financial stability risks more seriously, it is slowly but surely leading global markets into another financial bubble boost-bust era.

In other news, the theme of hawkish central banks elsewhere remained evident, with the Bank of Canada lifting rates and a (likely well sourced) Wall Street Journal article hinting the ECB’s Mario Draghi will announce 2018 plans to scale back bond buying in a major speech next month. Thanks to Trump Jr., the Trump- Russia saga also took another iteration, which saw equities briefly wobble.

Meanwhile, early results from the US earnings reporting season among financials were reassuringly positive, even though the financial sector’s share price performance was held back by the decline in bond yields. In the absence of major data, the increased tempo from the US reporting season – particularly among financials - should be an even greater global focus this week.

Australian Market Review & Outlook

The major development locally last week was surge in the Australian dollar on dovish Fed rhetoric and - to a degree - the rebound in iron ore prices. The further lift in the NAB measure of business conditions – to the strongest levels prior to the GFC – was also welcome. Housing finance data also revealed investor home lending continuing to slowly retreat in the face of tighter credit conditions.

This week, minutes from the RBA’s July meeting will be analysed for any hint of hawkishness not evident in its post-meeting statement – I still hope and expect none will be found. Indeed, given the recent surge in the Australian dollar, the RBA seems even less likely to want to hint at higher rates anytime soon. Also of focus will the June labour market report, which seems likely to show continued solid employment performance – though which, so far at least, has failed to translate into higher wages or consumer confidence.

Have a great week!

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