Politics aside, Soros’ principle of reflexivity is particularly appropriate given yesterday’s Fed statement. While the inaction on rates was expected and arguably maybe even “cautiously prudent” the commentary and downgraded projections were a sham! The Fed sees itself as the World’s central bank and its mandate as encompassing even-handedness with regards to foreign economies and currencies when setting US monetary policy. People of Greece, Italy, Spain, Japan and China, Yellen has your back! Yellen promised she’d be data-dependent – I guess she meant with respect to Chinese data! US data has been conclusive on the jobs front for sometime now. Yesterday’s January CPI data is a testament that inflation data is also becoming conclusive that price increases >2% is the trend. The committee’s arrant ignorance of these data trends, given the extremely dovish sentiment of the statement and the fact, which Yellen alluded to in her Q&A, that the committee nearly determined the risks were balanced to the “downside” (where was Fischer’s dissent?) can only be explained as wanton submission. So what are traders to do, now that the Fed has shown itself pliant to the whims of the ECB, BOJ and PBOC? Convention, which captured traders yesterday, argues the dollar should suffer because there wasn’t a rate hike and therefore should dictate:
Dovish Fed = Fewer FFR Hikes = Weak Inflation Outlook = Weak Rates = Weak Dollar = “Risk On” = Higher Equities & Higher Oil = Lower Gold
We got most of that, except equities didn’t really rally, oil was rallying for geopolitical/Iranian/OPEC rumours well before Yellen and Gold ended up leaping higher. It appears the “chain of convention” had a kink in fully transmitting the “risk on” signal. Dollar strength is always more predicated on the potential/expectation of future FFR hikes than on actual hikes. Inflation, especially during this tepid recovery period has been independent of dollar strength. Remarkably, so too has oil. What has been correlated, though are movements between oil prices and inflation indices. With oil up >35% since the Fed last met, inflation should be too; and the data confirms it is. Increasing inflation should raise future inflation compensation, which should resolve itself in upward pressure on rates. Together, these factors should push the dollar higher. However, the important question here is whether dollar strength is directly attributable to increases in rates and future inflation compensation or whether it is an indirect result of these factors boosting market expectations for FFR hikes. Sure we saw the dollar up 25bps on the CPI release yesterday and the 2s-10s curve steepen post Yellen, but the really dramatic moves occurred at 2pm when it became apparent the Fed had shifted the goalposts, once again. Based on yesterday’s price action, it appears to be the later.
Enter reflexivity. Inflation is rising. The Fed’s inflation threshold for FFR hikes has increased, so market expectations for future hikes falls and the dollar falls with it. But, inflation is still rising, and is still expected to continue to rise. Based on reflexivity, I see yesterday’s moves lower in USD as a simple re-pricing due to new goalposts rather than the signaling of a new trend. US macro data will continue to impress and inflation will continue to move higher. As such, markets will soon look upon the Fed’s March balk and question whether the Fed is now even further behind the ball and the “catch up” trade will be resumed dollar strength.
I’m still perplexed by the lack of a rally in equities given the spike higher in gold and the decline in the dollar. The first-order explanation is that the dollar fell, so dollar denominated assets should rally, but US equities didn’t. The second-order explanation is that gold rallied because the market saw through Yellen’s ignorance of inflation data and is worried that inflation is here and accelerating. Hmmm, the negative consequences of inflation are rising prices, including the cost of money (rates). Rising prices should be good for US equities, but again, they didn’t rally and the yield curve steepened, so it actually became more expensive to hold gold, yet it was strongly bid. The third-order explanation is that traders bought gold because they weren’t buying equities. They got scared by the Fed’s pessimism and bought safe assets. That makes sense; 10yr bonds were bid, gold was bid, Euro was bid, and US equities were avoided. This explanation is simple and makes sense. It also undermines claims that the macro trend has shifted and traders ought to sell dollars and buy gold because of looming dollar weakness and/or inflation fears.
To sum all of this up: the Fed’s forecasts are a joke, yesterday’s price action, across asset classes was a simple re-pricing, not a signalling of a trend shift, the “catch-up” trade will materialize and it’s ok to continue to short gold!