Yellen Will Fail To Have Her Cake And Eat It Too

Bank of England minutes: Considerable focus today is on the UK's Bank of England (BoE) minutes for the June 4-5 meeting. The latest move stronger in sterling was triggered by governor Mark Carney’s recent comments that clearly indicated the monetary policy committee is bringing forward the date of its first rate hike to as soon as late this year (November or December is the current high-probability zone). This came after Carney was formerly more clearly in the dovish camp. Recall that these BoE minutes are from a meeting that took place two weeks ago, so the committee was presumably unaware of the latest sharp drop in the unemployment rate. And we go into this release with already hawkish expectations and will need considerable support for those expectations to maintain the strong bid in sterling. I would expect the focus in the minutes to be on the degree of slack in the economy and particularly in the jobs market, as the bank’s previous minutes clearly show the bank has no concerns on the inflation front. Housing activity, meanwhile, has dropped considerably, and activity often precedes a cooling in prices, so I doubt that we see any loud alarm bells on that front. Market reaction: A rather indifferent set of minutes could see GBP consolidating recent gains versus both the euro and the US dollar (again – we’ve got hawkish expectations baked into the cake) and then a nervous wait for the Federal Open Market Committee (FOMC) meeting later today. If the FOMC is dovish (see below), we get GBPUSD ripping above 1.7000 and possibly on the road to 1.7200. If the Fed is hawkish, GBPUSD plunges and we would possibly start a long bout of range trading as we have to consider whether the forward rate differentials for the UK versus the US can stretch much wider than they are at present.

A hawkish set of minutes might not do much more than see GBP supported at current or slightly higher levels, with some further appreciation against the euro after the FOMC minutes if they prove neutral to slightly dovish. One has to notice that as the fears have notched higher of a more hawkish Fed, however, that the Euro has shown more resilience, I suspect from a risk appetite angle. So if the Fed is clearly hawkish and we have a strong general risk off move across the board, I would expect GBP might weaken against the euro as well in the shortest term.

Chart: GBPUSD
Upside from here will likely depend more on the FOMC meeting than the BoE minutes. If the Fed finally waxes more hawkish and there isn’t much new in the mix from the BoE minutes, we could get a rather hard reversal back lower through the key support zone between 1.6850 and 1.6900. The upside potential may be more modest, though a very dovish FOMC could see a test of the semi-ascending wedge upper bound in the days ahead. FOMC: The FOMC meeting is the main focus today and after further thought I have narrowed down the menu of scenarios to two general ones: Total dovishness. Yellen chooses to ignore the latest uptick in inflation levels and the run-up (melt-up?) in asset prices and insists that the recovery and particularly the jobs market remain on shaky legs. There is no change to the rate of the taper nor any mention of financial stability risks and only small tweaks. This scenario has a bit more traction today if we read Jon Hilsenrath’s article in the Wall Street Journal overnight, in which he suggests the timing of the Fed’s rate hike will focus on the long-term unemployed and whether the recovery is broadening enough to full bring these cohorts back into the jobs market. This scenario would see carry trades (EM currencies in particularly) ripping back higher and commodity dollars doing the same, and the USD obviously generally weak across the board. Yellen tries to have her cake and eat it too. I favour this scenario. The idea here is that the Fed may finally be growing increasingly concerned about financial stability risks, but doesn’t want to come out lobbing “irrational exuberance” grenades at the market, as it at all times fears its own shadow. Instead, we may get: a) a hint that the Fed still knows that there is something called financial stability, whether in the press conference or in the statement itself. b) no mention of financial stability risks but an increase of the taper to 15 billion/month, a tempting idea given that this would mean two more meetings after this one and the Fed has entirely stopped expanding its balance sheet. Alternatively, we can look for the Fed to send its message indirectly with no change to the taper or significant change in the wording, but a change in the inflation projections and/or policy forecasts, though with the median already at over 2.00 percent for end-2016, this is somewhat doubtful (though a move higher by some of the doves on the dot plot without a move higher in the overall median would still be a hawkish development, as the key decision makers are still clearly on the dovish end of the spectrum.) The market has perhaps already priced in the least hawkish versions of the hawkish scenario outlined above, but not the more hawkish versions, so I would expect a powerful USD rally if the Fed sends a stronger message, particularly against EM currencies and the less liquid of the major currencies as well. USDJPY may prove range-bound if risk appetite goes sharply south, but will likely gun higher if bond yields spike significantly. Stay careful out there – and recall that we have a Norges Bank and Swiss National Bank meetings up tomorrow. Upcoming Economic Calendar Highlights (all times GMT) • UK Bank of England Minutes (0830) • Eurozone Apr. Construction Output (0900) • Switzerland Jun. Credit Suisse ZEW Survey (0900) • UK BoE’s Weale to Speak (1115) • UK BoE’s Haldane to Speak 1730) • US Fed FOMC Rate and Rate of Asset Purchase decision (1800) • US Fed FOMC policy statement and release of economic and policy forecasts (1800) • US Fed’s Yellen holds press conference (1830) • New Zealand Q1 GDP (2245)