Asia Session: Markets Believe Powell Will Soon Pivot To Less-Dovish Tone

The Fed gets set to walk the line, hoping for Goldilocks without the Rabbit Hole

Factors driving asset markets continuously evolve, but UST real yields remain the most crucial variable in assessing cross-asset moves. The uptrend in real yields is a tailwind for the broad-based USD and value over growth in global equities but a headwind for EM FX and gold.

Muted cross-asset price action ahead of Wednesday’s FOMC meeting hints at a lack of conviction around communication since no policy changes are expected.  So, the Fed is getting set to walk the line, hoping for Goldilocks without falling into the Rabbit Hole

Since the Committee’s views, the uptrend in yields context of a greatly-improved economic outlook enhanced by the rolling out of an unprecedented fiscal package, no push back is expected

The Fed’s own 4.2% estimate for 2021 GDP looks set to be upgraded to around 6% in the Summary of Economic Projections, judging by Chair Powell’s recent commentary, with UBS economists expecting a reasonable chance of inflation overshot of 0.1pp in 2023.

On its own, a much more optimistic economic growth outlook justifies higher real yields. The market runs with a 25% probability that the median ‘dot’ shows a rate hike in 2023, effectively endorsing market pricing. Even if that outcome does not materialize, investors will more likely focus on the more optimistic outlook that should drive yields higher.

Beyond the numbers, the reaction of UST yields and, in turn, cross-asset moves depends on whether Chair Powell hints that the Fed could lean against higher yields in the press conference. Nervousness around higher yields would likely drive a bid to USTs, but the Fed should be sanguine given still-loose financial conditions.

By embracing above-target inflation in its new monetary-policy framework, the Fed should stick to its guns in anchoring front-end rates. Its new framework allows it to credibly lift-off the zero bound with extreme caution without having to downplay a rapidly-improving economic outlook. That, in turn, points to higher UST long-end real yields. 

The bond market is more up in arms about inflation than stocks thanks to the Fed commitment to hold short-dated rates in check through 2023, but will the Fed  blink?

VIEW 

One of the most debated yet quantitatively important unknowns is how much price normalization we will see in goods affected by the pandemic. Indeed this is what's creating an extraordinary level of inflation uncertainty. And with 10-year yields remaining above 1.6 %, investors are ostensibly buckling in for higher inflation. 

At the moment, the bond market is more up in arms about inflation than stocks thanks to the Fed commitment to hold short-dated rates in check through 2023; however, any blink on that commitment could send the stock market lower.

If we are realistic, we know that even the slightest hint of any rate rise expectations moving forward would see equities move significantly lower. So increasingly, will central bank messaging then become more market dependent rather than data-dependent in their views? Perhaps we might find a hint of that view via the FOMC messaging later today.

According to the latest BAML fund manager survey, just over 40% of investors think US 10y yields can get back to 2% before causing a drop of 10% or more in equity markets. The other shift in the survey was that since February 2020, COVID is not the number one tail risk for markets for the first time. That honor goes to higher than expected inflation with a bond market tantrum at number two. So indeed, inflation tops the markets new 'Wall of Worry."

MARKETS

It was another quiet session Tuesday, the S&P down 0.2%. US10Y yields back up 2bps to 1.62% as stocks step back from all-time highs in whippy trading ahead of this coming FOMC meeting where the board is up against a market call that believes even if Powell does not pivot to less dovish at the March meeting, he will shift his tone soon after that.

Such are the types of presumption and challenges that suggest any relief Powell provides against higher bond yields will be short-lived. Similarly, Powell will have a hard time delivering a believable signal, and that could hurt the USD on a sustained basis.

The Fed will be loath to send any hawkish signal; still, the board faces a tricky balancing act as incorporating the US stimulus into their forecast will lower unemployment and push inflation over 2% in 2023; hence the tail risk is that the median dot shows a hike in 2023.

In December, five FOMC participants expected liftoff by 2023. But Chair Powell said that he was not "even thinking about" removing accommodation and has tried to project a dovish tone. And while I suspect he does not want a median hike at this round table, not everyone will be like-minded. With the Fed likely increasing its inflation forecast, there is a chance two or three more participants show a hike in 2023.

UST and, by extension, long-duration stocks, fear two things: a shift in the dots to suggest an earlier than expected rate hike and secondly that the Fed's lack of pushback on higher yields continues. 

As a reminder, in December 2020, the dots showed 12 FOMC members thought rates will still be as they are at the end of 2023, one member thought the rates take-off would be before the end of 2022, three thought there'd be one hike in 2023, one that there would have been 2 hikes and one that there would have been 4. 

While it takes 4 of the 12 to move the median for 2023, perhaps it only takes one or two to shift position to move the markets, such are the challenges Chair Powell faces not to rock the boat while walking investors through recalibrated policy goal posts that are neither too dovish nor hawkish.  

US DATA 

US February retail sales were not significant to the overall view. The control group came in at -3.5%, lower than forecasts for -0.6% and after +6.0%. Take the miss with a bit of a pinch of salt, though. After the bumper number in January (which was revised higher), there was inevitably going to be a comedown. The winter storms during the month will have messed up the numbers and expectations.

The price index for U.S. imports rose by 1.3 per cent in February 2021 as higher oil and natural gas prices resulted in a surge in fuel import prices, the U.S. Bureau of Labor Statistics said on Tuesday.

Interestingly, the market emphasized higher US export/import price indices than the weaker US retail sales. As a result, the knee-jerk reaction to the numbers was both yields and dollar up, in line with the current heavy focus on inflation risks and the Fed being behind the curve. However, this also means that if Fed Chair Powell manages to out-dove markets today, the impact could be sizeable.

OIL MARKET

The market was wrong-footed but still pleasantly surprised after US oil stockpiles unexpectedly fell last week as a narrower weekly draw in gasoline stocks signalled that refiner activity was normalizing after a big freeze in Texas smothered production the previous month.

However, still possibly capping near-term prices, word on the street is that China is buying close to 1mb/d of sanctioned Iranian crude at discounted prices, displacing oil from its usual suppliers and complicating OPEC+ efforts to tighten supply and accelerate the draw-down global inventories. 

Oil is also under soft pressure from headlines that global COVID infections ticked up last week and concerns over side effects within one of the primary subscribed vaccines. 

However, neither of these stories represents a material risk to the recovery trajectory currently being predicted.

After the run oil has had so far this year, with Brent still comfortably above $68/b after a minor correction, it is unsurprising to see profit-taking on upticks in response to even marginally negative headlines.

Stil with the much improving economic outlook amid OPEC determination to have inventories draw, this is far from over. Still, as demand visibly increases and catches up with the sentiment, it will encourage OPEC and other oil producing-nation to ease production curbs. And these extra barrels depending on the velocity coming back to the market, will likely prove to be the oil price's main headwind as the year unfolds. 

FOREX

The consensus for Wednesday's FOMC decision expects more optimistic forecasts and dots, but a dovish Chair Powell. And looking at the rally in stocks over the past week, Fed communication credibility is strong right now, which if it holds could slow down the move higher in yields and US dollar appetite. But the market is cautious that this view will hold the test of time, and some think it won't even remain 30 minutes post-FOMC. 

However, a hands-off FOMC message on yields leaves EURUSD extremely vulnerable, especially with EGB yields biased lower in the region in the near term. 

The euro has been dealt the weak hand in the forex world. The suspension of the AstraZeneca (NASDAQ:AZN) jab will delay the EU vaccination target. The flawed rollout across the region will continue to weigh on the growth and outlook of the economy. 

On the other hand, the US is on track to meet its vaccination targets, and the Fed seems unable to stop the charge in US rates and the dollar. 

The political risks in Europe are also starting to prevail, with the recent CDU defeats adding to uncertainty in the region ahead of the German elections later this year. 

Malaysain Ringgit 

The MYR remains deterred by the strong US dollar and higher UST yields. And with the real possibility of US economic outperformance and higher yields becoming more pronounced in Q2.

For the time being, the Asia FX market, including the USDMYR, has shifted into buying the US dollar dip mode while keeping an eye on US yields. 

Still, it is probably a good idea not to lose sight of Asia growth acceleration via the global trade revival. 

GOLD MARKET 

Investor sentiment towards gold is less damaging, and positioning is cleaner and physical demand is still strong, with Korea joining the gold bars buying bonanza. While boots on the ground suggest that China is showing decent interest to import physical gold, indicating a solid chance of new import quotas granted in the coming weeks. However, India has pared down slightly this week, heading into local elections at the end of the month

Assuming 'steady dovish state' after the FOMC absent of any post FOMC less dovish fireworks, $1761 spot could be the next focus. Friday is SPDR® Gold Shares (NYSE:GLD) option expiry, and the USD165 strike (USD1761 spot) has 530k oz in open interest, providing a target for speculators to throw darts.