The Daily Prophet: Don't Fight the Fed? Not For Bond Traders

Connecting the dots in global markets.

The Federal Reserve went out of its way Wednesday to provide a lengthy explanation of what happened to inflation after Hurricanes Harvey and Irma. Here's the executive summary: Higher gas prices boosted overall inflation in September and the after-effects will continue to impact inflation, though for items other than food and energy inflation remained soft.

In short, the Fed is still confident that inflation, which is running at about 1.3 percent, will ultimately, someday, eventually rise to its 2 percent target and that another rate increase is warranted in December. Bond traders are not as confident. That can be seen in the narrowing of the so-called yield curve. The difference between yields on five-year and 30-year Treasuries has shrunk to 83.5 basis points Wednesday, its narrowest level since 2007. That typically happens when traders don't expect growth to be strong enough to generate faster inflation that would erode the value of fixed payments over time. As a result, they accept less in yield to own longer-term bonds relative to what they can get on shorter-maturity bonds.  

Steven Englander, the head of research and strategy at Rafiki Capital Management, summed up the thinking of bond traders in a research note before the Fed statement: "The case for a December hike is increasingly that the economy looks to be on a roll -- excluding inflation -- and the Fed should take advantage of the opportunity to (further) distance (itself) from the zero-bound. However, Fed rhetoric does not seem comfortable admitting that they are downgrading inflation, and there are enough voters on the FOMC who are clear that they see hikes as contingent on inflation outcomes." 

For small-cap stocks, details of the Trump administration's tax plan can't come soon enough. The Russell 2000 index of equities fell Wednesday after the plan's release was delayed to Thursday. The benchmark is down about 1.4 percent from its high on Oct. 5, despite gains in the Dow Jones Industrial Index and the S &P 500 Index, which track much larger companies. “The market is pounding the table asking, ‘Where is this plan, why have I not seen it yet, the calendar is getting short,”’ said Michael Antonelli, managing director of institutional equity trading at Robert W. Baird, told Bloomberg News. If the bill is released Thursday, one day later than planned, GOP leaders will have just 10 official legislative days before the Thanksgiving holiday to do nothing short of rewiring the U.S. economic engine, according to Bloomberg News's Sahil Kapur. "We continue to assign 75 percent odds, but they are now trending down, that Congress will pass a tax reform measure by the first quarter of 2018," said Height Securities strategist Stefanie Miller. Cowen's Chris Kruger put it like this: "On taxes, everyone wants to go to heaven, no one wants to die. House GOP draft will show who robs Peter to pay Paul. Tomorrow marks the realization that tax reform equals tax raises for many, or the House plan has no details and time-frame delay continues."

The Bank of England is expected to join the tide of major central banks slowly exiting from ultra-loose monetary policy by raising interest rates for the first time in more than a decade on Thursday. The move would be largely symbolic, because the rate would only be going from an extremely low 0.25 percent to a super-low 0.5 percent and stay there for an extended period of time. If that's what the BOE signals, expect the pound to slide to $1.30 from about $1.3250 on Wednesday, according to the median forecast of eight analysts in a Bloomberg survey. But if the BOE indicates that a November move is the first step in a hiking cycle, either through its language or through the number voting for an increase on Thursday, the pound could rise about 1 percent to $1.33, according to Bloomberg News's Charlotte Ryan. A shift in the BOE's rhetoric in recent months has sent expectations surging for the first rate hike in a decade, with traders pricing in an 88 percent chance of an increase. With the fallout from Brexit hanging over the economy, why is the BOE likely to raise rates? It's not seeking to quell price pressures generated by stronger growth, but rather the BOE is trying to slow inflation driven above its target by the weakening of the pound and the slide in the economy's long-term trend, according to Bloomberg News's Fergal O'Brien and David Goodman.

The commodities market has become captivated by the surge in metals, and it's not over. Four of the top five gainers on the Bloomberg Commodity Index this year are metals; aluminum, zinc, nickel and copper lead the pack, with returns exceeding 20 percent, according to Bloomberg News's Ranjeetha Pakiam. There was a further pop on Wednesday as nickel soared to the highest in more than two years on the London Metal Exchange, aided by enthusiasm about demand that may come from electric vehicles. Pakiam reports that the gains are being supported by a cocktail of drivers that reinforce each other. Consumption has been aided by resilient global growth, while China's crackdown on bloated capacity and pollution is hurting supplies of some materials, especially aluminum, creating shortages. Alumina, the raw material used to make aluminum, has jumped 56 percent since August after China shut down some production, triggering a wave of buying by traders and aluminum smelters. Top copper producer Codelco suggested a run toward the metal's all-time high of $10,190 a ton in 2011 may be possible, from $6,950 on Wednesday. "Our projections show a sustained increase in deficits and we don’t have any reason -- that we know of -- for closing them in the future," Chairman Oscar Landerretche told Bloomberg News.

For the first time in years, it seems as if a vast majority of investors and strategists are talking up Japan, putting it at or near the top of their recommendations. And for the first time in years, the nation's equities markets are rewarding the bulls. The benchmark Topix index of more than 2,000 stocks closed Wednesday at its highest level in more than a decade. The gauge is up 10.5 percent since the end of August, compared with 4.14 percent for the MSCI All-Country World Index. That outperformance marks a reversal from the first eight months of the year, when the Topix rose 6.51 percent, trailing the MSCI's 13.4 percent gain. The International Monetary Fund in October raised its 2017 growth forecast for Japan by 0.2 percentage point to 1.5 percent, saying the economy is being driven by global demand and policies designed to keep fiscal policy supportive. Japanese shares were driven higher Wednesday by strong earnings, particularly from Sony Corp. The company's shares climbed 11 percent to their highest since 2008, after Sony increased its annual operating profit outlook to a record 630 billion yen ($5.6 billion). That exceeded the 591 billion yen average analysts projected.

President Donald Trump said he will announce on Thursday his choice to lead the Federal Reserve. Betting website PredictIt has Fed Governor Jerome Powell as the leading contender at about 82 cents. Current Fed Chair Janet Yellen is in second at nine cents, and Stanford University economics professor John Taylor is close behind at six cents. However the bond market reacts to a decision that could influence the direction of monetary policy for years to come, Morgan Stanley has some simple advice: Do the opposite. Any knee-jerk move in Treasury yields won't last long, according to Matthew Hornbach, Morgan Stanley's global head of interest-rate strategy. Bloomberg News's Brian Chappatta reports that Hornbach recommends fading the initial reaction within the first month. If Powell gets the nod, do it in the first week.

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