The Daily Prophet: A Hawkish Fed? Tell That to Dollar Traders

Connecting the dots in global markets.

The Federal Reserve on Wednesday raised interest rates again and signaled that at least two more hikes are on the way before the year is out. That was expected, but what was unexpected was the part where the central bank downgraded its characterization of economic growth from solid to moderate while at the same time raising its growth forecast for the year. If you find that confusing, you’re not alone.

So, is the Fed more or less optimistic? Judging by the reaction in markets, it’s probably the latter. The S&P 500 Index, which was up as much as 0.82 percent, erased its gains and ended lower. Yields on two-year U.S. Treasuries, which are more sensitive to changes Fed policy than longer-debt, dropped the most since early February. The Bloomberg Dollar Spot Index tumbled the most since January. To many investors, the key part of the Fed’s statement that explained its decision to lift the federal funds rate target range to 1.5 percent to 1.75 percent from a range of 1.25 percent to 1.5 percent was an observation that household spending and business fixed investment have "moderated from their strong fourth-quarter readings." That was the “less hawkish” component of the text, the rates strategists at BMO Capital Markets wrote in a research note.

The greenback took the decision hard, with the Bloomberg Dollar Spot Index dropping as much as 0.89 percent. Not only did the Fed fail to suggest that it was leaning toward four rate hikes this year, as some expected, but it kept its inflation forecasts little changed. The absence of much higher rates to lure international investors might make it harder for the U.S. to fund the ballooning budget and current-account deficits, the economists at Wells Fargo said. “We look for modest dollar depreciation in coming quarters,” they wrote in a research note after the government said the current-account deficit -- the broadest measure of trade -- expanded to $128.2 billion in the fourth quarter, the most since 2008.

For equities, there was good and bad news in the statement. Although the Fed downgraded its current assessment of the economy, it’s still optimistic that growth will pick up as the year progresses. That should be supportive of corporate earnings. Plus, equities have benefited from a falling dollar, which can make U.S. exporters more competitive. The S&P 500 Index surged 19.4 percent last year as the Bloomberg Dollar Spot Index fell 8.52 percent. “Dollar moves are an important determinant of the relative direction of multinational stocks,” the equity strategists at Bloomberg Intelligence wrote in a research note Tuesday. Coinciding with the currency's decline this year, stocks of multinational corporations handily outpaced their domestic-only counterparts in the S&P 500 by 4 percentage points in the first two months of 2018, extending the 13 percentage-point outperformance from 2017, according to the BI strategists. Since 2001, the relative performance of S&P 500 multinationals has had a correlation of minus 0.76 to the dollar, meaning that stocks and the dollar tend to move in the opposite directions.

Short-term Treasuries, which have been under siege for months as the Fed raised rates and the U.S. government boosted sales of the debt to pay for a growing budget deficit, got a bit of a reprieve. Yields on two-year notes fell 4.5 basis points to 2.30 percent as the Fed failed to signal that it was leaning toward four rate hikes this year. To be sure, that shouldn’t have been totally unexpected. As Peter Boockvar, the chief investment officer at Bleakley Financial Group, noted in research report, it’s only March, so why would the Fed lock itself into four rate increases so early in the year? Although some will say that the market got ahead of itself in recent weeks anticipating a more hawkish Fed, the central bank’s "statement offered a bit of a more tempered assessment of current conditions against the backdrop of a slew of more recently disappointing data,” Lindsey Piegza, the chief economist at Stifel Nicolaus & Co., wrote in a research note. “While more accurate, the slightly more downbeat characterization appears at odds with a more aggressive outlook for rate increases in the future. If the data continues to disappoint, the Fed will no doubt have to realign their outlook with a more moderate reality."

The price of a barrel of oil rallied the most in eight days on Wednesday, rising the most since July.  The gains helped push the Bloomberg Commodity Index up by the most in six weeks, or as much as 1.03 percent. Traders were encouraged by the news that refiners and brokers pulled more than 2.6 million barrels of crude from American storage facilities last week, confounding more than 80 percent of analysts in a Bloomberg survey who were expecting an increase, according to Bloomberg News’ Jessica Summers. The withdrawal occurred amid speculation the U.S. may intensify sanctions against Iran, OPEC’s third-largest supplier. U.S. crude stockpiles underwent “a pretty strong draw, especially when you look relative for this time of year,” Nick Holmes, who helps manage $16 billion at Tortoise, a Leawood, Kansas, investment firm, told Bloomberg News. “There is some geopolitical tension and we’re starting to see some of that premium creep into the price.” Wednesday’s report by the Energy Information Administration showed U.S. crude inventories fell by 2.62 million barrels last week, compared with the gain of 3.25 million that was the median estimate from analysts in a Bloomberg survey.

The big news in the foreign-exchange market Wednesday was the big gains in the Mexican peso and Canadian dollar, which rallied after a report that the U.S. compromised on one of the most contentious issues in North American Free Trade Agreement negotiations. The Trump administration dropped a demand that all vehicles made in Canada and Mexico for export to the U.S. contain at least 50 percent U.S. content, the Globe and Mail reported, citing people with knowledge of the talks. The peso led gains among the world’s major currencies, while the so-called loonie was the leader among Group of 10 currencies against the dollar, Bloomberg News reported. “This is a very positive sign for Nafta negotiations. Auto rules of origin has been one of the most sticky issues,” Credit Agricole foreign-exchange strategist Vassili Serebriakov told Bloomberg News. “It shows for the first time flexibility on the U.S. side, which means other issues could be resolved as well.” In particular, that could benefit the Canadian dollar, which remains the worst-performing G-10 currency this year. Progress on Nafta should have “hawkish implications” for the Bank of Canada, which has repeatedly cited escalating trade tensions as a risk, according to Serebriakov.

Sterling has been on a roll this month, with the Bloomberg Pound Index gaining about 2 percent since the end of February. The gauge rallied for the ninth straight day on Wednesday after the Office for National Statistics said Wednesday that wages in the U.K. are rising at their fastest pace since the end of 2016, boosting speculation that inflation is poised to accelerate. Markets are starting to price in two interest-rate increases from the Bank of England this year, starting in May. That makes Thursday’s BOE policy meeting much more important. Economic optimism has also gained a boost after Brexit negotiators reached a breakthrough this week on securing a transition deal once the U.K. quits the European Union next year, according to Bloomberg News’ Lucy Meakin. The BOE last month identified the split as the most significant source of uncertainty over the outlook, with Governor Mark Carney previously urging the government to agree a hand-over deal the sooner the better.

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Stocks Will Need More Than GDP Growth to Prosper: Aaron Brown

Heed the Data, Not What Fed Officials Say: Charles Lieberman

What Does Europe Care About? Watch Its Spending: Guntram Wolff

The U.S. Can't Win a Trade War All on Its Own: Michael Schuman

What China Revealed in Its National Congress: Daniel Moss

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