A March interest-rate increase by the Federal Reserve, an unlikely scenario just days ago, is now suddenly on the table after an unexpectedly strong inflation print and hawkish testimony from Fed Chair Janet Yellen to Congress.
Traders’ expectations for a hike next month jumped after consumer prices rose the most in January since 2013. Derivatives traders are pricing in a 42 percent probability that the Fed raises rates at its March 14-15 meeting, up from 24 percent on Feb. 6. That’s based on the assumption that the effective fed funds rate will trade at the middle of the new FOMC target range after the next increase. The uptick in March odds also comes after Yellen reiterated in semi-annual testimony to the House and Senate Tuesday and Wednesday that waiting too long to tighten policy “would be unwise.”
While traders are still pricing in only two rate hikes for 2017, expectations are starting to catch up to the Fed’s projections for three increases this year, a swing in market sentiment that risks driving Treasury yields even higher. The shift stands in contrast to the past two years, when the Fed tightened less than forecast.
“The acceleration in the inflation picture along with the continued strong performance of the consumer sector opens the door and increases the probability that the Fed will raise rates as soon as March,” said Ward McCarthy, chief financial economist for Jefferies LLC in New York.
Benchmark two-year Treasury yields reached the highest since late December after Labor Department data showed the consumer-price index rose 0.6 percent in January, the most since February 2013. Compared with the same month last year, costs paid by Americans for goods and services rose 2.5 percent, the most since March 2012.
The difference between yields on five-year notes and Treasury Inflation Protected Securities, a gauge of trader expectations for consumer prices during the life of the debt known as the breakeven rate, rose the most since Dec. 22, to 2.01 percentage points.
While March may be too early for the Fed to raise rates, it’s a good opportunity for the central bank to prepare markets for a move in May, Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. in New York, wrote in a report Wednesday, bringing forward his call from June.
The odds of a Fed rate increase in March have risen to 30 percent from 20 percent previously, Goldman Sachs Group Inc. economists led by Jan Hatzius wrote Wednesday.
“Even though data makes a pretty strong argument for a Fed rate hike and people are starting to buy into it, they’re not jumping in with both feet,” said Todd Colvin, senior vice president at futures and options broker Ambrosino Brothers in Chicago.
A once-popular trade against Chinese-listed stocks in Hong Kong has all but dried up as the world’s second-largest economy defies naysayers and its equity markets rally.
Short interest on BlackRock Inc.’s Hong Kong-listed FTSE China A shares ETF declined to a one-year low of 3.5 percent of shares outstanding on Monday, according to data from Markit. China Asset Management Co.’s Hong Kong-traded fund tracking the same index recorded short interest of 3.99 percent of shares outstanding, the lowest since July 2016.
Fears of a hard landing for China’s economy have mostly subsided as mainland authorities in the past year moved to stem capital outflows, shore up stock markets with cash injections and curb excess leverage by ordering banks to limit lending. At the same time, non-performing loans on bank balance sheets have failed to translate into big losses, frustrating some perennially bearish hedge funds.
“Investors are less negative on China A shares this year,” said David Quah, head of ETFs at Mirae Asset Global Investments, a unit of Mirae Asset Financial Group. “Since the A-share market crash from its peak two years ago, the continuing high liquidity in mainland China may again see local funds rotate from property and commodity bubbles, so people think the A shares will come back up.”
The BlackRock ETF is up 5.6 percent this year, though still down 30 percent from its June 2015 peak. The MSCI China Index has rallied nearly 30 percent from a year ago. A share ETF stock borrowing positions have “unwound to very low levels” since mid-December as China’s manufacturing data has improved and the market itself has made gains, according to Susan Chan, head of ETF and indexing investment for Asia-Pacific at BlackRock in Hong Kong.
“It’s encouraging that short interest is now low and a clear sign that the mood has become more positive,” said Marco Montanari, head of passive asset management for Asia-Pacific at Deutsche Bank AG. The good news on the economy is “a key reason why short interest and outflows have reduced.”
In addition to declining short interest, both ETFs have experienced significant outflows from a year ago, hurting their popularity with hedge funds and other speculators. Investors have withdrawn a net $1 billion from BlackRock’s fund and $111 million from CSOP’s since February 2016, according to data compiled by Bloomberg.
“Hedge funds and short sellers don’t want to pull the trigger now if liquidity is low, as they can be short-squeezed and can’t put on a large enough trade,” said Melody He, head of ETF and index solutions at CSOP Asset Management Ltd. in Hong Kong. “There isn’t a big trend either way so we don’t see much long interest either.”
The firm that invests the personal fortune of billionaire investor and philanthropist George Soros eliminated its shares in Barrick Gold Corp in the October to December period, the fund’s last remaining stake in bullion after dissolving its shares in the world’s biggest gold exchange-traded fund SPDR Gold Trust in the previous quarter.
New York-based Paulson & Co, led by longtime gold bull John Paulson, cut its stake in SPDR Gold Trust to 4.4 million shares, worth $478 million, from 4.8 million shares, worth $600 million, at the end of the third quarter, according to filings with the U.S. Securities and Exchange Commission.
Spot gold prices fell to a 10-1/2-month low at $1,122.35 an ounce in December, following the U.S. presidential election and after the U.S. Federal Reserve sounded an unexpectedly hawkish note on U.S. interest rates.
Paulson held stakes unchanged in AngloGold Ashanti Ltd, IAMGold Corp and RandGold Resources Ltd, but reduced them in NovaGold Resources Inc, the filings showed.
In the fourth quarter, spot gold prices dropped 12.5 percent, their biggest quarterly tumble in 3-1/2 years. Prices rallied briefly after Donald Trump won the U.S. presidential election in early November, but then fell.
By early February, prices reached a three-month high as attention shifted to worries over Trump’s policies and political risks posed by elections in Europe.
Earlier this month CI Investments Inc, an investment manager of Toronto-based CI Financial Corp, reported that it also cut shares in SPDR Gold Trust and dissolved shares in Barrick Gold, though it held onto some of its shares of option calls in the miner.
When successive coin flips turn up heads, a gambler’s instinct would dictate the next toss results in tails — even if the odds are still 50-50.
That’s the so-called gambler’s fallacy, and financial markets are at risk of making the same mistake of emphasizing past precedent when it comes to Federal Reserve interest-rate hikes, some investors warn. While traders have been lulled by a record of the Fed proving less hawkish than expected, things could change over the coming year.
The scenario some are eyeing: the Trump administration’s coming fiscal stimulus spurs a rapid pick-up in inflation, given the lack of slack in the U.S. economy, with unemployment historically low. Fed Chair Janet Yellen, who has overseen just two rate rises since taking the helm three years ago, then might need to move faster, triggering a surge in the dollar.
“Trump will be inflationary,” Vimal Gor, head of income and fixed interest at BT Investment Management, which has about $67 billion under management, said at a conference in Sydney Tuesday. “The curve out for the next couple of years looks woefully” low in its interest-rate expectations given the likelihood of a Fed response to changing fundamentals, he said.
Though Yellen on Tuesday underscored that the Fed should avoid waiting too long to remove policy accommodation, and flagged that March would be a “live” meeting to consider raising the benchmark rate, markets still are discounting just two hikes this year. Looming in investor memories: the Fed at one point anticipated four moves in 2016, only to enact one.
Yellen also highlighted that the outlook supports higher rates with or without President Donald Trump enacting fiscal stimulus — read about that here.
It has been rare for the Fed to surprise on the tighter side of policy, though under Ben S. Bernanke it was charged with moving too slowly to ease as credit markets seized up in the summer of 2007. The dollar climbed briefly in May 2013 when Bernanke warned of the potential to taper quantitative easing, and advanced in January 2005 when the Fed unexpectedly said rates were “below the level” needed to slow inflation.
“Trump runs the risk of overstimulating the economy,” said Matthew Sherwood, head of investment strategy at Perpetual Ltd. in Sydney, which manages about $21 billion. “At basically full employment, an injection of fiscal stimulus soaks up spare capacity, and that’s associated with rising inflation. The Fed at the moment is very dovish and they’ll only change their spots if inflation supports doing so.”
The experience of other developed nations shows what can happen when central banks turn hawkish. Australia’s dollar jumped almost 50 percent during 2009 and 2010 as a mining investment boom saw the Reserve Bank boost rates by 1.75 percentage points. The Canadian dollar climbed more than 5 percent in 2010 as the Bank of Canada bolstered its benchmark to 1 percent. Both countries, and New Zealand, saw policy makers reverse course after currency strength contributed to undermining economic growth.
“The Fed could actually turn hawkish and tighten policy too much,” Joachim Fels, chief economic adviser at Pacific Investment Management Co., told the Sydney conference via a video link on Tuesday.
One wild card on Fed policy is the makeup of its board. Two of the seven positions are open, and a third member’s pending resignation gives Trump almost half the slots to fill. And later this year, markets may be caught up in speculation on a successor to Yellen, whose term as chair ends in February 2018.
Michael Every, head of financial markets research at Rabobank Group in Hong Kong, encapsulated investors’ premise about the outlook, in a note after Yellen’s first of two semiannual congressional hearings on the economy:
“It is not like the Fed we all know (and love?) to ever dare to surprise us with a hike” that investors weren’t certain was coming.
Fans of the precious metal – not shy of a good conspiracy theory – have been deliberating over the move ever since Germany detailed it back in 2013. Initially, there was a sense that trust between central banks had broken down with claims that Berlin was effectively questioning the credentials of New York Federal Reserve.
But the talk has now stepped up a notch with the Bundesbank confirming Thursday that it has already moved 583 tons of gold out of New York and Paris. Its plan to hold half its gold in Frankfurt is now three years ahead of schedule.
Reporting the news, Reuters said that some argue the world’s second-biggest bullion reserve “may be needed to back a new deutsche mark, should the euro zone break up.” This seems pretty far-fetched, especially given that the Bretton Woods system of fixed exchange rates ended back in the 1970s. Could Berlin really be prepping for the fall of the euro?
Then there’s the Donald Trump angle. On Thursday, Bundesbank board member Carl-Ludwig Thiele felt the need to speak about the new U.S. president at his press conference – presumably because someone asked him.
“Trump has not triggered a discussion about the storage facility in New York,” he said, according to reports. Trump scaring global central banks to repatriate their gold in case he confiscates it? Sounds equally unbelievable.
Then there’s the rumors coming from Russia. Sputnik News, which incidentally has strongly denied accusations from NATO that it’s a Kremlin propaganda machine, reported that Germany had been given the wrong gold. Quoting Russian economist Vladimir Katasonov, the news site said the U.S. may have sold Germany’s gold bars years ago and hurriedly bought some back as the Bundesbank came knocking.
It seems when something major happens in the gold market there’s a conspiracy theory not far behind. Instead, the official line is a little dull in comparison with the Bundesbank saying the new storage plan is “to build trust and confidence domestically.”
In 2015, it even released a 2,300-page list of its gold bars. The list contained the bar numbers, melt or inventory numbers, the gross and fine weight as well as the fineness of the gold. It appears it’s a tough job placating the demands of the gold bugs.
Add Goldman Sachs Group Inc.’s chief economist to the list of those concerned that President Donald Trump won’t jumpstart economic growth.
A week after a group of the bank’s political analysts warned of risks from protectionist moves, Jan Hatzius and economist Jari Stehn wrote that they anticipate a delayed boost from increased government spending because a bill likely won’t pass until late 2017 or early 2018. In addition, the economists noted that “the more adverse parts” of the Trump agenda remain substantial.
“The risks around U.S. policy have also turned somewhat more negative,” Hatzius and Stehn wrote in a note to clients on Monday.
So far, any predictions that Trump will be a drag on the economy have fallen flat. The S&P 500 is up more than 8 percent since his election, climbing Monday for a fifth day to a fresh record. The dollar has rallied 3.5 percent and bonds have fallen as investors bet the administration and Republican Congress will supercharge growth rates.
Goldman, though, is growing concerned. Indeed, when you put the bank’s assumptions about Trump’s plans into the Federal Reserve’s economic forecasting model, the conclusion is that the policies will actually be a negative for growth relative to the status quo by the end of his term.
As the chart shows, the underperformance relative to the baseline forecast would only get larger from there as the positive effects of fiscal stimulus fade while the limits on labor force growth remain.
“An increase in the effective tariff rate on imports seems likely and we now assume a somewhat bigger decline in net immigration flows than we did immediately after the election,” they wrote.
The investment bank’s increasing pessimism is striking considering the plethora of Goldman alumni in the president’s inner circle, including Treasury Secretary nominee Steven Mnuchin, National Economic Council Chief Gary Cohn and Dina Powell, who is working on economic growth issues and empowering women.
Cohn, who was Goldman’s president before taking the position with the administration, is reportedly leading the effort to create a “phenomenal” tax plan.
Hatzius and Stehn compiled a “full Trump” case that includes $450 billion in fiscal stimulus through a combination of infrastructure and tax cuts, tit-for-tat tariffs, and immigration restrictions that reduce the labor force by 2.5 million from the pre-election baseline underpinning the Federal Reserve’s September projections.
While the economists don’t spell out this conclusion specifically, the “Full Trump” case results in the level of gross domestic product rising by a little over 7 percent by the end of 2020, compared to baseline growth of 8 percent in the Fed’s projection. Based on the data, Goldman’s house view also anticipates a smaller economy by the end of 2020 compared with the Fed’s September forecast.
“Our simulations suggest that Mr. Trump’s policies could boost growth slightly in 2017 and 2018, but are likely to weigh on growth thereafter if trade and immigration restrictions are enacted,” they wrote.
One part of Trump’s fiscal policies is conspicuous by its absence from Goldman’s report. There’s no reference to deregulation boosting growth and offsetting the supply-side hit caused by stricter immigration controls.
While some skeptics may also call into question the legitimacy of Goldman’s projections given the persistent yawning gap between the Fed’s “dot plot” and actual rate hikes, it’s worth noting that monetary policymakers did fairly well forecasting the evolution of economic variables in 2016.