The US Federal Reserve meeting is likely to Trump every other economic data point, at least in the first half of this week. The bank is set to raise interest rates by 25 basis points on Wednesday, but considering the market is 100% expecting that (according to the Fed Funds Futures market), the key event will be Janet Yellen’s press conference and a hint of what’s to come from her in the future.
The market seems to be a bit behind the curve when it comes to the prospect of rate increases for next year, with a less than 10% chance that interest rates could rise to 1.5-1.75% by the end of 2017, which would only be one rate hike per quarter. Historically speaking, even that would be a mild rate hiking cycle. While Yellen is likely to be careful about committing to future rate hikes, a more confident economic outlook, and a sigh of relief that a Trump government is going to do the heavy lifting on growth for a while, could be enough to trigger a readjustment in the bond market.
Janet Yellen: the riskiest woman in finance
The threat of another leg lower in the bond market (an increase in bond yields) is very real, with 10-year treasury yields just 4 basis points away from 2.5%, the prospect of a breach of this key level is now in sight. If that happens, a move back to 2.6% for 10-year Treasuries is likely, which could be enough to trigger a sharp move higher in the dollar before year-end. 120.00 in USDJPY, anyone? How about parity in the euro? All of these things could become more likely if Yellen doesn’t hold back on Wednesday, since the bond market rout has been a key driver of the stronger dollar in recent months.
Can “good news” from Italy ease the euro rout?
Looking ahead, the euro is likely to be in focus this week. We noted last week in our spectacularly inaccurate ECB forecast, that euro downside could be limited. Well, a euro-killing ECB mild taper, and a 400 pip drop later; we’ve been forced to change our forecast. While we think we could see a mini recovery on Monday on the back of news that Unicredit has managed to raise nearly $4 bn of much-needed capital through the sale of its asset management unit, Pioneer, to Amundi, and a surprisingly quick announcement that former Foreign Minister Gentiloni is set to be the new Italian PM. On Sunday, the markets have gently sold the euro, perhaps we will see back to 1.05 in EURUSD, the low from 4th Dec, before any bounce back towards 1.06. However, we expect plenty of sellers to be waiting ahead of the Fed meeting. EURUSD 6-month option market volatility has risen to its highest level since June, in a sign that the market could be looking for EURUSD parity in the first half of 2017.
Why our focus remains the Europe-US yield spreads
Our view that the German – US yield spread may not have further to go as it approaches its lowest ever level, was also incorrect last week. The yield spread did decline further, and is now a mere 20 bps from its lowest ever level at -2.3% Yellen will determine if this spread moves to a fresh record low. If it does in the coming days then the euro is doomed to return to parity, sooner rather than later. This is why the German – US yield spread will be our key one to watch during the Fed meeting.
Europe’s test: can it capitalise on the euro weakness?
In fairness, a move back to parity for EURUSD would be brilliant for the European economy. A weak currency and an anti-trade Trumpian US could make Europe a trade mecca, along with reviving productivity in the region. Of course, only time (and lots of it), will tell.
After reading AA Gill’s final column for the Sunday Times, and deeply regretting the fact that the Sunday Papers have become a bit more banal since this great man’s passing, there were a few things that are worth sharing from the business news:
- Irwin Steltzer from the Times brought up the fact that Trump is not always good for business, just ask Boeing. He has picked his enemies in the corporate world, and they include Amazon and Silicon Valley (he hates Apple because of its production bases outside of the US). While he may do certain positive things for corporates: lower taxes, an amnesty on profits returned to the US from overseas, those fully engaged with the US equity bull run should be wary that the benefits need to be weighed alongside the negatives – his unpredictability, which could be a very dangerous disruptive force over the next four years.
- Bloomberg noted that Italy’s new PM Gentiloni, is an “avatar of Renzi”. If he can form a government then it could be good news for Italian bonds, and its banking sector.
- Monte dei Paschi hadn’t been nationalised as I wrote this, but if Qatar and co. didn’t come up with the $5bn cash the bank needs by the end of this month in order to comply with ECB regs during their negotiations this weekend, then it is likely to be put under state control on Monday. If this is done in an orderly fashion, and there aren’t too many losses for Italian retail investors in the bank’s bonds, then this event may not hit markets too hard at the start of a very important week.