James Bullard, President of the St. Louis Fed delivered an interesting speech recently in which he formulated answers to 5 pertinent questions. Amongst these were US Dollar appreciation, China risks, US labour market and financial stress conditions. The most interesting topic in his talk was about the US inflation outlook with the first chart below indicating the expected CPI outcome under assumptions that oil prices do not rise or fall sharply in the coming months. The forecast is derived under assumption oil prices stabilise at current levels while the rest of the categories in the US CPI basket continue to exhibit its more recent rate of change we have grown accustomed to.
Chart 1 reveals Bullard’s expectations of US CPI to exhibit a rapid rise in the coming 3-4 months from 0-0.3% range currently to near 2.5% by mid Q1 2016, before returning towards 1.5-2% trend over next 12-18 months. (SEE LINK to his SLIDES at the end of this ARTICLE for more details). Currently the US fixed income market (and by extension global core bond markets and EM (which is also to a large degree a function of US rates, is not well prepared nor priced for such a rapid shift in US CPI outcomes. UST 10y is arguably at least 50-70bp too low in such a case and should be much more anchored in the 3-3.25% handle compared to near 2.25% we see currently.
Bullard, in a separate speech said the Fed should be starting to raise interest rates and shrinking its huge balance sheet toward more "normal settings." He mentioned that the Dallas Fed's trimmed mean inflation rate is at 1.7% - close to the Fed's 2% target. Bullard is a non-voting member at the Fed's December policy meeting, but will be a voting member next year who will help shape the rate at which the Fed decides to tighten policy. The faster CPI trend back to or above 2% heightens the risk of not just a single ‘lift-off’ hike by FOMC in December followed by a lengthy 6 months or longer pause (extended pause), but increases the possibility of successive Fed rate hikes that could jolt both bond, fx and equity markets initially.
Chart 1 – US Headline Inflation once Oil prices stabilise
Currently UST 5y breakeven inflation is closer to 1.2% and should commodity prices stabilise JP Morgan recent research indicates US 5yr breakeven rates could rise by as much as 70bp. In even of this happening it likely implies rising nominal UST yields during a path of US monetary policy tightening (as policy tightening is typically associated with higher real yield environment also) which we expect will commence in December 2015.
Having highlighted upside US CPI risk above from Bullard’s recent speech, our own analysis is at odds with the St. Louis Fed’s view, leaving us with high degree of uncertainty over the Fed policy reaction function in coming 3-6 months. Why is this you may ask…. ? Well.. significant upside US CPI risks can be drawn into question if one studies the lead-lag relationship (1qtr) between DXY (US dollar index traded on ICE and US Headline CPI. Stated differently, as the value of the dollar rises it exerts, with a lag, a disinflationary force on the US economy.
With DXY threatening to retest (and surpass) 100.39 which is the March 2015 high (Chart 2 below) , the risk of rapidly rising US CPI certainly looks less threatening when considering the tight historical relationship between these two variables (Chart 2). Should this relationship continue to hold, it implies additional USD strength from here arguably poses the biggest obstacle to a fast pace of US rate hikes that the market currently expects (around 2.84 x 25bp hikes priced in by FOMC over next 12 months – See chart 3). Recall the Fed’s own dot plot median is for Fed Funds rate to rise from its current effective rate of 0.14% to around 1.125% by end of 2016. A much stronger dollar will restrain the degree to which and also speed of which the Fed can tighten policy.
The pace of US rate hikes priced into the USD curve still seems too high even though it is below median Fed DOT Plot median of 1.125% Fed funds end – 2016 (market prices roughly ~84bp Fed funds rate come Nov 2016) and is likely to be re-assessed post Dec FOMC when the Fed statement and post statement press conference Q&A session is analysed by the market and economists globally for clues about its present sense and calibration against either a dovish pace of hikes or aggressive pace of hikes that will dictate the direction for USD late 2015 into early 2016.
For ourselves as money managers and our clients, the risk is that the market FIRST starts to price a faster pace of FED hikes by Fed e.g. 3-3.5 hikes which is largely construed as EM negative news. Note the 12 month avg of MSP0KE sits at 3.5 hikes priced during the past yr – SEE MSP0KE indicator chart 3 below. This compares to present read of MSP0KE at 2.84 hikes (25bp increment hikes) . This is a particularly likely outcome should either Dec 4 and/or Jan 9 payrolls dataset prove the recent strong data was not a flash in the pan. Once the market expectations and pricing of rate or pace of hikes has stretched too far, and is restrained by USD appreciation and less robust US Housing manufacturing and service sector data to support such faster pace of hikes, we expect risk will then be that markets price OUT again the pace of rate hikes as US CPI upside risks abate as we approach the end of Q1 2016.
Chart 2 – DXY Index and US Headline CPI y/y
Chart 3 - MSP0KE – MS POKE index of 2.84 implies US is priced for 2.8 hikes of 25bp increments over the coming 12 months
So, between now and end of year we are faced with the initial Fed hike risk and more potential for an even weaker EMFX environment. Local SAGBs also face significant sentiment headwinds into Dec 4 ratings agency review on SA sovereign rating, notably Fitch and S&P that will make for more investor caution. In terms of current potential market drivers beyond the Fed rhetoric is the looming upside inflation risk, which could be destabilising to global interest rate complex. USD strength suggest downside risks to US inflation will persist, however if Bullard’s view on US CPI path is correct we fear a kneejerk step up adjustment could happen in core bonds which drags everything in the interest rate complex higher. This in turn, once occurred will brings golden opportunities for patient bond investors once market has re-priced more risk of US higher inflation, a further EMFX adjustment unlocks value in EM and the point of extreme USD optimism is reached once a faster pace of the US rate hike cycle is entrenched that in 2016 is found by markets has run too far. EMFX woes are also likely to reach a point of exhaustion once signs emerge that EM growth has bottomed and is starting to show a tickup which still seems like a very distant reality when looking at incoming economic data.
So for now we continue to advise cautioun on overweighting bond exposure but we stress that we do not rule out in the least the prospect for SAGBs to deliver double digit returns over 12 month horizon, if we pick good entry levels which may only arrive in Q1 2016 once the SARB has delivered an additional 25bp hike and SA inflation cycle approaches its own peak.