“For what it’s worth”, Nomura’s Charlie McElligott thinks “the pressure” on Jerome Powell to be “even more dovish” at this week’s Fed meeting is “growing”.
On Sunday, we previewed the FOMC, noting that between political pressure, a hyper-focus on inflation and the forthcoming rethink of the Fed’s inflation framework/reaction function, there’s every reason to believe that Powell will go out of his way to try and pull off a “dovish hold.”
On Monday, core PCE came in cooler-than-expected, unchanged in March versus estimates of a 0.1% uptick. The YoY print was 1.6%, also below expectations and the most sluggish since January of last year.
“We expect [PCE core] to slip even lower to a Nomura forecast of 1.55% [and] the pressure on Chair Powell to be even more dovish at this week’s FOMC meeting” is mounting, McElligott wrote, just ahead of the data, adding that the proximity of the June Fed research conference in Chicago only makes it more likely that the dovish lean will persist. Charlie also mentions the “run-labor-hot” policy we hinted at in the linked post above.
He goes on to write that the market justification for a cut is building, and reinforces the extent to which the dollar’s ascent to YTD highs is bringing the “shortage” narrative back into the conversation.
“The US Dollar ‘shortage’ thesis and concurrent ‘funding-squeeze’ dynamic gained more steam over the past two weeks, further evidencing itself via the Fed Funds (Effective) trading through IOER phenomenon”, he writes, adding that this all feeds into “escalating recent turmoil across EMFX” which is coming off its worst week of the year.
Emerging markets are facing a rather vexing quandary, where a Fed that’s predisposed to cutting rates at some point should be a boon, but the outperformance of the US economy is keeping the dollar buoyant, to the detriment of EM sentiment. Idiosyncratic risks are flaring up in Argentina and Turkey again, raising the specter of a 2018 re-run.
“After a long period of dormancy, emerging market currencies might become interesting again [as] there are little tremors that could spread to the wider EM universe”, SocGen’s Jason Daw wrote Monday, warning that “for now, they are small and localized, but with the market caught long EM trying to eke out the last juice from the carry trade (proverbial nickels) it could upend the calm that has prevailed this year.”
The worry is the same as it was last year – namely that EM could suffer a VaR shock as de-risking ripples across crowded trades. Here’s Daw:
Recall that last year Argentina was the canary in the coal mine and Turkey was the death knell for EM. Contagion happened not through trade or financial linkages but through broad-based de-risking and FX hedging due to portfolio VaR shocks. This could happen again.
In addition to the fact that some EMs took a proactive approach last year, thereby instilling a bit of confidence in markets (e.g., Indonesia), the bright side is that the macro environment looks set to improve (think: China inflecting) and, again, the Fed is widely expected to ease at some point.
Coming back to the point made above, and tying it into the larger debate, McElligott reminds you that there’s “again a mounting belief in the market for a Fed ‘technical’ IOER cut at some point into the summer, as a necessity to ‘buy time’ into still-tightening / shrinking excess reserves prior to the Fed again expanding the balance sheet to add reserves in the fall via commencement of ‘QE Lite’.”
All of that makes the case for Charlie’s long-held steepeners view, which he reiterates, citing the “insurance cut” we talked about on Sunday evening (see first linked post above).
You might recall that McElligott thinks the Fed will likely take an aggressive approach right off the bat. He’s sticking with that.
“When the Fed does indeed ‘go’, they’ll go large (think 50bps out of the gates, and likely sooner than most expect), as they now have three cut ‘justifications’ — 1) cycle ‘insurance’, 2) ‘reflation’ and 3) near-term Dollar funding dynamics as banking system reserves continue to shrink prior to the re-expansion of the BS in 4Q19.”
The case is made, but is the die cast?