Market was caught off guard by hawkish FOMC minutes

Market was caught off guard by hawkish minutes from the 27 April FOMC meeting and is all of a sudden reassessing its views on US monetary policy.

Following the release of the minutes, as the committee expressed support for a possible (data dependent) hike in June, the market implied-odds of a June hike jumped from roughly 15% to 35%; the odds stood at just 7.4% two-days ago before a number of hawkish Fed speakers.

This doesn't change the call for a September hike, but steers the market away—at least for now—from overly dovish US rate expectations that have largely dominated over other themes this year. This also means that the great support that EM assets have received since after the January selloff—which may not be entirely due to, but definitely is rooted in such implied odds—may start to falter, in the same way as oil prices are immediately feeling the heat of a stronger dollar.

European currency markets are trailing behind with the high yielders (TRY, ZAR and RUB) skewed towards weakness vs the CEE currencies flat or slightly positive. It’s still too early to say which direction may prevail, but we suspect that correlations with equities will continue to hold, and stock markets are currently in the red. So if the equity slump advances, there will be little in the way of further EM FX corrections. This is in line with our medium term view, but doesn’t reconcile with our more optimistic short-term one that is based on the assumption that the market would remain dovish on implied US rate expectations until the end of Q2.

If  wrong on this assumption, however,the majority of EM FX are recovering rapidly bridging the gap between short term and medium term forecasts; in other words, we could see  Q3/Q4 forecasts materializing a lot faster than we thought.

Australia's Central Bank Cuts Key Rate to 1.75% to Combat Disinflation

Australia’s central bank cut interest rates to a fresh record low as it moves to counter the emergence of disinflation that’s swept the developed world and limit currency gains that could complicate an economic transition.

Reserve Bank of Australia Governor Glenn Stevens and his board lowered the cash rate by 25 basis points to 1.75 percent Tuesday, as predicted by 12 of 27 economists surveyed. Data last week showed quarterly deflation in the consumer price index and the weakest annual gain on record for core inflation -- which the RBA aims to keep between 2 percent and 3 percent on average.

“Inflation has been quite low for some time and recent data were unexpectedly low,” Stevens said in his statement. “These results, together with ongoing very subdued growth in labor costs and very low cost pressures elsewhere in the world, point to a lower outlook for inflation than previously forecast.”

The currency has risen as much as 15 percent since mid-January and is likely to further restrain import prices in Australia. The resurgent Aussie also casts doubt on the sustainability of both the Australian labor market’s improvement and the burgeoning tourism and education industries that led a 1 percentage point of gross domestic product turnaround in services exports. 

Aussie Plunges

The Australian dollar fell after the decision, trading at 75.66 U.S. cents as of 3 p.m. in Sydney, from as high as 77.19 cents earlier in the day.

The RBA has also been monitoring the impact of tighter regulations on home loans as residential prices in Sydney and Melbourne surged on easy policy.

“In reaching today’s decision, the board took careful note of developments in the housing market, where indications are that the effects of supervisory measures are strengthening lending standards and that price pressures have tended to abate,” Stevens said. “At present, the potential risks of lower interest rates in this area are less than they were a year ago.”
 
Global policy is diverging and creating cross-currents as Europe and Japan move to negative rates and the U.S. tightens policy. That, together with a resurgent price for Australia’s biggest export, iron ore, has helped lift the Aussie dollar. 

Iron Ore Rebound

The RBA reiterated that “an appreciating exchange rate could complicate” the economy’s transition. It also noted the rebound in the iron ore price in response to policy easing in China, Australia’s biggest trading partner.

“Commodity prices have firmed noticeably from recent lows, but this follows very substantial declines over the past couple of years,” Stevens said. “Australia’s terms of trade remain much lower than they had been in recent years.”

He also noted that China’s growth rate “moderated further” in the first part of the year. 

Stevens was upbeat on Australia’s growth after the economy expanded 3 percent last year. “Indications are that growth is continuing in 2016, though probably at a more moderate pace,” he said. “Labor market indicators have been more mixed of late.”