Tuesday, 27 February 2018

EQUITY MARKETS EXPECT A DOVISH POWELL; CURRENCY TRADERS ON THE SIDELINES

After a strong rally in U.S. equity and bond markets on Friday, the upward trajectory resumed on Monday. The S&P 500 gained 1.18% and the Dow added an impressive 400 points, ending the day 1.58% higher. Both indices are now 3.4% away from their record highs, after regaining more than two-third of their correction losses.

Investor appetite for risk has returned strongly in the past two trading days, thanks to stabilizing interest rates. Not only did U.S. Treasury yields fell further away from last week’s highs, but even high yield bonds attracted some decent inflows. Volatility fell to a three-week low, with the VIX Index ending the day below 16, having declined 68% from its 6 February peak.

Having been welcomed to office by the steepest correction in more than six years, equity investors feel that the new Fed Chair, Jerome Powell, will restore confidence. However, the reaction in currency markets was muted, with the EURUSD and USDJPY trading in narrow ranges as traders appear to be sitting on the sidelines until Powell provides a new catalyst.

Powell’s first semi-annual monetary policy testimony to Congress later today is likely to be the most significant risk event of the week. The new Fed Chair will likely downplay the latest market correction and show confidence in highlighting improvements in the economy, but the markets’ reaction will depend on how the Fed reacts against such a development.

Investor focus should be on whether recent inflation and wage growth figures are starting to become a concern for the central bank. If Powell stated that faster-than-expected inflation would lead to a more aggressive tightening policy (suggesting four rate hikes instead of three) in 2018, investors will go back on the defensive, and risk appetite will be killed. Such a scenario will see a sharp rally in the U.S. dollar, and a steep selloff in equities and bonds.

However, financial markets believe that Powell will not be this transparent regarding the path of interest rate hikes, and that a gradual policy normalization with three rate hikes this year is likely to be the base case scenario in today’s message.  There’s likely to be some room for disappointment here, especially if Powell feels that the Fed is slightly behind the curve and isn’t overly concerned about investor response.

In Europe, the focus will return to macro data, with the German preliminary CPI release likely to show that inflation abated in February. Meanwhile, speeches from the ECB Governing Council members, Jens Weidmann and Yves Mersch, will be of greater importance to the Euro, especially if they provide fresh insights on the ECB’s monetary policy outlook.

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