Lack of trust in Fed communications
The Fed’s communication strategy is suffering from a lack of credibility. This week, Fed speakers consistently provided a hawkish message yet, the USD and more importantly the US yield curve, failed to reprice a September rate hike. The rates markets estimate a low probability for a September hike at 20% and 45% for the December FOMC meeting. Clearly the markets don’t trust the Fed’s language (why would they considering the Feds track record?). New York Fed President Dudley has indicated that the US economy remains strong, supported by a healthy labor market and rising wage prices and suggested that the markets were underpricing the probability of a Fed tightening. Meanwhile, Dallas Fed President Kaplan suggested that there was room for the Fed to raise rates. These comments seem to be preparing the groundwork for Chair Yellen’s speech at Jackson Hole to signal a rate hike. A sudden shift in expectations would clearly catch the market flat-footed, quickly lifting US front-end yields and providing a boost to USD. However, we suspect those analysts calling for a hike are missing the global context and overestimating historically marginal US economic strength. The US economic momentum only appears robust when compared to sputtering global data. GDP growth remains a tepid 1.2% q/q which is hardly worth getting excited about. The Fed minutes released last week highlighted the sluggish US inflation outlook as July core CPI moderated to 2.2% from 2.3%. While evidence has increased that the consumer remains cautions as retail sales continue to decelerate.
Short USD on repricing confusion
In addition, a rate hike now, with global yields low and heading negative, would exceed tightening aim as capital floods into US assets stressing financial conditions.
In short we expect minor reduction in external risk to the US outlook and strong labor market will be sidelined for Fed members wait for further evidence activity is improving. We continue to fade USD rallies and see the current bullish momentum as closing long positions in illiquid markets (exaggerating moves), rather than a sentiment shift.