Philip Wee, FX Strategist
DBS Group Research
Rates: The Fed signals patience and flexibility
US Treasuries and stocks surged as the Fed delivered the ingredients for a risk-on rally. Parts of the statement (see here) were largely expected with the Fed reiterating “patience” while keeping policy rates on hold. However, the reference to further gradual rate increases (which was present in December’s statement) was removed, suggesting that any further normalisation will be in mid-2019 at the earliest. There was a rally in Fed funds futures as the market took the Fed to be dovish out the next 2-3 years. In our view, it may be premature to rule out rate hikes entirely for 2019.
The other key aspect was the additional statement (see here) that revised earlier guidance on balance sheet normalisation. In 2018, twin tightening was occurring (Fed hikes and balance sheet shrinkage) and there were worries that the pace of run-off may be too fast. We agree and have stated several times that the Fed will have to slow/stop quantitative taper (QT) sooner, rather than later. By signalling flexibility on the size of the balance sheet and acknowledging that monetary policy would be operating under an environment of ample reserves, autopilot QT fears should be put to rest.
Assets across Asia should do well when markets open. The combination of lower USD rates and weaker USD should spark a reach for yield, benefitting the higher-yielders (Indonesia, India and the Philippines) in the region. Lower yielding govvies should also do well but may be relatively less attractive compared to their high-yielding peers. With the Fed removed as a headwind for risk taking, attention will soon turn to the outcome of the China-US trade talks on Friday.
FX: The Fed is cautious, not dovish
Sentiment for the US dollar has remained soft after the Fed decided to pause on rate hikes following its last increase on 19 December. Global financial markets cheered when the Fed signaled a prolonged pause at yesterday’s FOMC meeting and brought the US dollar lower. The better-than-expected ADP employment data was brushed aside. Expect the same treatment for tomorrow’s US nonfarm payrolls data. Instead, the bets are on next week’s advance estimate on US GDP to disappoint in 4Q18 (2.6% QoQ saar vs 3.4% previous) next week. We remain wary that the market is treating bad news as good news in America.
The Fed’s pause should not be misconstrued as a dovish but a cautious stance. Eager to put capital to work at the start of the year, the market has been keen to view upside risks as the easing of the two primary downside risks – a hawkish Fed and US-China tariff war – that hammered risk appetite last year. Ergo its optimism for a US-China trade deal and the UK averting a no-deal Brexit in March. Markets need to pay attention to Fed Chairman Powell’s concerns over the slowing global economy and disorderly Brexit risks cited in his post-FOMC press conference. Hence, markets need to be careful in expecting this year to repeat the Global Reflation Trade of 2017. To run away from the US dollar, players need a sustainable alternative investment destination that is relatively stronger than the US.