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FOMC review - running a line under liquidity

Chris Weston
Chris Weston
Head of Research
Jan 29, 2020
The market went into the FOMC meeting expecting a snoozefest, where USDJPY overnight implied volatility, if we use this as a proxy, sat around 9% through European trade and if we genuinely felt the FOMC meet was to be a volatility (vol) event it would be closer to 12%.

The same can be said in AUDJPY overnight vol which refuses to push above 10% despite China’s Q1 data clearly going to take a hit from the reduction in consumer activity, fallout in confidence and a refocus of supply chains – 10% being a level I feel defines sentiment in FX, where a push through here would indicate FX markets, and even asset classes like equities, bonds and credit may start to see more pronounced moves in price.

The fact is, vols has fallen a touch thanks again to the Fed, and ironically Fed chair Powell, even touched on the idea that the Fed weren’t directly trying to suppress volatility in money markets. Perhaps directly no, but the Fed’s balance sheet expansion, subsequent increases in excess reserves, along with a widely held belief that any rapid tightening of financial conditions will be met with a show of defiance - with interest rate cuts, yield caps, or increased liquidity conditions, has been a strong contributor to record low vol seen in FX markets, and subdued vol in fixed income and equities too.

Tweaks to IOER and its liquidity timetable

The Fed did lift IOER (interest earned on excess reserves) by 5bp to 1.60%. This was a point of contention for interest rate traders, who were divided on whether they would lift IOER at this meeting or in the months ahead. Outside of rates markets, this hike mattered little for price discovery, other than it would lift the Fed funds effective rate into the middle of their Fed fund target band of 1.50% to 1.75% and allow flexibility should we see excess reserves (in the banking system) grow from current levels of $1.535t into, and above $1.7t, which would have the effect of lowering the fed funds effective rate towards the 1.50% lower bounds of the FF range.

The Fed have detailed that they will remain in the market offering repo and T-bill purchases (currently running at $6ob p/m) through to Q2, which, in turn, could be the catalyst for excess reserves to lift through $1.7t. So, when they decide to phase out, or taper the program, there should be enough liquidity in the system to hold above the floor of $1.5t – a new defined level Powell has now introduced.

Introducing this floor is important, it shows Powell is clearly cognisant that the equity and credit traders have bid up risk, pushing equities to all-time highs and reducing vol in correlation with its balance sheet and increased excess reserves. So, he is concerned that any reduction here, as they phase out the program, will work against the markets, causing traders to close short vol positions (such as VIX futures) and out of equities.

(Red - S&P500, yellow - Fed's balance sheet, white - excess reserves)

S&P500 balance and reserves chart
Source: Bloomberg

A dovish turn on inflation

We also heard that the Fed “are not comfortable with inflation running persistently below our 2% objective”, and that read as dovish to market participants. While there are many other comments to consider, these on inflation caused the reaction with rates traders buying into January fed funds and eurodollar futures, subsequently increasing rate cut expectations for year-end by 4.5bp. We see 1.6 rate cuts now priced by December, up from 1.2 cuts.

US 2-year Treasury yields are 5bp lower on the day, and 3bp lower since the Fed meeting, with all parts of the Treasury curve lower by 5 to 8bp. Real (inflation-adjusted) yields are lower, and we see 10-year real yields turning decidedly negative at -5.5bp, with 5s -18bp and it interests me that gold is only up 0.7% given we are seeing US yield curve inversion and ever deeper negative real yields. AUD-denominated gold looks the better trade and we eye new all-time highs here.

USDJPY has lost small ground on the moves in US bonds and rates and once again looks to test the 109-handle, with solid two-way flow in USDCHF, with increased buying into 0.9730. Flip onto the daily though and see the pinbar (chart below) looking ominously in play. EM FX has seen a mixed fare and perhaps hasn’t seen the buying one would expect given we’ve seen a Fed happy to keep liquidity in check and offering a slight dovish turn on inflation. I guess we still have the 2019-nCov to work through and the economic overhang that will require the PBoC to go hard on liquidity to keep hibor and shibor in check and allow efficient access to working capital for Chinese businesses.

USDCHF daily chart

US equities have closed down a touch, although all the action is taking place post-market with Facebook and Tesla reporting. The market has treated these names very differently, with Tesla currently up 6% in the post-market trade, while Facebook is lower by the same amount. Not sure this helps NASDAQ futures too greatly though. We see the lead in for Asian equities as somewhat soggy, but I’d expect the ASX 200, Hang Seng and Nikkei 225 to open modestly lower.

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