The Fed ‘out doves’ the market, and Brexit chaos fails to trigger pound panic

Central bank largesse is alive and well after the Federal Reserve followed the ECB and surprised the market with more dovish outcome than expected on Wednesday. The US central bank is worried about US growth prospects, it is expecting to keep rates steady until at least next year, and it will cease selling assets on its balance sheet from September. Overall, this was an extreme shift into dovish territory for the Federal Reserve, and it is likely to have a long—term impact on markets. 

What’s changed at the Fed?

There were three major changes at the Federal Reserve on Wednesday. Firstly, its US GDP forecast for this year was slashed from 2.3% to 2.1%. Secondly, it cut its CPI forecast to 1.8% from 1.9%. Lastly, the Fed doesn’t expect a rate hike until 2020, according to the median ‘dot’ on the dot plot of interest rate expectations, and it will end its balance sheet runoff in September. This meeting suggests that the Federal Reserve is concerned about the US economy, and does not think that it can withstand a further tightening of interest rates for the foreseeable future. In fact, according to the CME’s Fedwatch tool, the market is pricing in a near 40% chance that the next move from the Fed will be a cut to interest rates, up from 25% earlier on Wednesday. 

Treasury volatility is dead, dollar bulls should watch out 

The biggest impact from Wednesday’s Fed decision is in US treasuries. US 10-year Treasuries staged their biggest rally since last May, as yields dropped more than 8 basis points to a 14-month low of 2.52%. The Fed’s dovish message, which keeps US interest rates lower for longer, has killed all hope that US interest rate volatility will rise any time soon. Pity the fool who fights the Fed, we believe that Wednesday’s decision should help to depress interest rate volatility for the long-term, which could weigh on the US dollar for the long term. In the immediate aftermath of the Fed’s rate decision, the greenback fell broadly, the dollar index was lower by 0.6%. If the Fed remains committed to its dovish message, and if the economic fundamentals underperform, then we would expect the dollar to grind lower into the middle of the year. 

Why we are bearish on the dollar 

Overall, we expect to see the dollar underperform relative to the euro and the yen in particular in the medium-term, both surged vs. the USD in the aftermath of the Fed’s decision. We are less clear on the outlook for GBP/USD. Instead we would focus on EUR/USD. This pair surged to its highest level since February, late on Wednesday. Although it met stiff resistance at 1.1450, we believe that the euro is the most attractive currency out of the majors in the short to medium term, and it may see some buying interest around the 1.1410 mark. 

Why European stocks could play catch up with the S&P 500 

Stocks are also worth watching. As the Fed confirmed its dovish shift on Wednesday, the S&P 500 clawed back earlier losses, however, the rally was not sustained, and at the time of writing, the S&P 500 had given back nearly 75% of post-Fed gains, and was hovering just above the 2,820 mark. This price action is significant, although a long-term pause in interest rates is important for US stocks, the Fed’s bleak economic outlook could dampen enthusiasm for the S&P 500. 

The weaker economic assessment from the Fed has given us more confidence in our view that European stocks may outperform their US counterparts for the medium-term. Firstly, there are signs of life in the European economy, the Eurozone economic surprise index is improving, and, according to Morgan Stanley, money has poured out of Eurozone equity funds for 50 straight months, thus, the tide could be in need of turning. Valuations are also looking more attractive than the US right now, and as long as the UK doesn’t crash out of the EU without a deal on the 29thMarch, then European stocks could be in for a good spring. The Eurostoxx 50 has stalled just above the 61.8% Fib retracement of the May 2018- Jan 2019 decline, if it can break back above the 3,400 level then we may see a return back to the May 2018 high at 3,600. 

Give the pound a wide berth as EU summit nears 

The UK is in full constitutional crisis mode, and the Europeans are sick of it. As we lead up to the crucial EU leaders’ summit at the end of this week, it is still not confirmed that the UK will get a much-need extension to Article 30. The EU has said that a small extension will be permitted, only if the UK Parliament passes Theresa May’s Brexit deal. However, the Speaker of the House has said that a third vote on that deal will not be allowed unless it is substantially different from the first and second votes. Thus, the pound is drifting lower, although the market doesn’t seem panicked by the prospect of the UK crashing out of the Eurozone quite yet. GBP/USD has dipped below $1.32 at the time of writing; however it looks extremely comfortable above $1.30 at this critical juncture for EU/ UK relations. The Brexit process, and thus the pound, is at a crunch point. This week’s EU leaders’ summit might shed some clarity – either the UK secures further sweeteners from the EU to get the Brexit deal through Parliament and thus it is granted an extension, to Article 50, or there is no change to the deal, there can be no vote in Westminster, thus there will be no extension granted and the likelihood of the UK crashing out of the EU without a deal surges. This is the worst outcome for the pound, and one that is likely to send GBP/USD crashing below $1.30. However, traders remain hopeful, and we continue to assume that politicians on the UK and European side will work hard to avoid a no deal Brexit next Friday. We have blind faith in capricious politicians, however our base case is that, by the skin of its teeth, the pound will avoid the cliff edge. For now, we recommend steering clear of the pound, the politics are too messy.