Dollar soars, markets sink as Bernanke announces the beginning of the end for QE3
24/Jun/2013 • Currency Updates•
It not often that a market strategist’s views are validated as thoroughly as our’s were last week. We have been pounding the table for some time that the US economy was on sounder footing; that the Federal Reserve was increasingly aware of this and was likely to be the first major central bank to start reducing monetary stimulus – and that the dollar stood to be the main beneficiary from all this. Last week saw the markets wrong footed by a relatively optimistic Bernanke, who went as far as to lay out an explicit calendar for the tapering of QE3. As a result, the dollar rallied violently against all major currencies, and the unwinding of positions, by heretofore complacent investors, gathers pace. Equities dropped for the fifth consecutive week, although they are still up for the year for the most part. Precious metals fell 7%, energy and industrial metals 3%. Bonds, not surprisingly, bore the brunt of the sell off, as the 10 year US Treasury yield rose nearly 40 bp and most emerging market bonds fared considerably worse.
The minutes for the MPC May meeting did not contain any surprises. The general tone is that UK activity data is starting to improve, and is now consistent with slow growth in the second half of the year. Inflation is expected to pick up this summer, but weak pay growth means that the 2% target is likely to hold over the medium term. May inflation seemed to validate the MPC’s hawkish turn, as inflation rose to 2.7% yoy, and core inflation pushed up to 2.2%. Money market futures are now pricing in a full 0.25% hike by September of next year. We think that this is overdone, given the uncertainty and the fact that Carney is joining the committee next month and this makes future policy even more uncertain. However, it seems clear that additional QE is off the table for now. Look for sterling to continue to strengthen versus most European currencies, and weaken against the Greenback in line with our forecasts.
Macroeconomic news out of the eurozone took a rare positive turn last week. The key PMI indices of business sentiment both rose, and the composite PMI now stands at 48.9. This is still consistent with a slight contraction in the eurozone economy as a whole, and continued job destruction. We estimate that the PMI index needs to cross 50 for the job market to stabilize, and 52 before net jobs are added; it remains to be seen whether the bounce for the last two months is the beginning of a sustained upswing. Recent market volatility and the flooding in Germany makes us sceptical, and we continue to expect the eurozone economy to post negative or flat growth for the remainder of the year. The euro traded mostly in response to Bernanke’s warning on the tapering of QE3, and it sold off over 1.5% against the Greenback.
Much expectation had been built around last week’s FOMC meeting, and this time markets were not disappointed. Ben Bernanke confirmed that, should the economic recovery continue as expected, QE3 will begin to taper towards the end of the year and be completed by the summer of 2014. Further, the FOMC unemployment forecast was revised downwards. In fact, the FOMC now expects that the 6.5% unemployment target will be hit sometime towards the end of 2014, rather than mid-2015 as was the case before. This is critical, as this is the sine qua non condition for starting to raise rates. At the press conference following the statement, Bernanke appeared to be unconcerned with the recent back up in rates and wobbliness in financial markets. This was a decidedly more hawkish line than markets had expected. Rates backed up across the curve, crowded trades continued to be unwound, sometimes violently, and the dollar rose strongly. We must say that we agree wholeheartedly with Bernanke’s assessment of the economic outlook, and were not surprised by either the statement or the press conference. We expect the market moves that followed to continue over the next few weeks, and would be very wary of any short dollar positioning.