Ever since the release of the April FOMC statement, the market-implied probability for a June hike had crashed to a low of 4%, as traders and market participants heavily discounted for what we call a "hawkishly-dovish" Fed, and on the heels of broad misses in U.S. macro, the prospect for a June hike diminished. No surprise here, but read on.
However as regular readers and subscribers to our journals will know, we believed that despite soft economic data and cautious/dovish Fed language, there was still a good chance for a Fed hike in June. The tides turned this week upon the release of the April FOMC minutes, and very abruptly so.
Hawkish turn by the Fed
A hawkish turn was something we warned about in the preceding days before the release of the April Fed minutes. It was also one of the risks we highlighted here, and here, under uncertainties regarding monetary policy.
April's FOMC minutes seemed to have revived the market's appetite to be long the U.S. dollar against risk, and certainly against the precious metals, with the latter seeing some of their best gains in almost 2 years, again on the heels of a weakening dollar bolstered by the market's sentiment that the Fed will hold off hike rates until later in the year.
As we've included in the chart above, April's FOMC minutes was rather divergent from the much more dovish and cautiously played statement. In short, FOMC members stated that June's meeting would be a live one, meaning members would have to make fresh decisions on interest rates. The Fed will remain data dependent, and will likely monitor recent weakness in the jobs markets (NFPs, weekly claims, and wage inflation).
Importantly, the minutes stressed that the Fed believed markets had underestimated its propensity to hike rates, and had grossly underpriced such a possibility (this is obvious given how low the FF futures implied probability of a June hike fell before the minutes were released).
By directly addressing market expectations, we feel the Fed is trying to manage expectations to what they might do in the future. This has always been a key ingredient to the relative success of the Fed. By varying its language, we believe the Fed is bent on taming market volatility when it does make a decision on interest rates come June.
The market's reaction to the April minutes was unsurprising to us. As the charts above illustrate, dollar strength was the main driver on the day, and we suspect this might continue in the coming days or even weeks. When the greenback fell precipitously from their 2016 highs, we warned that the markets were getting ahead of reality, and that there was a good chance they have misread the Fed. The fierce counter moves we saw in the pays few days are proof of this.
Anti-dollar assets, chiefly the precious metals, were hit exceptionally hard following the minutes. The FF futures implied probability of a June hike spiked from the 4%-10% range to 30% currently. Treasury yields were volatile but seem to be relatively indifferent about this repricing of risk. This is clearly a strong dollar weak dollar trade at play.
Interestingly, Eurodollar futures (chart below) had been discounting for higher money market rates since the middle of May, diverging from the weakness in the dollar (lower/unchanged rates, dovish policy) and strength in treasuries relative to equities. We encourage traders to eye Eurodollar rates and prices because they are usually the most sensitive even to micro shifts in sentiments at the highest tiers.
We still stick to our prognosis that a June rate hike is on the table, despite what the overall market believes. The gist of the matter is that markets usually overshoot reality and will therefore get things (such as monetary policy decisions) wrong. We might be in one of such cases.
We will be watching how the U.S. dollar and related assets perform in the coming days and weeks. We see more dollar strength ahead as short dollar positions will likely be forced to cover as the market renormalizes in time for the June FOMC statement and rate decision.
On risk, we are on the fence for American equities but are ready to turn on a dime should technical factors align. We expect volatility to be concentrated in commodities and FX. Other than that, all eyes will be on the coming May NFP (first week of June), and the June FOMC rate decision.