The Overnight Report: RIP QE

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By Greg Peel

The Dow closed down 31 points or 0.2% while the S&P lost 0.1% to 1982 and the Nasdaq fell 0.3%.

It may be traditional for Wall Street to rally the day before a Fed statement but Bridge Street was content to err on the side of caution yesterday, converting an initial 29 point rally for the ASX200 into a flat close. There was distinct evidence of a switch trade between Australia’s two dominant sectors of banks and materials, with the former falling 0.9% and the latter rising 1.3% despite another drop in the iron ore price.

The trade reverses the trend of late, being a strong recovery from the bottom for the previously knocked down banks but ongoing weakness in materials as the iron ore price again heads towards five-year lows. As to whether it was on opening or closing (profit-taking) trade is unclear.

For the record, Japanese industrial production rose 2.7% in September, beating expectations of 2.2% and turning around a 1.9% decline in August. It’s the fastest rate of expansion this year and, along with Tuesday’s very strong retail sales result, further implies Japan’s economy may suddenly now be behaving as it should under extensive Japanese QE.

Speaking of QE, that’s what last night was all about. US indices were flat going into the 2pm release of the Fed policy statement and then volatility broke out, as per usual, as traders swiftly moved before they even had time to read it. And there was a notable degree of confusion.

The Fed announced QE3 would wrap up next month, just in time for the mid-term Congressional elections. While the odd Fedhead had hinted leading into this policy meeting that QE could always be extended if needs be, there was no great surprise that it is coming to an historic end. At least, one assumes, for now.

But there was a deal of confusion regarding the tone of the language. Wall Street had entered last night’s session expecting the Fed’s tone to be more dovish, but instead it was suddenly more hawkish. The “considerable time” period for low interest rates was retained, but while in its last statement the FOMC had pointed to “significant underutilisation” in the labour market, meaning a lot more people still out of work than the official unemployment rate implied, last night’s statement suddenly suggested underutilisation is “gradually diminishing”.

Another supporting argument for why the Fed might prefer to remain dovish is that of apparent disinflation. One of the original targets that would trigger the first rate rise was a 2% inflation rate, but inflation has been easing this year to levels that have caused concern. Last night’s statement dismissed this concern, pointing to low energy prices as having held down inflation, and suggesting “the likelihood of inflation running persistently below 2% has diminished somewhat since early this year”.

To sum up, a couple of months ago Wall Street decided the Fed had become more hawkish, and thus began to expect a rate rise sooner rather than later. That’s what triggered the reversal of the carry trade, including the “Sell Australia” trade as I have called it. Then opinion swung the other way, largely because of Janet Yellen’s concern regarding the labour market and also mention of problems across the global economy, which implied a more dovish tone. Thus, interest rates would rise later rather than sooner. Well, now we’re back to assuming rates will rise sooner rather than later again. October 2015 was favoured going into last night’s session, now March might even be possible. At least June.

Traders were initially stunned – rabbits in the headlights. Even the computers, which act blindly on words used in the statement, were confused. It’s bad, isn’t it? And down went the Dow by 100 points. But is it really that bad if the US economy is performing better than we thought? Back up went the Dow, briefly to flat again.

It was really quite a remarkable show of resilience, given no one would have been at all surprised if the Dow fell 300 points on the back of assumed tighter policy. But then we need to wait for tonight’s session. As I always note, the “smart money” does not act in the last two hours after a statement release, but thinks through the appropriate response and acts the next day.

If the stock market response was interesting, so too was the US bond market response. The ten-year yield rose 4 basis points to 2.32%, which is fair enough, but the two-year yield shot up when the thirty-year yield fell. The yield curve thus flattened, which typically implies expectations of a slowing economy – not an improving one as the Fed is implying. Once again, the central bank and the bond market are at odds.

There was no surprise, nevertheless, in a 0.8% rally in the US dollar index to 86.04. Gold thus fell US$17.00 to US$1210.80/oz, and the Aussie dutifully came back 0.8% to US$0.8793.

The interesting thing from the point of view of the Australian market is that we’ve swung from hawkish to dovish and back to hawkish again. Hawkish gave us Sell Australia, from 5600 to 5150 for the ASX200, and dovish gave us the bounce, back to 5450, which happens to be roughly a Fibonacci retracement. Now we’re hawkish again. Will the foreign sellers return? Or did they all get out the first time around?

The LME closes just before a Fed statement release, and typically trading is quiet in the lead up. But last night saw some strong upside moves for aluminium, zinc and tin by 1% or more, offsetting a 0.5% fall for copper. We await tonight’s session to gauge the post-Fed reaction, noting that the US dollar has since jumped 0.8%.

While oil prices have been impacted by the rising greenback these past months, it is really the global supply-demand equation which has sent prices spiralling. The oil market appears to still be set rather short, given last night’s surprising drop in US weekly inventories (they’re always surprising) sparked a US$1.01 jump for West Texas to US$82.26/bbl and a US$1.28 jump for Brent to US$87.24/bbl, in defiance of the stronger greenback but arguably consistent with a more upbeat Fed.

The spot iron ore price, which is very much unaffected by what the US central bank might be thinking, fell another US20c to US$78.60/t.

The SPI Overnight, in possibly another sign of confusion, closed up one point.

So now what? From Bridge Street’s perspective, it might be wise to wait and see just what the true response is on Wall Street tonight, noting that tonight also delivers the first estimate of US September quarter GDP.

There will also be much to weigh up domestically on the micro front today, leaving aside the macro for now. National Bank ((NAB)) will deliver its FY14 result. Wesfarmers ((WES)) will deliver its September quarter sales numbers (Woolworths won’t, despite me having suggested two weeks running that they will, because they keep moving it back.) There will also be another big round of production reports, AGMs and investor days today.

Rudi will appear on Sky Business at noon and again at 7.30pm for the Switzer Report.
 

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