The Overnight Report: December Looms Larger

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By Greg Peel

The Dow closed up 198 points or 1.1% while the S&P rose 1.2% to 2090 and the Nasdaq rallied 1.3%.

Cup Favourite?

The tenor of the minutes of the RBA’s October policy meeting was one of a board reasonably satisfied with the progress of Australia’s difficult economic transition, and happy that both the currency had come down to more realistic levels and that regulatory tightening had resulted in an easing in the housing bubble. The assumption one could make from those minutes is that the RBA is not going to cut its rate next week, nor even in December.

But since then we’ve seen the major banks reprice their mortgage rates, affecting a tightening of monetary policy for Australian households without the RBA’s involvement. This act of blind treachery, as the populist media and politicians have effectively labelled it, will now force the RBA to cut next week, most have suggested.

Why?

Mortgage repricing directly addresses the RBA’s concerns. The central bank was this month relatively happy with how things are progressing, but still concerned about the housing bubble. Now it doesn’t need to be concerned.

And then along came yesterday’s September quarter CPI result. The headline number came in at 0.5% quarter on quarter growth, missing economist consensus of 0.7%, for a 1.5% annual rate. There you have it, said all and sundry – now the RBA will cut rates on Tuesday. The CPI is well below the 2-3% comfort zone.

Except that it isn’t. One can say it until one is blue in the face but no one ever seems to listen. The RBA’s comfort zone is based on core inflation, ex-food & energy, as represented by the trimmed mean, not on the headline number. This measure rose only 0.3% in the quarter but is up 2.2% year on year – smack bang inside the comfort zone.

What dragged down the September headline CPI? Falls in food and energy prices.

So will the RBA cut on Tuesday? Not everyone is on that bandwagon.

The forex market is clearly backing a Cup Day cut. The Aussie is down a cent over 24 hours to US$0.7096. It was a game played in two halves. First came the weak CPI number and then came the latest Fed statement and a subsequent US dollar rally overnight.

The stock market also backed a rate cut yesterday, despite another soggy but immaterial close. Three sectors finished one percent or more in the green to balance out general sogginess elsewhere. They were healthcare, utilities and telcos. Defensives and yielders. Most of the offset came from falls in the resource sectors yet again.

How to paint oneself into a corner

All through 2015, Fed policy statements have declared that the FOMC “would determine how long” to keep its rate at zero, without ever putting a timeframe on it. Last night’s statement declared the FOMC would determine “whether it will be appropriate to raise the target range at its next meeting”. It is the first time a specific meeting has ever been referred to officially, despite Janet Yellen constantly repeating that a rate hike this year looks likely.

As for “appropriate”, the statement declared the FOMC would assess the progress, “both realised and expected”, towards its dual objectives of maximum employment and 2% inflation. In other words, neither goal actually has to be achieved, it just has to appear as if both are on track to be achieved.

Throw in an apparent easing of concerns from the Fed over global markets and Wall Street has now lifted the odds of a December rate hike to 50% from 30% beforehand.

But how does Wall Street react to this turn of events? That’s the hard part.

We recall that all year commentators were warning that the first Fed rate hike would trigger a correction on Wall Street. We didn’t get a rate hike in June when it was expected, but we had the correction anyway, thanks to China. Then everyone expected a rate hike in September, but it was not to be, thanks to China.

So Wall Street sold off, which seemed counterintuitive on the assumption it would be a rate hike, not lack thereof, that would spark a sell-off. Wall Street sold off because of the uncertainty the Fed was perpetuating. The market really just wanted to get a rate hike out of the way.

Then came two surprisingly weak US jobs reports in succession. Following the September report, Wall Street decided there was not going to be a rate hike in 2015. Thus uncertainty evaporated, and hence it was time to start buying stocks again.

However, last night’s statement suggested December is still goer. So what did Wall Street do? The Dow was up a hundred points ahead of the Fed release, largely due to the well-received earnings result from Apple. On release, the Dow fell back into the negative, driven by computers. Immediately it bounced and rallied two hundred points. Computer programmers were left scratching their heads.

Wall Street has just seen a 10% rally from the correction lows because it seemed there would be no rate cut in December. Now that it seems there will be, surely that must be negative? At least that’s what the computers assumed.

The bottom line is Wall Street is now split into two camps. One camp suggests the Fed now feels it should have raised in June, and, in retrospect, could have raised in September, so to end the criticism of its indecision and to end uncertainty it simply has to raise in December. Last night’s statement all but confirmed this.

The other camp believes the Fed won’t raise in December, and will likely wait until at least March. The Fed needs to be satisfied its two goals of employment and inflation are close to being achieved. We’ve seen two shocking jobs reports in a row. Inflation, thanks to the stronger greenback, is more likely to fall than rise into the end of the year. Ergo, by the Fed’s own measure, there will be no rate rise in December.

The confusing point is that we could put the 200 point Dow rally down to either camp’s view being right. A December rate rise would end uncertainty, so that’s positive. No December rate rise means stocks remain the only place to invest, so that’s positive.

We can, nevertheless, look to other markets to gauge Wall Street sentiment. The US dollar index is up 0.8% to 97.66. That says December rate rise. The US ten-year bond yield rose 6 basis points to 2.09%. That says December rate rise. But then, the Fed futures market is pricing December at 50/50.

And that about sums it up.

Commodities

The LME is always closing just ahead of Fed releases so while base metal prices saw small falls last night, we’ll need to wait until tonight to see a Fed response.

The iron ore market doesn’t really pay much attention to outside influences, so its fall of US$1.30 last night to US$49.50/t likely has nothing to do with the Fed.

On the strength in the US dollar, and on an increase in US weekly inventories, we would expect the oils to have gone the same way as iron ore. But no, West Texas is up 6.3% or US$2.73 to US$45.95/bbl and Brent is up 4.6% or US$2.17 to US$49.03/bbl.

The suggestion is that when WTI fell through 45, the market got itself very short on the assumption this break-down from the range meant the next stop would be in the thirties, rapidly. While WTI has been a little weaker this week, it has not been dramatically weak. Thus, someone decided to cover their shorts last night and suddenly the scramble was on.

And now we’re back inside the 45-50 WTI range once more.

Gold is saying December rate hike. It’s down US$10.20 to US$1156.30/oz.

Today

The SPI Overnight closed up 42 points. Somewhere in that number will be allowance for an expected bounce-back for the energy sector but likely weakness for the materials sector.

Locally we’ll see new home sales data today, and tonight we’ll see the first estimate of US September quarter GDP, just to add fuel to the fire.

ANZ Bank ((ANZ)) will report full-year earnings today and Woolworths ((WOW)) will report September quarter sales amidst another busy round of AGMs and production reports.

Rudi will make his weekly appearance on Sky Business' Lunch Money today, noon-1pm.

 

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