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Another Brexit reversal; a critical Fed decision; reverting to 'December' - DFX Key Themes

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JohnDFX

Another Week, Another Set of Brexit Scenarios

It seems the weather patterns behind the Brexit seem to changing at a more rapid clip – always ending up back ‘in irons’ (pardon the nautical terminology) as the clock steadily winds down to the March 29 separation. This past week, was particularly momentous with the Prime Minister’s proposal supposedly going to vote in Parliament; but May decided to pull the vote before the allotted session as it was clear it would be voted down handily. And, considering the MPs had voted the week before to give themselves more power in the event the PM’s effort was rejected, she wanted to avoid losing any further control over the already stumbling process. The week wasn’t uneventful however as frustrated conservatives called a no confidence vote in May’s leadership. Ultimately, she survived the challenge and cannot be contested again for a year – though that doesn’t prevent further political pressure nor does it make navigating negotiations on the separation from the EU any easier. 

It could have been the case that Juncker, Tusk and their European colleagues were waiting to see the outcome of the UK no-confidence vote to prepare further concessions that would warm May’s government; but that did not prove to be the case. After enduring the challenge, May attended to two-day European Community summit where Brexit and a no-deal outcome in particular were to be discussed. She received a clear rebuff on any further compromises from the EU and in fact had some features of the previous offer revoked. We have long ago passed the event horizon for a balanced deal to be struck such that the technical work would be ready by the actual separation date. It is unlikely that this is holdout from both or either side to earn further concession as the brinkmanship only adds to the economic and financial trouble down the line. That means this situation is more likely to continue unresolved until UK leadership makes the call. 

If May can wrangle the conservatives to accept a temporary backstop, it may be the closest middle ground to be found. Alternatively, we will end up in either one of two extremes: a no-deal break or the call for a second referendum. If we end up with the former, it is more  likely to be pushed all the way to the predetermined end date. A second referendum however would likely be called weeks – perhaps even months – before the March 29 deadline. All the while as uncertainty prevails, external capital will continue to drain from the UK. Already with a default backdrop of uncertainty, global investors will want to avoid an overt threat like the Brexit. Further, domestic capital will increasingly be moved to safe guard rather than applied to more productive, growth-oriented means (such as business spending, property development, wage growth, etc). As has remained the case for some time now, trade Sterling cautiously and with a clear intent – if at all.

A Critical Fed Decision to Set the Course of 2019 

Top event risk over the coming week is the FOMC rate decision in my book. This final policy update of the year from the world’s largest central bank is one of the comprehensive events we expect on the quarters. Along with the routine update on rates and the monetary policy statement, this event will include the Summary of Economic Projections (SEP) and Chairman Jerome Powell’s press conference. First and foremost, the central bank is expected to hike rates 25 basis points for the fourth time this year to bring the range up to 2.25 to 2.50 percent. While Fed Fund futures project this outcome at a 77 percent probability – I would set the chances even higher. The Fed has established forward guidance as the primary tool for monetary policy even though it has raised rates at a steady pace and started to reduce its balance over the past year. 

The utility of guidance is that it can acclimate the market to tangible policy changes before they are implemented to defuse the detrimental financial market volatility it could trigger otherwise. That is extremely important given the transitional phase global monetary policy is in following nearly a decade of emergency-level accommodation. Markets have grown more than accustomed to the support, the have grown somewhat dependent. Normalizing its essential to promote a healthy financial system, healthy risk taking and restore the buffer necessary to fight future downturns. Yet, if this fraught course is piloted poorly, a policy authority can inadvertently trigger the next crisis. Of course, if risk trends are already unsettled, a market that is seeking out threats could fixate on this disturbance readily enough. That said, the Fed may already be picking up on some strain in the economy and markets, looking to trim its pace so as not to run aground. 

Preparing the market for that deceleration is just as important as setting expectations for its unrivaled hawkish drive over the past few years. Powell seemed to do start the adjustment a few weeks ago when the language in his speech on bonds seemed to denote greater caution and recognition of tension in the market. We have seen markets respond by  pulling rate forecasts via Fed Funds futures and overnight swaps down to only fully pricing in one 25 basis point hike – whereas previously the market had afforded three with debate of a fourth. We are due a definitive view for rate forecasts from the group in the SEP. The update for December showed a majority – by a single person – projecting three moves in 2019. Given how finally balanced that forecast was and the language from some key members, it is very likely to be downgraded. The question is whether a downgrade to just 2 hikes will then be construed as better-than-expected and if the tempo change will trigger concern amongst market participants about financial market health. 

Was Italy Capitulation, Trade Concessions, A Brexit Vote Save Enough to Revert to ‘December Conditions’ 

Thus far, we have witnessed a remarkable December. Historically, this tends to be one of the most reserved months of the calendar year for volatility and volume which in turn translates to steady gains for traditionally risk-leaning assets. What we have seen instead is a continuation of the previous two months were high volatility has leveraged incredible swings in popular benchmarks like the S&P 500 and Dow while the VIX holds precariously high. It is inevitable that liquidity will hit holes over the coming weeks owing to market closures, but that doesn’t mean that the markets have to drift calmly into holiday conditions. Shallow market depth and high volatility can converge to produce extreme moves. 

It is always wise to head into market closures or known liquidity contractions defensively, but that would be especially true of our current conditions. The question now is whether some relief on a number of ominous fundamental themes is enough to soothe the beast until markets fill back out in earnest when 2019 rolls in. Some points of progress optimistic bulls can point to include the agreement by China and the United States to a 90-day freeze fire on further escalation of tariffs, Italy softening its aggressive budget position and UK Prime Minister May surviving a no-confidence challenge. None of these developments are a long-term solution to the threats they represent, but it is breathing room at a time when the markets seem to need it most. Market biases can shift the response to events and themes – from exacerbating seemingly harmless issues into the foundation for true panic or quieting fear over a looming catastrophe. Ultimately, in conditions like these, hedges are worth it.

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