Chicken and egg

Today's news headlines:

‘Emmanuel Macron dashes Boris Johnson’s hope for Brexit deal’. Yesterday, the French President let Boris Johnson know that any re-negotiation to the withdrawal agreement would leave it little changed from the original. Macron said that the Irish backstop was an ‘indispensable’ part of the accord after Angela Merkel expressed hope that the UK and EU could find a solution to the issue in the next 30 days. Macron agreed that the two sides should be able to work together constructively if there is goodwill on both sides, but concerns remain about Johnson’s ‘Trumpian’ attitude. (Financial Times)
‘Hong Kong protesters target airport week after arrivals hall mayhem’. Hong Kong awaits a new wave of anti-government protests on Friday with fears rife that the airport could be targeted once more. The widespread protests are already affecting the city’s economy as the region stands on the brink of its first recession in a decade. Beijing has warned that military intervention is still possible with forces stationed just over the mainland border. China has also accused Britain and other Western countries of meddling in its affairs with Hong Kong, raising diplomatic tensions. (Reuters)

Easing dissonance

The revealing Federal Open Market Committee meeting minutes (which we commented on yesterday), are a growing source of market tension and are heading towards a moment of reckoning. Some have characterised the Fed's approach to monetary policy as a touch too reactive to market movements in the yield curve, while others have argued precisely the opposite. That sounds like a confusing statement, so let's expand on this a moment.

There are two ways to look at the complex chicken and egg process that is monetary policy. Firstly, the central bank decision-making body, the Federal Open Market Committee, should look primarily at economic factors and business survey data to determine the pace of economic growth and price inflation in order to make judgements about the correct policy setting. The other view is that central bankers should look to the market—in its collective omniscience—to determine the right policy setting. Reality is a mix of these approaches. The FOMC makes economic judgements and then communicates policy intentions to the market, which in turn is a sounding board for future adjustments. Market factors—like the yield curve or asset prices—can also help the FOMC understand how effective its policy has been and if there are any unintended effects—like asset bubbles in equity markets—which might change future decisions.

The problem (as we have often commented), is that economic fundamentals are diverging from asset prices, which puts the Fed in a precarious position. It would be a fair criticism that recent Fed decisions have put greater emphasis on market prices—particularly falling bond yields—and ignored externalities, like soaring equity prices. Equally, criticism from other quarters has been that the Fed is too slow and timid in its support of a clearly deteriorating economic outlook. The FOMC meeting minutes seem to mirror this bipolarity in view while decisions seem to follow a middle-of-the-road course. At some stage soon, there will need to be a repricing of overly optimistic valuations to acknowledge the Fed simply isn't going to go as low or as quickly as the market has signalled.

Bottom line: At some point, the market's divergence with economic reality simply can't be ignored. The status quo has been Dollar positive, but it’s likely a retrenchment of eccentricities that could create a greater safe-haven demand, particularly in the strongest economy, the US.

GBP/USD

The Dollar Index edged higher overnight following a turbulent trading session yesterday that saw Cable gain over 1.0% against the Greenback. This morning, Sterling bounced off resistance around the 1.22 level against the Dollar as markets remain short-term positive over a potential Brexit breakthrough. Any fresh selling pressure could see the pair target the psychological 1.20 mark again.

GBP/EUR

The pair shifted around 1.5% higher in yesterday’s session when muted price action was spurred into life by positive Brexit comments from German Chancellor Angela Merkel. Technically, the trade-weighted Euro Index has continued its downward trajectory towards the bottom of its current range and could be poised to target lows not seen since 2017.

EUR/USD