Markets have second thoughts ahead of Fed

Summary

Despite chances of a ‘dovish’ hike, there are sound reasons to fade stock market bounces ahead of Wednesday’s Fed statement.

Auto sector slows

As prospects for a typical ‘Santa rally’ recede into the distance, global shares are looking at their first December fall since 2016. Declines by key global indices so far in December are now largely irreversible. Hence ‘momentum’ –  defined simply as the tendency for trends to extend, partly due to sentiment—should now also handicap the early part of 2019 too. To be sure, with the S&P 500 on course for its biggest ever fall in December in terms of points and world peers also limping, intermittent bouts of bargain hunting are highly probable. Indeed, the wash of red across European markets improved for a while as the U.S session approached. A lack of commitment persisted though and Europe’s broad average has failed to make it into positive territory. Renewed crude oil price falls keep a firm drag on that heavyweight sector. Furthermore, one of the most ubiquitous sectors of the year, cars and parts, has led the session, underlining characteristics of a reversion that eventually fades.  At last look, STOXX’s Auto & Parts sub-sector had more than halved its earlier advance. Oil & Gas’s fall deepened.

Fed hopes overshoot

In the context of Monday’s sharp retreat, current conditions might be better calibrated for shares ahead of what is widely expected to be the Fed’s ‘dovish hike’. But the prevalence of such expectations in itself is another possible headwind. More to the point, expectations are more likely to be moderated by Thursday’s Fed commentary than confirmed. After Wednesday’s almost inevitable 25 basis point hike, Fed funds futures attribute the highest probabilities to no further tightening throughout 2019.

Figure 2. Fed Funds rate probabilities – December 2019 to January 2020

The rate path, if we’re not mistaken

In contrast to the U.S. President’s idea of what would constitute a policy “mistake”, the Fed is highly unlikely to meet such expectations. Avenues for disappointment therefore remain, even if the dot plot of FOMC rate forecasts duly turns lower and the statement turns unmistakeably dovish. Isolated exceptions aside—like November payrolls—U.S. economic data continue to portray a solid economy. Hence a clear signal that tightening has run its course is probably off the cards. And the Fed will probably flag the next “data-dependent” rise sometime in the first half of 2019. The immediate effect of such a reminder from the FOMC would be a reinvigorated dollar and all that that has implied this year, with underpinned yields. Commodity-related currencies like the Aussie and yuan and other troublesome FX markets like the euro and sterling will also probably lose traction apparently gained this week. Equity markets have barely needed such cues in recent weeks to head lower. A broader ‘risk-off’ would be sufficient to confirm the widely anticipated end to 2018 that stock markets already point to.