Comment: What to watch for in the Fed announcement

Employment levels are pretty much where the US Federal Reserve wants them although some members of the FOMC were of the belief in the September meeting that further progress was possible before the labour market could be considered in line with the mandate, writes analyst Brenda Kelly.

The relatively poor payrolls report for September, which clearly missed expectations and the downward revision to the August number came as a surprise yet if you look at the U6 unemployment ratre – the broader picture, which is seen to be around 1% away from full employment. Many would argue that this is the precursor to a rise in US wage growth – but this has so far been elusive.

We are seeing GDP expectations falter somewhat as much of the US macro data lately has not exactly been stellar and led many of the banks to reduce expectations for Q3 GDP. We are back to the point, assuming we ever left, where poor macro data is bullish for equities evidenced by the fact that despite the massive correction in late August the S&P500 is with 3% of a new all-time high.

The major risk to this new upward momentum in stocks is a sharp improvement in US data.

Yet, the housing market looks like it is losing some steam, US consumer confidence on Tuesday failing to meet expectations ahead of key holiday is yet another example of a barrier to any move towards a tightening cycle. This, coupled with the sharp slowdown in macro momentum and the actual PBOC easing, potential ECB additional easing has pushed the dollar higher on a trade weighted basis.

A recurring theme in the companies that have reported thus far was the strength of the dollar.

With the ECB comment last week we got a big move in the US dollar, and the dollar index (DXY) is testing its March downtrend at around 97.20, which is a key level. But it was driven by euro weakness rather than dollar strength or expectations of a hike in the near term.

The two-year US-Eur spread has widened, favouring the USD. The general rule is that 10bps on the spread is around 1% on the FX pair.

Should the ECB eventually deliver on a cut in the depo rate, we will once again be looking at a burgeoning US dollar which only feeds into the disinflationary environment all central banks wish to avoid.

Price action in gold would also point to further upside, likely at the expense of the greenback, having broken out of a 10-month downtrend.

The September minutes revealed some concerns over the stability of inflation expectations – ‘some’ participants noted that it might be a mistake to raise rates and only increase downside risks to CPI until it becomes clear that economic growth would remain at an above trend pace.

With the uncertainty around China abating at least for now amid action from the People's Bank of China, which is expected to cushion the deterioration in its growth, it’s still worth looking at commodity prices.

The BBG commodity index is now trading near 16 year lows – yet central banks continue to view this as transient. And many Fed members feel under pressure to be pro-active rather than reactive when this rout ends.

Given that most of the other major central banks are in easing mode, another rally in the dollar (should the Fed go ahead and do it anyway) would only exacerbate the volatility in EM. Many were erroneous in the view that ‘data dependency’ pertained to the domestic picture only, Yellen has made it clear that the global economy is also a factor and a major one at that.

The notion that the Fed merely need to make the decision and hike rates even slightly has been compared to ripping off a band aid. The risk is that the wound will be re-opened.

The Fed language will be closely watched by traders. Given that we have seen a rally last week in equities followed by a consolidation/sideways action over the past two days, the onus is on the Fed to be upbeat. At this point, a failure to make good on clear action and timing of the rate hike is likely to be to the detriment of risk assets.

Should December expectations be ramped higher - and this seems to be the aim of many members - then we will likely see a move higher in the dollar and the US 10-year bond price but a tendency to downside in risk assets.

Energy stocks are likely to be under the cosh even more owing to the rout in oil – this will be exacerbated by a hawkish fed.

A mention of emerging markets and the concerns surrounding it will likely be initially taken as a negative before a higher leg up in equities.

Brenda Kelly is Head Analyst at London Capital Group