Standing by for the Federal Open Market Committee

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Florida dodged a bullet as the worst fears over hurricane Irma were fortunately not realized. Market attention is now turning to the FOMC meeting and US rate-setting.

2017 Atlantic hurricane season: the most destructive since 2005

On the heels of last month’s hurricane Harvey, Irma came ashore as a category 4 storm, marking the first time ever that two category 4 Atlantic hurricanes made landfall in the US in the same year. But Irma stayed away from Miami and Tampa, instead moving up the central area of the state. The storm lost strength along the way and for the most part avoided major population centers.

While hurricane Irma undoubtingly caused a substantial amount of destruction, the damage in Florida was far less than anticipated, allowing financial markets to breathe a sigh of relief in the second week of September.

Spreads on fixed-income risk assets, which had moved sharply wider in the first week of September reflecting a perception of increased risk as Irma approached Florida, snapped in on Monday 11 September. US equity markets moved higher, closing the second week of September at or near all-time highs.

Geopolitical issues weighing less on financial markets

Geopolitical events were also highlighted as the UN Security Council voted to impose additional economic sanctions on North Korea. Financial markets were somewhat calmed by a watered-down version of the resolution, which passed unanimously. North Korea responded with another intermediate range missile launch over Japan. Markets largely shrugged this off, appearing to have grown immune to escalating tensions with North Korea. Likewise, a terror attack on the London subway system on Friday 15 September had little to no impact on financial markets, solidifying the notion that investors have grown numb to these types of events.

Hurricane worries and geopolitical concerns left US 10-year yields close to a low for the year on Friday 8 September at 2.06% after touching 2.01% earlier in the day (see Exhibit 1 below). However, the flight-to-quality rally was quickly unwound as the market perceived diminishing tensions with North Korea and saw far less damage from hurricane Irma than anticipated. The 10-year yields finished the week at 2.20%.

Risk assets performed well on the week with US high-yield credit posting a 64bp positive excess return and the S&P 500 share index touching 2 500 for the first time, closing at an all-time high at 2 497.

Exhibit 1: A flight to quality drove the yield of the US 10-year Treasury bond close to a low for the year in the first week of September, but the move unwound rapidly (graph showing changes in US 10-year bond yields between 20/09/2016 and 20/09/2017)

bulletSource: Bloomberg, BNP Paribas Asset Management, as of 20/09/2017

Market focus now on the FOMC

The market’s attention now turns to the Federal Open Market Committee (FOMC) meeting on 20 September. The FOMC is widely anticipated to announce an October commencement of the tapering of its mortgage-backed securities (MBS) and US Treasury re-investments, and a gradual normalization of the balance sheet. Recent US economic data has been positive with an upward revision from 2.6% to 3.0% to the second quarter’s gross domestic product (GDP) and a solid September payroll report.

Recent inflation data appears to support the Fed’s view

The Consumer Price Index (CPI) data for August, released on 14 September, ended five consecutive misses to the downside of expectations. Core CPI was up by 0.2% MoM, largely driven by an increase in the lodging component (see Exhibit 2)

Exhibit 2: After falling for five consecutive months, the US consumer price index rose by 0.2% in August versus the previous month towards the Federal Reserve’s target of 2% (graph shows changes in the US CPI for the period from 30/09/2011 to 31/08/2017)

bulletSource: Bloomberg, BNP Paribas Asset Management, as of 20/09/2017

Near-term trends suggest that US inflation is firming, which lends support to the Fed’s consensus projection for one additional increase in the fed funds rate in 2017, which would likely come at the December FOMC meeting. Current pricing of fed funds futures shows market participants split about 50/50 over a December rate rise. Recent weakness in the US dollar, coupled with continued labor market strength, suggests that the Fed’s view of inflation moving towards its 2% target may in fact finally be right. That would come as a surprise to bond markets and it could induce US yields higher. So too would any more hawkish language from the Fed statement today.


Written on 20/09/2017

John Carey

Head of structured Securities, CFA Charterholder

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