How markets could react to Fed and ECB meetings

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• A mixed batch of inflation readings moved market expectations, but it is more important to remember the Fed's inflation dashboard.
• Low liquidity in the equity markets may enable a bear market rally.
• Watch dollar, rates, and energy markets as the ECB confronts fragmentation risk and Europe awaits energy supplies.

On the heels of the hot headline U.S. CPI number released Wednesday, July 13, chatter in rate markets suggested the Fed might be tempted to increase the federal funds target rate by 100 bps at their next meeting on July 27. That risk faded relatively quickly on Friday, July 15 when the University of Michigan's consumer survey revealed a pretty substantial downtick in 5- to 10-year expected inflation. The preliminary number from the June survey substantially surprised to the upside prior to the June Federal Open Market Committee (FOMC) meeting and its dramatic 75 bps increase, before it was subsequently revised down.

The Fed's inflation dashboard

FOMC speakers are now in their "quiet period" ahead of the next meeting, Wednesday, July 27. While I suspect they will take some comfort in the fact that both the Michigan survey and break-even inflation measures implied from the TIPS market have eased substantially, in our view, it is MUCH too early for them to back away from hawkish rhetoric. Another data point from Friday, July 15 that flew under the radar was the quarterly update of the Fed staff's Index of Common Inflation Expectations. Fed Chair Jerome Powell has spoken about this measure as the Fed's inflation dashboard. In the press conference following their June meeting, he said the measure "has moved up after being pretty flat for a long time, so we're watching that, and we're thinking, 'This is something we need to take seriously.'" Given the measure's recent upward trend, the dashboard has NOT given them the all-clear, in our view. In fact, quite the contrary.

The Fed's inflation dashboard is pointing up

Source: Board of Governors of the Federal Reserve System

Liquidity conditions favorable for bear market rally

Positioning in the equity market is quite light at the moment: Net and gross leverage for hedge funds is low according to some key prime brokerage data and in aggregate, CTA (commodity) and trend-following strategies are likely close to max short. As such, it is reasonable to expect another bear market rally on any whiff of "peak hawkishness" or peak sizing of rate hikes, but — make no mistake — central banks are likely not finished tightening policy and the Fed put is, for all intents and purposes, gone for the foreseeable future.

Rising volatility in rates and the dollar

Measures of fixed income market liquidity have, if anything, deteriorated since May 11, exacerbated by both continued quantitative tightening and summer seasonal patterns. Tighter liquidity will likely keep volatility elevated, and to paraphrase our colleague Michael Atkin, Head of Global Sovereign Credit, two of the three most important prices on the planet (the exchange rate value of the U.S. Dollar and the yield on 10-year U.S. Treasury notes) have seen substantial upticks in volatility over the past several months.

Volatility is rising for interest rates and dollar exchange rate

Sources: Bloomberg Finance LP. VIX Index is CBOE Volatility Index; OVX Index is CBOE Oil Volatility Index, CVIX Index is Deutsche Bank Foreign Exchange Volatility Index, MOVE Index is Merrill Lynch Option Volatility Estimate. Used with permission of Bloomberg Finance LP.

Europe navigates fragmentation risk and energy supplies

The ECB meeting on Thursday, July 21, unveiled their much-anticipated "anti-fragmentation" tool kit [fragmentation risk is the potential for a sudden rise in sovereign bond yields of countries on the periphery, such as Greece, Italy, Portugal, Spain, and Ireland, relative to core markets]. This comes, somewhat ironically, on the heels of Mario Draghi, who a decade ago as ECB president promised to do "whatever it takes" to preserve the euro, threatening last week to resign as prime minister of the fragile governing coalition in Italy over a budgetary issue.

If market participants seek to test the ECB's resolve in containing peripheral bond spreads during a summer liquidity lull, watch for spillover effects into other risk asset markets. The ECB meeting takes place on the same day that natural gas is set to resume flowing through the Nord Stream 1 pipeline after a 10-day maintenance shutdown. Gazprom, as of last week, has declared force majeure on Nord Stream 1 delivery contracts, creating risk that sets the stage for an escalation in Russian economic warfare. This would almost certainly cause a substantial increase in volatility in energy markets, which, for the most part, have been reasonably well behaved this year (the third of those three most important prices on the planet: the price of a barrel of oil).

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