It’s a Fed hiking cycle Jim, but not as we know it
Tomorrow’s Fed policy meeting decision is unlikely to throw up any surprises, with the market having priced out any chance of a hike. The real focus will be on the language of the accompanying statement.
The market has arguably already priced in the possibility of a slightly less dovish Fed, with US yields at a one-month high. The US labour market remains robust, inflation expectations have ratcheted up, as have house prices. Chinese economic activity has picked up and global equities and commodity prices have surged in the past couple of months.
But the Fed is also likely to reiterate its concerns about slowing global growth, US business investments and exports and the headwind to US growth from the manufacturing sector. This nuanced picture is summarised in the heat-maps in Figures 5 & 6.
Moreover, the Fed has made clear it would look beyond potentially temporary developments and could well play down the recent rebound in global energy prices and in major economies such as China.
I therefore expect the Fed to be constructive enough tomorrow to keep US yields in reasonably narrow ranges but to stop short of encouraging a significant repricing for a June hike.
This remains a challenging balancing act for the Fed as equity markets and non-commodity currencies have been flat-lining recently. If the Fed intensifies its dovish warnings, markets could start looking more closely at what is keeping the Fed from delivering only its second hike in a decade. Conversely, a more hawkish stance could spook a market attuned to dovish Fed rhetoric.
My core scenario remains for the Fed to hike rates once or twice this year, which would be sufficient to expose the soft under-belly of EM currencies.
Market having to rely on mostly qualitative analysis of Fed statement
The market has priced out the probability of the US Federal Reserve hiking its policy rate when it concludes its meeting tomorrow (27th April). The policy rate is indeed all but guaranteed to stay on hold at 0.25-0.50% this week as there has been no suggestion whatsoever from any Fed official in recent months that a hike was potentially on the cards let alone imminent.
As per its normal schedule, the Fed will not release new economic projections or an updated FOMC “dot-chart” and will not hold a press conference. So the focus will be on the Fed’s policy statement, which typically runs over two pages.
The only hard quantitative information will be in the last paragraph, which summarises how the ten Federal Open Market Committee (FOMC) members voted. Federal Reserve Bank of Kansas City President Esther George was the only dissenting member in March, voting for a 25bp hike. So the market will therefore have to rely on a mostly qualitative assessment of the language used. Undoubtedly, every word – which on average number 575 – will be analysed and weighted in order to glean any change in the FOMC’s position on the appropriate setting for US monetary policy.
In its March policy meeting, the Fed concluded that “the stance of monetary policy remains accommodative”, “only gradual increases in the Federal Funds rate” were likely warranted and the Fed Funds rate would “likely remain, for some time, below levels that are expected to prevail in the longer-run”. Markets are therefore likely tomorrow to focus first and foremost on this section of the statement before turning their attention to any possible changes in the specific factors which the Fed highlighted in March. Specifically, the Fed flagged the following negatives and positives:
- Global economic and financial developments;
- Soft US business investment and exports;
- Low US inflation expectations; and
- Inflation which is likely near-term to remain below the Fed’s 2% target
- Moderate pace of US economic activity and household spending;
- Improving housing sector;
- Strengthening labour market;
- Expectation that US economy and inflation would expand moderately medium-term
Rates market seemingly prepared for a marginally less dovish statement
The market has arguably already priced the possibility of the Fed acknowledging some incremental improvements in the US and global economy and being marginally less dovish tomorrow than it was in March and in subsequent weeks when Fed Chairperson Yellen reiterated her dovish position.
The rates markets is currently pricing in a 23% probability of a 25bp hike at the Fed meeting on 15th June (or put differently 6bp of hikes), based on CME Group Fed Fund futures prices. While this is still very shallow, it compares to a 16% probability (4bp) only a month ago (see Figures 1 & 2).
Similarly, while the market is still pricing only a 71% probability of one or more rate hikes by end-year or a weighted average of 26bp of hikes, this compares to a 56% probability (19bp of hikes) a month ago. Note that Bank of Boston President Eric Rosengren, who votes tomorrow, last week expressed concern that the extremely shallow market pricing of rate hikes was at odds with a fundamentally sound US economy and may require the Fed to hike rates faster than desired.
Further down the maturity curve, US Treasury yields have also risen, with 2, 5 and 10-year rates up respectively 11bp, 17bp and 14bp since the end-March lows, in tandem with decent US data and more buoyant global risk appetite (see Figure 3). Specifically:
- Global commodity prices (and currencies) and equities have hit multi-month highs, spurred in part by the pick-up in Chinese economic activity (see Commodity rally and central bank dovishness hand in hand, for now, 21 April 2016). This may at the margin alleviate the Fed’s concerns about global economic and financial developments near-term;
- Most measures of US inflation edged lower in February but this is broadly in line with the Fed’s expectation expressed in March that “inflation is likely to remain low in the near-term, in part because of earlier declines in energy prices”.
- The crude oil price is up 20% since the Fed hiked on 17th December, the US dollar trade-weighted index is down about 5.5% since its mid-January highs and US inflation expectations, as measured by the 5-year break-even rate, have risen to a nine-month high (see Figure 4). This is likely to be reflected in some guise in tomorrow’s statement.
- US employment data remain sturdy, with seasonally-adjusted initial jobless claims in the week ending 16th April falling to 247,000 – the lowest level for initial claims since 24 November 1973. While the unemployment rate crept up to 5.0% in March this was in part due to the participation rate rising to a 2-year high of 63.0. The Fed may therefore opt for a similarly constructive language regarding the labour market.
- Personal consumption expenditure in the past three months has risen at a similar pace as in the three months running up to the December hike.
- House-price inflation inched up at the turn of the year, but the data are now three months old.
- The US manufacturing ISM rose to an 8-month high in March and the non-manufacturing ISM rebounded after a sharp fall in November 2015-January 2016.
But the Fed is also likely to reiterate its concerns about US business investments and exports, with core durable goods orders and merchandise both weakening sharply in March and February, respectively (March export data are due for release tomorrow, before the meeting statement at 19.00 London time).
The manufacturing sector, while modest in relative terms, remains fragile due to low productivity growth and a strong dollar. It likely weighed on US GDP growth which analysts forecast to have halved in Q1 2016 from an already modest 1.4% qoq seasonally adjusted in Q4 2015 (preliminary Q1 GDP data will be released on Thursday, after the policy meeting). The Fed may also allude to a slight softening in earnings and wages growth. This nuanced picture is summarised in the heat-maps in Figures 5 & 6.
Moreover, the Fed has made clear that it would look beyond cyclical and potentially temporary developments and instead focus on underlying trends. As a result the Fed could well play down the recent rebound in global energy prices and in major economies such as China.
Based on the fall in the global manufacturing and in particular services PMI to multi-quarter lows in Q1, global growth likely slowed further in Q1 2016, from my estimate of 2.8% year-on-year in Q4 2015. The IMF recently revised down its global growth forecasts for 2016 and 2017 and the respected Monetary Authority of Singapore (MAS) in April moved to an exchange rate policy setting it last introduced during the 2008 great financial crisis. Moreover, the recent cyclical recovery in the Chinese economy is likely due, at least in part, to the 25% year-on-year rise in new loans in Q1 – a trend which medium-term is likely to exacerbate structural weaknesses, including non-performing loans and asset bubbles.
With this in mind I would expect the Fed to be constructive enough tomorrow to justify the recent rise in US yields, leaving the door ajar for a June hike and keeping US yields in reasonably narrow ranges. But the Fed is likely to stop short of encouraging a significant repricing of the probability of a June hike, in order to put a floor – however creaky – under global commodity and equity markets for now and gently guide the dollar weaker.
A precarious Fed balancing act
But this remains a challenging balancing act for the Fed as US and global equity markets have flat-lined in the past 8-9 sessions and non-commodity emerging market (EM) currencies are broadly unchanged for the past three weeks.
If the Fed intensifies its dovish warnings, markets could start looking more closely at what is keeping the Fed from delivering only its second hike in a decade. After all, if the Fed pushes out a rate hike into late-2016, it would be the first time the Fed has hiked 25bp (from a very low starting point) and then stayed on hold for a significant period of time (see What if Fed hikes, leaves rates on hold…or cuts, 29 January 2016). This in itself should give the market bulls pause for thought.
Conversely, if the Fed is seen as having moved to an outright hawkish stance, the market could be spooked at the prospect of one of the key engines of the recent risk-rally – loose US monetary policy – stalling.
My core scenario remains for the Fed to hike rates once or twice this year, which would be sufficient to expose the soft under-belly of EM assets and put the weaker EM currencies under modest pressure (see Emerging Market currencies, don’t call this a comeback, 6 April 2016).
Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.
 This is the weighted probability of the Fed delivering no change, one hike, two hikes etc…
 On 25 March 1997 the Fed hiked rates 25bp to 5.50% but then left rates unchanged for 17 months, before delivering three successive rate cuts in August-November 1998 during the height of the Russian crisis.