Fed on the ropes but not down

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The US Federal Reserve and markets have been engaged in a bruising duel for the past six months. Round 6 should have been an easy one for the Fed given reasonably well behaved equity and FX markets, surging energy prices and signs that global GDP growth was stabilising.

But softer US employment data for May have put the Fed on the ropes, with markets having now all but priced out a hike next week and only pricing in a 24% probability of a hike on 27th July.

The Fed is not down, however, thanks to decent earnings, income and spending, a pick-up in most inflation measures in April and a robust housing market, which all point to a rebound in GDP growth in Q2.

In the labour market, an increasingly high percentage of those who want a job are finding one and the steady share of full-time employees points to decent hourly earnings growth in months ahead. There is still slack but arguably less than in December when the Fed hiked.

The Fed will be hoping that the next data set, particularly for the labour market, manufacturing and inflation, will go its way so that it can finally deliver a second-hike in a decade at its July meeting.

This is still my core scenario, although if labour data for June disappoint the Fed may well turn to its 21st September meeting as its next possible trigger point.

A July or September hike would leave the Fed with another few rounds to hike its policy rate by another 25bps, in line with Fed members’ current average forecast of two hikes in 2016. The Fed will want to show markets that it will not be swayed by soft data punches or temporary market developments and is still in control, but without flooring markets.

 

Fed and markets in sixth round of bruising encounter

The US Federal Reserve (the Fed) and markets have been engaged in a bruising duel for the past six months. After a convoluted and much hyped run-up, the Fed won the first round back in December when it delivered its first hike in nearly a decade, with market admittedly prepared for the move and left standing.

The Fed was then bruised and battered in rounds 2 and 3 by mixed US data, slowing global growth, a sharp sell-off in equity markets and surging US dollar in Q1. Round 4 in April was probably scored as a draw, as risk appetite recovered but the Fed was still too dazed and confused to deliver another hike. The Fed’s 27th April policy meeting, which was short on specifics, seemed to go the markets way (see Fed pulls off 40-word Houdini, 28 April 2016), but in the dying seconds of round 5 the Fed countered a complacent market with a punchy set of hawkish policy meeting minutes (see Sticking to forecasts: Fed summer hike, dollar hat-trick still on the cards, 25th May 2016).

Round 6 should have been an easy one for the Fed. Reasonably well behaved equity and FX markets had seemingly tired themselves out, energy prices had surged to 7-month highs, US GDP in Q1 was revised up and global GDP growth seemingly stabilised around 2.8% year-on-year in Q1 according to my estimates (see Figure 1).

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But softer US employment data for May, released on 3 June, have put the Fed on the ropes, with markets having now all but priced out a hike at the 15th June policy meeting and only pricing in a 24% probability of a hike at the 27th July meeting. While Chairperson Yellen did not throw in the towel for a summer hike, she made reasonably clear in her speech on 6th June that the Fed is now unlikely to pull the trigger next week.

Moreover, there are few major US data releases scheduled between now and next Wednesday, bar retail sales (14 June) and industrial output/PPI-inflation (15 June), which gives the Fed few data points to anchor a policy tightening (see Figure 9).

 

US macro picture and outlook keeping Fed in the fight

The Fed is on the ropes but not down thanks to decent hourly earnings, income and spending, a pick-up in most inflation measures in April and still reasonably robust labour and housing markets.

The USD-value of wages & salaries rose 5.3% yoy in February-April, the fastest rate of growth since early 2015 (see Figure 2), while nominal retail sales growth of 3.0% yoy in April was the second fastest. Even adjusting for inflation, year-on-year growth in disposable personal income was a trend-hugging 3.3% yoy in April while personal expenditure growth hit an 8-month high of 3.0% yoy (see Figure 3). Data for May show that growth in hourly earnings for non-farm private sector employees remained undiminished at 2.5% yoy.

As Yellen pointed out, these data bode well for Q2 GDP growth which the “GDPNow” real-time forecast from the Atlanta Fed currently has at 2.5% quarter-on-quarter annualised. The first official GDP estimate is due for release only on 29 July – after the July meeting – but the Fed will by then have a pretty good grasp of US growth in Q2.

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Underpinning decent wages and expenditure growth is a labour market that has improved markedly in the past twelve months. As I detailed in US economy not at full employment (13 May 2016), markets tend to focus almost exclusively on three labour market releases: non-farm payrolls (part of the employment survey), and the unemployment and participation rates (part of the household survey).

The May numbers clearly underwhelmed, with non-farm payrolls up only 38,000 – the weakest addition number since September 2010 – while the unemployment rate collapsed but only as a result of a significant increase in the non-labour force.

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This data set was certainly weak enough to put doubt in the Fed’s mind. But the Fed has the luxury of being able, in its own time, to digest and weigh a far broader and more detailed set of labour markets data – and Yellen’s assessment is that a number of these indicators were encouraging. I would tend to concur.

  • Based on household survey data, the ratio of those employed to those employed, unemployed and outside the labour force but looking for a job inched up to 91.9% in May – the highest ratio in eight years, according to my calculations (see Figure 4). The other way to think about it is that an increasingly high percentage of those who want a job are finding one.
  • Moreover, the share of full-time employees has been broadly steady at 81.5% in recent months. As a result, I estimate that the ratio of those employed full-time to those employed, unemployed and outside the labour force but looking for a job has been steady around 75% (see Figure 5). History suggests that the current proportion of full-time employees in the working age population will support earnings growth in coming months (see Figure 6).
  • Finally, these jobs are not being created at the expense of working weekly hours which have been broadly constant in the private sector, according to the employment survey.
  • With annual growth rates in those employed and hourly earnings at around 1.7% and 2.5%, respectively, payrolls are still rising in excess of 4% (see Figure 7), which tallies with wages & salaries growth of around 5% yoy.

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Reports that many jobs are being created in low-paying industries and the unexplained increase of over a million in March-April in the number of those outside the labour force who do not currently want a job suggest that the US economy is still nowhere near full employment (see Figure 8). But this data series has been volatile – the number of those outside the labour force who do not currently want a job fell 744,000 in the previous six months. There is, at the margin, arguably less slack in the labour market than in December when the Fed last hiked rates.

 

Fed has seven weeks to get ready for round 7 – a potential July hike

The Fed will be hoping that the second half of round 6 goes its way so that it can finally deliver a second-hike in a decade at its July meeting. In particular, it will want to see a rebound in job creation and business investment in June (and ideally upward revisions to the May employment data), confirmation that GDP growth accelerated in Q2 and a continued up-tick in inflation (see Figure 9).

A July hike is still my core scenario, although another set of disappointing labour data for June may well see the Fed looking to its 21st September meeting as its next possible trigger point (see Sticking to forecasts: Fed summer hike, dollar hat-trick still on the cards, 25th May 2016).

A July hike would leave the Fed with another five rounds to hike its policy rate by another 25bps (to 0.75-1.00%), in line with the Fed members’ current average forecast of two hikes in 2016 (see Right Said Fed, 18 March 2016). The Fed will want to show markets that it will not be swayed by soft data punches or temporary market developments and is still in control, but without flooring markets. After all for the Fed to look good, it needs markets to look good. No one likes a one-sided fight.

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Olivier Desbarres

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.

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