Fed: This is what it sounds like when doves cry

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Too many dark spots for a March hike…

The Federal Reserve is unlikely to hike its policy rate from 0.25-0.50% at its 16th March 2016 meeting and may have little choice but to revise down its expectations to around 3 hikes for 2016 in its accompanying projections. In the 16th December “dot-chart”, the median expectation among the 10 voting Federal Open Market Committee (FOMC) members and 7 non-voting members was for four hikes this year (the weighted average was for a slightly less hawkish 91bp of hikes).

This would imply a hike every other meeting, most likely faster than the “gradual” approach Chairperson Yellen and other members have systematically referred to and too hawkish relative to the latest domestic and global macro data and market prices summarized in Figure 1. Specifically, US GDP growth halved in Q4, with negative contributions from domestic investment, an inventory drawdown and net exports. Growth in the service sector has also slowed while a strong US dollar, weak global demand and capital spending cuts in the oil sector are weighing on the manufacturing sector (12% of the U.S. economy). Oil prices remain depressed and the dollar is still strong by historical standards.

Globally, real GDP growth slowed to around 2.8% yoy in Q4 2015 and likely slowed further in Q1 2016, dragged lower by contracting trade, particularly from China with exports and imports collapsing 25% yoy and 14% yoy, respectively, in February. Finally, while US and global equities have rallied in recent weeks, they are still down since the December meeting.

The Fed and markets are thus likely to remain sensitive to particularly weak numbers, with US inflation and retail sales numbers for January and Chinese inflation, investment, industrial output and retail sales data due for release between now and 16th March (see Figure 2).

…But Fed could start preparing market for a June hike

However, the nuanced picture painted in Figure 1 could encourage the Fed next week to issue a statement which prepares the ground for mid-year hike, by referring to the following key trends:

  1. The US labour market remains robust, with the unemployment rate below 5% for the second consecutive month and participation rate ticking up to a 12-month high in February.
  2. Growth in earnings, wages and income has remained robust, as has credit growth, which should support retail sales and personal consumption.
  3. House prices have gathered steam, rising 5.2% yoy in Q4 2015.
  4. The dollar TWI is down 3.5% from its mid-January peak and trading below mid-December levels (see Figure 3). It’s noteworthy that the dollar had appreciated in the run-up to the December hike.
  5. Crude oil prices are up about 42% from their multi-year low recorded on 20 January.
  6. Consumer and producer price inflation, as well as inflation expectations, have steadily risen.
  7. US and global equities are up about 8.4 and 8.8%, respectively, from their year-to-date lows recorded on 11 February.

Olivier Desbarres - Fed Hike 1

 

Olivier Desbarres - Fed Hike 1a

Olivier Desbarres - Fed Hike 2

The possibility of a not-so-dovish Fed statement is seemingly not fully priced in, with the Fed funds market still only pricing 2-3bp of hikes next week (or a 10% probability of a 25bp hike) and 28bp of hikes for the full-year (one hike and a 12% probability of another full hike).

Olivier Desbarres - Fed Hike 34jpg

European Central Bank monetary easing at its 10th March policy meeting could, somewhat counter-intuitively, ease the Fed’s job of presenting a more bullish/hawkish outlook. A 10bp cut in the deposit rate to -0.4% and step up in the ECB’s QE program would, even if marginally, further support growth in the eurozone – which absorbs about 17% of US merchandise exports.

Furthermore, to the extent that the market is already pricing further ECB easing, EUR/USD is likely to remain near its one-year level of around 1.10. In any case the Fed would likely take in its stride modest euro depreciation in the wake of the meeting. The euro TWI, despite its recent weakening, is still nearly 2% stronger than three months ago and currency competitiveness is key for the eurozone’ open economies (see Figure 4).

Looking further ahead

My core scenario remains for two 25bp hikes this year, which would help put a floor under the US dollar (see What if the Fed hikes, leaves rates on hold…or cuts, 29 January 2016). But FOMC members will likely want to see a recovery – or at least stability – in the following variables in order to deliver the first hike of 2016 at its 15th June policy meeting:

  1. US GDP growth and its drivers, particularly productivity and the manufacturing sector (preliminary Q1 GDP data are due on 28 April);
  2. Real wage and personal consumption growth;
  3. The economies of its main trading partners, including China, the eurozone, Japan, UK and Brazil where growth has slowed in recent months based on the fall, in some cases quite sharp, in manufacturing and services PMI in February.

Alongside these necessary, if not sufficient conditions, the Fed may want to witness an ongoing, even if slow, rally in global energy prices and US and global equity markets. While seemingly not overly concerned by the dollar’s strength, the Fed will take greater comfort from a stable dollar, or at the very least only moderate appreciation from current levels.

US elections and UK referendum unlikely to derail very modest Fed rate hikes

The Fed has historically remained apolitical and shown a willingness to look through discrete global events and there is little to suggest this time will be different. The Fed hiked rates in the run-up to both the 7th November 2000 and 2nd November 2004 presidential elections and there is no obvious reason why this years’ elections would derail a mid-year hike.

Similarly, the Fed is unlikely to be swayed by the UK referendum on EU membership scheduled eight days later on 23rd June. While the UK is the second largest EU economy after Germany and a British vote to leave the EU could at least near-term weaken the UK economy and currency, undermine the EU and create volatility in global equity markets, the UK ultimately accounts for less than 4% of US exports and sterling for only 3.3% of the US TWI (see UK referendum on EU membership – Darkness before Dawn, 26 February 2016).

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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