Right said Fed
The Fed left its policy rate unchanged at 0.25-0.50%, as expected, and the 10 voting Federal Open Market Committee (FOMC) members and 7 non-voting members halved their median expectations of rate hikes in 2016 from four to two in their updated projections (see Figure 1). The Fed’s statement, projections and press conference had an undeniably cautious tone, with clear focus on global risks. The rally in US equities (to a new 2016-high) and 2-year rates (to a March low) and further depreciation in the dollar post meeting clearly indicate markets’ dovish interpretation (see Figure 2).
However, note that the revision to the weighted average of expected hikes was less pronounced, with the 17 members now expecting 65bp of hikes, down from 91bp in the 16th December “dot-chart” (see Figure 1). This 26bp revision – equivalent to one hike – was very much in line with the downward revisions in the prior three dot-charts in December, September and June 2015 of respectively 19bp, 27bp and 27bp (an average of 25bp – see Figure 3).
April meeting could see Fed starting to gently prep markets for June hike
The Fed’s tendency in recent years to over-estimate the need for rate hikes begs the question of whether it will have to further cut back on its expected and actual rate hikes this year. The Fed’s accompanying statement yesterday left much wiggle-room to leave rates on hold on 15th June should domestic and/or international conditions deteriorate. The market certainly thinks the Fed is still being overly-hawkish, pricing in only 11bp of hikes in June (or a 44% probability of a 25bp hike) and one full hike this year.
However, I think the Fed is ultimately trying to put itself in the best position to benefit from its preferred course of further modest rate hikes later this year while minimising the costs to the domestic economy and potential damage to the global economy and markets. I expect the Fed, at its 27th April policy meeting, to start tentatively preparing the ground for a hike on 15th June. Precedent suggests that the Fed would be reluctant to only deliver a single-hike this year and I would expect a second hike in H2 2016, in line with the 17 Fed members’ current median expectation of 50bp of hikes in 2016.
By the April meeting, the Fed will have March employment and ISM figures and February income, spending, trade and durable goods orders data, which should give it a fair idea of how real GDP fared in Q1 (the advance estimate is out the day after the Fed meeting – see Figure 4). The Fed will want to see a growth recovery in productivity, exports, and the manufacturing and services sectors after seasonally-adjusted GDP growth halved in Q4 2015 to 1.0% quarter-on-quarter annualised.
Importantly, the Fed will be able to assess its theory that the lagged dampening effect of low oil prices and a strong dollar may temporarily derail the four-month rise in core inflation to 2.3% yoy in February and in the core PCE price index to 1.7% yoy in January.
A rebound in GDP growth and extension of the inflationary trend – my core scenario – would make it easier for the Fed to refocus the market’s attention on the reasonably buoyant US labour market and income growth, robust credit growth and a housing market gathering steam, as highlighted in Figure 5 (see Fed – this is what it sounds like when doves cry, 8 March 2016).
The global picture has come into sharp focus for Fed
The global perspective, which can be broken down into two sub-components, clearly weighed heavily on the Fed’s thinking. First, economic growth in the economies of the US’ main trading partners, including China, the eurozone, Japan, UK and Brazil likely slowed in recent months based on the fall, in some cases quite sharp, in manufacturing and services PMI in February (global PMI data for March are due on 1 April). The fall in energy prices and global equities in January-February was certainly partly to blame and this takes us to the second component of the global picture – the impact of US monetary policy on global markets and economies going forward.
The dovish argument is that the Fed needs to keep rates on hold in order to keep the dollar under control and further spur global energy and equity prices and ultimately put a floor under global growth. The Fed itself seemingly doubts whether the recent rally in global energy prices and equity markets, after a very volatile few months, and dollar depreciation will extend or reverse.
Policy divergence… and the beginning of currency convergence
Doves also argue that the Fed should be weary of hiking rates, or even signalling possible hikes, when other major central banks are cutting and in the case of the Bank of Japan (BoJ) and European Central Bank (ECB) pushing ahead with quantitative easing (QE).
But the interest rate policy divergence since the Fed’s December hike, along with stronger global energy prices, has actually been associated with a degree of exchange rate convergence (see Figure 7). The net effect is that monetary conditions – the product of interest and exchange rates – have been reasonably stable in major economies. Specifically:
- The dollar nominal effective exchange rate (NEER) is down 3.2% since the 16th December Fed meeting.
- The yen NEER has appreciated nearly 10% since early December, despite the BoJ’s attempt to loosen monetary policy to sustain economic growth.
- The euro NEER has been remarkably stable in the past six years, despite the ECB taking policy rates into negative territory and expanding its QE program.
- The sterling NEER, which had appreciated throughout 2015, has given up all of its gains and more this year. Yields are also broadly back to early 2015 levels, implying that UK monetary conditions are currently not much different from 15 month ago.
- Commodity currencies, which had been depressed in both developed economies (Australia and Canada) and emerging economies (Brazil, Indonesia and Malaysia) have been edging stronger.
This “currency convergence” has admittedly not been uniform. Economic, political and geopolitical considerations are still hampering the Mexican Peso, Russian Rouble, South Africa rand Turkish Lira, while the Swiss Franc has unwound only half of its January 2015 revaluation (see Figure 8).
Moreover, this currency convergence is still in its infancy and if the Fed mishandles or mistimes its hiking process – however gradual – the dollar could recover while global energy and equity prices weaken, causing volatility in global markets and damaging other economies which would in turn impede the US economy’s recovery.
So the Fed will be hoping that data in coming weeks are strong enough for it to start preparing the markets for a June hike, without spooking equity or energy markets like it did in January, and that it can eventually deliver a “dovish hike” which will not interrupt the dollar’s downtrend. It’s a tough balancing act – if the Fed leaves it too late the market may not have time to digest a 180 degree turnabout from dovish to hawkish.
Olivier Desbarres is an independent G10 and emerging markets economist, rates and currency strategist with over 15 years experience with two of the world’s largest investment banks.