The first hike is the hardest…and so is the second and third
The consensus amongst portfolio managers, analysts and finance specialists recently surveyed is that the US Federal Reserve will hike its policy rate target range 25bp to 25-50bp from 0-25bp at its meeting on 16th December. This is broadly in line with market pricing, although there’s a residual risk of the Fed delivering a de facto policy rate hike of 12.5bp or 37.5bp.
Respondents are less confident about when the Bank of England (BoE) will start to hike rates and by how much the Fed and BoE will hike over the next 12 months. There is however an overwhelming view that the rate hiking cycles this time round will be very slow and gradual, particularly in the UK, with the Fed and BoE expected to hike rates by only 54bps and 30bps, respectively, between now and end-2016 (see Figure 1).
This scenario would be even less hawkish than the current market pricing for Fed hikes of 63bp over the next 12 months although it would still narrow the gap between the Fed and BoE policy rates to only 13bp (from 37.5bp currently). This seems broadly appropriate given US and UK economic fundamentals, as I argued in US Slow Sizzle, UK Slow Boil (3 December 2015).
Notably, one in five respondents expect the Fed over the next 12 months to either leave rates on hold after this week’s hike or actually reverse its decision next year by cutting rates.
If this survey is anything to go by, the expectation (or hope) that a Fed hike tomorrow will shore up the Fed’s credibility and reduce market uncertainty will be tested in coming months.
The survey consisted of four sets of questions and was open from 9th December (08:00) to 12th December (20:00). Respondents could chose to skip one or more questions. 51 respondents from finance and industry filled in the survey. Thank you to all who responded to this survey.
Consensus that Fed will opt for “dovish hike” on 16th December…but still some doubts
Question 1: Do you expect the US Federal Reserve to hike its policy rate 25bp at its meeting on 16th December?
80% of the 51 respondents surveyed forecast that the Federal Reserve (Fed) will hike its policy rate this week (see Figure 3) – the first hike since 29th June 2006 when the Fed hiked rates to a now-almost-inconceivable 5.25% (see Figure 4). This is broadly in line with the 90% probability of a 25bp rate hike priced in by the markets.
Market participants seemingly expect a dovish tone to the accompanying statement and a downward revision to FOMC members’ “dot” rate forecasts, to reflect muted inflationary pressures, the weak US manufacturing sector and tepid global growth – what is being coined a “dovish hike” or “hike-light”. However, it is still unclear whether the market has fully factored in the other possible (albeit less likely) outcomes at Wednesday’s meeting, which include the Fed setting a point target of 25bp (a de facto 12.5bp hike) or a point target of 50bp (a de facto 37.5bp hike).
I do not expect a big surprise this week, specifically forecasting the Fed to hike its policy rate to a new target range of 25-50bp from the current 0-25bp range. This would be line with the Fed’s September dot chart in which the median forecast for the target level of the Federal Funds Rate stood at 37.5bp for end-2015.
The hurdle for the Fed to hike its policy rate going into December was already high; the latest US macro data, in particular decent November non-farm payrolls and upwardly revised September and October NFPs, and broadly stable US dollar since early November have all but removed that hurdle. It would likely take a monumental event in the next 24 hours – way beyond the past fortnight’s significant fall in global oil prices and equity markets – for Fed Chairperson Yellen to backtrack on her quasi-promise to hike rates by end-year. Keeping rates on hold would be a serious loss of face and credibility.
Range of mostly dovish views as to how much Fed hike will hike by end-2016
Question 3: By how many basis points do you expect the US Federal Reserve to hike its policy rate over the next 12 months?
Figure 5 shows that respondents are less confident about how much the Fed will hike over the next 12 months, although the over-riding impression is that this hiking cycle will be very slow and gradual. A third of respondents expect the Fed to hike 50bp but half think the Fed will either hike only 25bp or a more meaningful 75bp. Not a single respondent expects more than 125bp of hikes.
The weighted average of responses is 54bp, or just slightly more than two full hikes. Assuming the Fed takes its policy rate to 25-50bp (a de facto 25bp hike) on Wednesday, this would leave only 29bp of hikes for the full-year 2016, or put differently one full hike and a 16% probability of a second hike. It would be a stretch to describe this as an actual hiking cycle given that the Fed is scheduled to hold eight policy meetings in 2016 (see Figure 9). By comparison the market is pricing in about 63bp of hikes (see Figure 2).
Notably, eight respondents expect the Fed over the next 12 months to leave rates on hold after this week’s hike (“one and done”) and two respondents expect the Fed to actually reverse its decision next year by cutting its policy rate. The first scenario, for which there is little precedent at the Fed (or other major central banks for that matter) would not do much for the Fed’s credibility. The second scenario would be a credibility-crushing and embarrassing u-turn.
BoE expected to delay start of hiking cycle
Question 2: When do you expect the Bank of England to start hiking its policy rate?
Survey participants expect a hawkish-light Fed but an even more conservative diet-and-caffeine free Bank of England (BoE). While Figure 6 shows a reasonably wide range of responses, only 20% of respondents expect the BoE to hike rates in the next three months, with 60% expecting the BoE to pull the trigger in H2 2016 at the earliest (see Figure 7).
Uncertainty about timing of BoE hike but tightening cycle expected to be very benign
Question 4: By how many basis points do you expect the Bank of England to hike its policy rate over the next 12 months?
Unsurprisingly, given the expected late starting date for the BoE rate hiking cycle, respondents expect very little policy tightening in 2016. Specifically, respondents’ weighted average of rate hikes is only 30bp – i.e. one full hike and a 20% probability of a second 25bp hike (see Figure 8). This is only marginally more hawkish than the current market pricing of 24bp of hikes.
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.