Is The Fed Back In Play?
July FOMC Minutes Suggest Possibly
On Wednesday, the Fed released the minutes of the July 27 meeting, where policy was left unchanged. The minutes showed the FOMC’s discussion was more evenly split between those advocating steady rates and those seeking a rate hike sooner rather than later. More recently, comments from Fed speakers in this past week suggest a growing consensus for a rate increase.
In particular, NY Fed Pres. Dudley, one of the three key FOMC members that should be listened to more closely, indicated markets are underestimating the possibility of a near-term Fed hike.
Markets initially treated the Fed minutes as benignly dovish, and discounted the likelihood of a rate hike at the Sept. 21 meeting; risk assets (Stocks and commodities) rallied. However, by the end of this week, market-based indicators (Fed Fund futures; bond yields) registered a slight uptick in the chances of a rate move in September. Looking at the charts below, the prevailing market sentiment remains focused on a Dec. rate hike (41% probability-top chart below) over September (24% probability-bottom chart below).
But I think investors should be aware that the Sept. meeting will be a live one, meaning a rate hike is not out of the question. My own expectation is that they’ll remain on the side of caution and won’t move in Sept., but we’ll have to see.
Implied probabilities of a FED rate hike at December 14 FOMC Meeting
Implied probabilities of a Fed rate hike at September 21 FOMC Meeting
Source: Bloomberg; DriveWealth
The economic case for higher rates has strengthened since the July meeting. Focusing on the two elements of the Fed’s dual mandate, a strong jobs gain in July came on top of a sharp rebound in June employment. Interim labor data suggest August payrolls should be in line with the average for the year at around +200K, meaning the labor market is quite solid. On the inflation front, price pressures are non-existent and are the main reason the Fed should be in no hurry to hike. Then there are the Fed’s global concerns, which the minutes indicated have dissipated somewhat.
Yellen Set to Shape Expectations
We will (hopefully) get a better picture of the Fed’s thinking when Chair Janet Yellen speaks at the Jackson Hole Conference next Friday. While I doubt she will strongly indicate a rate hike is imminent (no action in September), she will likely use the speech to shape expectations going into 2017 and beyond (the ‘medium term’). On that subject, there is the potential to shake-up highly complacent market expectations beyond this year.
Markets are currently pricing in less than a 50% chance of a ¼% rate hike between now and the end of 2017, and only around a 25% likelihood of two rate hikes between now and the end of 2017. Given the pace of job creation over the last few months and a headline unemployment rate sub-5%, prospects of full employment and the potential for wage-push inflation pressures are likely to figure into Yellen’s thinking. That holds open the potential for Yellen to introduce a more profound shift in market thinking, which could trigger significant near-term risks.
Source: Bloomberg; DriveWealth
Watch the Greenback
If Yellen does seek to manage medium-term market expectations higher, investors would be well-advised to keep an eye on the strength of the US dollar. The greenback has fallen recently on the back of reduced interest rate expectations and is currently sitting on key trendline support (white line on chart above). The US dollar index is below the daily cloud (blue zone), keeping the focus lower on that view, but it has effectively closed the gap from the Brexit reaction (red horizontal line). Abrupt market reversals frequently follow when a major price gap is closed.
Higher rate hike expectations could see the USD recover further, which would weigh on commodities in particular, and stock market sentiment more generally. The environment for a sustained dollar bounce is especially ripe in light of the likelihood that other major central banks may still opt for further easing, putting the dollar in sharp contrast to other major currencies. Lastly, emerging market (EM) currencies and stock markets have performed extremely well during the recent commodity rebound and dollar decline, so I would urge EM investors to be especially alert.
Looking beyond Yellen’s speech next week, the August US payroll report on Friday, Sept. 2 is likely to take on added significance, as it will be a key data point for FOMC members favoring an imminent rate hike. Continued strong job gains in August may be sufficient to alter the balance and move the Fed to hike sooner than markets are expecting.
On the flip side, if Yellen continues to suggest uncertainty on the timing and pace of interest rate normalization, markets will interpret it as another ‘lower for longer’ outcome, and risk assets should extend recent gains. Stay tuned!
Image source: Image source: Board of Governors of the Federal Reserve
© 2016 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.