Federal Reserve – the Father Christmas of central banks
Thursday’s Fed policy meeting contained few major surprises, even if the divide amongst FOMC members has received much attention.
The bottom line is that 14 out of the 17 FOMC members, and at a minimum 7 of the 10 voting members, estimate that at least one 25bp rate hike before year-end would be appropriate.
Should the Fed hike in December – currently my core scenario – this almost unprecedented glacial pace of hikes would be in line with my January forecast of only 1-2 hikes in 2016.
The Fed’s accompanying statement and Yellen’s press conference were, if anything, reasonably upbeat. There were no direct allusions to the dollar, property, equity and bond markets or to global factors, with some justification (for now at least).
The Fed’s two main concerns are squarely centred on sub-target inflation and areas of weakness in the labour market.
It will thus be paying particular attention (and so should markets) to evidence of slack in the US labour market, with the unemployment rate becoming a less useful measure per se of labour market strength and potential wage/price pressures, in my view.
The Fed is clearly giving weight to the historically low neutral Fed funds rate. Even so FOMC members may have to further tone down their 2017-2018 estimates of the appropriate policy rate in relation to realistic (if still a little optimistic) economic forecasts.
Financial markets’ reaction has so far been mostly text-book: a jump in market pricing for a December hike to 16bp, a bull-flattening of the US yield curve, a slightly weaker dollar, a rally in EM and commodity currencies and stronger global equities.
But now comes the hard part. Volatility in Fed fund futures is likely to remain fluid in coming weeks, with financial markets increasingly sensitive to key US data, particularly on inflation and labour markets, speeches by FOMC members and presidential opinion polls.
Should Clinton win the US elections, US data improve and the Fed hike in December, I would expect the dollar to end the year stronger, EM currencies and global equities to struggle to hold onto post-US election gains and major currencies to underperform.
The more problematic scenario for the Fed (and its credibility) is one whereby Donald Trump wins and/or US economic activity slows down.
This would likely cause a sharp sell-off in global equities while safe-haven assets (e.g. gold, Swiss Franc) would outperform the dollar and in particular EM currencies. Moreover, these moves could struggle to reverse even if the Fed decided to pause in December.
Divisions and consensus
For all the noise and debate in the run-up to Thursday’s US Federal Reserve (Fed) policy meeting, the decision, accompanying statement, press conference and updated forecasts contained few surprises and markets’ reaction has so far been text-book.
The Fed kept its policy rate unchanged at 0.25-0.50%, in line with market pricing of only a few basis points of hikes and my forecast (see Fed – sense of déjà-vu, 7 September 2016). The voting pattern and updated “dot-chart” suggests that three broad camps have emerged.
- “Hawks”. Three voting FOMC members and all presidents of regional Federal Reserve Banks – Esther George (Kansas City), Loretta Mester (Cleveland) and Eric Rosengren (Boston) – dissented in favour of a 25bp hike in September. This was only the fifth time that three voters have dissented in 30 years but not totally out of tune given these members’ hawkish bias and hawkish comments from Mester and Rosengren in recent weeks.
- “Doves”. Three (undisclosed) members, based on the updated “dot-chart”, further softened their position and no longer think that a rate hike by end-year would be appropriate (see Figure 1). I would venture this was Lael Brainard and Daniel Tarullo, both voters, given their dovish comments in recent weeks. Janet Yellen is unlikely to have been the third dissenting voice, in my view; as Chairperson she would want to be on the “consensus” side of the fence come the December meeting.
- “Neutrals”. The other eleven voting and non-voting members think that a rate hike by end-year would be appropriate.
This apparent divide has received much attention but the updated “dot-chart” suggests that most of the 17 members scaled down their estimates of the appropriate policy rate for end-2016 by a full 25bp (see Figure 1). In that sense the three doves would have been following trend. The bottom line is that fourteen out of the seventeen voting and non-voting FOMC members estimate that at least one 25bp rate hike before year-end would be appropriate, with a consensus of ten members estimating that one hike would be appropriate. Even if we assume that the three “doves” who don’t believe a year-end hike would be appropriate are all voters, that would leave a majority of seven (out of ten) voting members who believe it would be.
It is important to note that the “dot-chart” represents FOMC members’ estimate of the appropriate policy rate, not their forecast of where policy rates will be at year-end. Put differently, it’s unlikely that any of the 17 FOMC members think the Fed should hike by more than 25bp in December but four of the FOMC members believe that it would have been appropriate for the Fed to have hiked at least twice this year.
Should the Fed again hike in December, as is currently my core scenario, this glacial pace of rate hikes would be almost unprecedented in recent times but in line with my January forecast of only one or two hikes in 2016 (see what if the Fed hikes, leaves rates on hold…or cuts, 29 January 2016). In the past 25 years, only once has the Fed delivered a one-off hike before staying on hold for a significant period of time. On 25 March 1997 the Fed hiked rates 25bp to 5.50% but then left rates unchanged for 17 months, before delivering three successive rate cuts in August-November 1998 at the height of the Russian crisis (see Figure 2).
A generally upbeat and confident Fed message
The Fed’s accompanying statement re-introduced a sentence which had been dropped at previous meetings: “near-term risks to the economic outlook appear roughly balanced”. While taken at face value this would seemingly imply that the odds of a hike are evenly balanced, markets have typically interpreted this language as setting the scene for a rate hike. Indeed Yellen said in her press conference that “the case for a [rate] increase has strengthened”.
The Fed’s accompanying statement and Yellen’s press conference remarks were, if anything, reasonably upbeat and confident. They noted a pick-up in economic activity, which is commensurate with the Altlanta Fed’s latest estimate of 2.9% GDP growth in Q3, solid job gains, a pick-up in participation rate and low unemployment rate, strong household spending growth and upbeat consumer sentiment.
The Fed once again highlighted soft business investment (a recurring leitmotiv in its communiqués), which was expected given weak manufacturing ISM and industrial output data for August. But the Fed did point out that drilling in the energy sector was stabilising and while it did not refer to the jump in durable goods orders in July, the rebound after two weak months will have likely tempered the Fed’s concerns.
As often the case what the Fed didn’t mention was almost as interesting. Neither the statement nor prepared press conference remarks made any direct allusion to the US dollar, US property market, US and global equity/bond markets or to concerns about global factors or events. Presumably these are, for now at least, not at the top of the Fed’s list of concerns, with some justification.
- The dollar nominal effective exchange rate (NEER), which is off 3.5% from the highs recorded in January, has been stable in a narrow 2.5% range since early May according to my estimates (see Figure 3). Importantly the dollar NEER is only 1% stronger than in the week running up to the 16th December 2015 rate hike. In any case the US is not a very open economy and therefore the dollar’s level and export competitiveness matter less to US policy-makers than they do to policy-makers in more open economies such as China or Korea. That is not to say that dollar and US export competitiveness do not matter to the Fed – after all a strong dollar is, amongst other factors, hampering the US manufacturing sector. But the Fed is more likely to go it alone than other central banks, as it did in December 2015.
- US housing prices continue to rise at a reasonably steady 5% per annum although Yellen in her question-and-answer session noted that affordability ratios had deteriorated and the Fed would continue to monitor the risk of “bubbles” in the property market.
- Global equity markets have been range-bound near record highs since mid-July and Yellen in her Q&A session suggested they were not over-valued relative to historical valuations.
- Global GDP growth stabilised around 2.8% yoy in Q2 2016 after nine consecutive quarters of slowdown (see Figure 4) and may have picked up in Q3 based on recent global PMI data, according to my estimates (see Global Central Bank Easing Nearing Important Inflexion Point, 16 September 2016). The UK has weathered the post-referendum storm reasonably well, albeit thanks in part to a 10% collapse in sterling (see UK economy post referendum – for richer, but mostly for poorer 25 August); and
- There have arguably been fewer market-destabilising events than in the summer, when the UK referendum, attempted coup in Turkey and terrorist attacks in France were dominating the headlines.
Twin concerns: inflation and labour market
The Fed’s two main concerns were squarely centred on sub-target inflation and areas of weakness in the labour market. While the Fed acknowledged the transitory impact of earlier declines in energy and import prices on US headline inflation, the Fed would clearly like to see an up-tick in inflation expectations and ultimately core PCE inflation which is currently running about half a percentage point below its 2% target.
The Fed was generally upbeat about the current and future state of the labour market but did note that measures of labour market slack had flattened out, not improved further (“which Yellen referred to as “running room” in her press conference). This is in line with my view that there is still slack in the US labour market, which has tamed nominal growth in aggregate weekly payrolls at only 3.5% yoy and in turn inflation, as per Figure 5 (see Fed – sense of déjà-vu, 7 September 2016).
Job creation growth was stable at around 1.9% yoy in August, which in itself is compatible with a Fed hike. But working hours fell, earnings growth slowed further and the pool of potentially available workers (those unemployed and not in the labour force but currently wanting a job) has now increased for three consecutive months. I think the Fed will be paying particular attention (and so should markets) to these labour market metrics. I would go as far as to argue that the unemployment rate in the US, and also the UK and Australia, has become a less useful measure of labour market strength and potential wage/price pressures as those employed are working fewer hours and the pool of potentially available labour is increasing (see Figure 6).
Lower neutral Fed funds rate starting to colour expectations of appropriate policy rate
The Fed has clearly taken on board the fact that the neutral Fed funds rate is quite low by historical standards – i.e. that interest rates need to be lower in order to generate the same kind of economic activity. Indeed, while Fed members kept their forecasts for GDP growth, inflation and unemployment for 2016-2018 broadly unchanged, they further cut back their expectations for the appropriate policy rate (see Figure 7).
To put it in context, back in December 2014, the 17 FOMC members’ weighted-average for the appropriate policy rate implied 100bp of rate hikes in 2015 and 140bp of hikes in 2016 – that’s nearly ten hikes over two years. So far the Fed has only delivered one of those hikes. By comparison, yesterday’s updated “dot-chart” has on average FOMC members estimating that another 65bp of hikes in 2017 and 80bp of hikes in 2018 would be appropriate – fewer than six hikes in aggregate.
I still think that the Fed’s estimates of the appropriate policy rate will prove too hawkish relative to realistic (if still a little optimistic) economic forecasts and that FOMC members will have to again tone down their estimates of the appropriate policy rate. But that’s a story for 2017. In any case, the days of the Fed thinking that a hike at every other meeting would be appropriate are behind us and current estimates for the Fed funds rate are getting closer to the realm of the possible, if not the likely.
Text-book market reaction: bull-flattening, weaker dollar, risk appetite rally
Financial markets’ reaction to the a Fed pause, coupled to a more clear-cut mandate for a December hike and downward revisions to the appropriate policy rate for the next two years has so far been mostly text-book:
- Market pricing for a December rate hike has jumped to about 16bp, or a 64% probability of a 25bp hike.
- The US yield curve has bull flattened, with 2-year rates down less than 1bp and 10-year rates down about 7bp (see Figure 8).
- The US dollar NEER has weakened about 0.6%, with a broad-based sell-off against major currencies and in particular commodity currencies (see Figure 10). The Japanese Yen is about 1% stronger versus the US dollar since the twin Bank of Japan (BoJ) and Fed meetings while the New Zealand dollar has weakened due to the RBNZ signalling a possible rate cut in November.
- The USD-CNY exchange rate is broadly unchanged and a GDP-weighted basket of EM currencies, excluding the Chinese Renminbi, has appreciated 0.9% against the dollar (see Figure 9). Asian currencies have typically underperformed.
- Global equity markets have rallied further to within touching distance of all-time highs.
Now for the hard part
So the Fed has set out a reasonably clear framework and markets have reacted in an orderly way. But now comes the hard part for the Fed and market participants. Volatility in Fed fund futures and market pricing for a December is likely to remain fluid in coming weeks, with financial markets increasingly sensitive to key US data, particularly on inflation and labour markets, speeches by FOMC members (14 are scheduled between now and 7th October), presidential opinion polls and major global data releases and events.
Scenario 1 – Clinton victory, decent data and a Fed December hike
Let’s first assume that i) Hilary Clinton wins the 8th November US presidential elections – a reasonable assumption given her albeit modest lead over Trump in the polls, ii) US labour and inflation data improve over the next three months and iii) there are no major exogenous shocks.
I would expect market pricing for a December hike to grind higher, to perhaps 20bp, even if that requires a little help from Fed members, and for the US dollar to appreciate, particularly against other majors including the euro and sterling. This would suit the ECB and BoE just fine, with both central banks seemingly intent on at least keeping their currencies near current levels. Note that the Sterling, Euro and Yen NEERs have all stabilised at similar levels if 2010 is used as the base (see Figure 11).
Currencies of EM economies particularly reliant on trade with the US, which include the Mexican Peso and Brazilian Real, would also likely benefit from a post-election bounce, given concerns that Trump would opt for a less open US economy. However, a looming Fed hike may ultimately cap any EM currency gains.
Assuming the Fed did hike rates at its 14th December meeting, I would expect a more broad based appreciation of the US dollar and for other major central banks to be more inclined to maintain their current stance on monetary policy. This would tie in with my core scenario of central bank policy rate cuts becoming increasingly less frequent and of the European Central Bank (ECB) and Bank of England (BoE) keeping the modalities of their current QE programs broadly unchanged for now (see Global Central Bank Easing Nearing Important Inflexion Point, 16 September 2016).
Net-net, in this scenario, the dollar NEER – which is now only down 1% year-to-date – could end the year stronger, as per my January forecast of a third consecutive year of albeit more modest dollar gains (see What to expect in 2016 – same, same but worse, 19 January 2016). EM currencies and global equities may struggle to hold onto post-US election gains while majors would underperform.
The Fed will certainly want to avoid a repeat of Q1 2016 when global equities and EM currencies sold off and the dollar appreciated. It will therefore reiterate its well-worn message that further rates will be data-dependent and in any case slow and gradual. Moreover, FOMC members could at the December meeting further revise down their estimates of the appropriate policy rate as they did at their December 2015 meeting (see Figure 7). Their success in communicating this message to a market sensitive to even the most benign Fed utterance will be a key determinant of whether (and how sharply) global appetite risk appetite corrects in the weeks following 14th December.
But ultimately the more problematic scenario is one whereby Donald Trump wins the US presidential elections and/or US economic activity slows down. This would likely cause a sharp sell-off in global equities, markets would significantly scale back their pricing for a December hike and safe-haven assets (e.g. gold, Swiss Franc, perhaps even the euro) would outperform the dollar and in particular the currencies of EM economies with strong trading links to the US.
Scenario 2 – Trump wins, weak markets and data, Fed pause
Even in this scenario, the Fed’s credibility would come into question if it didn’t hike rates in December and the dollar would weaken further. Moreover, EM currencies and global equities may not follow their typical pattern of appreciating following a Fed pause as the headwinds from particularly weak US and/or global data and the policy uncertainty associated with a Trump presidency could outweigh the benefits of US rates (and financing costs) remaining lower for longer.
Scenario 3 – Trump wins, weak markets and data, Fed still hikes
If the Fed decided to still hike, this would likely lead to a more pronounced collapse in global risk appetite similar to Q1 2016, due to the triple whammy of weak US/global data, Trump policy uncertainty and tighter US monetary policy. This would in turn likely force the Fed to delay any further rate hikes and incentivise other central banks to cut policy rates further – again a repeat of the pattern in the earlier part of 2016.
 I use a weighted average of FOMC members’ estimate of the appropriate rate, rather than the median estimate which the Fed refers to in its “dot-chart”, as I believe that it better reflects the distribution of members’ estimates.