There’s an old Wall Street saying, “Don’t bet against the Fed”. But in recent times, markets have been doing exactly that and winning.
Only last December, the Federal Reserve set out a clear path for tightening US monetary policy: four increases in interest rates this year, with the first likely coming in March. Markets didn’t believe the Fed at the time – and, it turns out, they were right. In the past few weeks, however, the central bank has made a concerted effort to move market sentiment in the direction of a summer rate rise. So far, markets seem to be falling into line: their estimate of the probability of a June rate rise has gone from below 5% before the Fed’s communications push to above 30% now, according to the Financial Times (20 May 2016). So what has changed markets’ views, and are they right to start betting with the Fed?
On paper, following the Fed makes sense. It has an unlimited quantity of money and can print more for whatever purpose it chooses. As a governing body, its focus tends to be on longer time horizons, rather than very short ones. It can also change its rules at any time to serve those broader horizons, as it did during the global financial crisis. It takes a brave soul to bet against an institution with the power to outlive other organisations, surprise markets and influence the values of all assets.
At the start of this year, however, the Fed’s omnipotence hit a global stumbling block. After a well-signalled rate rise last December, growing fears about the health of the US recovery, China’s economy and falling commodity prices prompted a sharp sell-off in global markets. This backdrop stayed the central bank’s hand in March, with members of its rate-setting committee debating the policy implications of global risks and Fed Chair Janet Yellen advocating a “cautious” approach. While this global focus is not unprecedented – the Fed cut interest rates in response to the Asian crisis in the 1990s, and coordinated similar moves with other central banks during the height of the financial crisis in 2008 – it is unusual.
“The most important contribution that US policy makers can make to the health of the world economy is to keep our own house in order”.
The US central bank has generally been more comfortable sticking to its mandate, which is focused specifically on domestic inflation and employment. In the words of Fed Board Member Stanley Fischer, “The most important contribution that US policy makers can make to the health of the world economy is to keep our own house in order”. Even after the 2013 ‘taper tantrum’, when the anticipated winding down of US quantitative easing roiled financial markets, the Fed’s view has been that global conditions should not generally trump domestic priorities.
Publication of the minutes from the Fed’s April meeting put its domestic focus firmly back on track. Ahead of publication, April’s no-change vote had given markets little reason to alter their view that US interest rates were unlikely to rise this year. We had taken a different stance, pencilling in two rate rises in 2016 on the grounds that the US economy remains reasonably strong and the Fed was likely to want to tighten policy in response. After publication of the minutes, and a number of Fed speakers coming out in support of higher interest rates, markets are now drawing a similar conclusion to our own.
So what do April’s minutes tell us? Against the backdrop of rising oil prices, a weaker US dollar and a strengthening domestic economy, the debate within the Fed is no longer over whether to raise interest rates following last December’s move, but when. For a rate rise as early as 15 June, when the Fed next meets, the economy must pass three tests: incoming data must add to signs of a rebound in activity; the labour market must continue to strengthen; and inflation must make further progress towards the central bank’s 2% target. Given that the US economy expanded by only 0.5% annualised in 2016 Q1, the bar to the first test is not high. The signs are also encouraging: Q2 GDP (gross domestic product) growth is currently tracking at 2.5% on the Atlanta Fed’s measure. The pace of job creation slowed in April, to 160,000 on the month, but remains consistent with a gradually tightening labour market. A similar reading for May (due to be published on 3 June) would therefore suffice. Inflation metrics are also picking up, with the Fed’s preferred ‘core’ personal consumption expenditures (PCE) measure registering 1.6% in the year to March, above its 2015 lows, and average hourly earnings rising at a healthy 2.5% annual pace in April.
But while a rate rise in June is possible, it is not a done deal. Three issues remain. First, there is the UK’s EU referendum on 23 June. Though Boston Fed President Eric Rosengren has said that “Votes by themselves shouldn’t be a reason for altering monetary policy”, any signs of market stress ahead of the referendum might argue for waiting until the central bank’s end-July meeting. Second, whilst the Fed hopes that it has put some distance between itself and global stumbling blocks, they have not necessarily disappeared. Some of those attending April’s meeting raised concerns about the risks from “unanticipated developments” associated with China’s management of its exchange rate. Finally, a number of April’s rate-setters flagged up “the importance of communicating clearly”, particularly when market views at the time diverged sharply from the Fed’s. Some of those concerns may have been allayed by the recent turnaround in market expectations, but waiting until July would give Janet Yellen the opportunity further to clarify the Fed’s thinking in her regular Congressional testimony, which takes place between the two meetings.
Our view remains that the Fed is likely to raise US interest rates twice this year. The chances of a quarter-point rise this summer have risen sharply following publication of the April minutes and subsequent Fed charm offensive. Even so, a summer move is not yet a foregone conclusion. As the Fed discovered at the start of the year, being the world’s most powerful central bank doesn’t guarantee that you can do exactly as you please. Financial markets could still have a say in the matter. Now place your bets
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