Why the FOMC should raise rates, but won’t

The FOMC has a history of being reactive to inflationary pressure and we expect that this trend is unlikely to change. The Fed should raise rates in September, but won’t

Then and now
When the Fed began its most recent tightening cycle in December 2015, the stage appeared set for another four rate hikes in the coming 12 months. Several issues have since kept the US monetary policy stance unchanged, including strength in the US Dollar, some intermittent softness in the labour market and bouts of financial market volatility.
Even the December 2015 rate rise was delayed, after global financial market volatility and the strong US Dollar (stemming from Chinese equity and currency markets) stayed the Fed’s hand in September 2015.

We believe that competitive devaluations resulting from central bank policy activities, primarily QE, have driven currency volatility higher, which has in turn flowed into other asset markets. In recent months, though, market volatility has broadly moderated across most asset classes. FX remains the exception, with volatility remaining relatively elevated.

Emergency?
Emergency rate settings are not appropriate for an economy that is not in a critical condition. A prime example is that the US economy has added around 10 million jobs since the beginning of 2009. Although the most recent US jobs numbers were slightly below expectations (150k vs 180k expected), the 3-month average is solid, hovering around 230k per month.
This compares favourably with the situation ahead of the December 2015 Fed rate hike, when the average jobs growth was running at 280k per month, after accelerating from its September 2015 level of 200k per month on average.

The Fed has a history of being reactive, rather than proactive, as central bank policy needs to be. Accordingly, policymakers are likely to believe they have time before any concerns over the inflationary environment arise. Indeed, despite the general tone of Fedspeak in recent weeks turning decidedly more hawkish, FOMC voting member Brainard was notable for indicating that ‘the case to tighten policy pre-emptively is less compelling’. We expect that while there has been more hawkish rhetoric coming from the Fed Governors in recent weeks, it is likely to be a signalling mechanism that prepares the market for an inevitable December 2016 rate hike.
Nonetheless, if the Fed stays on hold but continues in its more hawkish rhetoric, as we expect, this will force the USD higher in Q4.

Inflation, inflation, inflation
Inflation expectations have stabilised not far below the Fed’s 2% target. However, rising wage pressure could begin to erode the ‘anchor’ of inflation.

The yield curve has flattened since the Fed’s first hike, in line with the 2004-2006 tightening cycle. As the Fed progresses through the tightening cycle, this trend will continue, providing support to the economy via stable (and depressed) long-end yields.

A flatter yield curve, as the Fed retains a large balance sheet while simultaneously increasing rates will be supportive of the US economy.

Real rates matter
Initial declines in the US Dollar followed the first hike last year. The US Dollar stabilised mid-year and has since trended higher within a broad range. Real rate differentials have widened in recent months, supporting the USD.

Importantly, the USD remains 5% below the peak level of January 2016, since its strength was one of the concerns for the Fed. Nonetheless, we expect that the Fed will overlook this and remain on hold, preferring to hike rates in December.

Market pricing
Market implied expectations for a rate hike at the September meeting hover slightly above 20%, down from a peak of 40% at the end of August. The market is pricing a 55% chance of a rate rise at the Fed’s December meeting. Clearly the risk is that if the Fed moves, the market is not positioned for such an occurrence, and could prompt a sharp USD rally.
Futures market net long positioning has rebounded in recent weeks as the uncertainty surrounding the EU Referendum roiled financial markets. The USD is trading around the middle of the range of the past year. We expect the USD to strengthen to the top of the range as the market begins to understand the Fed will need to raise rates more aggressively in 2017 to  contain rising inflationary pressures.

Martin Arnold – Director –FX & Macro Strategist – ETF Securities