On Monday interest rate futures markets were pricing a 35% chance of a rate hike from the Federal Open Market Committee (FOMC) at its March meeting. That seemed to us to be too low. Today, markets put that probability at 80%. That seems to us to be too high. If you’re now thinking I’m never happy – you’re probably right.
Minutes of the January FOMC meeting suggested the Committee saw a third rate hike coming “fairly soon”.
Since then the data has served to increase the chances of a hike in March; jobs growth continued at a solid clip at the start of the year (though wage growth was on the soft side), CPI inflation came in higher than expected (both headline and core), and we’ve seen generally solid activity data. That said, wage growth and the annual rate of change in the personal consumption expenditure deflator remain more subdued.
The increased chance of a March move has been supported by comments from various Fed officials in recent days. The most meaningful of those so far has been comments from William Dudley, head of the New York Federal Reserve. Dudley is reputedly at the ‘dovish’ end of the FOMC spectrum: he believes the case for further rate increases has become “a lot more compelling”.
There is still a lot of meaningful data before the US Federal Reserve (the Fed) meets in two weeks. We get another set of labour market data (employment, unemployment and wages), and February CPI data will be released the day of the FOMC statement. Wage data remains key to the FOMC’s view of sustained increases in core inflation.
There is also more Fed-speak this week with speeches from both the FOMC Chair (Yellen) and Deputy Chair (Fischer) in the next few days. This will be the last chance for the Fed to lay the groundwork for a rate hike in March. That said, they can’t be uncomfortable with the current probability of a move in March sitting at over 50%. There’s no big drama either way.
President Trump’s speech to the joint session of Congress yesterday didn’t provide any new clarity on his fiscal policy intentions. It’s simply too early in the new term for any detail, but markets have taken the rhetoric positively. The big risk here of course is the President (and markets) don’t get everything they want once we do get the detail.
Our view of a greater chance of a March hike than the market was expecting (at least earlier in the week!!) centred on the fact that the risks for the FOMC are transitioning. There are two primary risks for a central bank in the rate rising phase of the interest rate cycle. The first is hiking interest rates too early and too aggressively risks derailing the nascent economic recovery. The second risk is leaving interest rates too low for too long, falling behind the curve and needing to play catch-up with more aggressive interest rate increases.
Right now we are in the transition phase between those two risks. Furthermore, my take on Janet Yellen’s recent Congressional testimony is that she is increasingly comfortable that the FOMC will meet its dual mandate. So while we are happy with the FOMC’s call of three hikes this year, we think the balance of risks is that if it’s not three hikes, it’s more likely to be four than two.
We put the chance of a March hike at 60%, but if they do hike in two weeks’ time, markets will start to contemplate the possibility of four hikes this year. While that’s not the best news for bond markets, the good news for equity markets is that the FOMC is hiking because the data supports it and that the economy is now more resilient to interest rate increases.
If market psychology continues in this direction, it is likely to re-ignite the strengthening US dollar / higher global bond yields / weakening peripheral markets dynamic that we last saw in the final weeks of 2016. From an NZ dollar perspective, the rally experienced in January would then continue to unwind with a weaker Kiwi dollar and scope for underperformance from domestic equities.
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