The Federal Reserve kept interest rates on hold at its latest policy meeting Wednesday, ensuring interest rates will remain near zero for at least another two months. Fed officials closed ranks voting 10-0 to keep interest rates unchanged, In what was a widely expected move by the broader market. With only three policy meetings remaining in which to make good on Janet Yellen’s signal to raise benchmark interest rates by the end of the year, the Fed faces an increasingly difficult decision on whether to move in September, or delay any change in policy to next year. Given the ongoing volatility in global markets, their decision will not be an easy one.
At the heart of the Fed’s dilemma is an improving employment picture, which goes some way to fulfilling the Fed’s mandate of achieving maximum employment, and has been cited on numerous occasions by Fed officials as the reason to start normalizing interest rate policy. Unemployment has fallen from nearly 10% at the height of the financial crisis in 2009, to 5.3% currently, and official month to month data continues to show signs of improvement. The advance reading of initial unemployment claims this week was 255,000, a drop of 26,000 from the previous week. The latest data marks the lowest level of weekly initial unemployment claims in over 41 years. Consensus expectations had been calling for initial claims numbers closer to 278,000. All else being equal, the employment figures would be enough for the Fed to start hiking rates at their September meeting, but everything else is not equal. There are several financial storms raging all across the globe which the Fed will need to ensure they do not exacerbate.
Commodity Price Rout Raises Deflation Concerns
The global rout in commodity markets is of particular concern, and plunging prices could see a return of the deflationary conditions which plagued the US CPI data for the first quarter of this year. Any increased probability of deflation would put
the other half of the Fed’s dual mandate of ensuring price stability in jeopardy, and any uncertainty regarding this half of the equation is likely to instill an increased degree of caution amongst Fed officials when it comes to raising rates.
The potential impact of the recent commodity crash was outlined in a recent report by Deutsche Bank analysts, who found that the current -29% drop in the benchmark CRB commodities index is likely to severely impact headline inflation in the coming months. DB forecasts headline CPI inflation to fall from 01.% currently to -0.9% in the next few months. If they are correct, this would be the biggest year over year drop in inflation since September 2009, and one of the lowest inflation levels on record.
Timing of Fed Hike Continues to be Pushed Out
Market reaction to the Fed’s latest minutes was upbeat, with benchmark US equity indices all posting modest gains. Treasuries rallied with yields falling on the back of increasing signs that a growing segment of investors are starting to discount the probability of any rate rise this year. A broader recognition of this new environment is likely to cement itself in the coming days after wall street analysts continue to digest the ongoing rout in commodity markets, and downward GDP revisions begin to come through. If the Fed fails to hike in September it is very unlikely that it would test the resolve of global markets by hiking in the midst of peak holiday season in December, a period when world wide liquidity is wafer thin and trading desks staffed by fresh faced grads out of college. The reality looks increasingly, as we have been saying all year, that there will be no hike this year – the earliest and most likely timescale for any rike would be mid 2016 at best. By then there should be some clarity on any potential impact from the fallout in China, and if the deflationary trends which were so prevalent at the start of the year reappear. Should deflationary conditions return, there will be virtually no room for the Fed to progress with its normalisation policy – and given the heightened volatility across global markets, it seems increasingly likely that a return to increased QE is likely to occur long before any rise in rates.
The U.S. economy got a little economic boost today with a stronger-than-expected CPI reading for February, and a strong Purchasing Manager’s Index (PMI) that continued to project GDP growth.
Headline CPI and core CPI both came in 0.2% higher than January, as slight price hikes at the pump for refined products balanced out a general breather in the declines in some of the base commodities. The headline numbers had been tracking negative for the past three months, which everyone was pretty much ok with chalking up to crude oil. Just so long as GDP growth came in respectably, there wasn’t any reason to panic.
But core CPI (ex-food and energy costs) was already lagging behind Fed goals of around 2%, and already in the midst of sending deflationary ripples up the global goods chain, into…well, just about everything.
Muddled Waters for First Rate Hike
It’s created a tense chess match between investors and the Fed the past few weeks. It started just after the stellar (as in +295,000) February jobs report last month, when the consensus started to form that the Fed would have to act sooner rather than later in creating a interest rate normalization cycle.
The key first step of that cycle is getting us off the floor of zero percent rates – a stance that doesn’t befit a growing economy and presents what Yellen herself has called an “asymmetrical risk”.
U.S. Definitely Growing…But How Much?
Just as soon as we seemed to have some headway into a summer rate increase, nearly every economic indicator in the U.S. started been printing well below analyst estimates. In fact, the depth of our misses has hit a multi-year high, according to Bloomberg analysis:
In light of this reversal, both investors and the Fed have had to take stock of things. First quarter GDP estimates continue to be ratcheted down – from the 2.5% – 3.0% level I highlighted last month (a number that was freshly lowered at the time) to an average Q1 GDP estimate of about 1.5% today.
Cranky Markets are Volatile Markets
It’s why we’ve seen a spike in volatility around every asset class – fixed income, forex, commodities, and equities have all been bumping around trying to align their compass to the next clear trend line. Would the Fed remove “patient” in the March FOMC meeting? Was September the new June (for the first rate hike)? Was 2015 off the table entirely?
Answering these questions is challenging enough in isolation, but it’s been exacerbated by the stunning rise the the USD index, which alters true price action in commodities and long bonds. The surging U.S. dollar is a de facto rate hike. It lowers the cost of imports dramatically (a deflationary force), and it makes our exports more expensive overseas.
And while the realities of pricier U.S. exports certainly hurt some companies more than others, the simple fact is that close to 50% of the total revenues of the S&P 500 member companies is derived in a currency other than the U.S. dollar.
2014, Part Deux?
It’s quite astonishing how much the first quarter of this year is looking like the first quarter of last year. Tick by tick, indicator by indicator, we seem to be replicating that market environment.
This time last year we were watching interest rates hit new lows, but convinced the party had to end any moment – inflation was coming, and we needed to position ourselves away from fixed income and into equities, gold, and other commodities. Fixed income turned out to deliver stronger returns than even equities did.
GDP looked to be on track for a good start to the year, but then a bout of really bad whether caused us to actually contract as an economy in Q1. Most of the top analysts said “don’t worry, we’ll be strong in the back half of the year”, and sure enough we were. The U.S. turned in over 4.5% growth in the next two quarters.
Looking around today, it’s much the same setup – so far. The key differences between then and now are this:
1) the unemployment rate is lower than last year; we have clearly moved close enough to full unemployment in the Fed’s eyes that it’s no longer an impediment to a rate increase. That box is checked off.
2) the USD is much stronger (10-20% or more) against every major global currency. As I’ve discussed, this move alone is the equivalent of a 25-50 bps rate hike.
In fact, if the dollar hadn’t been zooming so hard the past six months, there’s a chance the Fed would’ve put a token 25bp hike out there last week. Instead, Yellen reminded us that the Fed isn’t there to make things easy for investors, saying the Fed “can’t provide and shouldn’t provide” certainly to markets when it comes to the timing of rate hikes.
We don’t seem to be in any danger of that.