Special report: US interest rates
City Index September 8, 2015 9:44 PM
<p>Will the Fed hold or is it finally time for rates to rise? Why Aren’t Traders Banking on a Fed Rate Rise? Back in January […]</p>
Will the Fed hold or is it finally time for rates to rise?
Why Aren’t Traders Banking on a Fed Rate Rise?
Back in January 2014, everyone “knew” that interest rates would rise as the Federal Reserve tapered its Quantitative Easing program, with some analysts even anticipating that the central bank would raise the federal funds rate by the end of the year. As we now know, this optimism was misplaced. The US economy was thrown off track by a weather-induced slowdown in Q1, and while the Federal Reserve did eventually wind down QE, expectations for a rate hike were pushed out to 2015. As a result, the benchmark 10-year bond fell consistently from 3% to 2% by the start of 2015.
In an eerie parallel, traders entered this year with nearly identical hawkish expectations: the most optimistic analysts thought that the Fed could raise interest rates as soon as March, the consensus anticipated a June rate hike, and even the most dovish of traders admitted that a rate increase by September was likely. Once again, forces have conspired to prevent an interest rate increase in H1 and as of writing in August, there is still a risk that the US central bank will may hold off until December or even 2016 before raising interest rates.
In this special report, we explore whether the US economy is strong enough to support a rate hike, what the market is pricing in, what factors could keep the Fed on hold, and most importantly, the potential implications of a delayed rate hike on the US dollar and global asset prices.
Can the US Economy Support an Interest Rate Increase?
In theory, the Federal Reserve’s dual mandate is simple: to promote maximum employment and stable prices. At first glance, the central bank is knocking the ball out of the park on the first objective, with the unemployment rate dipping to just 5.3% as of the July employment report. This represents the lowest unemployment reading since April 2008, when the economy was firing on all cylinders, and is near many Federal Reserve officials’ estimates of “full employment” (accounting for unavoidable “frictional” unemployment, when an in-demand employee temporary transitions between jobs).
However, looking beyond the unemployment rate alone reveals a more nuanced picture. One of the biggest factors driving the unemployment rate lower has been the precipitous decline in the labor force participation rate, which measures the percentage of Americans actually working or looking for work. By definition, the unemployment falls as so-called discouraged workers leave the labor force, but it doesn’t necessarily indicate that the labor market is improving. As of writing in August, the labor force participation rate has fallen to its lowest level since 1977 at just 62.6%, driven both by discouraged workers and retiring baby boomers.
While the Federal Reserve is putting in a mixed performance on the employment half of its dual mandate, the central bank continues to fall short on the “stable prices” half (interpreted as 2% growth in the Core Personal Consumption Expenditures price index). As of the May Bureau of Economic Analysis (BEA) report, the Core PCE inflation rate was just 1.29% year-over-year. More worrying, the trend in the price index remains clearly lower over the last three years since the Core PCE rate briefly hit 2% back in early 2012.
Of course, Federal Reserve officials have recently noted that the inflation rate does not need to be at the 2% target to start raising rates – after all, monetary policy will still remain accommodative even with the Fed Funds rate at 1 or 2% – but the consistent lack of upward pressure in Core PCE, the more widely-followed Consumer Price Index (CPI), and average hourly earnings suggests that the central bank may hold off for longer than many analysts expect.
What is the Market Pricing In?
Speaking of expectations, there is a big divergence between expectations for “liftoff” among the Fed itself, economists, and traders. As we go to press, the median FOMC official still anticipates two rate hikes in 2015, according to the so-called “dot chart” from June’s Summary of Economic Projections. Economists are nearly as bullish, with a recent Wall Street Journal survey showing 82% of economists anticipate a rate increase in September, with another 13% expecting a hike in December.
However, when we look at traders who are actually putting money on the line, the outlook is starkly different. According to CME’s FedWatch tool, Fed Fund futures traders think there is just a 36% probability of a hike at the Fed’s September meeting and only a 67% chance of a rate hike this year. These implied probabilities are notoriously volatile, so they should be taken with a big grain of salt, but it’s clear that traders are substantially less optimistic about the prospects for the US economy than most economists.
Shown another way, Morgan Stanley’s “Number of Months to 1st Rate Hike” indicator has not been keeping pace with the passage of time and remains near 5.5 months as of writing, suggesting that the first rate hike will not occur until around January 2016.
Given the stark divergence between the opinions of traders and economists, US economic data will be closely scrutinized in the coming months, with traders likely to overreact to the day-to-day gyrations of US economic data. If the economic figures remain mixed heading into the Fed’s meeting on September 17th, it could be one of the year’s most volatile days regardless of what the central bank decides.
What Other Factors Could Keep the Fed on Hold?
Beyond the Fed’s ambiguous performance on its dual mandate, there are other major concerns that could prompt the Fed to keep its powder dry in September. One of the biggest worries is that the US economy faces long-term structural issues that could impede its long-term sustainable growth rate. The ratings agency Fitch recently touched on these issues, citing aging demographics, a zeitgeist of saving in the wake of the Great Financial Crisis, a strong dollar, and declining productivity growth as factors that make the economy “unlikely to sustain 3% annual growth through 2016-2017.”
The International Monetary Fund (IMF) recently echoed many of these concerns, warning the Federal Reserve should hold off until 2016 before raising interest rates. The global financial organization expressed its concern that a rate hike in 2015 could exacerbate the recent strength of the “overvalued” US dollar, spark a big rise in long-term interest rates and/or lead to a drop in equity markets. Further afield, the IMF also noted that the ongoing crises in Greece and Ukraine (and now China) represent “unpredictable wild card” risks to the US economy.
What Does This Mean for Markets?
To a certain extent, recent strength in the US dollar can be seen as already having priced in the expectation of a rate hike sometime this year. With that being said, however, this expectation has certainly not been the primary driver of the bullish trend for the US dollar over the past year. Therefore, if the Fed fails to raise interest rates this year, it may be a hurdle that serves to stagnate the dollar, but the impact is likely to be limited with respect to the EUR/USD currency pair.
For EUR/USD, US dollar strength has certainly played a major role in forming the sharp bearish trend that has been firmly in place since the 1.4000-area high in May of last year. Weakening prospects for the euro, however, have also played at least an equally important role in this EUR/USD downtrend. This euro weakness is likely to continue further in light of the fundamentals threatening the shared currency.
From a longer-term perspective, as noted, EUR/USD has been entrenched in an unmistakable bearish trend for over a year. During most of this downtrend, the currency pair has managed to stay well below its 200-day moving average, dropping to progressively lower depths. A long-term trough just below 1.0500 support was hit in mid-March, establishing a 12-year low of 1.0461 before the currency pair bounced. This 1.0500 support level was then re-approached in mid-April, forming a rough double bottom pattern, before a rebound lifted EUR/USD once again towards 1.1400-area resistance. After that rise, a large, prolonged trading range ensued, with borders generally between 1.1400 to the upside and 1.0800 to the downside, that is still valid at the time of this writing.
That 1.1400 resistance region should continue to serve as the proverbial ‘line in the sand’ that separates a down-trending EUR/USD from a potentially recovering EUR/USD. If the currency pair continues to trade under this level as expected, preserving the longstanding bearish trend, a break below range support at 1.0800 should clear the way for a return back down to 1.0500. Any sustained breakdown below 1.0500 could pressure the embattled currency pair towards 1.0200 support and then potentially down to parity.
As with EUR/USD, US dollar strength in the past year has been readily apparent on the USD/JPY chart. USD/JPY has been well-entrenched within a multi-year uptrend that has lifted it far above its lows below 80.00 in 2012. This trend geared into acceleration mode in July of last year, eventually pushing the exchange rate up to a 13-year high that approached the 126.00 resistance target in early June of this year.
In the event that the Fed declines to raise rates in 2015, the impact on the USD/JPY could be somewhat more pronounced than for EUR/USD. In the absence of a rate hike, further US dollar strength may well be threatened, and any continuing turmoil in the global markets, most notably China, could simultaneously trigger the ‘safe haven’ appeal of the Japanese yen. With these two compounding forces potentially in play, USD/JPY could find itself declining in an extensive pullback or correction.
We saw a similar scenario begin to play out in early July when USD/JPY dropped below key support around the 122.00 level as well as a further break below a major uptrend support line that has defined the accelerated uptrend for the past year. Primarily due to the safe haven phenomenon strengthening the Japanese yen in response to China’s troubled equity markets, the USD/JPY made a rapid decline before recovering and resuming the entrenched uptrend.
In the event of another such breakdown in the absence of a rate hike this year and a resulting dollar correction, USD/JPY could once again drop towards the noted 122.00 support level and possibly begin to re-target the next major downside support objective around the 120.00 level, below the 200-day moving average. On any break below 120.00, the next key downside targets is at the 118.00 support level, which is also the 38.2% Fibonacci retracement of the bullish run from the 105.00-area low in October of last year to the noted 13-year high near 126.00 in June.
US equity markets have long benefited from the Fed’s low interest rate policy, and have generally been entrenched in a prolonged bullish trend for more than six years. Despite widespread expectations of an impending rate hike in 2015, both the S&P 500 and the Dow Jones Industrial Average have managed to remain relatively buoyant, though the S&P has essentially been stuck in a large trading range since February. Despite this, the index reached a new all-time high of 2134 as recently as May of this year, while the Dow did the same at a record high of 18,351.
Since those highs, the US indexes have pulled back relatively modestly. But even at their lowest levels this year, they were far from entering into correction territory, which is normally defined as a pullback of 10% or more. While this has recently been the case, any increased turmoil in global equity markets, especially in China, could help spur further downside for US equities. In this event, the S&P 500 could be pressured back down towards 2035-area support, which is what occurred in early July. On any further breakdown below that support area, the index could drop towards major downside support around the 1975 level, which was last hit in February.
If it becomes apparent that the Fed will not raise rates this year, however, US equity markets could receive a boost that may help to temporarily counteract any further damage. In this event, and if the troubled China market further stabilizes, the S&P 500 may potentially rise back up to continue its longstanding bullish trend, potentially targeting a re-test of its noted high. In the event of any further break above that 2134 high, the next major target in previously uncharted territory is at the 2200 level, which is also near the key 161.8% Fibonacci extension of the most recent pullback from the noted May 2134 high down to the noted July low around 2035.
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