Wealthy Nations Daily Update - FOMC

Today’s the day that could potentially see the first interest rate hike in the US in almost a decade with the announcement from the Federal Open Market Committee’s (FOMC) policy decision meeting this evening, at 19:00 GMT.

Although US data releases continue to paint a mixed picture, the US economy is starting to look increasingly strong and importantly, more stable. However, the Fed’s “dual mandate”, which weighs up price stability and maximum employment in conducting monetary policy, is being skewed by subdued inflation, while job creation has been strong; unemployment tumbled to an “equilibrium" level of 5.1% in July while PCE (the Fed’s prefered inflation measure) rose by only 0.3%, remaining well below the Fed’s 2% target. Yesterday's CPI release for August has done little to boost confidence posting the weakest reading so far this year. With continued concerns of broader global deflationary pressures, low commodity prices and oil floating at sticky lows (Crude remains below $50), inflation in the US could continue to disappoint. One thing to note is that year-on-year inflation calculations are based on current prices verses where there were a year ago; oil prices in January were roughly where they are now, so we may actually see inflation pick-up in the coming months, once the oil factor is no longer a drag, that is if they stay at these levels and do not drop further. Another point to consider is that historically, interest rate rises have been effected to actually stem inflationary pressures; the last time the Fed raises rates nine years ago, inflation was at 2.8% and the labour participation rate, which currently runs at 62.6%, was at 66%.

Our proprietary models suggest that global growth is declining, as emerging market concerns deepen and China’s economy softens as it transforms its economic model to the “new normal”. Global macro factors have been troubling some Fed officials, including some of the voting hawks. New York Fed President, William Dudley said that a rate hike “seems less compelling” than it was prior to the equity market meltdown in August. Back in July, Fed Chair, Janet Yellen said that it would be appropriate to raise short-term interest rates this year; since then financial market conditions have somewhat deteriorated. Meanwhile, Chicago Fed President, Charles Evans stated that he does not think rates should be hiked until the middle of next year.

Futures are currently pricing the probability of a Fed move at 32%. It is therefore surprising that six months ago, when economic conditions could not substantiate a rate hike, the probability of a Fed move at this month's meeting was as high as 67.9%. Just for reference, the futures market is pricing a 47% chance (up from 44.6% yesterday) of a rate hike at the next meeting in October.

In the build up to this meeting, the Fed have held their cards very close to their chest, in an attempt to prevent a “taper tantrum” like ripple effect, and the only hints have been some marginal changes in language. In fact the market appears more concerned, not about the initial rate rise, but the trajectory of future rate hikes. The Fed have reiterated time and time again that rate rises will be modest and gradual. If we look at the futures' expected rate rise trajectory it is not until mid-June next year that will see rates above 1.5%, and only a 0.2% probability. In fact going into the November meeting next year, currently the futures market is pricing a 2.3% chance of rates going up to as much as 1.5-1.75%. This suggests that the Fed funds rate may actually remain below 2% into the end of 2016. We note this because, ahead of the financial crisis, interest rates were at 5.25%!

Investors across the world have been fixated on the timing of “lift-off” since Fed members first started to mention “policy tightening” over a year ago. It seems that as much as investors initially feared a rate hike, most have become frustrated with the waiting game and want the Fed to pull the trigger and just get it over and done with. Whether the move to raise rates is announced tonight, or the Fed signal that they will move in October, a so called "hawkish hold", is pretty irrelevant to the market as a 0.25% increase to short term rates has already been priced in and will certainly not take anyone by surprise!