Article / 24 June 2016 at 1:39 GMT

After Brexit vote, back to the main game: US interest rates

Managing Director / Technical Research Limited
New Zealand
  • By poll close, bookmaker money had pushed odds on a Remain vote to 85% 
  • At first vote count Ladbrokes' Leave odds surged to 50% and GBPUSD fell to 1.4300
  • Post-referendum attention will return to US Fed and whether it will raise rates 
  • Odds of a July interest rate hike are currently sitting at only 10%

By Max McKegg

The old adage “follow the money” looked to be a good lead ahead of the Brexit vote. By the time polls closed, weight of money on bookmaker sites had pushed the odds on a remain vote to 85% and only a few “Rule Britannia” hold-outs were prepared to take the other side, more in hope than expectation. So it was in the FX markets where carry-trade favourite NZDUSD, a leading risk-on indicator, was topping the charts as polls closed, hitting 0.7300.

 As Asian markets opened, the risk-on trade looked to have run out of steam, especially when GBPUSD hit 1.50. Photo: iStock
But as the Asian markets opened, the risk-on trade looked to have run out of steam, especially when GBPUSD hit 1.50, and many traders were waiting for buy-the-rumour-sell-the-event opportunities to present themselves when the official poll results were announced. 

For a while it looked like they had missed the boat, as some nervousness crept in when the first vote count results emerged: at Ladbrokes the Leave odds surged to 50% and GBPUSD slumped all the way down to 1.4300, with FTSE futures following suit.
Assuming the Brits avoid a massive own goal, some of the circa 72% of eligible voters who turned out might like the opportunity to change their mind as Euro 2016 continues and despondency sets in when, one by one, the UK teams exit via the inevitable penalty shoot-outs.
Back to the main business
As the dust settles later today on Brexit, attention will return to the main game in town: will the US Federal Reserve raise interest rates again in 2016? As the chart below shows, the US forward rate curve has been flattening out as the markets come to the conclusion the Fed has got cold feet over the whole idea of rate increases, despite occasional tough talk.


Source: Bank of New Zealand . Create your own charts with SaxoTrader; click here to learn more.
In her June 15 speech on the economic situation, US Federal Open Market Committee Chair Janet Yellen said, “In light of the current shortfall of inflation from 2%, the Committee will carefully monitor actual and expected progress toward its inflation goal”. 

Next Wednesday the Committee –  and the markets – get an update on the situation via the May Personal Consumption Expenditures (PCE) price index, the Fed’s inflation benchmark. As shown in this chart, the headline rate is currently at 1.1% and core at 1.6%. Base effects will gradually close the gap between the two measures as oil price rises this time last year drop out of the annual headline calculation. So the Fed will be more interested in the core rate. 

Expectations are that the annual rate will have crawled up in May, back to the 1.7% recorded a couple of months ago. It would have to beat that by another percentage point to increase the odds of a July rate hike, currently sitting at only 10%.

Janet Yellen is scheduled to speak again next week, but we’ve heard a bit from her lately and her cautious “first, do no harm” approach is well known. Perhaps of more interest will be a speech by St Louis Fed President, James Bullard. It was he who owned up last week to being the rogue low-ball “dot” on the FOMC’s rate projection graph, shown here.

 Source: Bloomberg
Only 10 of the 17 Committee members represented by those dots actually get to vote on monetary policy this year and Bullard is one of them. Thus his views are worth taking note of. 

He has announced a “new narrative”, the guts of which is that the Fed’s concept of a “long-run steady state to which the economy is converging” has now “outlived its usefulness”. That steady state nirvana is represented by the 3% federal funds rate median the Committee is projecting for the longer term. 

In contrast, Bullard’s low-ball projection is based on the assumption that the current “regime” – assumed to be 2% GDP growth, unemployment of 4.7% and inflation around 2% – persists over the next two and a half years. If so, according to his model, the federal funds rate will need to be only 0.65% in 2018, lower even than the market’s forward curve.
Regimes can change, but Bullard thinks the current one will be “persistent”, and that it is wishful thinking for his Committee colleagues to consistently project a best-of-all-possible-worlds outcome.
The St Louis Fed President is an influential figure and it will be interesting to see if any of his fellow FOMC members come around to his way of thinking. It’s worth noting from the chart that “the market” – as demonstrated by the purple line on the chart – already agrees with him.
The Brexit vote concentrated traders’ attention today, but the British have always overestimated their influence in the scheme of things. Next week normal service resumes.

– Edited by Susan McDonald

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts an article or trade, then click here to follow him.
Patto Patto
A leave vote would indeed be a massive own goal as you say Max ..........


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