Article / 30 May 2016 at 15:30 GMT

Hawkish Harvard speech boosts rate hike hopes

Managing Partner / Spotlight Group
United Kingdom
  • Fed chair Yellen not ruling out raising rates
  • Last week’s FOMC minutes caught the market by surprise.
  • Most private sector economists target a hike on July 27

Janet Yellen
Janet Yellen has changed the market's outlook for US 
interest rates. Photo: Federal Reserve/Flickr 

By Stephen Pope

Federal Reserve chair Janet Yellen said in a speech at Harvard University last Friday that an interest rate hike would be appropriate in the coming months if the economy continues to show signs of improvement.

Many have taken this as a clear signal that she is trying to prepare the markets for an increase in Fed Funds in either June or July.

The fact that Yellen was offering the market a degree of forward guidance, now an accepted instrument in the monetary policy toolbox, was appropriate as at Harvard she was being honoured with the Radcliffe Medal which celebrates a commitment to excellence, forward thinking and inquiry.

As Yellen said on Friday:

“…Growth looks to be picking up from the various data that we monitor, and if that continues and if the labour market continues to improve… and I expect then it would be appropriate to raise rates…”

FOMC minutes have raised the temperature

Expectations of a rate hike at either the June 14/15 meeting or the July 26/27 one have increased following the release of the April Federal Open Market Committee minutes on May 18.

They revealed that Fed officials believed the strengthening economy may offer justification for a rate hike in the summer months. There is no meeting in August and no further meeting is scheduled until September 20/21. The minutes caught investors by surprise because they had come to believe the Fed would not move that quickly.

Many private-sector economists (myself included) believe a June rate hike isn't very likely. The Fed is, of course, primarily concerned with the welfare of the US economy, but in recent months Yellen has indicated that she does also consider the global impact of any Fed decision.

It will not be overlooked that on June 23 the UK holds a crucial referendum on the issue of European Union membership. So I would regard ti as highly unlikely that the Fed will raise rates in advance of the UK vote. I suggest that a rate increase on July 27 is more likely.

Empirical evidence

Fresh evidence has emerged that the US economic situation has begun to improve following a slow start to the year. Consumer confidence looks to be buoyant and the housing market has shown steady, sustainable improvement since Q1 2010.
US data
Source: Bureau of Labor Statistics, Federal Reserve Bank of Philadelphia, University of Michigan and Census Bureau

Sentiment shift

This new tenor in the markets is quite a turnaround as until the recent FOMC minutes, markets had virtually written off a summer rate increase. This was very much the case after Yellen gave a speech in late March that was notably lacking urgency.

However, based on CME Group 30-Day Fed Fund futures prices, the following pattern of expectations has been established:

Date of FOMC: rate/probability

June 15: 0.50% (current level)/72%, 0.75%/28%, 1.00%/0%, 1.25%/0%
July 27: 0.50% (current level)/39% 0.75% 48%, 1.00%/13%, 1.25%/0%
September 21: 0.50% (current level)/32%, 0.75%/46%, 1.00%/19%, 1.25%/3%

The probability of a rate hike is calculated by summing the probabilities of all target rate levels above the current target rate of 0.50%. Probabilities of possible Fed Funds target rates are based on Fed Fund futures contract prices assuming that the rate hike is 0.25% (25 basis points) and that the Fed Funds Effective Rate will react by an equivalent amount. 

The data from the CME indicates that the message has been received loud and clear. A measure derived from asset prices shows that investors now see almost a 68% chance of a rate increase by September.

The Fed started raising rates in December, seeking to slowly withdraw the highly accommodative stance of monetary policy and although Q1 did witness a pause in the movement away from the zero bound, it does appear that now the Yellen Fed is ready to resume the gradual pace of tightening.

Central Chicago
Recent data point to an accelerating US economy. Photo: iStock 

Many voices

I have always taken the view that while the opinion and commentary of the various Fed talking heads is important to listen to, the only voice that really matters is that of the Fed chair. So I set greater store in what Yellen said on Friday:

“…Let me say a few sentences, so I won’t delay them very long… that the Fed will gradually and cautiously increase its benchmark rate, and that probably in the coming months such a move would be appropriate…”

This appears to be one time when the talking heads are all following the same song sheet. William C. Dudley, president of the Federal Reserve Bank of New York, said earlier this month:

“…The June-July time frame is a reasonable expectation…”

I am not so moved by the cautious tone of Jerome H. Powell, a governor of the Federal Reserve who has said he wanted to see:

“…significant strengthening… depending on the incoming data and the evolving risks, another rate increase may be appropriate fairly soon...”

Judging by the evidence shown in the panel of charts I presented in this note, I think Powell should be satisfied that he has his evidence.

Perhaps he is moved by the opinion of many US academic economists. For example, Louise Sheiner, a fellow at the Brookings Institution, has said that lower-income Americans have seen:

“…little improvement in income, little improvement in health, little improvement in life expectancy…No wonder there’s so much anger out there…”

In a similar vein, Douglas W. Elmendorf, Dean of Harvard’s Kennedy School, said that the architects of policy carried a responsibility to stimulate growth and reduce economic inequality.

“…We tend to talk in this country about the importance of overall economic growth…That logic, that focus on overall growth, worked best in the period when a rising tide lifted all boats… In an era of yawning inequalities…We need to be more explicit about our distributional concerns…”

The empirical evidence to support the mood of the market is to be found in the level of the most directly affect Treasury Bill and the Dollar Index.

The three-month T Bill straddles the June July period when a Fed Funds rate change is most likely and as such provides an excellent gauge as to market sentiment. The same can be said for the Dollar Index which captures the sentiment of global forex traders with regard the level of the Dollar and its major pairs.

Three-Month Treasury Bill: May 18 0.282%, May 27 0.317%, May 30 market closed
Dollar IndexMay 18 95.06, May 27 95.50, May 30 95.69

We have seen that market probability pricing for a July rate rise has become elevated and this sentiment will break substantially higher if US data don’t disappoint this week.

The key US data points this week and expectations are:

Tuesday: Personal Consumption Expenditure 1.6%, Consumer Confidence 96.0
Wednesday: ISM Manufacturing PMI 50.5

And the most important of all:

Friday: Nonfarm Payrolls, 161,000, unemployment  4.9%, average hourly earnings 0.2%.

Has US industry kept pace with rate hike haws' hopes? Photo: iStock 

— Edited by Michael McKenna

Stephen Pope is managing partner at Spotlight Ideas. Follow Stephen or post your comment below to engage with Saxo Bank's social trading platform.


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