July hike would see the Fed have its cake, eat it, too
- Expectations of a summer hike have reached their probable maximum
- The June meeting is likely to promise a hike in July
- With the hike already priced-in, USD strengthening could stop
The second-quarter economic data has shown improvement and the financial markets have been docile (the S&P 500 stock index is close to all-time highs). Labour markets are doing great and higher oil prices are lifting the inflation outlook.
In fact, market-implied inflation expectations have been rising as the five-year, five-year forward hit a high of 1.83% toward the end of April. Inflation expectations have since come down as the expectations of a new rate hike have increased.
It is important to realize that investors still believe the Fed will miss its inflation target in the coming years. This provides the only hope for the doves in the FOMC – the committee's potential wariness of being seen as tightening policy too fast (and risking a slowdown later).
The 10-year US Treasury yield has mostly been consolidating, and has drawn a nice descending triangle around levels that are close to all-time-lows.
The CME Group’s FedWatch tool shows the futures-implied probability of a rate hike at the June meeting is 24%, and by the time of the July meeting the probability of at least one hike is 53%.
The odds for at least one hike by other months are as follows: September 64%, November 67%, December 78%, February 80%.
Unfortunately, the tendency for the dollar to creep higher together with rate hike expectations limits the Fed’s willingness to hike rates. We will likely see one, maybe two hikes in 2016. Getting the timing right is important for the central bank; it does not want to scare investors with its hawkishness and thus will give plenty of warnings ahead.
On the other hand, the Fed does not want to sound too hawkish as expectations could force it to ease its forward guidance. The FOMC wants to show it understands and respects the global event risks.
Hiking in July hawkish enough
The perfect policy answer would be for the Fed to announce in June that a rate hike will be coming in July as long as the outlook remains supportive. By committing to a rate hike in July, it can essentially deliver the hike in June while keeping its options open in case the Brexit vote or economic data provide nasty surprises.
By choosing to wait, the Fed would not look weak or indecisive, but bold. Delivering a rate hike without the usual press conference and an hour’s worth of explaining the decision would be a message of confidence.
It’s time for investors to abandon their training wheels and get accustomed to a Fed that can hike rates without every time softening the message and saying how sorry it is. The US central bank is not sorry – it's overjoyed. The economy is doing better and the Fed can hike. It is good news.
The June/July hike odds are getting close to “100% unless something bad happens”. I’d say the chance of a Brexit or some other negative surprise before June/July-meetings is about 30%, so there is not much room for the rate odds to increase further for now – unless investors begin to temporarily forget that the negative surprises can happen.
If the rate hike odds are not about to increase by much, maybe USD’s recent strengthening is now behind us, and some consolidation or even a weaker USD is what we could see next.
The next key events to watch
- June 2 European Central Bank’s meeting on
- June 3 US jobs report
- June 6 Janet Yellen’s speech
- June 14 US retail sales report
- June 16 FOMC meeting
- June 23 Brexit referendum
- July 27 FOMC meeting