Article / 07 June 2016 at 3:11 GMT

One step forward, two steps back for Yellen’s Fed

Managing Director / Technical Research Limited
New Zealand
  • Money market pricing suggests there will be no rate move at the Fed's June meeting
  • However, the Fed chair retains a 'largely favourable' outlook on the economy
  • Next week's dot plot from the FOMC will be of most interest to traders  
  • But the chances of the USD getting a boost from the meeting are slim

By Max McKegg

Federal Reserve chair Janet Yellen opened her speech on the US economic situation yesterday with the comment that her message would be “largely favourable”. 

Indeed it was; even with the caveat that Friday’s jobs-added number had been “disappointing” and “concerning”. But gone was last week’s suggestion of another rate hike “in coming months”, instead it was replaced with the old mantra that “monetary policy is not on a pre-set course and the FOMC will respond to new data and reassess risks so as to best achieve our goals”.

Star gazing. If the December 2015 rate move was 'one small step' for the Fed, any 'giant leap' in the direction of its normal rate of 3.25% remains off the horizon. Photo: iStock
Fortunately we won’t have to wait long for that reassessment: each committee member will submit updated economic forecasts at next week’s policy review meeting. Of most interest to FX traders will be the resulting “dot plot” for the federal funds rate out to June 2019.
In the meantime, after a roller-coaster ride this year, money market pricing suggests the chance of a rate move at the June meeting has virtually disappeared, despite Yellen’s “largely favourable” outlook. As the yellow line in the bottom panel of this chart shows, at the start of the year markets had the odds of the fed funds rate being in the 0.50%-0.75% range by June 15 at almost 50%; now it’s close to zero. Instead, the blue line shows almost a 100% chance the rate will stay in its current 0.25%-0.50% range.

Fed odds
 Source: Bloomberg

However, the table also shows that traders still price the the chance of a July 27 hike at close to 30%. This is based on the view that the path to normalisation of monetary policy is not linear but two steps forward, one step back. Others would argue that it should be the other way round because Friday’s jobs number was a game changer. 

What we can say with certainty is that if the long-awaited December 2015 rate move was “one small step” for the Fed, any “giant leap” in the direction of its medium-term normal rate of 3.25% remains off the horizon.
The basis for Yellen’s “largely favourable” outlook on the economy is the labour market. However, an update to the Labour Market Conditions Index, a composite indicator developed by Federal Reserve economists, was released today and, as the chart below shows, the index has slipped into negative territory, helped along by Friday’s jobs report. 

Optimists – and US dollar bulls – will have to hope that the number was an aberration and that subsequent revisions will show a more positive picture. They will note that the initial print for May 1999 was 11,000 jobs added but that revisions showed the real number to have been 211,000.

 Labour Market Conditions Index

Even if we take a "glass half-full" view of the labour market, emphasising the 4.7% unemployment rate, there’s still the nagging problem of inflation, or rather the lack of it. Yellen is aware that the longer the headline rate remains well short of the 2% target, the greater the danger that inflation expectations will fall away and start to have second-round impacts on price and wage-setting behaviour. 

Yellen said that survey measures of expectations had “moved a little lower” of late while those inferred from market pricing had “moved down more noticeably” and “enough to get my close attention”.
Of particular concern will be the breakdown in the link between the market’s medium-term inflation expectations proxy (the five year/five year forward break even rate) and the oil price, as shown in the chart below. A similar picture has emerged in the Eurozone and it suggests that markets think low inflation rates in the major economies are a structural issue that won’t be fixed by a cyclical rise in oil prices.

US 5y/5y and oil


Even so, it’s likely the Federal Reserve will again talk tough next week, producing a flight path for rate hikes only slightly lower than that in its previous set of forecasts. Again, the market won’t believe it and the federal funds curve will continue to sit well under that derived from the Fed dot plot. As such, the chances of the US dollar getting much of a boost on the back of the FOMC meeting next Wednesday are slim.
This will be exasperating for the central banks of Australia, New Zealand and Japan, all due to hold their own policy reviews over the next 10 days. In each case, they were hoping the Fed would do the right thing by them and raise rates, thus putting downward pressure on their own currencies. 

Similarly with the European Central Bank following on from its own updated forecasts last week: ECB forecasts put inflation near target, but markets remain wary
But for now they will have to settle for the observation made by Winston Churchill that the Americans will always do the right thing – but only after they have exhausted all the alternatives.

– Edited by Gayle Bryant

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.
Patto Patto
Astute analysis ..............
Max McKegg Max McKegg
thanks Patto. More to the point, my trade is on track and as a professional trader this is what counts!


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