Research Focal Points: The Fed’s Interest Rate Glide Path

The Fed’s Janet Yellen delivered her semi-annual testimony this week with a hawkish tone, signaling that rates need to “normalize” sooner rather than later. The Fed’s timetable is certainly not carved in stone. Yellen explained that the Fed is prepared to take their first step towards policy normalization, “…at some point during 2015”. The Sep and Dec meetings are the final two meetings of the year with an accompanying live press conference and economic projections; the Dec 16th meeting being the most likely candidate for the first rate hike.

The Fed seems to be on track for this first rate lift-off citing strong employment markets, an anticipated lift-off in inflation and growth overseas picking more quickly than markets may be ready for…or are they?

Looking at the latest core CPI y/y release, which came out just after Yellen’s testimony, we received an inline print at 1.8% which is below the all-important Fed 2% threshold, and has been hovering thereabouts for some time now. Upcoming headline CPI numbers may be weighed back on account of the recent drop in crude oil and dollar strength in the face of the global money printing press.

Growth overseas remains a major concern, recent downtick in Chinese growth numbers have sparked some concerns and spooked equity markets earlier this week. It may appear puzzling, when trying to reconcile the Fed’s foreign growth optimism. Perhaps it stems for the recent tensions in Greece being settled, for now. However, premiums are still priced in sovereign yields and it may be a longer, rather than a shorter, path before the market starts believing in the European growth story. Euro finished the week in the red at 1.0828, offside nearly four handles from 1.1200 Monday. Though European stock prices have not suffered, as the relief rally pushed forward, STOXX printed 3672 last from 3480 earlier this week.

Taking a closer look at the US implied OIS curve (chart on the left), market participants have rolled the hike cycle further into the future. Since March of this year the curve has bull flattened (Orange is Current and Blue is March), in line with the Fed’s signals. Looking at the associated probabilities (chart on right), markets are pricing in an 80% chance of a first hike during the Dec 16th 2015 Fed meeting. This is where things get fuzzy, as the Fed does have several options for the initial rate lift-off. Assuming that the Fed set Federal Funds Rate (FFR) to 25bps, from the current 0.00 – 0.25bps (13bps last), rather than hiking 25bps outright, the Dec 2015 meeting is actually 100% priced in. The March 2016 Fed meeting is priced for 50bps and the Jul 2016 is priced in for 75bps. In the current economic climate it appears unlikely to follow this “glide path”.

Continued dollar strength may curb inflation going forward. Despite not being a part of the Fed’s dual mandate to manage the greenback outright, the magnitude of the currency’s upswing may become a factor to consider. As well, Payrolls, while treading water, have failed to crack the 350 threshold since Nov 2014. Taking a glance at the unemployment rate, we are currently well below the agreed upon Fed threshold of 6.5% at 5.3%. This threshold was cracked in May 2014, however the Doves of the FOMC have explained away their conditional pledge a long time ago.

For this glide path to be realized, there may have to be a significant uptick in employment or inflation, or perhaps both. All eyes remain on the upcoming payrolls, unemployment rate, and inflation numbers in the second half of this year. A much more likely scenario would be for a single step towards policy normalization, trailed by a “wait and see” approach for “some time” rather than a two-meeting-spaced hike cycle. Though, given the recent developments, it is much more likely for the first step towards normalization to be pushed back yet again, which may bode well for stocks. The S&P is flirting with its 2134 all-time high. It is likely, if the Fed delays its first hike or takes a gentler path than the one currently priced into the OIS curve, that stock prices go much higher, barring any other unforeseen global events.

-David Felkai


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