Lately economic data has arrived soft. CPI core numbers have been as expected and in-line with 1.9% y/y growth, below the Fed’s threshold, and producer prices have come out weak, with the most recent reading arriving at -0.3% vs 0.1% (Exp). Our first glimpse into manufacturing for the month of November via Empire State was quite weak at -10.7 vs -5.3 (Exp), and later Philadelphia Fed edged slightly higher at 1.9 vs 0.0 (Exp). Retail Sales have disappointed as well at 0.2% vs 0.4% (Exp), though retail activity expected to pick up as the holiday season nears.
However weak the second tier economic releases have been, it should be noted that the most recent payrolls number arrived far above expectation at 271K vs 181K (Exp) indicating strong labor market growth. The unemployment rate came out at 5.0% as expected down from a prior 5.1%, and far below the Fed’s expired conditional pledge levels. While it is doubtful that this one report has cemented a 25 bps hike before the year is out, if it is followed by additional upbeat economic reports prior to the Dec 16th Fed meeting, it may become likely that an overwhelmingly large proportion of Fed members vote in favor of it.
Currently, the Fed Funds Futures are pricing in a 72% chance of a 25 bps hike before the year comes to an end, up from just 46% at the beginning of November. An overwhelming majority of analysts feel that the first interest rate rise, since the US financial meltdown of 2008, will be a done-deal by the end of the year.
The majority of Fed speakers this week have hinted towards rates moving higher, soon, at a very gradual pace, and that policy will still remain accommodative. Fed’s Mester (Non-Voter, Hawk | 2016 Rotation) explained that it is time to commence raising the Fed Funds Rate if economic data releases meet Fed’s forcasts. Fed’s Lacker (2015 Voter, Hawk) told markets that the Fed may be getting behind the curve, as rates remain at unprecedented low levels, and the labor market continues to strengthen. Fed’s Lockhart (2015 Voter, Neutral) reiterated that the Fed’s criteria for a rate liftoff has been met and that the US economy is on a “stable path”. The path forward for the Fed Funds Rate will be gradual and first increase is “appropriate soon”. Fed’s Dudley (2015 Voter, Dove) does not foresee a big market reaction after the Fed moves the key interest rate; no “huge surprise” anticipated. Fed’s Kaplan (Non-Voter, Neutral | 2017 Rotation) emphasized that key interest rate will be moved at gradual pace and that policy will still continue to remain accommodative, though accommodative policy is not commensurate with a 0% rate.
General market expectations for a hike have been escalating, beyond fair coin-toss odds, however it is noteworthy that the market still remains in disagreement with the Fed’s terminal rate and glide path as presented in their quarterly economic projections. It remains likely that the glide path for the interest rate going forward will be gradual and convergence from above (FED) rather than convergence from below (The Market) will take place. The pace, as indicated by the Fed “dots” is calling for a 1.4% Fed funds rate by the end of 2016, which equates to roughly four hikes (quarterly) during that calendar year. The Fed funds future contracts are currently pricing in a much slower pace with just 1-2 hikes prices for the year of 2016, as seen in the chart above. If the Fed does go ahead with a rate lift off at its Dec 15th meeting, most expect a statement and press conference to reinforce that the pace of this hike cycle will be very gradual and data dependent.
The yield curve bear-steepened over the month of November so far, with the short end and belly of the curve (5 year) absorbing the lion’s share of the pop in yields (declines in price, see chart above). The 2-5-10 and 5-10-30 fly spreads have begun to turn-up (in terms of ylds) on the back of hawkish sentiment in the US Treasury market place (See chart below). It appears that for the flys to pop and for the flatteners to come into play, the market may need absorb a couple of hikes and receive additional information from the FED to get a better handle on the pace of the hike cycle this time around, before participants offer a full commitment to these trades.
On the whole, odds for a Dec Fed rate hike have dialed up over the past couple of weeks. Second tier economic released have been largely ignored as have recent inflation data, as a deterrent to the very first Fed hike. Labor market conditions have acted as the main catalyst for policy action and rate expectations. The dual mandated Fed has seemingly become a single mandated Fed, as the inflation leg of the mandate has been disregarded as they set the stage for the rate lift off.
A few key data points, the recent Fed minutes, Fed commentary, and the recent market moves all point to the Fed Funds Rate moving before the end of the year. Most market participants expect the pace of future Fed hikes to be very gradual and it is unlikely that the rate moving away from the current near 0.0% floor to be taken as anything but accommodative, so long as the Fed sticks to their “gradual pace” rhetoric.
This week, traders and other market participants will carefully be eyeing upcoming commentary from Fed’s Dudley and Williams on Friday and Saturday respectively. No other key data points remain on the docket for the remainder of the week. Next week kicks off with Existing Home Sales on Monday, Confidence on Tuesday, Wednesday the Fed’s preferred inflation metric PCE will be released alongside New Home Sales to cap the week off into the Bank Holiday that commences on Thursday.
-David Felkai Uptick GMA.
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