Are Investors Complacent On The Prospect For US Rate Hikes In 2016?
When the US Federal Reserve raised rates for the first time in nearly a decade last December, it signalled there could be approximately another four hikes in 2016. Since then, however, significant market volatility and mixed domestic economic data have caused the Fed to scale back those expectations to only two hikes. Meanwhile market expectations have become even more pessimistic; the implied probability of a rate rise in June is now only 4% whilst there is less than a 50% chance assigned to a 25bps rate rise by December.
So far the market has been right to undershoot the Fed, but perhaps policy makers’ inaccurate cries of “wolf” have bred a complacency creating the skewed level of pessimism priced into US Government bond yields. After a dovish FOMC March meeting swayed by surging volatility, statements from San Francisco Fed President Williams and Atlanta Fed President Lockhart affirmed that they view the markets dismissal of a summer hike as being too complacent.
Meanwhile core inflation in the U.S continues to pick up (latest reading at 2.2%) whilst the recent rebound in the oil price could drive headline inflation even higher as the year progresses. If such a scenario materialises, it could leave the Fed worryingly behind the curve especially if the energy sensitive American consumer begins to factor in higher inflation into wage expectations. Wages have already been creeping up gradually as a result of the tightening labour market and are arguably becoming a more important gauge of spare capacity at this point in the cycle than the widely watched Non-Farm Payroll figures. Further evidence of diminishing slack in the labour market, supportive of further wage increases, comes from the latest NFIB (small businesses) and JOLT (job openings) surveys. These point to a continued strong pace of hiring, a difficulty in filling vacancies with suitable candidates and an increasing willingness for workers to leave their current job for another, presumably better, role.
If inflation does require taming, the Fed will have to manage the tightening process very carefully. Corporates and market participants remain nervous following a turbulent start to the year, wary of the next growth scare. Without an improvement in the growth outlook, many would fear that a pre-emptive rate hike would turn out to be a policy error. While the US Dollar has been slightly weaker of late, providing some relief to emerging markets, a stronger Dollar is likely an inevitable part of a divergent monetary policy and could cause a re-emergence of stress in less developed economies, particularly those dependent on commodities.
In our opinion, valuations in the Treasury market do not allow for even a modestly more hawkish Fed. The yield on 2 year Treasuries is currently only 0.74%, lower than the level of both headline and core inflation and discounts only one quarter point hike by the Fed over the next two years.
In the absence of global macro shocks and if the US manages to repeat its trend in recent years of recovering from a slow first quarter, the Fed will likely put more emphasis on the recent trends in inflation, leading to a sharp upwards reassessment of yields from their suppressed levels. Given many bond market participants are merely tourists, hiding in ‘risk-free’ instruments away from equity markets, they could face losses they are not prepared for.
By Chun Lee
All figures sourced from Bloomberg – as at 12.05.16
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