The Fed could be back in play in 2016

One or more rate hikes by the Federal Reserve in 2016 remains a real possibility. Why would the Fed consider such a policy action given the recent collapse in inflation expectations?

Over the past couple of months many analysts and the futures markets have assigned a rather high probability to the so-called "one and done" - no change in policy in 2016. Indeed, here is what we've heard recently from St. Louis Fed President James Bullard:

Reuters: - The Federal Reserve must act to stop inflation expectations from getting too low, St. Louis Fed President James Bullard said on Wednesday, reiterating his concerns about continuing to raise interest rates.

The U.S. central bank cannot let low inflation expectations "get out of hand," he told a dinner of bond traders here, adding he "can't stomach" currently low readings. "It's just that they've fallen so far that it's got to be a concern."

Source: @auaurelija

However a number of researches have suggested that with a relatively stable core inflation in the United States, oil prices would need to collapse to levels that are neither consistent with today's forward curve nor sustainable. Therefore, these studies argue, the current market-based inflation expectations are simply irrational.

1. Here is the latest analysis from Goldman Sachs.

Source: Goldman Sachs

2. Also, a study from the St. Louis Fed shows a similar result.

Source: St. Louis Fed

Moreover, US inflation measures are starting to stir - especially in the services sector. This is something the FOMC is not going to ignore. Below we have some of the recent reports.

1. The core PCE inflation, the Fed's primary inflation measure, exceeded consensus on Friday.

2. US CPI measures, both the headline and the core, also came in above expectations.

Source: Investing.com

3. As an example of where some of this inflation is coming from, shown below is the medical care CPI. It has been subdued last year but is now is waking up again.

Source: St. Louis Fed

Additionally, the cost of shelter in the US is now rising at over 3% per year, with the rate continuing to increase. Sadly, this is materially higher than the national wage growth rate, putting pressure on Americans with low-paying jobs.

Source: St. Louis Fed

4. We also see the so-called "sticky" CPI (the less volatile components of the CPI) reaching 2.5% - the highest since 2009.

Source: St. Louis Fed

Some analysts (RBS for example) have been suggesting that deflation is about to sweep the global economy, pulling in the US along the way. For now however there is simply no evidence of deflationary pressures in the world's largest economy.

Other indicators released last week could add to the ammunition of the more hawkish FOMC members.

1. US consumer spending was stronger than expected last month. Alas, some of this increase was driven by higher spending on healthcare, but it's an important data point nevertheless.

Source: St. Louis Fed

2. While this next item is more symbolic in nature, it's an important milestone nevertheless. US house prices (at least according to the government's index) are finally above the pre-recession peak.

Source: St. Louis Fed

The futures markets are starting to react to all these reports, with the Fed Funds futures falling on Friday (lower futures prices imply higher rates).

Source: barchart

In the coming months the Fed will be closely watching two key economic measures as the Committee contemplates further rate hikes.

1. Any indications of acceleration in wage growth will get the Fed going again. The high-frequency Gallup jobs indicator suggests that US labor markets remain stable, but material improvements in wage growth have been elusive.

Source: Gallup

2. The recent market turmoil has ignited concerns about tight credit conditions. The Fed's surveys suggest stricter underwriting standards in business lending while other indicators point to weakness in credit availability for middle-market and smaller businesses. And of course credit spreads have risen sharply, especially for the more leveraged firms. However the overall corporate loan growth remains close to 11% per year - for now.

Source: St. Louis Fed

Some suggest that raising rates in the current environment is nothing short of insanity. Given the monetary easing by the ECB, the BOJ, etc. (as rates move deeper into negative territory) or the dovish stance by the BOC, the BOE, and others, the US dollar is bound to resume its rally, causing further damage to the US economy. In fact the latest PMI measures, (from Markit as well as ISM) suggest that the US economic activity has already slowed sharply in the first quarter. Nevertheless, given the Fed's focus on some of the indicators discussed above, rate hikes in 2016 are now back on the table.

Source: Markit

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SoberLook.com

US consumer is the last defense against strong dollar drag on the economy

We continue to receive questions about the impact of the recent dollar strengthening on the US economy. The most immediate impact of course is on trade, which has created an immediate drag on the GDP growth.

Source: St Louis Fed, Goldman Sachs

We know that the impact on US industrial production in particular has been terrible.

On the other hand this currency appreciation, combined with weaker energy prices, is supposed to improve consumption as imports become cheaper.

The chart shows US import price index

And of course all the cheap fuel (combined with a warmer winter) should be providing material support to US households.

US average gasoline price

Will that be enough to give US consumer spending a boost? Goldman outlines two potential scenarios, the second one of which leads to a contraction in US gross output.

Source: Goldman Sachs

The full impact of the US dollar rally thus depends very much on the behavior of the consumer in the months to come. From a balance sheet perspective US households certainly don't seem to be "stressed", as the Financial Obligations Ratio remains near multi-decade lows.

Source: @SoberLook, FRB

Moreover, high-frequency economic sentiment data, while showing some stock-market induced jitters, remains robust.

Source: Gallup

Whether this will translate into stable spending patterns remains a question. According to Gallup, at least through December, US consumer spending has been solid.

Source: Gallup

The equity markets however are now pricing in a much weaker discretionary spending pattern, while companies focused on staples seem to be doing much better. Note that much of the divergence has taken place this year. Is the market concerned about consumer retrenchment?

Source: Ycharts

The December GDP report (0.7% growth) showed that growth has already slowed as financial conditions tightened. A great deal of this tightening has been driven by the US currency appreciation.

  Source: @jbjakobsen  

Consumer spending stability in the next few months is therefore critical. Strong US dollar has created a significant drag on economic activity but economists are betting that the consumer tailwinds should support growth,. If however the consumer (spooked by the recemt sharp correction in the equity markets) retrenches, US growth could stall.


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SoberLook.com

Beijing may question the yuan peg as the Fed prepares for liftoff

Today's ISM non-manufacturing report showed US services sector expansion considerably stronger than economists had anticipated. The strength of services sector expansion however has diverged materially from what we see in US manufacturing.

Source: St. Louis Fed, ISM

The reason for the divergence is the strength of the US dollar, which on a trade-weighted basis is at the highest level in over a decade.

Source: St. Louis Fed

Strengthening US currency has generated a significant drag on growth in the manufacturing sector. We've all read the headlines.

But haven't we seen this divergence between the services and the manufacturing sectors elsewhere? Indeed just yesterday Markit published a similar chart for China.

Source: Markit

This of course is more than a coincidence. China's currency tie to the US dollar resulted in a similar dynamic of manufacturing sector significantly underperforming. Unlike the US however, China's manufacturing is more sensitive to exports, making the slowdown far more pronounced - resulting in an outright contraction (PMI below 50 in the chart above).

In recent months the yuan has been firmly pegged to the dollar. There are a number of reasons for this linkage, including China's wish to make the yuan part of the so-called Special Drawing Rights (SDRs), a basket of currencies constructed by the IMF and held by various central banks. Beijing reasoned that the yuan's stability would help them with that cause.

Source: barchart

However, yesterday we got this headline.

Source: Reuters

Time to give up the peg? There are of course other reasons China may want to maintain the link to the dollar - one of them is to continue "rebalancing" the economy.

Source: MRB

This policy however could prove to be too costly, as competitors whose currencies have been devalued may take market share from China. Here is how the yuan has appreciated against the Mexican peso for example (chart below). With margins tightening in a number of industries, when a manufacturer decides where to build a factory, Mexico (and a number of other countries) may now be a cheaper solution.

It's unclear if China will ultimately let the peg go or if the yuan will continue tagging along with the US dollar. Will China want to wait until the 2016 IMF decision on the SDR inclusion? With the Fed getting ready for "liftoff" in September while most central banks are easing, the dollar could continue marching higher. This could slow China's economic growth materially below the current ("reported") 7% per year. In effect the tightening of monetary conditions in the US will be transmitted to China via the peg. If the dollar indeed moves higher as US rates rise, will Beijing finally run out of patience?



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SoberLook.com

The biggest risk to US growth: further dollar rally

The biggest risk to US economic growth remains the possibility of an extended US dollar rally. The Fed rate hike expectations have been pushed out to December and many doubt that the Fed will hike right before the year end. That's because the hike will involve three rates: FF, IOER, and RRP and could be disruptive to money markets over the turn (year-end). That means if we don't get a hike in September, we may not see liftoff until 2016.

At least that's what the markets expect. But if the Fed unexpectedly hikes this summer, the impact on the markets could be severe. And the dollar is likely to rally further as a result.

We've seen what a strong dollar can do to US manufacturing employment.

Source: ISM, Investing.com

But there are other "unintended consequences". Consider for example US farming businesses and the banks that provide them credit. It's hard for US farmers to compete with Canadian, Australian, Ukrainian, and other foreign producers after those nations' currencies have been sharply devalued vs. the dollar. That's why grain prices, farms, and banks that lend to them are vulnerable to further US dollar strength.

Wheat futures (source: barchart)

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SoberLook.com

By insisting on a rate hike the Fed has "imported" some of the global slowdown

Economic data out of the United States remains lackluster. We now see more evidence that a strong dollar can be quite damaging to US growth, as manufacturing employment in the US unexpectedly shifts into contraction mode.

Source: ISM, Investing.com

With this miss in the Friday's ISM PMI report (which was generally weaker than consensus), the Bloomberg Economic Surprise index hit the lowest level since early 2009.

Source: @MktOutperform

Some argue that this economic soft patch is driven mostly by seasonal effects, as Americans increasingly tend to "hibernate" over the winter.

Source: Scotiabank

If so, will we see an improvement in Q2? There is quite a bit of debate around this topic, but so far a number of high-frequency indicators point to a softer than expected start to Q2. The ISM manufacturing report discussed above is one of them. Moreover, regional manufacturing inventory levels seem to support that data.

Source: @Not_Jim_Cramer

We also have the Atlanta Fed US GDP tracker - which correctly predicted poor GDP performance in Q1- pointing to growth that is substantially below the "blue chip" consensus.

Source: Atlanta Fed

Note that this model has been shown to be quite reliable in predicting the initial GDP releases in recent quarters.

Source: @Not_Jim_Cramer

The Fed officials seem to have gotten the message that it's not the slightly higher interest rates in and of themselves that would impede growth. While the US economy on its own can easily withstand higher short-term rates, it is the dollar's strength, driven by higher rate expectations, that could be damaging. The chart below shows the increased focus on the dollar.

Source: @M_McDonough

While the rest of the world is easing policy, the US central bank can't begin tightening without negative consequences. And the global monetary policy is in a rapid easing mode. Except for Brazil, Ukraine, and a couple of other nations that have been desperately trying to defend their currencies, we've had over 30 individual rate cuts by central banks globally this year alone.

There is another way to think about this effect. The chart below shows the global nominal GDP growth (measured in US dollars) - which is projected to decline in 2015 for the first time since 2009 (see write-up). By swimming against the world's monetary policy tide, the US risks "importing" some of that global slowdown. And that is indeed what the the Fed has done by telegraphing a hike this summer.

Guggenheim

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SoberLook.com

The 2015 theme unfolds on the first trading day

2015 started with a fresh US dollar rally, as the DXY dollar index jumped nearly a percent on Friday. The dollar strength and its consequences will be a key theme for the economy and markets this year.

Source: barchart

One of the consequences of course is continuing pressure on commodities markets, as Brent crude futures tumbled below $57/bbl.

Source: barchart

In fact the whole commodity complex took another led gown, as aluminum and copper came under pressure. Here are a couple of broad commodity indices worth following: the CRB BLS Spot Index and the Continuous Commodity Index - both at multi-year lows.

Source: barchart

With commodity prices under pressure again and import prices expected to fall due to stronger dollar, the U.S. 5x5 forward inflation expectation rate (5-year inflation expectation starting 5 years out) hit a 3-year low.

It's difficult to imagine how the Fed could consider raising rates (expected in Q3) in this environment - even if labor markets continue to improve. Consider the fact that monetary conditions have tightened sharply over the past couple of months even without the Fed doing anything, as real rates rose.

While setting the overnight rate at 50bp will by itself  have a minimal effect on the economy, the expectations of higher rate differentials with other developed economies will send the dollar even higher, further weakening inflation expectations and materially tightening monetary conditions.

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SoberLook.com

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