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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The possibility of a 2015 rate hike in the US should not be ignored

Futures-implied probability of a 2015 rate hike in the United States remains below 40%. Some market participants have all but dismissed this possibility as they look at weak global growth as well as soft inflation and inflation expectations in the US. Some have even suggested that the next policy move by the Fed should be a rate cut into negative territory.

Source: St. Louis Fed

However global growth and US inflation expectations may not necessarily the main focus at the Fed. For example, numerous economists continue viewing the energy market crash as having only a transient impact in inflation. The logic here is that if we freeze crude oil prices at current levels (below $45/bbl), by early 2016 the year-on-year change will be around zero.

And a number of energy analysts expect crude oil prices to begin gradually rising going forward. To many forecasters this would imply that crude oil price weakness will no longer have such a severe impact on the rate of inflation.

Of course some would say that low fuel prices have not yet fully made their way through the economy - suggesting that the disinflationary pressures will persist for some time. Similarly some argue that the full effects of the dollar rally in the first half of 2015 are yet to be fully felt.

Nevertheless many economists view the headline inflation approaching the core measures by early 2016, with the core CPI turning higher as well. Moreover, a slew of recent US economic reports suggests that while the US economy probably slowed in the second half due to dollar strength and weakness abroad, the effect may be transient.

The housing market for example continues to recover and consumer sentiment and spending does not seem to be impacted by the recent market volatility.

Source: St. Louis Fed

Source: Scotiabank

Source: @GallupNews

Source: Deutsche Bank, @MKTWeconomics

Even US manufacturing which has been under pressure recently is showing signs of stabilization. The latest Markit manufacturing PMI report surprised to the upside.

Source: Markit, Investing.com

But what about the relatively poor payrolls report for September, which clearly missed expectations? Some economists argue that this is as much about slower hiring as it is about tight labor markets. For example (as we saw in the latest Pulte Homes quarterly report), the homebuilding industry is struggling with acute labor shortages. Of course as the Wall Street Journal recently pointed out, the US housing correction has been so severe that a whole generation of construction workers has permanently exited the industry, creating shortages as the sector recovers. Nevertheless when the Fed hears about labor shortages in an industry such as housing, they take notice.

Source: WSJ

Signs of tighter labor markets have also appeared in the latest NFIB reports on small business. When speaking with small businesses it becomes clear that there is no shortage of applications for each opening they have. But they can't seem to find people with the right experience and/or skill set (skills gap).

Source: NFIB

Moreover, the broader unemployment measures continue to improve. Here is the so-called "U-6" for example, which according to some economists is about 1% away from "full employment" (see quote).

Source: St. Louis Fed

Whatever the case, many argue that this is a precursor to acceleration in US wage growth. We haven't seen a great deal of evidence of that so far, but many economists (including those at the Fed) are convinced that it's only a matter of time.

One of the concerns the FOMC had in September was the risk of a rapidly deteriorating economy abroad, particularly in China. It has since become clear that while China's economy continues to slow, the combination of aggressive fiscal and monetary stimulus there is likely to cushion the decline.

Source: Investing.com

Some may remember that in September of 2013 in the wake of the so-called "taper tantrum" the Fed decided to continue with QE. The central bank however started tapering three months later. The "playbook" this time around could be similar.

Are global markets prepared for a December liftoff? It seems that while credit markets remain cautious, there is much less uncertainty priced into US equity markets. A relatively strong employment report next week for example could reignite market volatility.

Source: BAML

Many argue that the US economy can withstand a rate hike at this point. Indeed it can. However, given that much of the world is currently in a monetary easing mode, such a move by the Fed would result in a further rally in the US dollar. We saw the Bank of Canada strike a dovish tone recently, the PBoC is in the middle of a major easing cycle, the BoJ is in a perpetual QE, and the ECB is fully expected to expand its stimulus.

A further dollar rally would exacerbate the rout in emerging markets, potentially forcing China to resume the RMB devaluation. Disinflationary pressures in the US could worsen and the manufacturing sector would take another hit. Nevertheless, it seems that many at the Fed are willing to overlook such an outcome and begin the first rate hike cycle in nearly a decade.



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Fed's lifotff: a shift in sentiment

Friday's US jobs report combined with the September FOMC decision has significantly altered market expectations for the timing of the first hike by the Federal Reserve. The Fed Funds futures implied probability of a 2015 liftoff has dropped below 30%.

Source: barchart

In fact the expected trajectory of the rate hike probability has shifted in a similar fashion it did after the September FOMC meeting.

Source: @MishGEA

We see this shift in sentiment reflected in the 2-year treasury rates move on Friday.

Market participants are becoming uneasy about the loss of momentum in US labor markets. This latest concern comes on the heels of a number of other headwinds (discussed here) that resulted in the FOMC's September inaction on rates and weaker growth projections.

The softness in the labor markets is not limited to the latest payrolls report, which missed economists' forecasts. This year for example has been marked by downward revisions in estimates, as the Labor Department consistently overestimated job creation.

Source: Floating Path

Another indicator that analysts have been focused on is the civilian labor force participation - which started declining again after leveling off for about a year. The US now has the lowest rate of participation since 1977.

The loss of momentum in the labor markets seems to be broader than just the manufacturing and energy/resource sectors. To be sure, the jobs situation in the United States is significantly better than in a number of major developed economies, but the improvement pace seems to have stalled.

Source: Deutsche Bank

To make matters worse, the wage growth acceleration many economists (including the Fed) have been promising never materialized (at least not yet). US wages continue increasing at around 2% per year and the concerns around wage pressures seem to have been overblown.

Given this latest shift in sentiment, we would like to conduct a quick survey on the timing of liftoff in the US. It's a single question (below) and the results will be published here and in the Daily Shot.

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Sentiment shift on US inflation expectations

We seem to be undergoing a market sentiment change as fresh signs appear that US inflation has bottomed.

Commodity markets are firmer, particularly industrial metals. We've seen nickel prices moving up sharply a couple of days back (see chart). Here is aluminum and copper.

Commodity indices are still near multi-year lows but seem to have found a bottom - for now. Here is the CRB BLS Spot Index.

Source: barchart

Moreover, the components of the US Employment Cost Index seem to indicate improved wage growth as well stronger increases in starting salaries.

Source: Deutsche Bank

As a result we continue to see breakeven inflation expectations moving higher. The Eurozone has also seen an improvement in breakeven rates.

Perhaps the most telling sign that inflation sentiment has shifted is the record jump in inflation funds inflows (ETFs and mutual funds).

Source: Deutsche Bank

The dollar of course continues to pose risks to this change in investor views. Should we for example see a 300K new payrolls print from the labor department this Friday, all bets are off. The Fed will be back in play, the dollar rally will resume, and inflation expectations will dive again. Such an outcome with the jobs report seems unlikely but a resumption of the dollar rally remains a risk.

Source: barchart

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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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The Fed concerned about "importing" disinflation

The latest Reuters poll is showing 24 out of 43 economists projecting the first rate hike in the US by June of next year. The futures market is pricing liftoff by September. Citi's latest analysis puts it in December. And all of these forecasts are running way behind the so-called Taylor Rule, which is suggests that the Fed Funds rate should already be at 1.5%.

Source: @Schuldensuehner, Citi

In fact the US economy can easily handle non-zero short-term rates at this point. The banking system is quite healthy and can easily manage funding costs of 1.5%. Corporate borrowers can deal with slightly higher rates as well. And as far as mortgages are concerned (to the extend higher short-term rates extend to longer maturities), borrowers for whom payments become prohibitive at 5% vs. 4% should not be taking out a mortgage to begin with. Furthermore the issue with the housing market these days has more to do with tighter mortgage credit rather than rates.

But it's no longer as much about the US economy as it is about external factors. The international situation has made the Fed's policy planning much more complex. The monetary policy divergence among the major central banks is the issue at hand. With the BoJ suddenly accelerating its QE program, the PBoC cutting rates, and Mario Draghi hinting at a potential QE program in the Eurozone, the Fed is becoming increasingly isolated in its plans to begin rate normalization. Even India's RBI, who has kept rates elevated for some time, may begin to ease soon as the nation's inflation and money supply growth slows.

As a result of this divergence, the US dollar has been on the rise this year.

Of course the recent increase in and of itself is not tremendous relative to historical levels. However, given the disinflationary pressures around the world, the rising US dollar effectively "imports" disinflation into the US. Moreover, the massive drop in energy prices, caused by a combination of a significant rise in North American production and weaker demand globally (as well as the Saudi "dumping"), is adding to slower inflation. In fact, in recent months a paradigm shift has taken place. Weakness in inflation is no longer viewed as a temporary phenomenon as the longer-dated market-based inflation expectation measures turn sharply lower.

Furthermore, professional forecasters are also downgrading their long-term inflation projections.

Source: Deutsche Bank

Even consumer expectations of long-term inflation have shifted.

Reuters: A Thomson Reuters/University of Michigan survey released last week showed that consumers see inflation averaging 2.6 percent a year five to 10 years from now, down from 2.8 percent predicted last month and the lowest reading since March 2009.

It's not going to be about jobs going forward, in spite of the comments we continue to hear from the FOMC. The Fed's focus has shifted to inflation and inflation expectations. And no matter how low the unemployment rate falls, it will be difficult for the Fed to pull the trigger on rates, risking further strengthening of the dollar and more downward pressure on prices. It is possible the Fed will wait for growth in other major economies to stabilize before liftoff in the US. Which is why some economists (like those at Citi) are pushing rate hike expectations further out in time. Unfortunately the longer it takes to get there, the more disruptive the effect of normalization will be on global financial markets - as the Fed's zero rate policy moves into its 6th year and possibly beyond.


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