Mighty Doves see off the Hawks over rates

Posted on September 22, 2016

The Marriner S. Eccles Federal Reserve building stands in Washington, D.C., U.S., on Tuesday, Sept. 1, 2015. Bill Gross said the Federal Reserve has waited so long to raise interest rates that any move now may be labeled "too little too late" as market turmoil restricts the room for policy makers to act. Photographer: Andrew Harrer/Bloomberg©Bloomberg

Washington’s “Mighty Doves” once again vanquished the “Regional Hawks” at this week’s monetary policy fixture, with the Federal Reserve electing to keep interest rates on hold despite concerns that the central bank would spring an unwelcome surprise on complacent financial markets.

Investors have written off the chances of the US central bank tightening monetary policy at its November meeting because of the looming presidential election, but the odds of a December move — almost exactly a year after the Fed first nudged interest rates off zero — still appear solid.

    The Federal Open Market Committee stressed in its statement on Wednesday that “the case for an increase in the federal funds rate has strengthened”, with forecasts indicating that most members expect to raise rates by the end of the year.

    Moreover, three hawkish members of the rate-setting committee — all of them heads of regional Federal Reserves — voted at Wednesday’s meeting for an immediate rate rise, while the central bank’s customarily more dovish board members voted to hold.
    Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research, noted that there has not been a three-vote dissent since 2014.

    “It shows that there must be a pretty lively debate going on about policy right now. It makes me lean towards the idea that barring a big surprise we will see a rate hike in December,” she said.

    Fed fund futures, derivatives that allow investors to bet on Fed interest rates, indicated a 63 per cent chance of a rate rise in December, up slightly from 59 per cent ahead of the meeting. The two-year Treasury yield rallied slightly on Wednesday afternoon, but still ended the day roughly flat at 0.77 per cent, reflecting the risks of a pre-Christmas rate increase.

    Nonetheless, the fact that the odds are not higher underscores the underwhelming nature of the economic recovery, and how sceptical many investors are that the Fed will imperil it by tightening monetary policy too quickly. The Fed said that it expected only “gradual increases” to its benchmark interest rate, but it is becoming clear that this is not a gradual monetary tightening cycle, but a glacial one.

    Given that some investors and economists had expected a “hawkish hold” — keeping interest rates steady but releasing a more upbeat statement with an even firmer hint of an increase in December — the dovish tenor came as a mild surprise for markets.

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    Coupled with the Bank of Japan’s overhaul of its monetary stimulus package — shifting to a “yield curve control” policy where it will aim to keep the 10-year Japanese government bond yield around zero — the Fed punting rate increases into the long grass helped the S&P 500 climb more than 1 per cent, after the Eurofirst 300 had gained 0.4 per cent earlier on Wednesday.

    Fund managers say “lower for longer” remains the leitmotif for markets. The median estimate of Fed officials is now that the Fed funds rate will average just 1.1 per cent next year — in other words just two more increases after one this year. That was down from the 1.6 per cent median Fed funds forecast made at the time of the June monetary policy meeting. The median forecast for 2018 was pruned from 2.4 per cent to 1.9 per cent.

    As a result, the 10-year and 30-year US Treasury yields fell 3bp and 4bp to 1.65 per cent and 2.39 per cent respectively. Given that shorter-dated bond yields nudged higher, that flattened the “yield curve” — the widely-watched slope of various bond maturities — with the difference between two and 30-year US government debt tumbling back to near 160bp.

    Meanwhile, interest rate futures imply that there is a better than even chance that the Fed will not be able to raise rates more than once before the end of 2017.

    Henry Peabody, a bond fund manager at Eaton Vance, thinks that another rate increase in December is still likely, but argued that the Fed is “boxed in” by ultra-easy monetary policy in Europe and Japan. “The Fed wants to raise rates, but I think they’re afraid of a strong dollar now that they’re at loggerheads with the European Central Bank and the Bank of Japan,” he said.

    Many investors and analysts remain unconvinced that rates will rise even this year. Kevin Giddis, head of fixed income at Raymond James, zeroed in on the Fed stating that the “near-term risks to economic outlook appear roughly balanced” as evidence that officials are not on autopilot towards a December rate increase.

    “That leaves the Fed continuing to look for conditions in which to raise rates,” he wrote in a note to clients. “So for all of the hype, hope, and fear, the Fed has once again merely kicked the can down the road one more time. Not that it wasn’t the right decision, it just prolongs the inevitable.”

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