IS Market Underpricing a June Rate Hike?

May 17th, 2016 6:22 am | by John Jansen |

Stephen Stanley of Amherst Pierpont Securities penned this excellent piece yesterday. He discusses recent rhetoric from FOMC participants and the possibility of a June rate hike. Ms Yellen is scheduled to speak on June 6 and he considers that speech a pivotal event.

Via Stephen Stanley at Amherst Pierpont Securities:

The hawks and the doves at the Federal Reserve often fail to see eye-to-eye, but either the consensus is shifting at the Fed or the hawks are gearing up to challenge the ruler of the roost, Chair Yellen.  Feathers are definitely ruffled, as the hawkish rhetoric over the last week or so has been extraordinary in my view and seems to be ratcheting up in intensity with each successive wave of speakers.  Meanwhile, the financial markets are very confident that the FOMC is not going to move in June and pricing in only slightly better than even odds of a single rate hike over the balance of the year, and policymakers’ rhetoric seems aimed, so far unsuccessfully, at altering that view.  Unlike most market participants and Street economists, I am not quite ready to write off a June move as out of the question.  With roughly a month to go before the June FOMC meeting and two days before the release of the April FOMC minutes, this is how I see the current state of affairs.

In my view, the Fed wanted the April FOMC statement to send the signal that a rate hike in June was possible but not guaranteed.  Officials were clearly not ready to commit at that time, but they did not like the fact that leading up to the late April meeting, the financial markets were only pricing in about a 20% chance of a June move.  Rather, in my opinion, the Fed was hoping to move the needle closer to 50-50 and then let the data be the determinant of whether the Committee pulls the trigger in June.  The sentence from the March statement about global economic and financial developments posing risks was deleted.  In addition, the Committee seemed to judge the strength in labor markets more important than the softness in Q1 GDP and accentuated the positives with respect to the consumer spending outlook.  Nonetheless, financial markets took the statement as no more than a baby step toward the next rate hike and proceeded to actually downgrade the perceived likelihood of a June move.

The first salvo of comments after the FOMC blackout lifted were fairly tame.  No one wanted to commit to anything with so much critical data still to be revealed (and with Q1 GDP just posting a paltry 0.5% advance).  Dallas Fed President Kaplan noted a point that Boston Fed President Rosengren had made before the April FOMC meeting, agreeing that the Fed would probably end up going faster than the markets currently expect.  He noted that if the consumer data were satisfactory, he would probably advocate for a move in June or July.  Atlanta Fed President Lockhart declared that June was a live meeting, but he also acknowledged that the looming Brexit vote would be a risk at that time.  San Francisco Fed President Williams said that June could be appropriate if the data came in as expected, and St. Louis Fed President Bullard concluded that it was too early to judge the merits of a June rate increase with so much data still to be released, though he too suggested that the markets were likely pricing in too shallow a path for the policy rate.  Finally, New York President Dudley in an interview with the New York Times repeated that he is still fine with an expectation of two rate hikes this year.

Clearly, none of this impressed market participants.  The July 2016 fed funds futures contract continued to rally, as market participants lowered their odds of a June move basically to zero.  This apparently did not sit well with a significant contingent of the FOMC.

The most recent and most interesting round of Fed commentary began last Thursday.  Rosengren, a consistent dove since the crisis, gave a speech in which he repeated – and more forcefully – that he felt the markets were off-base: “In my view, the market remains too pessimistic about the fundamental strength of the U.S. economy, and the likelihood of removing monetary accommodation is higher than is currently priced into financial markets based on current data.”  He proceeded to describe why he believed that Q1 GDP was an anomaly, that labor markets are tightening, and wages and prices are beginning to accelerate.  He then dedicated three pages of his speech to fleshing out several of the risks of

leaving rates “too low for too long.”  All of this would have been easily dismissed if it had come from a known hawk, but Rosengren has been near the dovish extreme of the Committee’s range of views for years.  On the same day (last Thursday), Kansas City Fed President George argued not just that a rate hike in the near future may be warranted (which would not be a surprise since she dissented in favor of an immediate move in March and April) but that “I view the current level (of rates) as too low for today’s financial conditions.”  So, now a representative from the dovish contingent is worried that the Fed is staying too low for too long, and a hawk believes that the Fed is already behind the curve.  This was a definite ratcheting up of intensity from the Fed’s normal language.

The drumbeat continued to get louder over the weekend.  Williams on Friday night noted that “it definitely still makes sense, given the data we’ve seen, to have two to three rate increases this year.”  While he said that he had not made up his mind about whether to support a June hike, he acknowledged that “the longer we put this off, the more back fill we are going to have to do later on.”  He also introduced a brand new concept that most market participants are going to consider radical: “I definitely don’t think we need to go into the meetings with markets convinced that we’re going to raise rates in order for us to raise rates.”  Williams’ views were echoed and extended by noted hawk Richmond Fed President Lacker in an interview with the Washington Post.  He sounded much like George in noting that “at this point it looks to me as if the case for raising rates looks to be pretty strong in June,” which is the Fedspeak equivalent of pounding his shoe on the lectern.  He argued that the repeated delays in the wake of episodes of financial uncertainty without follow through once the turmoil subsided has left the Fed decidedly behind the curve (again, a significant step beyond simply saying that a rate hike is justified soon).  He then seconded Williams’ point: “The prospect of surprising markets shouldn’t stay our hand if we think an increase in rates is warranted.”

So, the Bank Presidents (or at least a handful of them) are clearly getting restless.  You may have noticed that we have not heard anything from the only voice that markets think matters: Chair Yellen.  Her last public utterance remains the radically dovish speech from late March.  In fact, the entire Fed Board has been almost entirely silent since the April meeting.  So, while it is tempting for a hawk like me to surmise that the thinking of the entire Committee is evolving in a significant way, it may just be that there is a silent dovish majority and the policymakers who we are hearing from are speaking out because their views are not being validated at the FOMC table.

In this context, the April FOMC minutes represent the last chance that the Committee as a whole will have to influence market thinking before the June FOMC meeting.  If my hypothesis is correct that the Committee wanted to nudge the market expectations closer to even in April, then it would be reasonable to assume that the minutes will have some hawkish tidbits in them that could finally shake market participants’ complacency toward the Fed (or at least try to).  However, in my view, if the Fed wants the markets to price in a reasonable chance of a June move before next month’s vote, then Chair Yellen is going to have to schedule a public appearance and change her tone noticeably from her March 29 missive.  Unless or until she does that, market participants are likely to stubbornly view a rate hike in the near term as unlikely, regardless of how the data come in.  And notwithstanding the comments from Williams and Lacker, the Fed leadership has proven itself to be extraordinarily timid over the past year or two so that the notion that it would hike rates when the markets are not expecting it just after postponing moves twice within the last year by 3 months or more specifically because of market volatility strikes me as very unrealistic.  By late this week, we will have the April FOMC minutes as well as the last CPI release before the June meeting.  Pretty soon, patiently watching the data is going to segue to crunch time.

In what can only be described as a bolt of lightning from Heaven, as I was proofreading this note, headlines hit the newswires that Chair Yellen will be delivering a speech on June 6 (one day before the blackout for the June FOMC meeting begins) to the World Affairs Council in Philadelphia.  That’s positively eerie, but it also significantly raises the odds in my view that the Fed is in fact seriously considering a June rate hike, and Yellen can deliver the decisive blow in support of one in this June 6 speech if the data support such a course of action.

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  1. 2 Responses to “IS Market Underpricing a June Rate Hike?”

  2. By pepe on May 17, 2016 | Reply

    The FOMC members’ “hawkish” comments are intended to induce the market to price in a higher probability of a June rate hike but that doesn’t mean a June rate hike is likely in absolute terms. A rate hike ahead of the Brexit referendum seems highly unlikely to me, given the Fed’s caution to date.

  3. By Robert @RetirementMedia on May 18, 2016 | Reply

    Let’s see what Chair Yellen says on June 6th. That may be the most important thing to happen for awhile.

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