Up and Down Wall Street
Yes, a Fed Rate Hike May Come Sooner Than Later
Surging stocks, plus strong jobs data, could ease Yellen & Co.’s concerns and spur a July 27 statement surprise.
Will new highs in stocks spur the Federal Reserve to raise interest rates sooner than the market expects, perhaps even later this month?
Given the Fed’s mandates to aim for maximum employment with moderate inflation (which it defines as 2% per annum), the level of U.S. equity prices should play little, if any, role in setting monetary policy. But even from a totally non-cynical view, there may be justification for the Fed to raise its interest rate target more and sooner than the single hike the financial futures market currently foresees later in 2017.
In a research note published Tuesday, Goldman Sachs’ chief economist Jan Hatzius wrote the Federal Open Market Committee, in holding rates steady at last month’s meeting, opted to “play for time” ahead of the U.K. vote on leaving the European Union and with uncertainty hanging over U.S. economic data after the shockingly weak May payrolls report.
But now, a lot of these uncertainties have cleared. He suggests the markets now may be unduly optimistic in expecting just a single Fed rate hike and too pessimistic in their assessment of the economy, especially after the “blowout” 287,000 jump in June nonfarm payrolls reported last Friday.
Payrolls are growing at a 150,000-175,000 monthly clip — a strong pace with the economy near full employment with a jobless rate of 4.9%, and arguably stronger than 225,000 a month with a 6%-7% unemployment rate, he suggests.
Wages and prices also have picked up, Hatzius continues, with Goldman’s pay tracker based on various measures accelerating to a 2.9% annual rate from the 2% pace that prevailed from 2010 to 2014. Forward inflation measures, both from break-even rates from Treasury Inflation Protected Securities and survey measures, show a moderate rebound in the past month or so, he adds.
Growth forecasts of 2% over the next two years look less daunting, he continues. That’s especially true given that the risks from Brexit and renewed turbulence from China have receded.
“On the positive side, our financial conditions index has now moved to its easiest level since July 2015,” Hatzius continues. “This is important because we estimate that the earlier tightening in financial conditions subtracted more than one percentage point from U.S. growth over the past year.
The current FCI level suggests that this drag will give way to a slight positive impulse over the next year.”
“So the economy is close to the mandate, financial conditions have eased, and the risks around our forecast of further above-trend growth look balanced. Given all this, why is the bond market priced for only a bit more than one rate hike over the next two years?” Hatzius asks.
That may owe partly to a less optimistic consensus outlook than the Goldman view. “But the strong performance of the equity and credit markets casts some doubt on the market’s growth pessimism,” he observes. In that regard, since their Feb. 11 low, junk-bond prices are up over 13% based on the iShares iBoxx High Yield Corporate Bond exchange-traded fund while the SPDR S&P 500 ETF is up 17% over that span.
Indeed, what has changed mainly are securities prices rather than economic realities. The economy is the proverbial supertanker while markets change tacks on a proverbial dime. Markets dart around like hyperactive kids.
The mythical man from Mars would observe that the Fed raised its federal funds target a quarter point last December when the stock market was on a positive trajectory with the Standard & Poor’s 500 not far from its previous 2135 high. The Fed backed off from rate hikes after the S&P 500 went into correction territory in early 2016.
And the central bank’s reluctance has persisted amid the uncertainties over the jobs numbers and Brexit but also while the S&P 500 had stayed below 2100. Coincidence? Perhaps.
Arguably, the recovery in risk markets owes mainly to the perception that, absent any imminent disasters, stocks and corporate debt are attractive relative to sovereign bonds yielding less than zero.
As the risks from Brexit and U.S. economic data dissipated, new highs were set in the U.S. stock market.
Could that leave the Fed an opening to boost rates? Hatzius suggests the July 27 Federal Open Market Committee meeting offers the possibility of sending a message that a rate hike could be coming this year.
A Sept. 21 rate increase could then follow. MFR’s chief U.S. economist, Joshua Shapiro, suggests this FOMC meeting offers the chance for the panel to move further from the zero bound on short-term rates — before the slowdown he sees for late this year or 2017 from deteriorating corporate profits forcing more cost-cutting and weaker jobs growth. The FOMC also will present a new set of year-end federal funds rate forecasts (the “dot plot”) and economic projections.
As for the studiously apolitical Fed, a September hike would be a politically adroit move to maintain its appearance of nonpartisanship. The Nov. 1-2 meeting would come a week before Election Day. The next FOMC meeting is Dec. 13-14, which would be a year after the Fed’s initial hike, to 0.25%-0.5%, and probably would be the next most likely candidate.
To be sure, the futures market doesn’t see any Fed rate increases for more than a year. Only by September 2017 does the probability of a hike exceed 50%, according to Bloomberg’s analysis.
All of which means the markets aren’t pricing any rate increase this year while the FOMC dot plot consensus calls for two quarter-point moves. Even though, as Goldman’s Hatzius points out, the data align for a rate increase.
So does the stock market’s record level. Don’t lose sight of what happened after last December’s rate hike.