As Fed hawk flip-flops, investors downgrade rate-hike bets.
St. Louis Federal Reserve President James Bullard reiterated his low-growth forecast for the US economy on Thursday, reminding investors that interest rates are expected to rise more slowly than previously thought.
“As I reflected on the general trend in data, in particular the slowdown in real output growth over the last year, it became clear to me that we could no longer count on the usual cyclical dynamics,” Mr. Bullard, who is also a voting member of the Federal Open Market Committee (FOMC), said at a speech in London.
Mr. Bullard surprised markets earlier this month when he admitted to being the lowest dot on the Federal Reserve’s so-called “dot plot” chart of interest rate expectations. Although some analysts labeled the traditionally hawkish Bullard as a “flip-flopper,”i his mood reflects broad central bank opinion that the domestic and global economies are too weak to support a more aggressive rate-hike path. Further, the latest drama surrounding Brexit, which triggered the biggest two-day selloff in stock market history,ii will likely give US and global central bankers the scope they need to keep interest rates lower for longer.
Why Does a Fed Rate Hike Matter?
The Fed’s “dot plots” have been known to move markets because they provide a possible timeline for when interest rates could rise. In June the median FOMC member saw interest rates between 0.75% and 1% at the end of 2016, suggesting at least two rate hikes this year. However, market participants are currently betting there will be zero interest rate increase this year, according to the CME FedWatch tool. Investors had previously priced in one 25-basis point increase in December before Brexit unleashed fury on the financial markets.
Interest rates have become an even more critical policy tool in the wake of the 2008 financial crisis, where economies have relied on record monetary easing to fight against recession. Therefore, expectations surrounding interest rates have direct implications on conversations tied to economic growth and inflation – variables that drive the global market.
The performance of the US and global financial markets are often driven by the outlook for the future path of interest rates. Given that the United States is the world’s largest economy, monetary policy decisions made in Washington have a far-reaching impact. It impacts everything from stock market liquidity to company profits to the performance of the US dollar. These interlocking elements drive trade and finance in the world economy. Therefore, decisions which impact these variables are viewed critically by financial market players.
The US dollar has been the prime benefactor of rate-hike speculation. Between July 2014 (when the Fed began talking about raising rates) to December 2015 (when the Fed actually pulled the trigger on a rate-hike), the US dollar spiked 25% against a basket of world currencies. A stronger dollar not only drives down relative demand for non-yielding assets such as precious metals, it makes it costlier for US multinationals to repatriate profits. A strong dollar has contributed to Wall Street’s declining earnings, with earnings growth at their lowest levels since the 2008 financial crisis.
Will Brexit Impact Fed’s Decision?
Britain’s vote to exit the European Union has thrown financial markets into disarray, as investors speculate about the political and economic consequences of the so-called Brexit. Experts are concerned that uncertainty tied to Britain’s future relationship with the EU could trigger new bouts of volatility in the market over the near and long term.
In this environment, the Fed is unlikely to raise rates this summer. The central bank has already sought to reassure investors that it will provide the liquidity the market needs via swap lines in place with other central banks, including the Bank of England, whose governor recently announced that additional monetary stimulus is likely this summer.iii
As the global economy muddles through various risks, investors, banks and businesses will continue to rely on interest rates and other monetary policy tools to gauge the health of the economy. The major concern among investors is whether advanced economies can actually survive without external stimulus. With the Fed still on course to be the first major central bank to raise interest rates, the United States will likely be the first case study.
i Greg Robb (June 30, 2016). “Fed’s Bullard says growth slowdown led him to dovish ‘low-dot’ projection.” Market Watch.
ii Sam Bourgi (June 25, 2016). “UK’s EU Referendum: Battle for Prime Minister Brewing following Brexit Vote as David Cameron Steps Down.” Economic Calendar.
iii Scott Hamilton (June 30, 2016). “Mark Carney says Bank of England stimulus likely, but warns only so much it can do.” Financial posts.