The Fed and Wall Street Differ on How High Rates Will Go

23 Dec 2015 | Author: | No comments yet »

Fed’s rate rise has shown America is strongLONDON: World stock markets jumped on Thursday as investors chose to take the first hike in US interest rates since 2006 as a mark of confidence in the world’s largest economy. U.S. stocks dropped Thursday on persistent concern over faltering global economic growth, led by declines in energy and materials shares, a day after shares had rallied on the Federal Reserve’s decision to raise interest rates.

Housing starts rebounded smartly in November, but industrial production tumbled 0.6% last month – the biggest monthly decline in more than three years.The Federal Reserve is indicating that it will raise interest rates four more times before the end of 2016, but traders in the financial markets don’t believe it.

Oil prices LCOc1 CLc1 extended recent declines on persistent oversupply worries and as the dollar .DXY hit a two-week high. [O/R] [FRX/] Dow components Exxon (XOM.N) and Chevron (CVX.N) were down, by 1.5 and 3.1 percent, respectively. Germany’s DAX surged over 3 percent, its biggest rise since August, and Britain’s FTSE 100 and France’s CAC 40 leapt 1.4 and 2.5 percent respectively. The stock markets cheered the Fed rate hike, but some economists saw the central bank as acknowledging how little it knows about where the economy might be headed. The Fed statement hedged the possibility that inflation might not pick up much and acknowledged that global pressures could influence its choices going forward, said Charles Calomiris, a professor of economics and finance at Columbia University.

The FFR, for those not au fait with central bank parlance – and who is? – is the equivalent of the Bank of England base rate, which is the rate with which the Bank attempts to guide all other interest rates within the UK economy. The global headwinds stemming from difficulties in emerging economies such as China, Russia and Brazil could further suppress inflation and hurt hiring, possibilities that the Fed might struggle to model. “The Fed is much more uncertain itself about what is going on in the economy and willing to express that,” Calomiris said. “It doesn’t have a very clear model of how the economy is functioning.” Bank of America says it is increasing the prime lending rate to 3.5 percent effective immediately, while Citibank, M&T Bank and PNC Financial plan to make the change effective Thursday. The reasoning, as the Fed explained, is the “considerable improvement in labor market conditions this year” and the outlook for inflation “will rise, over the medium term, to its 2 percent objective.” But the economic data is mixed, as yesterday’s sharply divergent US macro updates remind us.

On Dec. 16 the rate-setting Federal Open Market Committee raised its target for the federal funds rate to a range of 0.25 percent to 0.5 percent from a range that touched zero, where it had been since December 2008. US Federal Reserve Chairperson Janet Yellen’s assurances that further tightening would be gradual and dependent on inflation soothed markets after the Fed’s first rate increase in nearly a decade, which followed months of waiting and several false starts. “Central banks now have a lot of skin in the game because of their hugely bloated balance sheets. The only difference between the two – other than the names – is that the base rate is a single number, a target if you will, whereas the FFR is two numbers, a range.

Investors’ focus returned on Thursday, however, to concerns about weak global economic conditions as the slide in commodity markets continued unabated. The increase signals that Fed rate-setters feel that the U.S. recovery, which began in June 2009, is finally strong enough that they can begin taking it off monetary life support. “The underlying health of the U.S. economy seems to be quite sound,” Yellen said at a press conference. So if they take markets off-guard, they get hurt themselves.” The rate forecasts, or dot points, from Fed members were a little higher than many expected, with 100 basis points of hikes pencilled in for next year and a terminal rate of 3.5 percent. China’s slowdown has been transmitted to the rest of the world through a fall in oil and commodities prices, said Hugh Johnson, chief investment officer of Hugh Johnson Advisors LLC in Albany, N.Y., which he said “is raising serious questions about global demand and the global economy.” The Dow Jones industrial average .DJI fell 253.25 points, or 1.43 percent, to 17,495.84, the S&P 500 .SPX lost 31.18 points, or 1.5 percent, to 2,041.89 and the Nasdaq Composite .IXIC dropped 68.58 points, or 1.35 percent, to 5,002.55. The Fed’s own expectations for rates are set out in the periodically released “dot plot.” Each dot in this chart represents a forecast for the fed funds rate by a member of the FOMC.

The Fed’s decision on Wednesday to increase the rate was well flagged, thanks to guidance by chairman Janet Yellen and some of the other 11 members of the Federal Open Markets Committee. Friday’s “quadruple-witching,” when options on stocks and indexes and futures on indexes and single stocks all expire on the same day, could exacerbate volatility. Declining issues outnumbered advancing ones on the NYSE by 2,016 to 1,048, for a 1.92-to-1 ratio on the downside; on the Nasdaq, 1,884 issues fell and 962 advanced for a 1.96-to-1 ratio favoring decliners.

About 8.0 billion shares changed hands on U.S. exchanges, compared with the 7.2 billion daily average for the past 20 trading days, according to Thomson Reuters data. Having not moved rates for seven years – and not done so in an upward direction for nine years – even the act of placing those marks on the so-called “dot plot” would have felt historic for the 12 men and women involved.

That’s still above the tipping point of -0.80 that marks the start of recessions, based on the San Francisco Fed’s analysis (“Diagnosing Recessions”). Translating the ADS data into probability estimates of recession risk via a probit model reveals a sharp jump in macro risk after yesterday’s updates.

It’s common for the market to underestimate the pace at which the Fed will change interest rates, Oubina says. “I think this time it’s even more pronounced because of the length of time we have been near zero.” Jan Hatzius, chief economist of Goldman Sachs, says the Fed’s forecast is probably better than the financial market’s. Until (or if?) we see confirmation in other business cycle indicators and economic data in the days ahead, it’s fair to stay that the case for modest growth in the near term is still a reasonable working assumption. A reporter asked Fed Chair Janet Yellen about the track record of raising the policy rate and the onset of economic downturns – a history that tends to manifest itself in the early warning signal of an inverted yield curve, i.e., short rates rising above long rates. But as they rise, and as clearing banks begin to follow suit – as a number have in the US over the past 36 hours – so money flows back towards the US will increase. In a Dec. 2 speech to the Economic Club of Washington, D.C., Yellen acknowledged that market measures of expected inflation had fallen to “historically low levels” this fall.

She said that while she’s not greatly worried at the moment, “declines in consumer and business expectations about inflation could put downward pressure on actual inflation.” The danger of losing control of monetary policy is obvious in Europe. One of the triggers that led to the recent emerging market bubble – a bubble which is now rapidly deflating – was the flow of money from advanced economies looking to earn better rates of return. With many of those countries now experiencing real problems – Brazil, Argentina and Russia being just three examples – US fund managers could be forgiven for keeping their investments closer to home. Meantime, Janet Yellen yesterday advised that one rationale for raising rates at this point is to minimize recession risk by rolling out a tighter policy relatively early so as to allow more time for gradual increases.

But be forewarned: Fed forecasts about economic growth have been notoriously inaccurate during the more than six-year recovery from the Great Recession. She reasoned that “an abrupt tightening could increase the risk of pushing the economy into recession.” Responding to a reporter’s question about the tendency for Fed rate hikes to trigger downturns, Yellen framed that history as a function of waiting too long to squeeze policy to combat rising inflation. He then used a speech at Lincoln Cathedral over the summer to suggest rates would rise at the turn of the year, only to backtrack, and suggest as recently as this week in a newspaper interview that the Fed’s increase would not mean that the UK will follow suit. This is a crucial sign that the rising inflation Fed officials expect to see might remain elusive, as cheaper oil undercuts the economy’s ability to achieve the Fed’s 2 percent target. The increases came despite the news that U.S. industrial output fell for the third straight month in November, another sign that American manufacturers are under stress.

Most Asian stock markets are finishing with big gains as anticipation builds for the Fed’s decision on whether to raise rates after seven years at ultralow levels. Hong Kong’s Hang Seng rebounded from a nine-day losing streak to advance 2 percent but gains were less robust on the Shanghai Composite Index in mainland China, which closed 0.2 percent higher. Tara Sinclair, a professor at George Washington University and chief economist at the jobs site Indeed, says hiring in both industries would likely be influenced by how quickly the Fed raises rates over the next year.

Higher borrowing costs could limit construction, and higher rates could also cause the dollar to rise, making U.S. manufacturing exports more expensive abroad. Logan Wright, director of China market research for Rhodium Group, says Beijing’s need to control capital outflows would hamper the ability of policymakers to stimulate China’s slowing economy by cutting interest rates.

Wright says “the potential for normalization of U.S. monetary policy should definitely be seen as a headwind for Chinese attempts to ease monetary conditions.” Low interest rates have been a boon for stock market investors for several years but Fed officials have telegraphed the likely decision far in advance.

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