Global Daily – Three scenarios for the Fed

by: Maritza Cabezas , Nick Kounis

Global-Daily-Insight-17-September-2015.pdf (53 KB)
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We expect the Fed to keep rates on hold, but to continue to signal a rate hike this year – Such a scenario would be relatively benign for financial markets – We sketch out a more negative scenario (a 25bp hike) and a positive one (signal of no hike until 2016)

Fed to keep rates on hold on Thursday

We expect the FOMC to hold fire on Thursday. In the run-up to the  meeting, the economic data released has been positive on many fronts, including the labour market, consumption and overall GDP growth. Although inflation and wages have been below expectations, the pace at which the slack in the labour market has been diminishing suggests that both could accelerate in time. Perhaps a larger concern for the Fed is the recent turmoil in financial markets associated with downside risks to EM growth. The Fed will probably want to wait to get a better assessment. The impact of this on the Fed forecasts will be reflected in the dot plot.

Dot plot will signal liftoff and pace of hikes

During June’s meeting, the outlook for the feds fund rate, the so called “dot plot” has forecasted that in 2015, the midpoint of the target range was 62.5bp, but with some dispersion. Seven from the seventeen members had forecasted a first rate hike in 2016 or later. In order for the rate hike to take place this year, we expect FOMC members to converge to the range of 0.5% and 0.75%. If this does not occur it is a clear sign that the rate hike is postponed until 2016. With respect to the path of interest rate normalization, the dot plot will likely emphasize a slow pace of rate hikes in 2016, with a lower midpoint that that which was communicated in June (162.5bp). This is in line with our forecast of a target range of 25-50bp in December and ending at 125bp-150bp at the end of 2016. Chair Yellen’s press conference will give more information on the reasons for delaying the rate hike from September to December.

Investors expect December rate hike

At the forefront of this rate tightening cycle, investors have been skeptical about the Fed hiking rates in the short term, mainly given the uncertainty around the global economy. Markets expect a probability of almost 70% for a rate hike in December. Communication with markets will be crucial in this meeting to reduce the impact of the adjustment. Below we sketch out some scenarios and their possible market impact.

 

Scenario 1 – Benign – Our base case, where the Fed keeps interest rates on hold but signals that a December move is still on the table should be modestly positive for Treasuries and equities, but slightly negative for the US dollar. This is because markets attached only some possibility of a move on Thursday (around 30%). The reaction should be tempered by the signal that a hike is still on for this year.

Scenario 2 – Negative  – A rate hike already on Thursday would be an initial negative for Treasuries, equities and gold, but positive for the US dollar. The FOMC could cushion the blow in such a scenario if it convincingly communicated that the next rate move was some way off.

Scenario 3 – Positive – The most positive scenario for financial markets would be if the Fed left interest rates on hold, while hinting that the first rate increase in its target for the fed funds rate had been pushed back to 2016. Such an outcome would provide significant support for equities, Treasuries and gold, while weighing on the US dollar