Lights out ahead of Fed's September rates surprise
The market had anticipated the Fed would use its last speech before its September rates decision to prep the ground for a hike, but the audience was instead given a list of reasons for the Bank not to act. The market reaction underlines the diminishing returns of ultra-loose monetary policy.
Federal Reserve dovish governor Lael Brainard soothed the market’s concerns about the US rates outlook on Monday, emphasizing the need for patience in the removal of policy accommodation. The market took that as a clear signal there will be no rate rise in September.
In the last comments before the Federal Reserve's blackout period, in which Federal Open Market Committee (FOMC) participants and staff are forbidden to speak publicly or grant interviews, Brainard argued that the neutral real interest rate was now around zero.
In fact, the 20% USD rally between mid-2014 and early 2016 is the equivalent of a 2% rate hike, she said.
If the claim was meant to appease those who feel the Fed should be doing more to rein in markets, it is unlikely to convince everyone. Kit Juckes, macro strategist at Société Générale, admits he is not sure whether her claim holds up – though it certainly reinforces her dovish credentials.
In essence, Brainard's view is there is little reason to rush into the second hike of the cycle, with the potential damage inflicted by a premature decision greater than the risk of a tardy one.
And she is not alone in her assessment: governor Daniel Tarullo had already suggested rates should remain on hold until there is clear evidence that inflation is returning sustainably towards its target, while Minneapolis Fed president Neel Kashkari has also called for patience.
The FOMC might also be feeling pressure from foreign central banks to stay its hand. Carl Hammer, chief currency strategist at SEB, says the Federal Reserve "most likely faced pressure from stressed emerging-market economies at [the G20 meeting in Shanghai] to proceed only very carefully with future interest rate hikes".
Yet claims about the asymmetric risk of the decision are also up for debate.
"Central banks are fearful of the effects of protracted periods of negative rates, and aware – notably the Bank of Japan (BoJ) – of the dangers of yield curves that are low and flat at the same time," says SocGén's Juckes.
Of course, the BoJ has been wrestling with the problem of low rates for far longer than the Fed. Governor Haruhiko Kuroda has acknowledged the ultra-loose policies many central banks have pursued hit the profits of financial institutions and the real economy.
Low long-term yields can hurt other business by forcing them to put aside more money for long-term pension obligations, says Jane Foley, head of FX strategy at Rabobank.
“For some time, dissenting BoJ committee member [Takahide] Kiuchi has been arguing that the marginal effects of the BoJ’s QQE [quantitative and qualitative monetary easing] policy have been diminishing and that the benefits had already been outweighed by the side effects,” she adds.
These diminishing returns were arguably on display in the hours after Brainard's comments. In the immediate aftermath, risk appetite saw the expected boost and the dollar weakened, but the impact was short-lived. The next day, USD was strengthening again, with 10-year treasuries rising seven basis points by the day's close.
Chris Turner, head of FX strategy at ING, says: "There were probably some other contributing factors, such as the prospect of the BoJ announcing a reverse operation twist next week – trying to steepen the JGB curve – and a poor US 30-year auction.”
Stronger-than-expected activity figures for China might also have played a part.
However, clearly there were residual concerns about the Fed's forthcoming decision as well. “It is interesting that market-based measures of US inflation expectations (5Y5Y inflation swap) are starting to nudge higher again," says Turner.
For all the debate about the Fed's intentions, there is a clear prevailing view: the market is now pricing the probability of a Fed hike next week at 22%, down from a peak of 43% in late August, and in the 30s last week.
Craig Erlam, senior markets analyst at Oanda, says: “While a hawkish consensus does appear to be building among the committee, the absence of some key policymakers from this makes a hike at the meeting next week very unlikely. [But] expectations for December are still higher despite September appearing to be off the table.”
However, the comments did not completely kill all expectations of a hike. Brainard is, after all, only one member of the FOMC. There are others, including Stanley Fischer and Eric Rosengren, who have been equally explicit in their view that the committee should act.
BNP Paribas FX strategists argue that the comments reflect the views of the more dovish members of the committee, rather than the committee as a whole.
“Our team continues to expect the Fed to deliver a rate hike at next week’s meeting, with the outcome expected to be softened by a shallower projected path of rates and a lower terminal rate estimate in the accompanying projections,” they wrote in a research report.
Divisions are not only evident inside the FOMC committee.
Simon Smith, chief economist at broker FXPro, says: “There has clearly been a disconnect between market thinking and what the Fed has been saying in recent weeks, so whilst on paper the risks may be low, in practice the market will be right in remaining nervous ahead of the September 21 meeting.”
Many in the market clearly share the concerns expressed by the more hawkish central bankers.
Rabobank’s Foley adds: “While Brainard’s remarks have appeased market sentiment, they do little to address underlying anxiety over whether policymakers are losing their faith in the benefits of ultra-accommodative monetary policies. The outcome of next week’s BoJ policy meeting is likely to be more informative with respect to this issue than that of the Fed.”