Fed may rethink rate pause if stocks and data keep looking up

Michalis Florentiades, XM Investment Research Desk

There has recently been some renewed optimism that the Federal Reserve could get up from the fence it has been sitting on since December of last year.  As can be seen from the chart of the 2-year Treasury yield, a gauge of short-term interest rate expectations for the next 2 years, expectations have recovered to near pre-Brexit levels.

The 2-year yield has managed to claw back to 70 basis points after dropping to around 0.5% in the immediate aftermath of the Brexit vote.  The immediate aftermath of the vote saw a sharp sell-off in risk assets and a major rally in bonds.  However, since then stocks have recovered with the S&P 500 breaking to new all-time highs, while a number of economic reports have painted a relatively rosy picture of the US economy.  For example, June’s payroll figures reversed the dire picture of the May numbers while retail sales for the same month were also very strong.  Industrial output also delivered a beat, while housing was also on a strong footing.  There was some disappointment from a significant miss from the University of Michigan’s consumer sentiment and a slightly worse-than-expected inflation reading, but both ISM indices (Manufacturing and Services) solidly beat expectations.  In addition to the strong numbers, there is an overall consensus that Brexit is unlikely to have any major impact on the US and may actually benefit the country as some investment may head to relatively healthier America rather than troubled Europe.

In this context, some of the Fed speakers’ caution in the immediate aftermath of Brexit now looks less justified.  With the benefit of hindsight, Brexit has not been such a stressful event for global financial markets.  This could have interesting implications on trades and investments that were made under the assumption that the Fed would be well and truly out of the picture for many months to come.

The Federal Reserve under Janet Yellen has earned somewhat of a reputation for being dovish so forecasts of the Fed staying put are usually on the mark.  In addition, judging the impact of Brexit from the financial market reaction to the event can be dangerous as markets can sometimes underestimate danger or operate under wrong assumptions – as they did on the eve of the Brexit result announcement.  Therefore, as the IMF also pointed out this week, Brexit is going to have negative effect on global economic growth and it has raised the uncertainty of the various outcomes.  For example right now it looks like it will take a lot of acrobatics for the EU and the UK to agree to a comprehensive deal given their starting positions on issues like immigration, access to the Single Market and budget contributions.

Nevertheless, the Fed cannot possibly await the outcome of the Brexit negotiations before it makes another move and this is an uncertainty it will have to live with – as will other central banks and investors and businesses everywhere.  The Fed might avoid the temptation to sound too hawkish at a time when other central banks such as the Bank of Japan, Bank of England and possibly the European Central Bank are all thinking of easing further.  This could drive the dollar sharply higher.  In addition, the Federal Reserve wants to stay out of US politics, so a decision in early November – a few days before the US Presidential Election – is very unlikely.  Markets are 100% sure that the Fed will not want to move in July as this would be a huge surprise for which the market has not prepared for.  This leaves September and December as the possible dates when a quarter point hike could be delivered.  December is probably more likely than September, but if the data keeps supporting an early move and if the global environment remains more or less stable, a quarter-point hike would provide a positive signal for the US economy.