Fed surprises markets with hawkish speakers – minutes

Michalis Florentiades, XM Investment Research Desk

The key development of the previous few days has been the shift in expectations about a possible Fed rate hike during the June / July period.  Whereas markets even a week ago attached a very low probability to a rate hike in the next two months, following this week’s Fed speakers and the release of the minutes from the April FOMC meeting, this perception has changed.

The result of this has been renewed strength of the US dollar, as the dollar index reached its highest in 7 weeks.  This is an important shift – even though realistically speaking it’s only regarding a 25 basis points move – as there could now be 2 or even 3 rate hikes during 2016 instead of the previous predictions of “1 maybe” by market participants.  It appears that positive US economic indicators such as encouraging readings on consumption, inflation and unemployment have emboldened Fed officials.  In addition, financial markets do not appear overly stressed about global developments and growth worldwide is holding on, making the ‘global worries’ argument less valid.  The rebound in the oil price and the easing of the threat of deflation might also have been factors.

It’s also possible that the Fed feels it is safer to move now that its major counterparts such as the European Central Bank, the Bank of Japan and the Bank of England appear to be on hold.  The ECB and BoJ for example had embarked on some major stimulus action during the first quarter.  Had the Fed hiked rates back then, this might have led to an unwanted dollar rally as it would have underlined the monetary policy divergence between the three central banks.  With the experience of Fed inaction still fresh, traders might be reluctant to push the dollar much higher just on the mere prospect of a small rate hike in 1-2 months’ time.  And indeed the dollar rally has been a measured affair and the market appears quite cautious to drive it sharply higher before the Fed actually hikes.

Although Fed officials appear eager to hike rates soon, they also appear worried about the possible disruption as a result of the UK referendum on EU membership.  Recent polls however have boosted the chances for ‘Bremain’ and if this trend continues, the Fed might feel more comfortable to move in June, some 8 days ahead of the referendum date.  Therefore, quite perversely, it’s possible that the greenback might also be a beneficiary of polls that show ‘Bremain’ prevailing.

Finally, the Fed’s communication strategy is also noteworthy.  As soon as the Fed saw the market straying too far from the consensus view the FOMC held about what to do on interest rates, several speakers came out and warned that interest rate hikes were more probable than what the markets were signaling.  The views of the various Fed officials were more uniform-than-usual during this period and this showed an intentional effort by the Fed to communicate with the market.  This shows that the Fed does not want to leave markets guessing about the future direction of monetary policy but instead is trying to be transparent and clear in guiding expectations.  The bottom line is that the Fed does not want to deliver surprises at this point and this contrasts with other central banks that see the element of surprise as a component of their strategy.  The Fed’s openness can of course backfire- in the case that the Fed has to make quick, unexpected changes in its strategy which may lead to a loss of credibility.  Nevertheless comparing with the taper tantrum of 2013, it looks like the Fed might have learned a lesson or two.  It’s also possible that the Fed is becoming more sensitive to the downside risks of keeping rates too low for too long.