Hawkish Fed Serenade Accentuates Data Dependence

The key takeaway from the FOMC statement is that the external conditions that were concerning to voting members have dissipated.

This article was written by Idan Levitov, head analyst for anyoption.com.

Amid all the fanfare surrounding the Federal Reserve’s monetary policy decision, the emphasis continues to be on forward looking data as the central bank leaves the door open for possible action in the upcoming meetings.

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With the benchmark interest rate left on hold at 0.50% as was widely expected, the focus now turns to the June 15th meeting of the FOMC. However, between now and then, financial markets will be closely monitoring macroeconomic developments and fundamental indicators for signs that the Federal Reserve is preparing to continue holding or raise rates additionally.

The key takeaway from the FOMC statement is that the external conditions that were concerning to voting members have dissipated.

Even though the Open Market Committee downgraded growth, it still stands to reason that they have a chance of raising rates in June should GDP growth manage to beat expectations.

Domestic Downgrade

Quick to highlight the steady improvement in labor market conditions, economic activity continued to be a troublesome development after being labeled as “slowed” in comparison to the prior statement which underlined more “moderate growth.”

The main focus continued to be on labor market developments, especially with the Atlanta Fed’s GDPNow model only predicting modest growth of 0.60% for the first quarter later of 2016.

The uptick in unemployment to 5.00% might not be a feather in the Federal Reserve’s cap, but the central bank was quick to cite income growth as “solid.”  However, comparing the Federal Reserve’s narrative to reality showcases a substantial disparity.

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Hourly earnings are rising, but average hours worked remains at 34.40 hours in a sign that job creation creation is falling short as the economy adds more part-time workers.  Inflation meanwhile is expected to continuing trending towards the 2.00% target, helping to boost rate hike expectations.

The Sole Dissenter

Kansas City Federal Reserve President Esther George continued to be a dissenter of the voting members, opting to vote for a 25 basis point hike in rates for the second meeting in a row instead of leaving monetary policy on hold.

While on multiple occasions George has underlined the fact that the Federal Reserve should not be sensitive to developments in financial markets, many market participants are concerned that an uptick in volatility could derail any future rate hikes.

When combined with any of the political developments in Europe and unfolding economic malaise in Asia, it is difficult to understand why the Federal Reserve removed the phrase regarding “global risk factors” from the statement.

Although all remaining voting members of the committee were in favor of continuing existing policies, the degree of the hawkishness of the Federal Reserve will become more apparent when the minutes of the meeting are released in May.

A more detailed review of the meeting will help provide insight into the thought process behind the latest change in language and how that will impact the outlook for policy.  While the latest action does leave the door open for a rate hike in the first half of the year, a multitude of indicators are pointing to impending challenges for officials as they try and frame a more hawkish narrative.

Futures Not Pricing Imminent Action

A quick look at the CME Group’s FedWatch tool which is based on 30-day Fed Fund futures shows that the implied probability of a rate hike in June jumped after the announcement from 1.20% beforehand to 15.00% at present, a sharp increase.  However, based on the futures prices, the probability of even one rate hike over the course of the year looks like a distant probability.

The 42.10% implied probability for a 25 basis point rise in December currently comes in as the most likely time for the Federal Reserve to hike rates this year.  However, with the dot plot prediction of rates set to be released in the next live meeting of the FOMC, the thought process of officials will be revealed with greater clarity.

The reaction to the news was volatile at first, but largely absent a major impact on financial markets.  Even with the more hawkish tone of the FOMC statement, risk assets were on the rise while the dollar gave up further ground.  S&P 500 futures rose after the announcement, only to tumble overnight following the Bank of Japan’s decision not to adjust its own monetary policy.

Although the reaction in gold was mostly negative, falling to nearly $1240 per troy ounce, the precious metal managed a rebound back above $1250 overnight in light of the slide in the USDJPY pair.

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