Expectations grow for September rate hike
Last week contained a few surprises for investors, starting with the FOMC announcement on Wednesday. While it was no surprise that the Fed chose not to raise rates, some of the wording in the announcement, which could be interpreted as more hawkish, did come as a surprise - at least to some.
The Federal Open Market Committee (FOMC) seems relieved that the Brexit vote has not been impactful and that the US economy is experiencing moderate growth, especially the labor market which rebounded strongly in June after a weak May jobs report.
The key language in the latest FOMC announcement that suggests the Fed is seriously considering a September rate hike is the FOMC's belief that "near-term risks to the economic outlook have diminished."
It is not surprising that one of the participants most eager to raise rates, Esther George, cast a dissenting vote at this meeting. Though the data flow between now and September will determine the next policy decisions, it seems clear that the FOMC is open to raising rates, and that inflation data will be critical. We saw expectations of a September rate hike, as gauged by fed funds futures, rise after the announcement-although it still remains relatively low.
Market participants were surprised again last Friday when the Bank of Japan (BOJ) issued its meeting announcement. The BOJ surprised market participants by not providing a heavy dose of stimulus.
It chose to keep interest rates at current levels and not embark on any additional bond purchases. It had even been speculated that the BOJ would invoke helicopter money in an attempt to stimulate the economy; instead it announced it would be purchasing ETFs and it would expand a lending program to local companies. However, it was encouraging to see in the announcement that the central bank will conduct a comprehensive assessment of its policy.
2016 GDP growth is weak thus far
Friday's release of GDP growth for the second quarter also surprised to the downside. While this was the initial estimate of growth and is subject to significant revision, it was well below expectations - and not much better than the disappointing first quarter GDP growth print.
While consumer spending was strong, business investment declined for a third straight quarter - and this latest reading was joined by a decline in housing investment. A reduction in inventory investment also negatively impacted growth in the quarter. However, the US was due for an inventory correction, and having booked it in the second quarter with household spending still strong, this bodes well for the third quarter.
If the annualized growth reading for the second quarter does not change much between now and its final print, this means that the US economy is growing at a very slow pace. This provides a conflicting read on the economy than what can be found by examining employment statistics.
These negative surprises helped push major stock indices lower for the week - and sent the yield on the 10-year US Treasury down to 1.452% by week's end, from 1.584% a week earlier. Finally, the stock market's post-Brexit rally, which seemed driven by the thesis that there would be greater monetary policy accommodation globally, at least in part because of the vote, has come to an end. That makes sense given that this recent run-up was not driven by fundamentals.
But the week was not yet over. We heard from New York Fed President William Dudley, who spoke at a central-bank seminar over the weekend in Bali and said, "...it is premature to rule out further monetary policy tightening this year."
However, perhaps most interesting about Dudley's speech was that he referenced aggressive monetary policy easing from both the BOJ and the European Central Bank (ECB) as causing a strengthening of the dollar, which made it difficult for the Fed to raise rates as quickly as it expected this year.
All eyes on economic data
While the most recent FOMC announcement makes no mention of the US dollar, we will need to monitor the situation closely. With the ECB and BOJ poised to get more accommodative, it may be more difficult for the Fed to raise rates. And of course we will need to follow the data - so we'll want to watch Friday's release of the July jobs report very carefully to see if it's more like May's report or June's in terms of non-farm payroll job growth. And we'll also want to follow inflation data very closely, as this may prove to be the catalyst that finally forces the Fed's hand to pull the lever to raise rates.
In short, despite the FOMC announcement, we could very well see the Fed remain lower for longer. After all, economic data and policy actions are often fraught with surprises.
Thus, in a period of uncertainty, it is important to stay dynamic, liquid, diversified and non-dogmatic. If we've learned anything over the past three years or so, it is that influences on market performance can change quickly and unexpectedly. Consequently, investors must monitor developments carefully, in a timely manner, and be prepared to adjust assumptions and even asset allocations marginally as fundamentals change. That's why active management has an advantage.
As I think about the past week, I am reminded of the words of Russian poet Boris Pasternak, who once said, "surprise is the greatest gift which life can grant us." It seems that we may be in store for an abundance of gifts this year.