The question whether the US economy is ready for the first rate hike is one that has gotten a great deal of discussion in the past months. An impending rate hike is probably the most anticipated and traded on event in the macroeconomic space at this moment. However, when it comes to the question as to when exactly this rate hike might occur, opinions differ greatly.
According to the Federal Open Market Committee, the US economy has been expanding at a "moderate" pace since QE has officially ended in October 2014. However, the current economic conditions have not yet warranted any further tightening of monetary policy. Ms. Yellen and her fellow committee members have been gauging a number of economic indicators in order to find guidance on how to proceed with US monetary policy. The two most important indicators the FOMC is looking at are the current labor market conditions and inflation expectations.
Improving labor market conditions but sluggish inflation outlook
A great deal of attention has been paid to the current employment situation. The last employment reports have shown significant job gains since late 2014 as well as a reduction in the unemployment rate to 5.5% in February. Although much credit was given to these recent strong improvements in labor market conditions during the last FOMC meeting on March 17-18, a number of officials were not convinced that the current conditions warrant further tightening of US monetary policy. In fact, the minutes of the FOMC's March meeting revealed that the Committee is still very much divided over the question of when to raise the target for the Federal Funds Rate, as some voters expressed concerns about a rate hike as early as June. According to these officials, a premature tightening of credit would further carry consumer price inflation away from the FOMC's longer-run objective of 2%. Consumer prices have decreased for the past 2 years and hit 1.5% over the course of 2014. This deflationary pressure was further fueled by the latest collapse in oil prices as well as the recent strengthening of the Greenback. In light of the sluggish inflation a number of committee members did not feel comfortable committing to a rate hike in the first half of 2015.
Disappointing March Employment Report
The March employment report, which was released on April 3, came in as a huge negative surprise. Economists had predicted a gain in Non-Farm Payrolls of 246,000, with the actual gain being much lower at 126,000. While this positive number still points to a further improvement in labor market conditions, this puts an end to employment reports positively beating expectations for 4 consecutive months. The relatively bad number implies that the improvements in labor market conditions have lost steam and suggests that job growth could slow down in the coming months.
Now, where does this leave the FOMC?
The Minutes of the FOMC's March meeting, which was held prior to the release of the US employment report for the month suggested, that looking exclusively at the current labor market conditions a rate hike as early as June may be warranted. However, the FOMC's other, equally important condition of an improvement in inflation expectations was not yet met. Given that the improvement in labor market conditions were the driving force behind the discussion of monetary tightening, the advocates have now lost their most valuable argument in favor of a June rate hike.
Some investors argue that Ms. Yellen has missed the time window to raise rates, which had presented itself earlier this year. Regardless of whether this may or may not be true, it is relatively certain that a rate hike as early as June is now completely off the table. Looking at the present term structure of Fed Funds Futures it can be seen that even a rate hike at the FOMC's July and September meetings is unlikely at this point. The market is currently pricing the probability of a rate hike at only 48% in the three meetings before October, with the 30-day Federal Funds Future for September only trading at 23bps.
In light of this analysis, we can now understand what Bill Gross means when he chooses not to buy "overvalued" government bonds, but recommends selling volatility around them. (Source) If we can expect a rate hike as late as Q4/2015, bonds as well as the USD are likely to stay where they are until well into the second half of the year. Especially in the FX space, this will create opportunities for investors. Carry trades in high yielding currencies, such as AUD against the USD should become more interesting again. Also, investors that have recently predicted or wagered the EUR/USD parity level may be advised to hold off until later this year.
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