Last week, amid all the hoopla of trade issues and the July fourth holiday in the U.S. the Federal Reserve Open Market Committee, released the minutes of their June meeting where they hiked the Fed Funds rate by twenty-five basis points. The June meeting struck a particularly hawkish chord with the market as the central bank added a fourth interest rate hike of one-quarter of one percent to their agenda for 2018. By the end of this year, the Fed Funds rate will likely stand at 2.25-2.50 percent.
The prospects for higher interest rates has been weighing on the prices of many assets including equities and precious metals since February when the long-bond moved to the downside. The Fed controls the very short end of the interest rate curve, but longer maturities are a function of market forces of supply and demand for debt securities. Since the highs two years ago in July 2016, the path of least resistance for longer-term bonds has been lower.
As the weekly chart of the U.S. 30-year bond highlights, the price moved from highs of 177-11 in July 2016 to its current level at 145.05 after trading to lows of 140-05 in May of this year. Longer-term rates remain much closer to highs than lows over the past two years. Meanwhile, equity prices are much higher than they were in July 2016, which is likely the result of fiscal stimulus via tax reform at the end of last year. However, the bull market in stocks ran into selling in Late January 2018 which was the last time the S&P 500 made a new high. In July 2016, gold reached its most recent peak at $1377.50 per ounce, but the yellow metal declined to its most recent price at the $1260 level. Higher rates and a stronger dollar over past months have weighed on the price of the yellow metal.
The latest minutes from that the FOMC released last week shed some doubt on the certainty of two more rate hikes coming in 2018. Although the central bank sent a hawkish message in their June statement, the minutes reflected a decent amount of uncertainty about the path of the U.S. and global economies and the potential for a deviation from their stated path that followed the meeting in June.
Two more hikes on the agenda widen the gap with Europe
Even if the Fed were to act just once more to hike rates by twenty-five basis points this year, the Fed Funds rate would eclipse the 2 percent level by the end of this year. Interest rate differentials are the primary fundamental factor that drives foreign exchange rates. With economic growth lethargic in Europe, the ECB remains far behind the U.S. Fed when it comes to tightening credit. At their latest meeting, President Mario Draghi said that QE would come to an end later this year, but short-term rates will remain at then negative forty basis point level until sometime in 2019, at the earliest. The growing rate differential between the dollar and euro currency lifted the value of the dollar index from its February 2018 low at 88.15. The euro accounts for around 57% of the dollar index.
As the weekly chart of the dollar index illustrates, the index moved to a high of 95.255 in late June and was trading at just under the 94 level at the end of last week. The growing interest rate differential between the dollar and euro has caused a rebound in the value of the dollar which remains a lot closer to its high than its low in 2018.
In the latest Fed minutes, members of the committee expressed concern about economic conditions in Europe and emerging market countries. A continuation of economic lethargy in Europe that would delay any tightening by the ECB could cause the Fed to pause when it comes to future hikes in the Fed Funds rate. If the gap between the U.S. and European rates widens from its current level, it would likely provide upside pressure on the dollar versus the euro currency. A stronger dollar could impact economic growth in the U.S. as it makes U.S. goods less attractive in the global market.
At the same time, the economies of Argentina and Brazil have been highly problematic and could cause a wave of contagion around the world. The IMF recently provided Argentina with the most substantial bailout package in history. The values of the Argentine peso and Brazilian real have been steadily eroding against the dollar throughout 2018.
With the Fed monitoring economic conditions around the world, any unexpected events or further deterioration could cause the central bank to reconsider two hikes in the short-term rate by the end of 2018.
Trade is a problem
Another issue discussed by the members of the committee at their June meeting was the impact of tariffs, retaliatory protectionist measures, and the potential of a trade war on the U.S. economy. The FOMC discussed the current issues facing steel, aluminum, and construction businesses in the U.S. and the overall potential of a recession if the administration and trading partners around the world continue to exchange tit-for-tat protectionist measures. The first round of tariffs on China and retaliatory measures against the U.S. went into effect on July 6. The eventual impact on the U.S. economy will be an issue for discussion at coming meeting of the central bank and could cause reconsideration of increases in the Fed Funds rate if it appears that China and the U.S. are at war over trade.
While the committee expressed concerns about trade, they were upbeat about the current state of the U.S. economy. If the European economy were growing at a moderate pace, emerging market countries did not face current pressures, and a protectionist wave was not sweeping across the globe, increasing the Fed Funds rate would be a no-brainer at this point.
Favorable economic conditions, but tightening is already a rote exercise
The U.S. economy was growing at a moderate pace on the back of years of monetary stimulus, and fiscal stimulus in the form of corporate tax reform gave it another shot in the arm at the end of 2017. Over past years, the central bank, under Chairperson Yellen, repeatedly called for fiscal stimulus measures from the legislature and they got what they wanted last year. Under Chairman Powell, the Fed is now navigating through an economic boom, despite the current trade issues facing markets. While the Fed Funds rate continues its gradual ascent, the program of reversing the effects of quantitative easing adds another form of credit tightening these days. In October 2017, the central bank began its rote exercise of allowing the legacy of QE to roll off its balance sheet which creates more supply in government debt securities further out on the yield curve. QE was a put option on bond prices, but these days without a put and additional supply coming on the market each month, the path of least resistance for interest rates in deferred maturities has been higher. While trade may slow economic growth, there are few signs that rate hikes in the short, medium and long end of the bond market have caused economic growth to stagnate.
Job creation supports hikes
The latest employment report showed that the number of jobs in the United States grew by 213,000 in June. Economists had expected an increase of 195,000, so the data provided another strong month and reason for the Fed to continue on its proposed course. The unemployment rate rose to 4 percent, but the increase was the result of more potential workers joining the labor force. Discouraged workers from past years are back out looking for jobs these days. However, average hourly wages only grew by 2.7 percent on a year-on-year basis which was one-tenth of one percent below economist’s expectations.
Overall, the employment report on July 6 provided more data that justifies the Fed’s approach to monetary policy at their June meeting. However, other issues still could prevent the Fed from carrying through on their promise to hike rates twice more before the end of this year.
A retreat could cause significant moves in the dollar and gold
If the Fed were to backtrack in coming months and the short-term rate does not rise to 2.25-2.50 percent, it would put a dovish slant back on monetary policy given the recent guidance from the central bank. The two markets likely to experience the most significant moves would be the dollar and the gold market.
The dollar priced in another two rate hikes and remains close to recent highs. Gold fell to lows of just $2.30 above its level of critical resistance at the December 2017 bottom of $1236.50 on July 3 before a recovery pushed the price of the yellow metal back to around the $1260 per ounce level. If the program of tightening credit slows when it comes to the Fed Funds rate we could see a sharp recovery in the price of the yellow metal.
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The Fed minutes from the June meeting provided some reasons why the central bank could deviate from their plan of action articulated in their June statement. Contagion from Europe, the emerging markets, or trade could become issues that stall the pace of tightening which would cause increased volatility in markets across all asset classes over the second half of 2018.
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