Fed doves of a feather flock together

In the grand scheme of things, the decision by the Fed to leave rates unchanged is indicative that the global economy and the US economy is performing worse than previously projected.

Federal Reserve
Source: Bloomberg

Even in July the probability for a rate hike at the Fed’s September meeting was sitting at 50%. It is a telling sign for how much the global outlook has deteriorated in the past few months, with the likelihood for even an October hike now sitting at 19.2%. For those central banks with an easing bias (ie the European Central Bank, Bank of Japan, Reserve Bank of Australia and Reserve Bank of New Zealand), the Fed’s decision to hold rates could provide the impetus to ease further.

Markets had largely been pricing in this result over the past week, particularly in the currency markets. The Aussie dollar had noticeably risen 2.8% since Thursday last week. US bond yields had begun moving upwards in the few days before the Fed meeting, but this largely looked to be cautious hedging rather than last minute repricing. Given expectations in many of these asset classes, it was not surprising that the rallies seen after the release of the statement were somewhat restrained.

Given the whipsawing seen in the S&P 500 around the Fed decision, markets seem somewhat undecided about the effects of unchanged rates. There are two major opposing interpretations: 1) the fact that the US economy is not growing enough to warrant rate hikes is negative for global growth and hence equities, or 2) easy monetary conditions in the US will now continue for an extended period of time to continue to assist the equity markets.

The Aussie dollar rallied 1.5% after the release of the decision at 4.00am AEST, but had given back almost of those gains by 6am. This clearly shows just how priced in the rate rise the AUD was. Going forward, the Aussie is likely to be gripped by speculation that the RBA may be forced to cut rates again, and Glenn Stevens speech today at 9.30am may well be a precipitating factor to further an AUD downside.

The Fed statement today along with Governor Janet Yellen’s press conference was noticeably more dovish than expected. New language was added in the statement that highlighted the Fed’s concerns about recent global developments, noting explicitly that the Fed is ‘monitoring developments abroad’. Many have read this as code for China. Unquestionably, the dramatic fall in Chinese stock markets and the unexpected devaluation in the renminbi were topics of hot debate at the recent Jackson Hole Symposium. The Fed noted that these ‘global developments may restrain activity and put further downward pressure on inflation.’

Most notable from Yellen’s press conference was the downbeat evaluation of the US economy. The Fed’s disappointment with inflation developments has been well established, but Yellen was surprisingly negative about recent employment growth as well. Yellen explicitly noted that despite steady employment growth, the participation rate and particularly the level of involuntary part-time employment were not where the Fed would like to see them. It is clear that the Fed is paying careful attention to much broader employment metrics, such as the U6 unemployment rate, which also includes those working part-time who would like to be working full-time.

The dot plot of Fed members expectations for the path of interest rates going forward were lowered by 0.25% across the board. The median of Fed members are now expecting the Fed funds rate to reach 1.5% by late 2016 and 2.5% by late 2017. Janet Yellen was also keen to emphasise that the majority of Fed members believed that a rate hike before the beginning of 2016 was necessary, and that delaying it could lead to risks that they may overshoot their inflation target.

Yellen noted that October was still a ‘live’ meeting, but she did seem to downplay the probability of a rate hike by saying it was only a ‘possibility’. Given her statements and the pricing of the bond market, if a Fed rate hike is to happen this year, December is now the most likely date.

While a number of assets have moved in the wake of the Fed decision, the metals complex and particularly gold and silver, both moved up over 1%. Their strength seems attributable to not only USD weakness, but also concerns about Fed policy. There was a strong contingent of analysts and investors who were adamant that the Fed should have raised rates at the September meeting no matter what. And holding off on a rate hike due to recent market volatility would severely impact the credibility of the Fed, making it seem beholden to the vicissitudes of the equity markets. This line of thinking seems to be finding expression through the movements in gold and silver.

With US markets closing down, Asian markets are expected to open down as well. The bout of strength in a range of Asian currencies against the USD is likely to affect export-oriented corporates who will see their price competitiveness impacted. This is likely to particularly weigh on Japanese and Hong Kong markets. The rally seen in the ASX yesterday was out–of-sync with European and US markets, and some of those gains could well be given back. If Glenn Stevens’ speech at 9.30am similarly provides a negative outlook for the Australian economy, this is also likely to weigh on the index.

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