Way paved for a Fed hike

Market analysis - 8/31/2016

Expectations have jumped for one or even two Fed upticks by end-2016. The decision will be based on job creation.

All eyes were on the US Fed Chair Janet Yellen last Friday as she addressed other central bankers gathered for their annual conference at Jackson Hole. The statement and minutes of the 27 July FOMC meeting had shown that the members of the Fed’s monetary policy committee saw fewer short-term risks facing the American economy than in the spring. In particular, they were less concerned about the recent developments. Moreover, the financial stress in the wake of the UK’s Brexit referendum decreased. In addition, recent comments, most notably by FOMC Vice-Chairman William Dudley on 16 August, seemingly pointed to a rate hike in the coming months.

With this in mind, investors were expecting Yellen to reiterate the prospect of further monetary tightening. In fact she did so, but only to a point. She confirmed that an uptick was possible considering the improvement in jobs data and the outlook for growth and inflation observed in recent months. This, she said, had strengthened the case for a rate hike. However, she gave no indication for the timing of such an accommodative move. Investors therefore failed to react immediately to her message. It was the speech by her deputy, Stanley Fischer, a few minutes later that shed real light on the prospects of a forthcoming uptick. For him Yellen’s words set the stage for a hike in the federal funds rate in September and perhaps even a second one by the end of the year. In Fischer’s view it would all hinge on the August employment report to be published this Friday.

So in the end it was Fischer’s address, more than Yellen’s, that provided a clear answer for investors. Expectations of further monetary tightening in the US jumped. By Friday evening, based on trading in Fed funds futures contracts, the probability of an uptick at the FOMC’s 21 September meeting rose to 42.0% from 32.0% at Thursday’s close and the odds of a further hike in December also rose, to 64.7% from 57.4%. As a consequence, the dollar appreciated against most other currencies. The DXY index, which tracks the greenback’s nominal effective exchange rate, was up 1.1% on Friday compared with its week-earlier level.


Meanwhile in the Eurozone, the latest PMI surveys showed an improving economic outlook in August. The composite index edged up to 53.3 points, a seven-month high, from 53.2 in July (see chart above). Although the Brexit vote has not dented the morale of purchasing managers in the 19-member currency zone, they are still worried about the weakness of economic growth worldwide. New orders in the manufacturing sector were down significantly this month and the recent upturn in commodity prices has started pushing up the prices of finished products. However, the rise in public expenditure that we expect to see in the second half of 2016 should spur GDP growth in the Euro Zone. The area’s low inflation rate (0.2% yoy in July) moreover gives the European Central Bank (ECB) enough leeway to step up its programme of corporate and sovereign bond purchases, providing another fillip for economic activity.

Despite political uncertainties, Euroland’s GDP growth could therefore deliver pleasant surprises in the coming quarters.

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