Yesterday the market got two hints that the Federal Reserve is increasingly unlikely now to move on interest rates in September. First of all there was further evidence that inflation remains sluggish in the US, and then the market was hit by further evidence that the FOMC is not yet ready to increase interest rates in September. This is set to drive US dollar volatility in the coming weeks as the debate continues. However, by next week, when the Personal Consumption Expenditure data is released, there could be the final nail in the coffin for a September rate hike.
I have been saying for weeks that the labor market is considered to e a ticked box for the Fed. We can pretty much take it as a given that the Fed if monetary policy was just concerned with the state of the labor market, the Fed would have already started to raise interest rates, Unemployment at 5.3% is very close to the 5.0%/5.2% level that the Fed considers to be “full employment”. You can argue over the details of what the declining participation rate really means, but essentially, the labor market is strong.
However as part of the dual mandate, inflation also needs to be considered. The CPI data yesterday showed that inflation in the US is not picking up, and the minutes from the FOMC released last night reflected the fact that this is a concern for members who noted that the conditions for policy firming had not yet been achieved. The core US CPI remains at +1.8%, whilst the headline data remains dogged by lower commodity prices at a paltry +0.2%.
The charts below show core CPI and core PCE. The core PCE chart shows that as per the Fed’s preferred measure of inflation, there has been little to suggest inflation will be moving towards its 2% target any time soon. This makes it very difficult to justify the doves shifting position.
However the FOMC does not look at CPI, it prefers to measure inflation via the Personal Consumption Expenditure. Whilst yesterday’s inflation number was a further factor for the doves to hang on to, it will be the core PCE data that is announced on Friday 28th August that could be the clincher. The core PCE number has been stubborn in remaining at +1.3% now for the past 6 months and remains at a 4 year low. If we get another month of core PCE remaining at 1.3%, then there really will be little reason for the doves on the FOMC to change their view at the September meeting on 16th and 17th. It would need a substantial increase in average hourly earnings in the payrolls report to really turn some of those doves into hawks.
Furthermore, market and global economic conditions have significantly deteriorated since the latest FOMC meeting. With commodity prices falling ever lower and China moving to devalue its Yuan (albeit by only around 3%) there are increased deflationary forces that have to be considered in the next meeting. These will certainly not help to persuade the doves to change either.
The market reaction to the minutes was considerable and the expectation for a September rate hike fell sharply. The chart below shows the Fed Funds futures September 2015 contract rose sharply to a one month high in the wake of the FOMC minutes. Having spent much of July becoming increasingly convinced of a September hike, this move seems to be unwinding now. (NB. remember the inverted relationship between these charts and the interest rate…)
Treasury yields also fell sharply, with the US 10 year falling back from a day high at 2.23% to now languish around the 3 month lows again under 2.10%. (from a charting perspective, also look how the resistance continues to be formed at the falling 21 day moving average.
This all means that the dollar will struggle to gain traction now in the coming weeks. The reaction on EUR/USD in the past 24 hours just shows this to be the case as it has added around 120 pips since the FOMC minutes were announced. This is a move that has unwound much of the dollar strength in the past few days. Expect this to be a theme in the coming weeks.
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