Fed rate hike today would surprise the market

Jim Leaviss (pictured), head of Retail Fixed Interest at M&G Investments,comments on a potential Fed rate rise today.

Whether the Fed hikes or not is less important than determining where the terminal Fed Funds rate is in a potential rate hiking cycle. Fed tightening in this cycle will likely be unusually slow, cautious and well communicated to markets. A rate hike today would surprise the market, which is pricing in a 30% probability of a move in interest rates.

The short end of the curve would likely take the brunt of any initial market reaction, resulting in some flattening of the US treasury curve.

In order to see bond yields move much higher, a reassessment of inflationary expectations would be required. A rising dollar, benign wage growth, high consumer debt levels and falling commodity prices suggests to us that this is unlikely to occur in the short-term.

Central to Fed Chair Janet Yellen’s dashboard of key economic indicators are several employment metrics, including JOLTS (Job Openings and Labour Turnover Survey) and quits (when employees voluntarily leave their current employment, often because they are accepting a new position).

These add an extra layer of dynamism to the wider labour market picture. Based on the bullishness of these indicators, a rate hike should sooner become a reality. But Yellen and the Fed remember the lessons of the Great Depression well – remove stimulus too soon, and a rapid descent back into recession could be on the cards.

The Fed is left gambling that it will be easier to fight inflation by hiking rates than combating deflation in an already zero-bound world. This in turn helps push back the potential risk that higher rates lead to dollar strength, further impacting US corporate profits.

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