News in Charts: Fed Caution Presents Opportunities

Released on Wednesday, Minutes of the Federal Open Market Committee’s March meeting revealed a split in opinion among its members, but ‘caution’ was very much the byword. Indeed, concerned that global developments continued to threaten the US economy, at the March meeting FOMC participants cut in half what they had previously judged to be the appropriate pace of tightening for this year.

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FOMC Minutes reveal split but underlying caution

Although concern among investors about the US economy appears to have eased in recent weeks, the Minutes revealed that the FOMC remained worried that global developments continued to threaten the US economy. Indeed, several members felt that the underlying factors that had led to a sharp deterioration in financial conditions earlier this year remained unresolved.

Participants were split on issues such as whether the labour market had reached full employment, and the extent to which the recent pick-up in inflation was sustainable. Several participants expressed the view that a rate increase as soon as April would “signal a sense of urgency that they did not think appropriate,” while some other participants indicated that a further rate increase might well be warranted if upcoming data remained consistent with their expectations.

The Minutes reinforced investors’ expectations that the prospects for rate rises were limited. Market pricing now sees no more than an evens chance of a rate hike this year. Recent comments from Chair Janet Yellen suggest that she lies on the dovish side of the split. And the Minutes revealed a concern among many that the asymmetry of possible interest rate movements warranted caution. Caution is very much the byword for the Fed at the moment.

We now expect the Fed to deliver just a single 25 basis point increase by December. That represents a downward revision to the path that we set out in our previous quarterly forecast, and explains why we are now more positive about the outlook for US equities.

Weak Q1 likely … again   

US growth looks to have been far from stellar over the turn of the year. Households appear to have been cautious during the period of financial market turmoil, choosing to save rather than spend much of their steadily rising income.

The closely watched GDPNow, provided by the Atlanta Fed, which seeks to provide an estimate of GDP growth up until the first estimate from the Bureau of Economic Analysis puts first quarter growth at a rate of just 0.4% (SAAR). A number in this region would mean two quarters in a row of disappointing growth.

However, weak growth through the winter months of the year has been something of a feature of this US recovery. Since the end of 2010, average growth during the fourth and first quarters has been almost a percentage point below average growth during the second and third quarters. This can be seen in our next chart.

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Labour market still tightening

Growth may not have been stellar, but it has been enough to absorb more economic slack. Growth in GDP is significantly outpacing growth in productivity, pulling more people into employment. We examine the reasons behind the slowdown in US productivity growth in our Global Economic and Markets Outlook for 2016 Q2, due to be presented to clients over the next few weeks. We find that the previous high level of oil prices may explain some of the decline in US productivity growth, but more importantly, our analysis suggests that prolonged low rates of interest have been a significant contributory factor.

We expect the labour market to continue to tighten. Job creation has continued unabated through the soft patch, and the tightness of the labour market will put more upward pressure on wages and core inflation.

Inflation to rise for core, and possibly non-core reasons

The longer that China’s economy remains in the doldrums – China’s true rate of growth is a long way south of the official data – the greater the chance that Beijing decides to throw in the towel on rebalancing. Indeed, our central view is now that it does precisely this, seeking to stimulate growth largely through a combination of increased investment and increased public spending, much as it did through 2008 and into 2009. In this environment, we would see some upward pressure on commodities prices, and by extension, on non-core components of CPI inflation around the world. If we are right, then US inflation breakevens are too low and present a buying opportunity.

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Rising inflation, combined with a reduction in financial market stress if China does double-down in the way we set out,  would give the Fed more confidence to raise interest rates in line with the ‘dots’ curve through 2017. Next year, risks to the market curve for the federal funds rate lie firmly to the upside.