The past two weeks have highlighted the divergence between the Fed and the rest of the world. Just one week after the ECB pre-announced another round of easing at the upcoming December meeting, the Fed this week sent a very clear signal to markets: a hike at the December FOMC meeting should not be ruled out.
The Fed shifted the language in the statement to a direct tightening bias saying in determining whether it will be appropriate to raise the target range at its next meeting and then repeated it will need to see some further improvement in the labour market and be reasonably confident that inflation will move back to its 2% objective over the medium term.
"We believe two factors caused the change in tone: first, the Fed felt the probability of a December rate hike implied by market pricing was too low and, second, the statement needed a hawkish twist to get support for the statement from as many Fed members as possible", says Danske Bank.
At the September FOMC meeting, eight of the 12 regional Fed Presidents proposed a 25bp hike in the discount rate, signalling they would also favour a hike in the fed funds rate. As we know, the board of the FOMC rejected this.
The combined soft tone from the ECB last week, followed by easing from the Chinese central bank, put upward pressure on the trade-weighted US dollar ahead of this week's FOMC meeting. Nevertheless, the Fed felt comfortable moving the language in the statement in a more hawkish direction. This highlights that the Fed is looking at financial conditions in a broad sense and not particularly at the USD. The rally in risky assets had largely offset the tightening in financial conditions from the USD strength. Left is the positive demand boost from easier monetary policy and diminishing risks of an even more severe global growth slowdown. Hence, the latest round of global monetary policy easing is welcomed by the FOMC and is not an obstacle for a near-term rate hike.
The rates market reaction following the FOMC meeting was surprisingly muted given the hawkish shift in tone. The market implied probability for a December rate hike moved from 32% to 45%, suggesting that the markets still see it as more likely that the Fed will stay on hold in December than that it will raise rates. In our view, this shows the loss of credibility that the Fed has suffered over the past year.
For markets to believe in an imminent fed funds rate hike, economists would need to see data confirming that the US economy will grow above potential into next year and/or data suggesting that inflation pressures are starting to build in the US. The coming week will provide the markets with important new information, as we are due to receive the October employment report and the ISM surveys. FOMC chair Janet Yellen is scheduled to speak at two events in early December and thus will have ample opportunity to guide the markets ahead of the actual FOMC rate decision announced on 16 December.
"We continue to place the highest odds on a January rate hike. The US manufacturing sector is suffering from global demand weakness and the stronger USD and we do not expect a turn in this sector before late this year. Hence, we believe the weakness in the manufacturing sector will keep the Fed in a wait-and-see mode at the December meeting", noted Danske Bank.
