Markets now put the odds of December Fed lift-off at 3:1

Markets now put the odds of December lift-off at 3:1 and with Draghi hinting at further easing this Thursday, the difference between US and German 2Y bond yields has risen to 1.35%, the highest in 9 years. The price of a euro has fallen to $1.057, the lowest since mid-March and, save for that brief dip to $1.050, the lowest since December 2002. Whether Fed/ECB policy divergence is now priced in remains to be seen. Some investors claim the euro has gone too far, others not far enough. No one knows for sure but come Friday, half will be heros, half will be bums. Come Monday, they may have traded places again. Another week hence, perhaps yet again. Markets never sleep. 

Where does all this leave the Fed? Most expect a 'slow and steady' rise in rates through the course of 2016 and into 2017. Specifically, markets now reckon the Fed will hike three times by the end of 2016. 5 hikes is more likely but what's the risk that we're both wrong - that a strong dollar and/or higher US interest rates puts the Fed on hold sometime in mid- year? Not great, because the Fed has set such a low bar for the data that most should easily clear it. But if something is going to stumble owing to the dollar and/or higher rates, it is likely to be exports, housing or capex expenditures. 

The trade-weighted dollar is up by 17% over the past 15 months and goods exports have fallen by 10% since February. This is putting a significant crimp into nonfarm payrolls in goods producing industries that would likely become even more significant were the dollar to head further north. Housing is the most interest rate sensitive sector of the economy. When rates surged in mid-2013, the then-two year recovery in housing stopped dead in its tracks. The subsequent drop in mortgage rates between mid-2013 and end- 2014 pushed housing back up again but both new and existing home sales have fallen steadily since the middle of this year. Higher rates won't help going forward. Housing is vulnerable. 

Capital expenditures are the third area to watch. The economy has grown at a 2% pace for the past five years and whether you think that's strong or weak the fact remains that core capital goods expenditures - the bedrock of US business investment - haven't grown by a single dollar in 3.5 years. Blame it on oil if you want but oil prices headed south 16 months ago, not 3.5 years ago. Higher interest rates imply lower investment. If core capex has run sideways for the past 3.5 years, theory says it's likely to run south when rates go up. Interest rates aren't the only thing that matter of course but Fed tightening won't be a plus. Watch the durable goods orders, starting with the October report this Thursday.