Markets could not be more divided on the Fed rate decision due tomorrow. While about a month back, most did expect a "lift-off", the global risk-off sentiment and increased volatility have reduced the odds of a rate hike tomorrow.
Following are my thoughts on the rate hike, if any tomorrow, and the subsequent outlook ahead:
1. Inflation is one among the two metrics often cited as key by Fed officials. With the latest print at 0.3% which is far away from their 2% target would have made markets infer that rate hikes are far off. However, some of the Fed officials such as Stanley Fischer have commented that Fed might overlook the current dip in inflation as owing to global commodities cool off which would base out and that inflation (PCE) would reach 2% in 2017. A brief analysis of the TIPS market against the US treasuries would lead one to believe that 2% is possible only sometime in 2020. If Fed is right, TIPS traders are just morons to sell them and the whole world should be loading up on TIPS.
2. There has been a consistent debate over U3 vs U6 employment rates in US and how the often reported U3 unemployment rate might hide the lack of wage pressure owing to a larger (and wider) U6 unemployment. If wage pressures are not coming through, I just do not see inflation picking up. Somewhere, the great minds at Fed should have to clarify their inflation targets in a believable way before hiking rates.
3. Market is tired off the uncertainty around what would happen after the lift-off. Most participants would not care a damn about the first hike of 25 bps; as the monkey off the shoulder feeling could release risk appetite back into the market.
My expectation of what would happen tomorrow,
Case 1: 25 bps hike with a reasonable clarity that no more hike is due this calendar year and further action to be done in Q1 of 2016. And some pieces thrown about increased volatility in world markets.
Case 2: No hike citing the volatility in the markets; but still optimistic about growth in US. Keep options open for October/December rate hike.
Case 3: No hike citing the uncertainties from the mayhem in world markets and their likely impact on growth and inflation expectations in US.
My base case is the first one. The third one is an extreme case which can lead to large scale risk-off mood. The second case just postpones the current uncertainty down the line.
Following are my thoughts on the rate hike, if any tomorrow, and the subsequent outlook ahead:
1. Inflation is one among the two metrics often cited as key by Fed officials. With the latest print at 0.3% which is far away from their 2% target would have made markets infer that rate hikes are far off. However, some of the Fed officials such as Stanley Fischer have commented that Fed might overlook the current dip in inflation as owing to global commodities cool off which would base out and that inflation (PCE) would reach 2% in 2017. A brief analysis of the TIPS market against the US treasuries would lead one to believe that 2% is possible only sometime in 2020. If Fed is right, TIPS traders are just morons to sell them and the whole world should be loading up on TIPS.
2. There has been a consistent debate over U3 vs U6 employment rates in US and how the often reported U3 unemployment rate might hide the lack of wage pressure owing to a larger (and wider) U6 unemployment. If wage pressures are not coming through, I just do not see inflation picking up. Somewhere, the great minds at Fed should have to clarify their inflation targets in a believable way before hiking rates.
3. Market is tired off the uncertainty around what would happen after the lift-off. Most participants would not care a damn about the first hike of 25 bps; as the monkey off the shoulder feeling could release risk appetite back into the market.
My expectation of what would happen tomorrow,
Case 1: 25 bps hike with a reasonable clarity that no more hike is due this calendar year and further action to be done in Q1 of 2016. And some pieces thrown about increased volatility in world markets.
Case 2: No hike citing the volatility in the markets; but still optimistic about growth in US. Keep options open for October/December rate hike.
Case 3: No hike citing the uncertainties from the mayhem in world markets and their likely impact on growth and inflation expectations in US.
My base case is the first one. The third one is an extreme case which can lead to large scale risk-off mood. The second case just postpones the current uncertainty down the line.
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