The market is pricing in only a 20% probability of a hike at Wednesday’s Fed meeting and the possibility of a hike by December stands at a 51.8%. In January this year, on the heels of the first Fed hike in years, markets were still assigning more than a 50% probability to a September hike. So, what has changed?
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Let’s look at the Fed’s scorecard.
- The labor market is steady but showing signs of deceleration. Claims are still at all-time lows but payroll growth has definitely slowed. Unemployment and part-time U6 underemployment rates have come down. But, the Fed’s Labor Market Conditions Index (LMCI),which combines 19 labor market indicators including quit rate, wages and part-time workers, has been negative for 7 out of the last 8 months.
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- Fed has been paying attention to the dollar strength and resulting weakness in manufacturing, but one month’s weak manufacturing PMI we believe won’t significantly affect the Fed’s decision. If we look back at December when the Fed finally raised rates by 25 bps, ISM was at 48 vs. 49.4 in August.
- Inflation is under control. PCE Inflation came out to be below target at 1.6%, and expected to hit 2% only over the next few years. Because of this, the employment situation & global risks remain the top most factors for the Fed.
Even though the probability of a hike is low, a surprise decision can’t be ruled out. What will happen if the Fed does hike now or in December? While it’s clear how the front end of the curve will react, the outlook for US growth is key to understand how the dollar and longer-dated bonds will move in response to a Fed hike news. Our view is that unless economic conditions deteriorate significantly in the next few months, we still expect a stable to steeper yield curve and higher rates by early 2017. Just like in December 2015, a single hike is not relevant, it’s the path of interest rates that matters for investors.