Have Forecasts For Fed Rate Hikes Gone Too Far?

Over the past week, the Fed’s scope for monetary policy has grown more difficult to discern; yet speculation of impending rate hikes has given little ground. Economic data has shown that the divergence between downside growth risks and upside inflation risks has broadened – meaning a turn to rate hikes would be fraught with economic complications.

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Over the past week, the Fed’s scope for monetary policy has grown more difficult to discern; yet speculation of impending rate hikes has given little ground. Economic data has shown that the divergence between downside growth risks and upside inflation risks has broadened – meaning a turn to rate hikes would be fraught with economic complications. What’s more, the credit market is still not out of the woods yet. There is still a distinct lack of liquidity among major banks and write downs are expected to continue through the rest of the year. In fact, an improvement in a number of credit indicators may be generating unwarranted optimism. RBS suggested in a report today that global credit and equity markets are heading for a full-fledged crash within the next three months. Nonetheless, Fed Fund futures reveal market participants consider a quarter-point hike by September a near certainty.


Risk appetite within the credit market has improved substantially this past week. Risk premium in the junk bonds spread finally marked a significant break with a nearly 50 bp plunge to its lowest level since January. However, a few reports this morning would once again caste doubt on the future. Goldman Sachs suggested firms may need to raise another $65 billion to compensate for ongoing write downs, while John Paulson (the hedge fund manager who turned a profit in the subprime meltdown) said write downs may total $1.3 trillion. Where demand for yield was in a headlong rally this past week, caution was still present when duration was a concern. Yields on short-term paper maintained their slow rebound with investors finding their way out of the negative real returns of treasury bills. However, much of the capital didn’t seem to find its way up the curve as three-month Libor rates stalled with demand still very robust. Holding long-duration debt is still a gamble considering analysts warnings and yet another TAF auction that would find $89 billion in bids for $75 billion offered.


Capital markets were relatively mixed this past week as investors took a wait-and-see approach for confirmation on economic activity and the Fed’s policy stance before accepting more risk. The Fed’s beige book painted an unfavorable picture of the economy as the report suggested expansion was “generally weaker” through April and May. What’s more, concern was growing over the global investment environment with many central banks being forced to respond to obstinate inflation trends even though growth was clearly deteriorating. Clearly, the business sector is suffering not only from high lending rates – artificially propped up by a lack of liquidity – but also the prospect that the Federal Reserve and other policy authorities are willing to let the economy cool in order to rein in inflation. Firms have already taken steps to revive revenues (one report has shown the biggest cut in corporate dividends in five years); but if the GDP is heading for a contraction, there seems little the business community can do to avoid it.


On the auspices of higher rates in the near future and inevitable period of negative economic growth, the benchmark equity indices have held near their recent multi-month lows. The Dow Jones Industrial Average was virtually unchanged for the week, but there were a few notable sector changes - the most interesting being the 2.5 percent jump in the battered financial sector. Goldman Sachs’ better than expected earnings helped things along; but Lehman’s first loss since going public reminded traders that conditions were still fragile. With bearish forces still holding strong over stocks, market condition indicators have steadily deteriorated. Over the past week, the S&P Volatility index fell nearly 3 percentage points; though this retracement would still leave the fear indicator well above the 10-year average 20.8 percent and keep the rebound from mid-May otherwise intact. At the same time, demand for portfolio-protecting puts hit a new 10-week high as notable support came into view across many of the major equity indices.


For currency traders, the prospect for higher interest rates must be weighed against the deterioration of the US economy. Indicators this past week confirmed stumbling growth and may even suggest a recession is still a threat later this year. The Fed’s beige book undid most of the optimism that was generated after the better than expected first quarter GDP figures were released weeks ago. Not only did the report (used by officials to determine monetary policy) note “generally weaker” growth through April and May; but it also detailed fading employment and wage trends as well as declines in consumer spending. Indeed, the University of Michigan consumer confidence report fell to a 28-year low in its June reading with an inflation outlook that matched its own 13-year high. However, the most recent retail sales data has yet to confirm this with a 1.0 percent jump that doubled expectations.


The market’s most timely economic indicators were largely on the lam last week. Housing trends continue to deteriorate with buyers still afraid to enter the market considering inventories are ballooning and values sinking. Mortgage approvals fell 8.8 percent – within view of its recent record low – as lending rates jumped to their highest levels since June of 2007. Elsewhere, employment trends were off to a bad start in June with initial jobless claims jumping to their highest level in 10-weeks. A surprising bright spot however was consumer sentiment which improved slightly once again from multi-decade lows. Economic activity is still a major question mark for policy makers; but recent data certainly does not offer promising signs. This past week, the near three-decade low in consumer confidence threatened the largest single component of the US economy – consumer spending. Elsewhere, the housing market was still a blatant anchor on positive growth with construction activity on new residences falling to a fresh 17-year low as foreclosures rise and inventories grow. Even trade has failed to take hold with the dollar pushing record lows. The first quarter current account deficit ballooned owing largely to the rise in oil prices.

[I]Written by: John Kicklighter, Currency Analyst for DailyFX.com

To contact John about this or other articles he has authored, you can email him at <[email protected]>.[/I]