The Fed Has Something to Prove to Wall Street

Is the Fed Experiencing a Failure to Communicate?
  • Central bank mentions possibililty of rate increase in June
  • Investors not convinced as economy lacks strength, HSBC says

It’s hard to fault investors for being complacent when the Federal Reserve says it’s on the brink of raising interest rates again.

Policy makers have been delivering that message since the start of last year, only to later back off when the data showed they overestimated the strength of the U.S. economy. This scenario is playing out again in global markets. Even after the Fed’s minutes Wednesday sent a strong signal that an increase may come as soon as June, the bond market is only pricing in a 28 percent chance of that happening. 

QuickTake The Fed Lifts Off

“The Fed and other central banks can get hawkish trying to manipulate the direction of rates, but the market says we don’t believe you,” said Steve Major, the London-based head of fixed-income research at HSBC Holdings Plc, which is one of the 23 primary dealers of U.S. government securities that trade with the Fed. “Structural headwinds to growth and the international backdrop are limitations on how far U.S. rates can go."

Fed’s Bluff

While minutes from the Fed’s April meeting indicated policy makers considered a rate hike likely next month if the economy continued to improve, investors see plenty of obstacles. A referendum in Britain on June 23 will decide whether the country remains a member of the European Union. Growth momentum in China is fading following a credit-fueled rebound earlier this year and the dollar is rising again.

Some money managers are saying it’s time for traders to start pricing back in the Fed. DoubleLine Capital’s Jeffrey Gundlach said Thursday that the central bank is signaling economic data are sufficiently robust to warrant a rate increase. Rick Rieder, chief investment officer of global fixed income at BlackRock Inc., said officials will likely wait until July to gauge the outcome and implications of the British referendum.

So far, the markets have been right to call the Fed’s bluff. The Fed officials have cut their median forecast for the long-term fed fund rates to 3.25 percent, from as high as 4.25 percent in 2012.

Economic Oomph

Policy makers have been pushing investors to prepare for rate increases for more than a year, but only delivered one. At 0.88 percent, two-year Treasury yields are lower than in December when the policy makers raised benchmark borrowing costs from near zero for the first time since 2006.

To the disappointment of policy makers, the U.S. economy is unable to keep the growth momentum as it did in previous rate-tightening cycles. It barely expanded in the first quarter, increasing at an annual rate of 0.5 percent. While the unemployment rate has dropped below 5 percent, inflation remains below the Fed’s 2 percent goal.

“The economy lacks enough oomph for the Fed to act decisively,” Christopher Low, chief economist at FTN Financial, wrote in a note to clients Thursday.

Then there’s the dollar. As expectations for a rate increase rise, the dollar rallies, putting U.S. stocks under pressure by eroding the profits of the multinationals. A stronger greenback and weaker equities tighten financial conditions, taking some vigor out of the economy.

Dollar Strength

The 18 percent advance of the dollar against major currencies over the past two years helped undermine commodities, which are priced in dollars. Renewed appreciation will reignite concerns about mass defaults in the energy sector, siphon off capital from emerging markets and weaken their currencies.

In March, Fed officials abruptly slashed their expectations for interest rates, the so-called “dot plot,” after China’s currency depreciation and capital outflows rattled global markets. Goldman Sachs Group Inc.’s economists called it one of the most dovish Fed decision of the 21st century.

On Thursday, strategists at Goldman Sachs said that while the possibility of the Fed rate increase in June has increased, it’s far from a done deal.

“The minutes underscore just how volatile Fed communications have been,” Robin Brooks and Michael Cahill of Goldman Sachs said in a note. “Normalizing policy, given that USD could appreciate a lot, is difficult for the Fed to do.”

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