Three of Fed’s Own Primary Dealers Warn Hikes on Hold Until 2017

  • HSBC, RBC, RBS say bet against bond-market consensus
  • Fed fund futures show 71% chance of rate increase by year-end

Why Three Dealers See a Next Fed Rate Hike in 2017

Three of the Federal Reserve’s own primary dealers are warning bond traders that a growing consensus the central bank will raise interest rates by year-end is misguided.

While none of the 23 banks that trade with the Fed expect a hike at the conclusion of Wednesday’s meeting, HSBC Holdings Plc, Royal Bank of Canada and Royal Bank of Scotland Group Plc remain steadfast that policy makers will choose to hold off on raising rates at the Fed’s Dec. 14 meeting as well.

History would seem to be on the trio’s side. Officials began the year anticipating they’d raise rates four times, only to repeatedly pare projections amid disappointing economic data. Yet a second-half uptick in growth and hawkish rhetoric from policy makers has prompted traders to price in more than a 70 percent chance that the Fed will pull the trigger by December. While they reserved the right to amend their calls over the next six weeks based on new data, economists at all three banks said the Fed needs to see clearer signs the economy is on the upswing and inflation is quickening before hiking.

"The FOMC has grounds for caution right now," said Kevin Logan, chief U.S. economist at HSBC in New York. “Slow growth in the U.S. economy, low inflation and the international repercussions of the Brexit decision in the U.K. -- there are plenty of signs of things slowing down globally and there will be too much risk in tightening policy.”

Bond traders are more confident. Yields on Treasury two-year notes, the coupon security most sensitive to Fed policy expectations, have climbed about 0.3 percentage point to 0.85 percent over the past four months.

The 71 percent odds traders are assigning to a rate hike are up from 59 percent the day after the Fed’s last meeting in September, when officials decided to leave the policy rate in a range of 0.25 percent to 0.5 percent. Those probabilities are based on the assumption the effective fed funds rate will trade at the middle of the new range after the central bank’s next hike.

So are other primary dealers, including Credit Suisse Group AG and Morgan Stanley, which both brought forward their forecasts to December in the last few days.

"Good U.S. and global data, and sufficient hawkish rhetoric by committee members have persuaded us to change our view,” James Sweeney, chief economist at Credit Suisse, wrote in a note to clients. Sweeney previously expected the Fed to hold off raising rates until May.

The U.S. economy expanded at a 2.9 percent annual clip in the third quarter as a build in inventories and jump in exports helped cushion softer household spending. Fed Bank of Chicago President Charles Evans said last week he expects policy makers to raise rates three times by the end of 2017, while St. Louis Fed President James Bullard called a December move “likely.”

No Go

HSBC, RBC and RBS say economic data belie renewed concerns over both growth and inflation.

The New York Fed’s Empire State manufacturing survey unexpectedly declined in October. A Labor Department report showed a gauge of core inflation rose less than expected in September, while orders for U.S. business equipment fell by the most in seven months. Even as U.S. economic growth picked up last quarter, consumer purchases grew at about half the pace as in the previous three-month period and corporate investment in equipment declined for a fourth straight quarter.

"It wouldn’t be the first time that the Fed has led people to believe that they are going to hike rates," said Kevin Cummins, an economist at RBS in Stamford, Connecticut. "It will come down to the data.”

Cummins wrote off a 2016 rate hike in June in the aftermath of the U.K.’s Brexit vote, and nothing has convinced him he needs to change his call. RBS doesn’t expect the Fed to raise rates next year either.

There are also political risks ahead, most notably the U.S. presidential election on Nov. 8 but also an Italian referendum in December that could reignite concerns about the European Union’s viability, said Jacob Oubina, senior U.S. economist at RBC in New York.

"Given the plethora of events that have potential to create noise in the markets in coming weeks-- the U.S. election, OPEC meetings, the Italian referendum, two more payroll reports -- there is a lot of scope for them to become derailed once again," Oubina said.

RBC and HSBC expect the Fed to stand pat until the second quarter of 2017.

Rate Path

Regardless of when the Fed moves, this policy-tightening cycle is poised to be the slowest and shallowest in recent history, based on the market for overnight index swaps, which reflect expectations for the fed funds effective rate. Swaps trading implies the effective fed funds rate will be about 0.86 percent in two years, and just 1.02 percent three years from now.

Some Fed officials are already signaling that the future path of interest rates is likely to be subdued. Bullard said last week that low rates are likely to continue to be the norm over the next two to three years. Dallas Fed President Robert Kaplan said in September that the path of rates is going to be flatter than it has been historically and that the Fed needs to act cautiously.

"People on the board have marked down the long-run fed fund rate,” RBS’s Cummins said. “The path of rate hikes is going to be very moderate, very slow."

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