By Michael O’Neill, Agility Forex Senior Analyst

Santa Clause

Even Santa isn’t expecting a FED increase in December  Photo: Shutterstock

Forget “Summer time Blues”.  Global financial markets are already singing Christmas songs despite a heatwave in large swathes of the Northern Hemisphere. Unfortunately, those songs are of the less cheery variety and include “Blue Christmas, by Elvis Presley and “The Season’s Upon Us” by Dropkick Murphy’s.  

It’s not actually Christmas that has markets down in the dumps, it’s the lack of clarity surrounding the Federal Open Market Committee interest rate decision, due December 14 and the increasing belief that Fed Chair Janet Yellen and the FOMC members have lost their way.

That sentiment isn’t new.  Last December, the Fed raised the target funds rate by a quarter point, from 0.0% -0.25% to 0.25%-0.50%, the first rate increase in seven years.  In fact, at the time, the decision was viewed as a “doveish” hike and one that was made almost reluctantly.  China’s August 2015 equity market meltdown and currency devaluation had triggered a stampede into risk aversion trades and underscored the fragility of the global economic recovery. Deflation was a major concern due to the impact from falling oil prices.  Still, the FOMC made a decision.

Today’s issues with the Fed stem from the December 2015, FOMC Economic Projections.  Back then, they forecast that the Fed Funds rate would be 1.4% in 2016, 2.6% in 2017 and 3.4% in 2018.

Markets being markets, became convinced that those projections translated into four rate increases in 2016, slotting one increase per quarter, in March, June, September and December.

Then a whole lot of things happened.  China equities melted down, again. China devalued the yuan, again. Bank of Japan stimulus initiatives not only failed to devalue the yen, but precipitated a huge rally. (From 125.60 to 100.00) The European Central Bank ran into the same problem.  ECB President Mario Draghi announced a ‘massive stimulus program in March 2016 but the expected EURUSD decline fizzled when he did a Bugs Bunny impression and said “That’s all folks”

In between, Daesh was terrorizing Europe, China had imperialistic sights on the South China Seas and Europe was attempting to deal with a gargantuan refugee and humanitarian crisis, all of which contributed to global economic downgrades by the likes of the World Bank, the International Monetary Fund and the Organization for Economic Cooperation and Development.  And to make matters worse, the United Kingdom held a referendum and voted to leave the European Union.

Despite all the global turmoil, China issues, failed stimulus programs, Brexit risks, and a reduction in global growth forecasts, the erstwhile Committee members of the FOMC fanned the rate hike flames.

Kansas City Fed President, Esther George said on July 20th that “the current level of interest rates is too low relative to the performance of the economy”.  Philadelphia Fed President, Patrick Harker was even more direct on July 13 the when he said “it may be appropriate for up to two more rate hikes in 2016”.  San Francisco Fed President, John Williams said that “the very low interest rates that we have today are not normal”. FOMC Vice Chairman, Stanley Fischer went as far as to imply that if Brexit hadn’t happened rates would have increased in June.

More recently, in early August, Chicago Fed President, Charles Evans said he was open to one interest rate increase in 2016 while Atlanta Fed President wouldn’t even rule out a September rate hike.

Then came the August 5, nonfarm payrolls report.  The surprisingly robust 255,000 increase in jobs combined with a bump in average hourly earnings is just the data that the FOMC said they needed to pull the trigger on a rate hike.

Except, the financial markets don’t believe it is.  The CME FEDWatch tool indicated that the probability for a September rate hike only jumped to 18% from 9% immediately after the data but it has since declined to 12%.  The December probability is only 34.3%.

FX traders apparently agree with the FEDWatch tool. Already, EURUSD and the Canadian dollar have recovered all of Friday’s post NFP losses while USDJPY is only slightly higher.

Ben Bernanke, Fed Chairman from 2006 to 2014, wrote an article for the Brookings Institute suggesting that “with policymakers sounding more agnostic and increasingly disinclined to provide clear guidance, Fed-watchers will see less benefit in parsing statements and speeches and more from paying close attention to the incoming data”. 

And therein lies the problem. The data is muddled and sending mixed signals. The employment report may have been strong, but Q2 GDP missed forecasts and was a weak 1.2%. The current Atlanta Fed GDPNow indicator attempts to show current levels of GDP and as of August 9, US GDP for Q3 is at 3.7%. Still, the FOMC statement noted concerns about soft business investment and inflation that “continued to run below the Committee’s 2% longer-run objective”.

Janet Yellen has continually stressed, since last December’s meeting, that rate hikes will be data dependent. At the same time, the FOMC still has at least one rate hike forecast for 2016. As long as the US economic data releases continue to be mixed and inflation remains low, markets should heed Mr. Bernanke’s advice about ignoring Fed speakers and just concentrate on the data. When Santa comes, he may not have a rate hike in his bag of toys.