Janet Yellen and William Dudley are trying their best to convince the markets that a December increase in the Fed Funds rate is, as the Fed Chair said Wednesday in Washington, a "live possibility."
Credit markets have responded smartly to the assertions of Chair Yellen and New York Fed President Dudley. The yield on the 2-year generic Treasury closed at 0.8116 percent on Wednesday, the highest since April 11th. On Thursday it traded to 0.8575 percent in New York, a four and a half year high. The return has soared over 30 basis points from 0.5487 percent on October 14th.The return on the 10-year has climbed from 1.9718 percent on October 14th as high as 2.2613 percent on Thursday.
Is the Fed setting the market up for another disappointment?
When the Fed declined to increase its benchmark rate at the October 28th meeting despite having fomented expectations that a hike was likely, markets immediately discounted an increase in December and pushed the forecast for the initial hike off into the first quarter of next year or later.
If Fed officials pointedly say that a hike is a possibility, markets assume they mean a probability and trade accordingly. No amount of reference to 'data dependency' will alter the direction of the market. Nor will any information short of the catastrophic change positioning. Poor economic data between now and the December FOMC meeting will be considered a temporary aberration.
When the Fed does begin to raise rates it has promised that the pace of subsequent hikes will be extremely gradual. Accommodation is here to stay, at least by historical interest rate standards. Fed rhetoric seems determined to prevent a rush higher in rates as credit markets are tempted to adjust rapidly the full extent of first tightening cycle in over a decade.
The Fed governors may feel confident that the U.S. economy will perform as they expect for the next two months enabling a December increase.
But the world is an uncertain place. Any number of economic or political developments could trump their expectations and damage global economic prospects sufficiently to block a U.S. rate increase.
China, Japan and the European Monetary Union are headed in the opposite policy direction. The potential damage to the U.S economy, commodity prices, inflation and emerging markets economies from a more expensive dollar are substantial. The FOMC underlined its new-found concern for global economic conditions at last month’s meeting. Will the governors then risk the potential economic damage just to keep their word on what is an economically trivial 0.25 percent increase?
What if, instead of telegraphing its desire for a rate increase now, and running the risk of interim adverse events, the Fed said little in the next five weeks, letting the data speak for itself and then raised rates on December 16th? Would the result be any different or more volatile than that obtained by letting the markets know aforetime.
One important factor is being ignored in the Fed’s transparency rush-- the central bank’s reputation for careful, deliberative policy.
If something untoward happens between now and December 16th which prevents a rate increase, a discrete Fed would have saved itself the embarrassment of having misjudged events and policy yet again.
Why the Fed governors take this wholly unnecessary risk with the bank’s credibility is a mystery.
Chief Market Strategist
WorldWideMarkets Online Trading