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Friday, November 6, 2015

Good Labour Data Puts Fed On Track To Hike Rates In December

Given the breakdown in bond prices in recent days, it's not a particularly original observation to note that the Fed is on track for "lift off" (raising the policy rate away from 0%) in December. The latest labour market report reinforces that outlook.  I do not think a rate hike in December is particularly meaningful, even for the narrow question of the pricing of long-term bonds. (I do not spend a lot of time tracking what is happening in the front of the curve, for example eurodollar futures, where there presumably is a lot of interesting relative value stuff going on. Interesting for fixed income quants, at least.)

As for the labour market report, I would view it as just a continuation of previous trends  (but I ignore the random number generator that is the Nonfarm Payrolls series). Over the past year, the employment-to-population ratio has not really changed. Even if we believe in the demographic shifts that the hawks use to dismiss these data, this only indicates a slight tightening of the labour market over the past year. Correspondingly, I see no reason to expect underlying ("core") inflation to rise any time soon. (I hope to write an article on the relationship between wage and CPI inflation that will be published this weekend.)

As for the Fed, I cannot see any reason to care whether the Fed Funds rate is 0% or 1%. Some people get all excited about the effect of raising rates from 0%, as they half remember the pricing formulae for consols. (A consol is perpetual bond, and the duration goes to infinity as the yield goes to zero.) However, overnight rates are at the extreme other end of the maturity spectrum, and nothing interesting happens there when rates go to zero.

Rate hike cycles matter for bond pricing. Bond bears will reasonably point out that bond returns have been crushed during rate hike cycles. Although I accept the logic, a lot of damage was done during the "taper tantrum" of 2013, and it is unclear how significant a further sell off would be relative to the trading range bond yields have been in over the past few years.

However, going further afield to discussing the economic outlook, I see no reason to expect any visible effect from a few rate hikes.

My lack of concern about rate hikes is not generally shared by market strategists. There are two influential groups in the financial markets and economics who have exaggerated beliefs about the importance of monetary policy: Austrians and New Keynesian economists. Their hyperactive concentration on monetary policy tends to infect other market strategists, which is why we are treated to the spectacle of equity portfolio managers pontificating on the critical importance of interest rates for the stock market outlook.

The safest course of action is ignore the monetary policy zealots. In both cases, the beliefs revolve around tribal identification, and have little to do with any reasonable analysis of what is happening in the economy.

Bottom Line: Although it looks like the Fed will hike rates in December, the more important question is when follow up hikes occur.

(c) Brian Romanchuk 2015


  1. This 'rate hike' meme is essentially a political act. There is no objective justification for it whatsoever.

    If it is a political act, why isn't it undertaken by an elected politician?

    Raising rates with no mechanical justification according to objective rules pretty much destroys the argument for central bank 'independence'.

    1. On the basis of the Fed's modelling framework, they can justify a rate hike. I do not agree with their framework, but that isn't going to bother them in the least. I think the economic effects of a rate hike now are mixed, and so I am not worried about a hike (even though I believe that growth rates are too low).

  2. Brian,

    Not convinced the Fed will raise rates if the USD keeps appreciating from now till December:

    For me, it's all about the mighty greenback and how it impacts inflation expectations, not manufacturing activity. Any thoughts on this and my comment? Thx

    1. It seems unlikely that the dollar could move far enough over the next month to derail a rate hike. U.S. inflation is not that sensitive to the currency, so it is unlikely that any plausible moves in the currency would move the inflation rate by enough to worry the Fed.

      Even if the dollar moves, financial market price changes can rapidly reverse; we saw that with equities many times over the past few years. The Fed needs to ignore financial market volatility.

    2. Thanks Brian, edited my comment to include this. We'll see if a Fed rate hike is already priced into emerging markets and the high yield bond market. A lot of things can go awfully wrong in a month but your point is well taken and barring some catastrophic event, a December rate hike looks like a done deal. Thanks.

    3. I realize that some risk markets might go crazy with a hike, but I am hard pressed to see any fundamental reason. Commentators might go crazy, but that just tells us about commentators.

      For high yield corporates, a 1% money market rate is hardly a plausible alternative for investors who are starved for yield. It will take a lot of hikes before interest rates would be at a level to cause a recession.

      Emerging market countries should benefit from a stronger dollar, as they are more competitive, the only risk is if they borrowed in dollars. But I think the currency market already moved to price in rate hikes a long time ago.

    4. One hedge fund trader who agrees with me shared his thoughts on the mighty greenback and the likelihood of a rate hike in December:

      " Dollar problem now has company (which was not the case during summer deluge): The entire US yield curve backing up aggressively. There will be no hike in December with follow through in all of the above. "


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