QNB Group: US Fed Will Raise Rates Twice in 2016

Doha, May 28 (QNA) -The US Federal Reserve (Fed) surprised financial markets last week. The minutes of its April rate-setting meeting indicated a significant likelihood of an interest rate increase in June, to the surprise of financial markets. In addition, a number of Fed committee members confirmed that message in a series of statements. As a result, markets sharply revised up their expectations of the path of US interest rates. They currently price in around 30% probability of a June rate hike, compared to just 4% two weeks ago. Despite the upward revision, we still think that markets are complacent. They are currently pricing in around one rate hike in the whole of 2016, while we believe that domestic US conditions warrant two rate hikes. We believe that the Fed will raise rates twice in 2016 for two reasons. First, the improvement in the US labour market is expected to lead to further declines in the unemployment rate. If the unemployment rate falls to 4.7% by year-end, as the Fed expects, then this will warrant one 25 basis point rate hike on its own, according to the Feds standard reaction function. Second, inflation is expected to continue to edge up as the labour market improves. The Fed expects core inflation to reach 1.6% by year-end compared to 1.3% a year earlier. Indeed, inflation is already at 1.6%. If such improvement persists, then it will warrant another rate hike. Other macroeconomic indicators also pave the way for additional rate hikes. Economic activity has picked up in the second quarter, with economic growth currently tracking 2.5% according to the Atlanta Fed model. Part of the pick-up in activity has been due to the recent slowdown in the appreciation of the US dollar, which had been a drag on growth last year. The labour force participation rate has rebounded in recent months, indicating that the decline in the unemployment rate was due to genuine employment gains rather than discouraged people dropping out of the labour market. Wage growth has also picked up in recent months, and has been consistently above 2%. Finally, financial markets have steadied after a wobble early in the year and the global economy is not facing any imminent crises. All this points to a Fed ready to raise rates twice this year. The question is when will it start? We believe that the most likely date is July. Despite the recent talk of a likely hike in the June meeting, this still faces two hurdles. The first is that it comes before the UK referendum on the exit from the European Union on 23 June. The Fed may want to wait for the outcome of the referendum before acting. The second hurdle is that markets are not yet ready for a hike in June. Goldman Sachs have shown that 90% of all US rate increases were at least 50% priced in 30 days in advance. That threshold was not met despite the recent revision in market expectations, which are currently attaching a probability of only 30% for a June hike. The Feds explicit mention of June may be an attempt to build up market expectations. With September being possibly too late given the Feds recent aggressive rhetoric, this leaves July as the most likely date for the next rate hike. The July meeting will take place after the British referendum and financial markets are currently attaching 54% probability of a rate hike by the July meeting, thereby overcoming the two hurdles. In conclusion, US economic conditions are expected to be consistent with two Fed rate hikes in 2016. In addition, the global economy and financial markets are currently sufficiently calm to convince the Fed to go ahead with monetary policy tightening. The most likely date to start the tightening process is July. But while markets are digesting the possibility of a July rate hike, they remain complacent about the number of rises this year, expecting only one rather than two. Markets expectations might need to adjust further in the near future. (END)