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US Fed maintains status quo on rates but growth is a worry…

World | Published on May 09th 2017 | Comment(s) 0
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In the latest meet of the Federal Open Market Committee (FOMC), the board of the Fed opted to maintain status quo on rates. Thus the Fed rate remains in the range of 0.75% to 1.00%. It may be recollected that the Fed rate was hiked in December 2015 for the first time after a gap of 9 years to a level of 0.25% to 0.50%. Subsequently, there were two more rounds of rate hikes in December 2016 and later in March 2017 of 25 basis points each bringing the rates to the current range of 0.75%-1.00%. Even ahead of the Fed meet, there was almost a market consensus that the Fed would not hike rates considering that the US economy had grown at a languid pace of 0.7% in the first quarter ended March 2017. However, the Fed is still confident of two more rounds of Fed rate hikes of 25 basis points each and even the markets are factoring in the probability of another two rounds of rate hikes in this calendar year. The table below captures the probabilities of rate hikes over the next 6 Fed meetings as implied in CME trading data on Fed Fund futures.

 

Probabilities for different Target Fed Rates over the next 6 Fed Meetings

 

75-100 bps

100-125 bps

125-150 bps

150-175 bps

175-200 bps

200-225 bps

14-Jun-2017

26.20%

73.80%

-

-

-

-

26-Jul-2017

23.60%

69.10%

7.30%

-

-

-

20-Sep-2017

13.30%

49.20%

34.30%

3.20%

-

-

01-Nov-2017

13.00%

48.50%

34.60%

3.80%

0.10%

-

13-Dec-2017

9.00%

37.50%

38.90%

13.40%

1.20%

-

31-Jan-2018

8.40%

35.70%

38.80%

14.90%

2.00%

0.10%

 

Please note that the above table captures real-time probabilities as on 04th May and is based on the implied probabilities in Fed Fund Futures trading on the Chicago Mercantile Exchange (CME). These probabilities are subject to change. What we can infer is that even if we consider the end of 2017, there appears to be an 85% probability that the Fed rates will not cross the range of 125-150 bps. That is a best case scenario of another 2 rounds of rate hikes of 25 basis points each during 2017.

 

Rate decision versus the original pre-conditions…

 

When the idea of rate hikes were first proposed back in 2014, the Fed had set 3 conditions to justify a rate hike…

 

  • The labour market must show consistent rise in job creation and the unemployment must be below the level of 5%. With the latest unemployment numbers coming in at around 4.5%, the US economy is as close to full employment as is pragmatically possible. Even though wages have not shown a sharp pick-up in tune with jobs, the overall labour conditions were conducive for one more round of rate hike.

 

  • The second and very important condition set by the Fed for a rate hike was inflation at closer to 2%. For over 2 years, the rate of inflation stayed under the 1% mark due to weak prices and due to weak demand. With the demand situation improving the inflation rate has shown a tendency to get back closer to the 2% mark. Also the core inflation in the US (excluding oil and food inflation) is already at 2%. Thus even inflation justified a rate hike.

 

  • Consumer spending and growth, which was the third pillar of the Fed decision matrix, was where the latest quarter tended to disappoint. The US GDP growth in the Jan-Mar quarter at just about 0.7% was at a multi-quarter low. Additionally, the markets needed greater clarity on the nature and colour of Trump’s fiscal policy and its impact on creating a virtuous cycle of spending and growth. That was, probably, the one consideration that has held back the Fed from hiking rates in this meet. It also indicates that the Fed rate hike process may have been just back-ended rather than being postponed. That is something that is evident from the CME Fed data too.

 

What is the Fed stance on tapering its bond purchases?

 

From a global liquidity standpoint, the good news is that the interest on bonds will continue to be reinvested. That is a relief because the Fed taper of the bond buying program was supposed to start with the interest component ceasing to be reinvested. In the light of the global uncertainty pertaining to BREXIT, the Fed is most likely to watch the global monetary system for some time before embarking on its tapering program.

 

What are the key takeaways for Indian markets?

 

The fact that the US Fed has back-ended its decision to hike rates will be temporary relief for the RBI. The rate hike possibility that was hinted by Dr. Urjit Patel in the last MPC meeting may not materialize for now. The risk of narrowing yield differential gets back-ended for some more time and that is likely to do away with the risk of major FPI outflows from Indian equity and debt. But the much bigger concern for the Indian markets was the Fed approach on tapering its $4.5 trillion bond portfolio. The proposed taper actually spooked markets in 2013 and it is likely to create a global liquidity tightening this time around too. For markets like India, which have benefited substantially from solid portfolio flows, a decision to taper could have more far-reaching repercussions.

 

The only real downside to the Fed decision from India’s perspective could be that most emerging markets were predicating their growth plans on a pick-up in US economic growth. If the first quarter in the US is just an aberration, that will be acceptable. But if the first quarter is indicative of a sustained slowdown in US growth, then that could change a lot of equations in global economics. India will have to watch out for that!




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