The US economic conditions are expected to be consistent with two Fed rate hikes in 2016, QNB has said in an economic commentary.
In addition, the global economy and financial markets are currently sufficiently calm to convince the US Federal Reserve (Fed) to go ahead with monetary policy tightening, it said.
The Fed surprised financial markets last week, QNB said.
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,” QNB said.
QNB believes 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 Fed’s 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,” QNB said.
The other macroeconomic indicators also pave the way for additional rate hikes, the economic commentary noted.
The 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.
The 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,” QNB said and noted the question was when it would start.
QNB believes 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 June 23.
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 has 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 Fed’s explicit mention of June may be an attempt to build up market expectations. With September being possibly too late given the Fed’s 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.
According to QNB, 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, it said.
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