Focus turns to US data after Fed rates threat

The US Federal Reserve caught the markets off guard last week when the Federal Open Market Committee struck a more hawkish tone on its future monetary policy than had been expected.

While there was little change to the Fed’s economic forecasts compared to December, committee members certainly moved the dial on the likely future path of rates. The committee members’ median expectation for the Fed funds rate at end 2015 moved from 0.75% to 1%, with a further move from 1.75% to 2.25% for rate levels by end 2016. Essentially, this implies two additional 25bps rate hikes compared to what committee members had previously indicated and the markets had priced in.

In a further torpedo for markets, new Fed Chair Janet Yellen hinted that the Fed is likely to keep rates on hold for about six months only, after its asset purchase programme ends, which is expected to be this autumn. This suggests rates will start to be hiked next spring rather than the second half of 2015 as the markets had expected. Equities sold off on the news, bond yields jumped, while the dollar made broad-based gains.

As expected, the Fed also abandoned its forward guidance that had tied interest rate policy to the unemployment rate. It will now adopt a more qualitative approach, looking at a broad range of indicators on the wider economy, labour market and inflation. This makes monetary policy more subjective and uncertain and leaves markets more vulnerable to swings in economic data. Thus, markets are going to be very focused on US data releases in the months ahead. Recent US data has been impacted by adverse weather conditions.

If the data in the coming months shows activity picking up momentum again, it will strengthen the belief that US rate hikes will be on the cards by next spring.

Much attention is likely to still focus on labour market data as a key indicator of spare capacity in the economy. The jobless rate has fallen from 7.9% to 6.7% over the past year. If the economy performs well in 2014, the unemployment rate could drop below 6% by early next year, moving into rate-hike territory.

While adverse weather has dampened activity in the early part of 2014, the prospects for the US economy look favourable for this year. Fiscal policy will have a far less dampening effect on activity compared to 2013. Deleveraging is also well advanced in the US.

Rising employment and the marked fall in inflation should boost consumer spending, with a further rise expected in housing construction to meet pent-up demand.

Meanwhile, business investment should pick up this year after a subdued performance in 2012-13. Exports strengthened over the course of last year, as the global economy improved and should perform well in 2014. Overall, US GDP growth could average around 3% this year, up from less than 2% in 2013.

US bond markets are nowhere near pricing in a significant increase in interest rates. Two-year swap rates are currently around 0.55% and are still below their highs of last year, when the market first sold off on Fed tightening fears.

Five-year Treasury yields are at 1.7%, with 10-year yields at 2.75%. These levels are hardly consistent with the expectations of committee members that rates could be at 2.25% by end 2016. On this trajectory, the Fed funds rate could be above 3% by end 2017, something markets have not priced in.

Thus, US bond markets look quite vulnerable if economic and labour market data prove to be quite strong in the months ahead. The dollar should benefit. However, with just a modest rise in US rates in prospect for next year, it is likely to be a gentle appreciation rather than a rapid rise by the US currency.