This article is from Colin Cieszynski, CMC's North American chief market strategist. Look out for further articles previewing the second quarter of 2015.
Q2 Market Outlook: Could the Fed start raising interest rates in Q2?
It’s a good thing I waited until after the March 2015 FOMC meeting to write this part. Throughout the first quarter, employment numbers and FOMC member comments indicated that the central bank was on track to start raising interest rates in June.
The latest Fed meeting sent the street a big curveball. By removing the “patient” language from its statement (which had been code for no changes the next two meetings), the FOMC indicated that it is taking a meeting by meeting approach to rate hikes starting with the June meeting.
On the other hand, FOMC members cut their GDP, inflation and fed funds forecasts for 2015. The Fed has a dual mandate to promote employment and control inflation. The idea behind interest rate normalization is to move real interest rates from negative to zero. In other words, to align the Fed funds rate with inflation. The Fed, the Bank of Canada and several other major central banks have a long run target of 2% inflation, so at 0.25% the current fed funds rate seems low.
That being said, with Fed members cutting inflation and growth targets, it now appears very unlikely that the central bank will raise interest rates this quarter. At the same time, the downward pressure on inflation from the oil price crash should fade in time as oil stabilizes. The Fed and other central banks such as the Bank of England have indicated they expect the inflation to rebound once the oil crash effect goes through so rates could still go up later in the year.
The average Fed funds forecast from FOMC members has dropped from 1.125% to 0.625%, suggesting 1-2 rate hikes this year rather than 3-4. This means that the FOMC could easily hold off interest rate liftoff until September at least.
Traders try to figure out when rate liftoff is coming may focus on the next round of projections in June. Although, Chair Yellen has tried to bring back the fear of the Fed by indicating they could move at any meeting, it would seen unlikely that the central bank would raise rates without raising their growth and inflation forecasts as well.
That being said there is a small chance the Fed could surprise and take a “one then wait and see” approach as we have seen on the other side from the Bank of Canada, Reserve Bank of Australia and Norges Bank in the last few months, so it’s important for traders to have a plan ready for both possible outcomes.
Global Monetary Policy Outlook
Even by staying on hold but with a view to raising interest rates eventually, the Fed finds itself at the hawkish end of the spectrum among major central banks. The ECB is the most dovish at the moment, having just launched a new QE stimulus program. Sweden and Switzerland with negative interest rates also appear well entrenched in the dovish camp.
The Bank of England remains firmly in neutral at the moment. For some time, the street has been expecting that the Bank’s next move would be a rate hike but not until after the election, and likely not before the Fed moves. With Europe in stimulus mode and the Fed sitting on its hands, a UK rate hike looks unlikely before very late in the year. There also has been some contention starting to emerge from some members that the next move could be more easing, which would come as a surprise to the street at this point.
Central banks with oil sensitive currencies in Canada and Norway cut rates once each in the last few months and have been on hold lately while they assess the damage the oil crash has done to their economies. Both central banks have left the door open to further cuts, Canada looks 50-50 this quarter.
The Bank of Japan continues to run its own QE program although chatter from there suggests an increasing level of discomfort with keeping it going forever and an increase looks highly unlikely. It’s likely though to keep the current program running through the quarter. A taper would come as a surprise.
The Reserve Bank of Australia surprised the street and kept interest rates steady while the Reserve Bank of New Zealand stayed the course but this was not a surprise. Both central banks appear to prefer using falling currencies to do their stimulus for them and will probably continue to focus on talking their dollars down.
What could a delayed or slower Fed liftoff mean for markets?
In the first quarter, US indices slowed their advance and levelled off in sideways channels as traders anticipated a more hawkish Fed and a higher USD could impact the growth of US corporate earnings. Meanwhile, indices in Europe and Japan continued to climb supported by central bank stimulus.
If traders start to this that the Fed could delay interest rate liftoff into the second half of 2015 or slow the pace of rate hikes, an overhang could be lifted from US indices and enable them to catch up to their peers overseas.
Similarly, USD has been steamrolling over everything in its path for the last several months as the Fed’s steady march toward higher interest rates while others were heading toward more stimulus stances put the Fed as the relatively hawkish end of the spectrum. With hawkish sentiment easing, the USD has started an overdue correction, lifting the lid off of other major paper currencies, gold and commodities, enabling them to rebound a bit. This bounce back could continue through Q2 if it increasingly looks like liftoff could be postponed.
Focus Charts: USA vs The World
The chart below shows how the Dow levelled off in December and has been trading sideways for the last several months. It has not participated in the massive rally staged by the Dax or the Nikkei among others through the winter. This indicates that if the Fed does hold off on liftoff, there could be substantial room for a catch up rally of 10% or more.
The chart below, meanwhile, shows that the pause in US indices has enabled markets that were underperforming to catch up. Interestingly, despite weakness in the energy sector, both the UK FTSE and Canadian S&P/TSX indices have been gaining on the Dow in the last few months.
This action suggests that the street expects the lower GBP and CAD combined with lower energy prices to boost other sectors as time goes on and overcome the energy hit to their economies.
The FTSE has really closed the performance gap as UK interest rate hike speculation has evaporated even faster than Fed speculation. This quarter, however, the FTSE’s performance may be uneven and it could lag again in the weeks surrounding the early May UK election.