Market analysis: Fed set for hike, but could a market tantrum hold it back?

Janet Yellen, chairperson of the US Federal Reserve, attends the first session of the G7 finance ministers and central bank governors' meeting in Sendai, northern Japan, on May 20. Kazuhiro Nogi / AFP

As markets hunker down for summer and think increasingly about Brexit risks, they appear to have taken their eye off the ball when it comes to the Federal Reserve.

After having more or less written off the possibility of a June Fed rate hike during the spring, the markets were shocked to see the minutes of last month’s Federal Open Market Committee meeting showing members actively considering a June move. We always thought that such a move was quite likely, but the markets will now be scrambling to catch up and recalibrate tightening expectations through the rest of the year.

The Fed Funds futures market now gives a 32 per cent probability to a June rate hike compared to 12 per cent before the release of the minutes, and in the coming weeks it seems likely that these odds could go higher still.

The minutes of the April FOMC noted that participants judged that if the data on growth, inflation and employment continued to make progress towards the Fed’s objectives, then it “would be appropriate for the committee to increase the target range for the federal funds rate in June”. Some participants were also reported to have judged it appropriate to raise interest rates at the meeting, as downside risks associated with global economic and financial developments had, at that point, diminished.

Since last month’s meeting, momentum in the US economy has clearly improved, with data for retail sales, consumer confidence, industrial production and consumer prices surprising relatively positively. So much so that estimates for second-quarter growth have been raised from 2 per cent closer to 3 per cent, something that should prove reassuring to Fed officials.

The committee will have one more round of key employment, retail sales, production and manufacturing data under its belt before the June 14-15 meeting. However, it could be said that the bar has now been raised higher for the Fed not to act than for it to move.

Also of note, the FOMC minutes highlighted how financial markets were underestimating the probability of a rate hike at the June meeting, and hence they emphasised “the importance of communicating clearly over the intermeeting period how the committee intends to respond to economic and financial developments”. This is an important issue for the Fed, as it risks losing credibility if its messages are not listened to – with potentially damaging consequences for US markets, not just in coming weeks but over the longer term.

In the past week several Fed officials have clearly stated their views about the possibility of interest rates rising at the next meeting. In this sense, the Fed is sending a message that it maintains the flexibility to increase rates, depending on the data. In the coming week the chairwoman Janet Yellen will be speaking, and it will be her words that will be most closely listened to. In the past she has on numerous occasions dampened tightening expectations, so what she now has to say will be crucial. Given her record, if she also now intimates that a June hike is looking likely then it will be tantamount to a done deal.

Other things that could still interfere with a move next month are the Brexit referendum on June 23 and the behaviour of global markets. There was only slight mention with regard to the United Kingdom’s upcoming EU referendum in the Fed minutes, with some participants noting that financial markets could be sensitive to those developments. The current opinion polls are relatively reassuring in this regard, but these could easily change as the referendum draws near, increasing anxiety across financial markets.

The behaviour of global markets in general is perhaps a more unpredictable caveat, however. The Fed raised global market concerns (especially Chinese-related growth fears) as an issue preventing it from hiking at the start of the year, but officials last month generally viewed global risks as having diminished since March.

However, with equities falling in the immediate aftermath of the April minutes, the market is bound to wonder whether another market tantrum could hold the Fed back again. This would be a bad precedent overall, as unless renewed volatility is justified by anything other than rate hike fears, the Fed should be prepared to look through this noise or risk further damage to its credibility.

Tim Fox is the chief economist and head of research at Emirates NBD.

Follow The National's Business section on Twitter