Investment Research General Market Conditions 15 June 2015 Mixed signals but Yellen should be more confident Updated projections will have a dovish twist As usual, the updated dots, which show the FOMC members projections of the Fed funds rate for the current and coming two years, will be at the centre of attention. The previous projections were released 18 March and the incoming data since then have been mixed, with downside surprises in April and May while the most recent data have been more upbeat. We believe that the mixed data have heightened FOMC members sense of uncertainty on the economic outlook and in response, we believe that a number of the dovish to centric members will have lowered their expected path for the Fed funds rate. How many is key to the market interpretation of the likelihood of a September lift-off. Our base case is that one member will lower his projection from one to zero hikes this year, which will leave the three most dovish members of the FOMC, Evans, Rosengren and Kocherlakota, with a lift-off date next year. On top of this, two members are likely to take down their projections from one to two hikes this year. In March, 14 out of the 17 members had pencilled in two hikes or more this year but that number will then drop to 12 in June. This would still send a message that September is the most likely date for lift-off. The risk is that more than two of the centric members take down their rate path this year, which would start fuelling doubts about a September lift-off. With recent data coming in strong though (see Strong retail sales show US consumer still alive, 11 June 2015, and Strong US job report - Fed set to hike in September, 5 June 2015), we believe that most members should feel confident in the Fed s base case, that a significant part of the weakness in Q1 was caused by transitory factors. Thus we believe that Chair Yellen, and with her the majority of the voting members of the FOMC, will continue to pencil in two hikes this year. This should also keep the median projected Fed funds rate unchanged at 0.625% in June but the risk is that it moves to 0.375%. In addition, the three most hawkish members of the FOMC had pencilled in an end-point of 1.375% and 1.625% respectively for the Fed funds rate this year, which does not look feasible. Hence they will need to lower their rate paths as well. This should in sum lower the average projected end-point for the Fed funds target rate this year from 0.77% in March to 0.64% in June. Turning to the 2016, 2017 and longer-term dots, there has been a lot of talk about lower potential growth in the US and a current very low neutral real Fed funds rate. This could have moved into at least some members projections for the coming years and would likely show up as a slightly lower longer-term Fed funds rate and a slightly lower average path for 2016 and 2017. Such lower rate projections are likely to be mirrored in the GDP growth forecasts and could show up as slightly lower GDP growth rates for 2016, 2017 and the longer run. For this year, GDP growth should be revised more significantly lower after the weak Q1 and we expect GDP growth to be revised down to 1.9% q4/q4 in 2015 from 2.5% in March. Senior Analyst Signe Roed-Frederiksen +45 45 12 82 29 sroe@danskebank.dk Senior Analyst Christin Tuxen +45 45 13 78 67 tux@danskebank.dk Important disclosures and certifications are contained from page 7 of this report. www.danskeresearch.com
Press conference should show a more confident Yellen In terms of the statement we expect the tone to be slightly more upbeat than in April given the latest more positive run of US data but we do not expect any major changes in the forward-looking part of the statement. More interesting will be Chair Yellen s comments at the following press conference. Key will be the FOMC view on how much of the Q1 economic weakness is temporary and how this, combined with the most recent more positive data, has affected its economic outlook. While Yellen and other key FOMC members have repeatedly said that they believe that weakness was in part due to transitory factors, others such as NY Fed President Dudley has sounded more worried. However, the strong May employment report, solid May retail sales and preliminary June consumer confidence on top of signs that wage inflation is moving higher and core inflation is stabilising, should have improved the FOMC s confidence in the outlook. Hence, at the current juncture we believe a majority of the voting members of the FOMC prefer a first rate hike at the September FOMC meeting. Yellen s comments at the press conference should reflect this increased confidence. While the April FOMC minutes showed that there was no backing for pre-announcing a coming rate hike, we do believe that Yellen will strike a more positive tone and state that if the recent improvement continues, come September it will likely be reasonably confident that inflation will move back to its 2% objective in the medium term. Volatile markets but end result to be higher short-term yields The market will get a flood of information during the FOMC meeting and the signals will be mixed. A lower rate path from the dots and lower longer-term GDP projections should put downward pressure on yields, while the following press conference should have the opposite impact. Current market pricing is consistent with an approximately 60% probability of a hike at the September FOMC meeting and the Fed funds rate pricing over the coming two-three years remains very subdued. We thus expect the end result after the dust has settled to be a somewhat higher probability for a September hike being priced into the curve and higher 2-year yields. Rates further out on the curve are likely to be more affected by the downward revisions to the longer-term growth and Fed funds rate projections and hence we expect the curve to flatten. The risk is that the market puts more emphasis on the lower dots than Yellen s comments or that the downward revisions to the projected Fed funds rate path are more significant than we expect. FOMC paving the way for USD strength ahead If we are right that the FOMC will give a two-sided message this week and thus spur limited upside pressure on US rates, we would not expect the meeting this week in itself to support USD crosses to any great extent. That said, it should nevertheless pave the way for a continued improvement on the data front to kick start the re-pricing of the US yield curve that we deem the greenback will be very sensitive to in the months ahead. With a September rate hike most likely to be kept as a viable option for the FOMC notwithstanding any downward revisions to the dots, our case for relative rates to support USD crosses in the months ahead remains intact. While the volatility in European bond markets is a lingering risk of EUR upside, we retain the view that notably the 2Y EU-US yield spread possesses decent negative potential from here. Coupled with positioning lighter on USD longs not least against the single currency there should now be room for another leg lower in EUR/USD. That is, Yellen will merely re-ignite USD potential rather than be the outright cause of it this week 2 15 June 2015 www.danskeresearch.com
FOMC chart book Labour market in one chart - most labour market indicators are at better levels than at the beginning of the 2004 hiking cycle Leading Temporary help services employment Payroll employment June 2004 May 2015 Job openings Employer behavior Unable to fill job openings Hires Initial claims Hiring plans Job finding Job availability Part time for economic reason Quits Utilization (slack) Marginally attached Unemployment Confidence Note: The diagram shows the level of tightness of different US labour market key figures at different times, compared with the level of the same figures in June 2004 (index=100). Counter cyclical figures (unemployment rate, jobless claims, marginally attached and work part time for economic reasons) are inverted; thus, the higher index (the further from the middle) the better (tighter) is the state of the labour market JOLTS data for December is an average of October and November data. Source: BLS (JOLTS), Macrobond Financial QE halted in October, next is a hike in the Fed funds rate Fed funds rate expectations have moved higher since April Source: Federal Reserve, Danske Bank Markets Source: Federal Reserve, Bloomberg, Danske Bank Markets 3 15 June 2015 www.danskeresearch.com
Core inflation is running below Fed s comfort zone......but momentum has improved lately Source: BEA, Danske Bank Markets Source: BEA, Danske Bank Markets Inflation expectations have dropped but have stabilized lately Source: Federal Reserve of Philadelphia, Macrobond, University of Michigan, Danske Bank Markets Source: Federal Reserve of Philadelphia, Macrobond, University of Michigan, Danske Bank Markets Job growth was solid in May Unemployment rate is drifting lower Source: BLS, Danske Bank Markets Source: BLS, Danske Bank Markets 4 15 June 2015 www.danskeresearch.com
Unemployment gap is getting smaller......and wage inflation is picking up Source: BLS, CBO, Danske Bank Markets Source: BLS, Danske Bank Markets Manufacturing ISM have bottomed and service remains high Consumer confidence has moderated but from cycle highs Source: ISM, Danske Bank Markets Source: University of Michigan, Conference Board, Danske Markets Retail sales now show a stronger path......following the weather related weakness in February Source: BEA, Federal Reserve of St. Louis, Danske Bank Markets Source: BEA, Federal Reserve of St. Louis, Danske Bank Markets 5 15 June 2015 www.danskeresearch.com
House prices have ticked higher but sales pace remains slow Mortgage and corporate funding costs have risen but remain low Source: NAR, U.S. Census Bureau, Danske Bank Markets Source: Moody s, MBA, Federal Reserve, Eurostat, Danske Bank Markets 6 15 June 2015 www.danskeresearch.com
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