Fed: Will we get a phantom rate hike in June? – ING

Research Team at ING, suggests that the markets have not been data-dependent of late, FOMC felt they had to step in.

Key Quotes

“The April minutes had a clear message: the Fed were concerned that markets were unduly underestimating the likelihood of a near-term rate hike. While recent Fedspeak has attempted to convey this message, the collective assessment reflected in the minutes has had the desired effect of boosting expectations (Fed Funds futures are pricing in a 28% chance of a June hike).

Yet, we think this week’s developments may have highlighted one of the flaws of the Fed’s data-dependent approach. We have noted that in recent months, the sensitivity of FX markets to US data surprises has been diminishing. This de-coupling typifies the challenge the Fed faces in guiding market expectations when it leaves data to do the talking; expect Fedspeak to get a lot louder.

Is it worth taking the risk of hiking ahead of the Brexit referendum? Should the FOMC feel that domestic economic conditions were apt to warrant a rate hike on 15 June, from a risk-management perspective, one could argue that a 6-week delay to allow for an “known unknown” (Brexit vote) to resolve may be the more prudent approach. For the US economy, the ripple effects from the UK voting to leave the EU may prove to be small, but they won’t be negligible (especially from a financial conditions perspective).

A better way of thinking about this is to ask ourselves whether the US economy is showing clear signs of overheating. For this to be evident, we think that we may need to see positive US data surprises ahead of the June FOMC event to convince the Fed that delaying any hike to July would be a mistake. See the table below for some guidance on how data needs to fare.

Will near-term USD strength stop the Fed from hiking in June/July? With the USD trade-weighted index rallying by around 3% since May, there may be some concern that a sustained recovery in the dollar will again become a negative factor in the Fed’s reaction function.

As we have previously noted, USD strength will not necessarily lead to a sharp tightening of US financial conditions; one (a) needs to differentiate between a warranted (fundamental) and unwarranted (risk-off) USD rally and (b) monitor how the other factors in our index (ie, equity markets, credit spreads, etc) progress. In fact, we note that even a full reversal of the 6% slump in the trade-weighted USD since early March would not see our FCI index return back to tighter January levels.”