Fed: Calm Before the Storm? - TDS
Research Team at TDS, suggests that the risk assets and broader financial conditions had so far weathered the repricing higher of Fed hike expectations pretty well but the weak payroll report should create a sense of unease with the Fed policy stance.
“This should particularly be the case if Chair Yellen continues to suggest that hikes remain on the horizon. This scenario is eerily similar to what happened in Jan and Feb this year. The Fed had just raises rates in December and was suggesting 4 hikes this year. However, growth data began to decelerate, stoking fears of a recession. Also the CNY is similar to levels in February. Do we get a repeat of price action in Jan and Feb where markets panicked after the Fed hiked? Or is it different this time?
Even though the payroll and non-manufacturing ISM reports disappointed, in general US growth data has been solid. Further, we would argue that there is a big difference between the market pricing of the Fed today versus heading into the first hike. Even though the market has priced in more than 80% chance of a hike by the end of the year, the pace of hikes beyond that is much slower.
We believe that this is a function of the market pricing in a changed Fed reaction function—incorporating a “Third Mandate”—which argues for greater sensitivity of the Fed to financial conditions and thereby a slower pace. We believe that this is the reason why the dollar has not strengthened as much even as the next hike approaches.
If the market continues to only price in one hike next year, we believe that the dollar will not strengthen much and risk assets will remain well behaved. However, if Chair Yellen suggests 2 hikes this year and more in 2017 or if the June dot plot continues to suggest 4 hikes in 2017, we believe that the risk asset calm could quickly unravel.”