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Fed in the driver’s seat – Goldman Sachs

Research Team at Goldman Sachs, notes that the implied probability of a hike at the September FOMC meeting has fallen to around 15% from 32% and this decline came on the back of a weak ISM nonmanufacturing print on Tuesday (September 6) and the lack of new information in the speech from San Francisco Fed President Williams.

Key Quotes

“The market was looking for clearer hints on the possibility of a hike at the upcoming FOMC meeting, which did not materialise. That said, the tone of the speech remains positive, and supportive of a near-term hike and a lower neutral rate, in line with Fed communication since the Jackson Hole symposium.

Interestingly, since the FOMC raised the policy rate last December, the market has sequentially lowered the probability of a hike at the next meeting with a press conference. On 16 December 2015, the market was assigning a 41% chance of a 25bp increase in the federal funds rate at the 16 March 2016 meeting. On March 16, the market assigned a 38% probability of a hike at the June meeting. On 15 June, the probability of a hike at the September was 24%. Contrary to what happened last year, when the Fed was able to guide the market to re-price sequentially higher the probability of a hike at the following FOMC meeting with a press-conference (i.e., making that meeting live), this year the market is sequentially downgrading this possibility.

US rates are also more responsive to negative than to positive data surprises. In our past research, we interpreted this as evidence that investors are pessimistic about the economic outlook. But, it can also be a signal that the market prices a dovish bias in the FOMC’s decisions. Whatever the reason for this asymmetry, data have to be quite strong for the market to price higher US rates by year-end without clearer guidance from Fed officials. Alternatively, if the FOMC aims to increase the market pricing of a near-term hike, a step-up of the ‘hawkish’ tone of communication may be needed to realign markets and Fed expectations.

Since the beginning of the year, the market has seen its expectations for the stance of US monetary policy validated, and shorting US rates or being long the US Dollar has not been a profitable strategy, contrary to our own forecasts. But, given the recent communication from Fed officials, who have begun to signal that another hike in the near term is appropriate, we think the market has become too complacent. Over the coming six months, the market prices the federal funds rate to increase to just 56bp, from 38bp currently, and it prices a full hike only by end-2017. This is a remarkably low profile of the federal funds rate for an economy that, as Mr. Williams said, is running “at full strength”.”

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