Déjà Vu All Over Again

As we begin the 4th quarter of 2016, market expectations are growing for an increase in the Federal Reserve’s policy rate, which would be the first since December 2015 and only the second since extreme policy measures were taken in the wake of the financial crisis. Investors likely recall the market reaction to the first hike vividly, which was marked by a spike in volatility across almost all markets and a material tightening of financial conditions. We are looking at eerily similar patterns developing, experiencing a sense of déjà vu. Concurrent with an increase in the odds of a hike, the dollar has been rising along with bond yields and volatility, resulting in a tightening of financial conditions. While none of these trends have taken off, they are a reminder of the fragility of our current economic circumstances. The Fed has always claimed data dependency, but what they don’t say as explicitly is how much their actions appear to be dependent on markets and asset prices. A large spike in the dollar could cause renewed capital outflows from emerging markets. It has already caused another decline in China’s currency versus the USD, and if a chain reaction unfolds as it did last time, it has the potential to sideline the Fed once more as we move through the remainder of this year. At SNW, we are watching these indicators for signs of what the near-term policy implications will be, and for potentially attractive opportunities in our markets. But taking a step back, our longer-term outlook remains aligned with the fundamentals, which continue to plug along at a moderate pace, likely resulting in a sustained range-bound environment for longer-term interest rates.

Chart of market-based Federal Reserve “hike odds” (yellow line):

Chart of the USD:

Chart of Bloomberg U.S. Financial Conditions Index (lower is tighter):

Source: Bloomberg, WSJ