As we discussed in last week’s market note, all eyes are on the Federal Reserve as it attempts to navigate policy normalization in a global economic environment that may best be described as “precarious.” We received the latest official update last week, with the release of the minutes from the Fed’s April meeting. While the Fed didn’t change rates at that meeting, the minutes indicate that many members were ready to continue tightening as early as June. One of the most important excerpts is this:
“Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the committee’s 2 percent objective, then it likely would be appropriate for the committee to increase the target range for the federal funds rate in June.”
Traders pushed up the expectation for a June rate increase from a 4% probability last Monday to a 30% probability after the minutes were released. Equally important was price action in the dollar, which rallied, and in stocks, which fell. This price action is similar to what occurred early in the year after the Fed hiked rates in December.
The Fed is in an interesting spot, as domestic economic data is consistent with higher rates. The unemployment rate is at 5% and core inflation is moving closer to its target of 2%. However, the rest of the world is not as strong economically, and China in particular would suffer with higher rates in the U.S. because its currency is pegged to the USD. In the next few weeks there are two metrics we will be watching closely to see if the Fed will be able to move forward with a rate hike: the relationship between the Chinese Yuan and the USD, and financial conditions in the U.S. While both of these were weaker after the release of the minutes on Wednesday, they stabilized later in the week. How these relationships move over the next few weeks will be the key to the Fed sailing on or keeping the anchor dropped.
Financial Conditions Index
Source: Bloomberg, Cagle Cartoons, Federal Reserve, RBS