Although 2007 trading has only just got underway, enough undercurrents have already shifted to suggest that some of the assumptions being built into futures expectations ahead of Christmas may already have altered. This has resulted in some volatile moments across developed equity markets already.
Our base case scenario has it that the US Federal Reserve will not begin the process of cutting base rates until Q2 2007 at the earliest. We acknowledged, however, the possibility that the Open markets Committee might be compelled to bring forward the timing of its move to the back end of Q1 and that the timetable of events before that date allowed sufficient time for the monetary authorities to signal their intention to the market in good time. Fed fund futures pricing had begun to wake up to the possibility that US rates might be reduced at the end of Q1, ascribing a probability in excess of 50% to a 25bp easing at the end-March meeting, encouraging hopes that, by acting swiftly, an economic hard landing might be avoided.
What do the 12th Dec FOMC Minutes suggest?
Imagine our surprise when reading the published minutes of the above meeting. Committee members are divided (as we have mentioned before) however, the latest conclusion appears to us as if the hawks have got their way: “Inflation will fail to moderate as desired”.
We note that one FOMC member did suggest that the statement include a line acknowledging that policy could be adjusted up or down depending on the path growth or inflation take over the next few months.
Given that Q4 GDP growth may yet emerge stronger than the market had anticipated (c3.0% V’s 2.7% annualised after strong ISM data) we suspect that the Fed is not yet ready, in its 30th-31st January meeting, to shift to a symmetrical risk position.
The minutes indicate that the impact of the weak housing market on consumer confidence, consumer spending patterns and business investment has, so far, proved limited. The FOMC accepts that the plunge in the residential property market has been significant, but believes that the strength in the US equity market, particularly over H2 (in which the Dow hit a series of new all-time highs), was sufficient to offset consumer gloom.
The Committee also acknowledged weakness in the automotive sector might be having a detrimental effect on growth, however, the revival in ISM data may provide sufficient confidence that US economic activity is emerging only mildly below trend to encourage the view that underlying inflation should ease of its own accord over time.
Conclusion: will the Fed hold US interest rates steady?
The minutes of the 12th December FOMC make it quite clear that the Fed regards the impact from the weak housing and automotive sectors as containable, that growth may disappoint, but only mildly so, and that core inflation should subside without much in the way of a nudge from policymakers.
This leaves the financial markets hamstrung. Investors must decide whether to take the FOMC’s word for it and that a soft landing might be achieved with little policy assistance, or, whether the Fed is still underestimating the fall-out from the property and auto sectors and that by holding rates steady for longer than the futures markets had previously anticipated, the Fed is still too insouciant regarding a hard landing. The consequence of this “no change to our message” message has been some hard thinking and some awkward volatility for investors seeking a smooth transition into 2007.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley