Did the U.S. Federal Reserve Just Tell Markets That It Would Raise Rates in December?

The U.S. Federal Reserve decided to hold its funds rate steady last week, but a key wording change served as a warning to markets that a rate rise may be imminent.

In its closing commentary, instead of continuing to use language consistent with a wait-and-see approach, the Fed was much more specific, indicating that it was now evaluating whether it will be appropriate to raise its policy rate “at its next meeting”.

This specific reference to the December meeting caused many analysts to speculate that the Fed was telegraphing a rate rise before the end of the year. That said, the U.S. futures market only increased the odds of a Fed rate rise in December from 35% to 50%, so it will take more positive economic data between now and then before a December rate rise becomes the market’s base-case scenario.

Those who read the Fed’s complete statement found plenty of language to support the view that its tightening timetable is not yet a forgone conclusion. The statement went on to say that “this assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.” Even more specifically, the Fed said that it would need to see “further improvement in the labor market and [be] reasonably confident that inflation will move back to its 2 percent objective over the medium term.”

Here is my take on the current state of the key elements outlined in the paragraph above:

• The health of the U.S. labour market – U.S. job growth has slowed markedly of late and there continues to be only minimal growth in average wages. The data-dependent Fed will look closely at the October and November employment reports for signs that the U.S economy is either returning to the robust U.S. job-growth momentum we saw from March, 2014 through to February, 2015, or continuing along the slowing momentum path we have seen from March, 2015 to the present. If we see strong October and November reports I expect the market to become increasingly convinced of a Fed rate rise in December, but that would require a reversal of the current momentum and as such, is certainly not a forgone conclusion.
• Signs of inflationary pressure – Overall U.S. inflation still hovers at 0% and the latest U.S. dollar surge that was caused by the Fed’s latest statement could push the U.S. economy into outright deflation. Central banks have many more tools to counteract inflationary forces than they do deflationary ones and, for that reason, they fear the latter much more than the former. That helps explain why, in less formal settings, Fed Chair Yellen has said that she would even risk above target inflation over the short term if she believed that keeping monetary policy ultra-loose was critical to maintaining overall economic momentum. Given current U.S. inflation levels, and given the Fed’s increased tolerance for rising inflation in the current economic environment, it’s hard for me to envision how the U.S. inflation data will cause the Fed any significant concern for some time yet.
• Readings on financial and international developments – The Fed’s more hawkish language fuelled another surge in the U.S. dollar, and this further strengthened the currency headwind that was already buffeting U.S. exporters while also causing more volatility in emerging-market economies. This is the Fed’s ongoing conundrum. Stronger U.S. economic momentum bolsters the Fed’s confidence and increases the odds of a rate rise, which then pushes the Greenback higher and in so doing, undermines that same economic momentum. Speaking of which, last Friday we learned that U.S. GDP growth rose by 1.5% in the third quarter, which marked a sharp slowdown for the 3.9% GDP growth we saw in the second quarter, so the first U.S. economic data released after the Fed’s latest statement shows that the broadest measure of overall U.S. economic momentum is already on the wane.

Canadian mortgage borrowers are well advised to keep an eye on the Fed because Canadian and U.S. bond yields have always been highly correlated, even more so over the past several years. If the Fed raises its policy rate and the Bank of Canada (BoC) stands pat, as is expected, this correlation will weaken, but Canadian monetary policy cannot entirely decouple from U.S. monetary policy for an extended period because our economies are so deeply integrated.

Financial markets understand the relationship between U.S. and Canadian bond yields well, so when the Fed does finally raises its policy rate, Government of Canada (GoC) bond yields are likely to be taken along for the ride, at least partially and initially. That means that our fixed mortgage rates, which are priced on GoC bond yields, are likely to rise in sympathy with U.S. rates. On the other hand, our variable mortgage rates, which are priced on the BoC’s overnight rate, can be expected to remain at their current ultra-low levels until well after the Fed’s first move, because the BoC has long said that it will lag the Fed’s initial tightening timetable.

Five-year GoC bond yields rose three basis points last week, closing at 0.88% on Friday. Five-year fixed-mortgage rates are available in the 2.49% to 2.59% range, and five-year pre-approval rates can be found at rates as low as 2.64%.

Five-year variable-rate mortgages are still being offered in the prime minus 0.65% to prime minus 0.75% range, but the most deeply discounted versions are now less widely available and may not be around for much longer.

The Bottom Line: The U.S. Fed has just indicated that it will be evaluating the incoming data to determine “whether it will be appropriate to raise the target range at its next meeting” and this overt timing reference has led to speculation that the Fed will raise its policy rate in December. While I think that is still far from a forgone conclusion, if I were in the market for a fixed-rate mortgage in the near future I wouldn’t want to be waiting for the release of the October and November U.S. employment reports without having a pre-approval firmly in hand. As always, forewarned is forearmed.