How the U.S Federal Reserve Surprised Markets Last Week

The U.S. Federal Reserve left its policy rate unchanged last week, as was widely expected, but it also surprised markets by adopting a far more dovish tone about the U.S. economy’s prospects.

How quickly circumstances can change.

When the Fed raised its policy rate in December, its rate-setting committee had predicted that there would be four more rate hikes in 2016. Now, just a month later, the Fed sounds much more cautious and U.S. fourth-quarter GDP growth just clocked in at a paltry 0.7%. Investors are now betting that the next Fed rate hike won’t be until February 2017 (according to CME Group 30-Day Fed Fund futures prices).

The U.S. Fed’s policy statements matter to Canadian mortgage borrowers because our economies are deeply interlinked. That means that while our respective monetary policies can diverge somewhat for a period of time, the Bank of Canada (BoC) will tend to move in the same direction as the Fed over the longer term. As such, the Fed’s policy statements act as a sort of distant-early-warning system for Canadian mortgagors who are trying to predict the timing of the Bank of Canada’s next rate hike (as distant as that prospect may now seem).

Here are the highlights from the Fed’s latest statement:

• “Labour market conditions improved further even as economic growth slowed late last year”. The Fed cited “strong job gains” and “some decline in the underutilization of labour resources”. The decline in the underutilization of labour resources refers to a further closing of the output gap, noteworthy because the Fed would normally be expected to tighten monetary policy at or about the time when the U.S. economy’s output gap closes.
• “Net exports have been soft and inventory investment slowed”. It’s no surprise that export demand has fallen because the U.S. dollar has been on a tear for some time now. In fact, economists estimate that the surging Greenback’s negative impact on exports has been equivalent to four rate hikes by the Fed. Inventory investment slowed but this did not come as a surprise because inventories surged in the fourth quarter of last year. At that time, a slowdown in the first quarter of 2016 was widely predicted.
• “Household spending and business fixed investment have been increasing at moderate rates in recent months, and the housing sector has improved further”. Average disposable incomes rose in 2015, thanks in large part to lower gasoline prices but also thanks to a modest rise in average incomes. U.S. consumers were choosing to increase their savings rather than their spending when their disposable incomes rose and the U.S. personal-saving rate increased for six straight months in the latter half of 2015. The Fed is somewhat ambiguous in interpreting this data. On the one hand, they interpret the “moderate” increase in household spending as a sign that consumer confidence levels are rising (with the rise in business investment signalling the same for business confidence). But on the other hand, in its previous statement the Fed had observed that these same measures were increasing at a “solid” rate, so in that context, the Fed’s current assessment of “moderate” consumer spending and business investment is actually a step down.
• “Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.” If inflation is expected to rise to only 2 percent over the “medium term”, this will allow the Fed to take its time when assessing whether market conditions warrant further tightening. In other words, benign near-term inflation allows the Fed to be cautious, especially as it “closely monitor[s] global economic and financial developments”.
• “The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” This is the key sentence that confirms that the Fed is in no hurry to tighten its monetary policy.

It is worth remembering that so far, central banks have reversed every policy-rate increase they have enacted since the start of the Great Recession. This fact is not lost on some of the experts whom I read regularly and they are predicting that the Fed is likely to do the same again. Their view is being bolstered by lackluster U.S. economic data to kick off the new year, by rising uncertainty about China’s near-term growth prospects, and most recently, by the Bank of Japan’s decision last week to impose negative interest rates on the excess reserves that it holds for institutions. It’s hard to imagine that the Fed will continue to raise rates when other countries are ramping up a currency war in a desperate (and flawed) attempt to stimulate their economies and to stem deflationary pressures. And against this backdrop, it’s hard to believe that only a month ago, the consensus was calling for materially higher U.S. interest rates in 2016.

In Canada, perhaps without precedent, CIBC World Markets has just downgraded its growth forecast for our GDP for the second time in a matter of a few short weeks.  How quickly circumstances can change indeed … on both sides of our border.

Five-year Government of Canada (GoC) bond yields fell by nine basis points last week, closing at 0.67% on Friday. Five-year fixed-rate mortgages are available in the 2.49% to 2.74% range, depending on the terms and conditions that are important to you, and five-year fixed pre-approvals are offered at rates as low as 2.79%.

Five-year variable-rate mortgages are available in the prime minus 0.45% to prime minus 0.30% range, which translates into rates of 2.25% to 2.40% using today’s prime rate of 2.70%.

The Bottom Line: The Fed surprised markets by sounding more cautious than in its previous statement about the U.S. economy’s prospects and about the timing of its future policy-rate increases. U.S. bond yields fell in response, as did GoC bond yields, which are highly correlated with their U.S. counterparts. The longer the Fed delays its monetary-policy tightening timetable, the more likely it is that our fixed and variable mortgage rates will stay at or near today’s levels for the foreseeable future.