Why a U.S. Fed Rate Rise in December Is Still Not Guaranteed

Right now markets believe that there is about a 75% probability that the U.S. Federal Reserve will raise its policy rate at its December meeting. These odds spiked after the latest U.S. nonfarm payroll report showed that the U.S. economy created far more jobs in October than were expected (271,000 actual new jobs versus the consensus forecast of 190,000 new jobs). But the Fed has earned a reputation for doing the opposite of what markets expect over the past several years and the contrarian in me is reminded of Bob Farrell’s Rule #9 from his famous 10 rules of investing: “When all the experts and forecasts agree – something else is going to happen.”

While I won’t be surprised if the Fed does raise its policy rate in December, if only to provide symbolic reassurance to markets that the Fed thinks the U.S. economy no longer needs emergency-level interest rates, that action is still not a foregone conclusion. In her most recent comments, made last week, Fed Chair Yellen said: “While the Fed now expects that the economy will continue to grow at a pace that will continue to generate further improvement in the labor market, and to return inflation to our two percent target over the medium term, and if the incoming information supports that expectation, then our statement indicates that December would be a live possibility [for a rate rise] but importantly, we’ve made no decision about it.”

This begs a key question. If the Fed is going to continue to rely on “incoming information” between now and December before deciding if it will raise its policy rate at its next meeting, which incoming data to be released between now and then are most likely to cause the Fed to stay its hand?

At this point the Fed would likely cite falling U.S. inflation rates or a weakening employment picture (or both) as reasons for raising its policy rate for the first time in almost a decade, and I think they will get both between now and their December meeting.

Here are some examples of factors that could stop the Fed from tightening its monetary policy in December:

• The three-month rolling average for overall U.S. employment growth has slowed consistently throughout 2015, and we saw a fairly steep drop in new-job creation in August and September. If the November new-jobs headline falls more in line with the year-to-date trend, then the initial October headline that set markets aflutter will be classified as an anomaly. Also, the initial estimates for the U.S. nonfarm payroll have tended to be revised downward in follow-up releases of late, and if this happens it should also undermine the view that the October headline was a definitive signal of “further improvement” in the U.S. labour market.
• The U.S. labour force participation rate now stands at 62.4%, which is the lowest that it has been since the start of the Great Recession. (As a reminder, the participation rate measures the percentage of working-age Americans who are either employed or are actively looking for work.) Fed Chair Yellen has repeatedly cited the participation rate as a key measure of the health of the U.S. labour market, and an all-time low certainly doesn’t signal “further improvement”.
• All of the October job gains came in the 55+ age category, while workers in the 25 to 54 age category lost 35,000 jobs during the month, with men in that category losing 119,000 jobs and women making up the difference. These trends are not new. Since the start of the Great Recession the 55+ age category of workers has added 7.5 million jobs while the 25 to 54 age category has lost a total of 4.6 million jobs over the same period. This has led several of the experts I read to conclude that would-be retirees can no longer afford to retire and that single-family households are becoming dual-income households out of necessity. If true, both trends should continue to concern the Fed.
• Part of the October employment spike was caused by retailers adding staff in advance of the holiday shopping season (retailers hired 44,000 new employees in October), but U.S. GDP growth slowed from 3.9% in September to 1.5% in October and that’s not a good omen for consumer spending. If the U.S. shopping season disappoints, layoffs will follow, and October’s gains in retail hiring would then become November’s losses.
• The more convinced markets become that the Fed will raise its policy rate in December the more the Greenback appreciates against other currencies. The soaring Greenback creates economic impacts that are similar to those caused by tightening monetary policy and as such, the appreciating U.S. dollar is effectively doing the heavy lifting that the Fed would otherwise need to use policy-rate increases to achieve. Furthermore, the surging U.S. dollar is lowering the cost of U.S. imports at the same time as commodity prices continue to fall, and both of these factors put more downward pressure on U.S. inflation. As such, if the Fed wants to delay raising its policy rate in December, it will almost certainly have the option of citing concern about U.S. inflation returning to the Fed’s two percent target over the medium term as its justification.

The Fed could use any or all of the examples listed above as reasons for not increasing its policy rate in December, but there are many more factors that could also come into play, such as a broad market sell off, rising global economic instability, geopolitical instability, plunging oil prices, bad economic data from China, and so on. The list is long and the interplay between of all of these variables means that we shouldn’t be counting on a Fed rate increase in December just yet.

What the Fed does still matters to Canadian mortgage borrowers because our economies are tightly linked. The Bank of Canada (BoC) has said that it will lag the Fed’s rate hike timetable, perhaps by a considerable margin, but if/when the Fed raises and the BoC stands pat, the Greenback will rise further against the Loonie. This will raise the cost of everything we import from the U.S. and lower the cost of what we export there, creating winners and losers in the process. Also, while it’s true that the BoC doesn’t have to move in the same direction as the Fed over the near term, Canadian monetary policy cannot decouple from U.S. monetary policy indefinitely, so the Fed’s shift towards a monetary-policy tightening stance serves as a distant-early-warning system for the BoC’s own tightening timetable (however far down the road that may still be).

Five-year Government of Canada bond yields fell eight basis points last week, closing at 0.95% on Friday. Five-year fixed-mortgage rates are available in 2.54% to 2.69% range and five-year pre-approval rates are offered at 2.74%.

Five-year variable-rates are available in in the prime minus 0.60% to prime minus 0.50% range, which translates into rates of 2.10% to 2.20% using today’s prime rate of 2.70%.

The Bottom Line: While markets are betting on a Fed policy-rate increase in December, I still think that is far from a foregone conclusion for the reasons outlined above. That said, even if the Fed does decide to raise next month, it is unlikely to do so without giving markets lots of reassurance that its monetary-policy tightening timetable will be much slower and more deliberate than in past cycles, and those soothing words should help minimize the potential impact on mortgage rates north of the 49^th parallel.