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The Bond Column

Markets Should Be Pricing in at Least One Hike in 2016
Updated: 2016-07-18, 08:55:55 ET
Analyst: David Kelland

This recent U.S. economic data shows that theFed has moved the U.S. economy away from the zero lower bound in a sustainable manner. SinceDecember's rate hike, there has been a plunge in WTI crude to almost $26/bbl.,there has been a referendum to disrupt a half-century-long political order inEurope, and China's bond market has gone into an issuance drought.

Nevertheless, the U.S. economic data over the past two weeks has been great. Industrialproduction rebounded from May's 0.3% decline to grow by 0.6% m/m in June. TheISM Services index for June was 56.5, the highest level in seven months.Producer price growth for June exceeded expectations on both the headlinenumber (0.5% m/m) and the core number (0.4% m/m). The consumer price indices,released on Friday, were just slightly under expectations, but retail salesbeat expectations quite handily. Initial jobless claims remain near historiclows and the U.S. economy added 287K nonfarm jobs in June.

Financial market stress is very low (S&P 500 at all-timehighs) and long-term interest rates remain extremely low, maybe even negativein real terms.

It's not that there are no causes for concern. Ultra-luxuryreal estate in New York City is showing signs of weakness. U.S. equities mayhave some valuation problems that would leave them vulnerable if rates rise.Abroad, there is malinvestment in China that is too big to grow right through.And Italy has a EUR360 bln nonperforming loan problem. There are politicalissues all over Europe and a protectionist might win the presidency in the States.Presidents of the United States have been delegated the power by Congress toslap retaliatory tariffs on other nations. A lot of these problems can be swept under the rug for sometime though, and Trump is still unlikely to win. Trade barriers might even push prices higher, according to some economists, in what might be a less-than-awful supply side shock to the U.S. economy. 

Given the balance of data, it is unreasonable to bet againstat least one rate hike in 2016. St. Louis Fed President Bullard is a newlyconverted dove (a la Narayana Kocherlakota, former Minneapolis Fed president).Bullard believes that we are in a new, low-growth regime for the U.S. economyand the timing of the escape from that new paradigm cannot be predicted. Butyet, Bullard still favors one more hike in 2016. Esther George, the most hawkish voter on the FOMC, would probablysupport a hike in July but will definitely be there in September. That's two votes for a hike in 2016.

Cleveland Fed President Loretta Mester said on July 12 thatit is too early to judge the effect of Brexit on the U.S. but that recent jobsdata (the June report) was heartening and she expects to see gradual rate rises.

Even after the dismal May jobs report, Fed Chair Yellen saidat the June post-FOMC press conference that a July rate hike was 'not impossible.' Now that the contagion riskfrom Brexit is behind us and the May jobs report proved to be a blip, at leastSeptember should be on the table. That's four votes for a hike sometime in 2016 .

Fed Vice-ChairFischer tends to be on Yellen's hawkish side and he said on July 1 that theU.S. economy 'has done pretty well' and that 'most of the incoming data lookgood.' That was before the past two weeks of almost exclusively positive datasurprises. That's five votes for a hike sometime in 2016.

Boston FedPresident Rosengren said on April 18 that the 'market's outlook for rates istoo dovishThe very shallow path of rate increases implied by financialfutures-market pricing would likely result in an overheating that necessitatesthe Fed eventually raising interest rates more quickly than is desirable.'Treasury yields were 7 to 29 basis points higher at that point than they arenow. He has not spoken since. I will call that six in favor of one hike by yearend unless the macroeconomic landscape deteriorates rapidly.

-- David Kelland, Briefing.com

*This review only accounts for the FOMC voters. If we were to examine all of the participants at the meetings, I suspect the probability of a hike would be even higher.