Daily Agenda: Recalibrating to the Fed

Markets pop on the central bank’s dovish talk; Abe loses a key ally as Amari resigns; UK GDP shows signs of improvement; Barings’ Matthew Whitbread on the FOMC.

Crude oil and emerging markets equities rose on Thursday as investors digested the message delivered Wednesday by the Federal Reserve. The Federal Open Market Committee noted that Fed policymakers are closely monitoring macro risk factors, including slowing demand in China and Europe. The major question facing market participants is whether the Fed will follow the course of rate hikes that it has scripted, or will refrain from further increases for a prolonged period. In a note to clients earlier this week, Jeffery Saret and Alex Dementiev of Two Sigma Investments noted many previous episodes of market adjustments to Fed policy, including the so-called taper tantrum during the summer of 2013, that proved destabilizing. According to their view, another tantrum could occur after the March 18 FOMC meetings if the Fed forces the market to reevaluate its expectations. “The U.S. Federal Reserve expects to hike interest rates four times during 2016 while the market projects only two hikes,” wrote Saret and Dementieve. “Something has to give.”

Japan’s Amari steps down because of scandal. On Thursday, Japanese Economy Minister Akira Amari resigned after allegations that he accepted cash from corporate leaders in return for using his political influence. Amari has been a critical part of the Abe administration’s stimulus strategy as well acting as the Japanese government’s primary negotiator during the Trans-Pacific Partnership trade discussions.

UK GDP improves. Gross domestic product data released by the British Office for National Statistics on Thursday revealed that the country’s economy grew modestly in the final three months of 2015, with the headline index expanding by 0.5 percent. As has been the case in recent quarters, service-sector activity was primarily responsible for the expansion. Despite marginally improving fundamentals and low unemployment levels, most analysts anticipate that Bank of England policymakers will retain historic low interest rates through the remainder of the year as deflationary pressures persist.

Potash cuts dividend. Potash Corp. of Saskatchewan announced Thursday the first reduction in dividend payments in the fertilizer producer’s history as a public company after lowering earnings guidance. The company has felt the impact of declining demand for agricultural products from developing economies in recent years and recently announced the closure of a potash mine in New Brunswick.

Jobless claims drop sharply. Weekly initial unemployment benefit claims data released today by the Department of Labor fell by 16,000 to 278,000 after reaching a multi month high the prior week. The data may have been impacted by severe weather conditions in some parts of the nation and a truncated week due to the Martin Luther King Jr. holiday.

Portfolio Perspective: Markets may be surprised by the Pace of Fed Tightening

The Federal Reserve’s January press release provided little surprise or new insight for investors. The Fed’s relatively consistent language would suggest that they do not believe the recent equity market sell-off and further declines in the price of oil will restrain economic activity. The FOMC’s view that energy price weakness and dollar strength are “transitory” remains unchanged; however, they acknowledged in the statement that inflation will remain low in the near-term due to further declines in energy prices. This is about as close as the FOMC can get to acknowledging the balance of risk has shifted a bit more negative without signaling to the market a meaningful shift in policy stance. In addition, Fed officials attributed the recent economic weakness in part to a slowdown in inventory investment. This too may prove to be a “transitory” weakness due to the highly cyclical nature of inventory investment.

Despite the shift in risk, the Fed’s statement does not rule out the possibility of a second rate hike in March. However, improvements in the economic data and/or financial market conditions will likely be necessary for the Fed to continue tightening policy in March. Further declines in oil, gains in the dollar, widening credit spreads or signs of instability from China are a few examples of market developments that could lead to a rate-hike delay similar to what we witnessed last September. A decision to delay tightening in March would not mean December’s initial rate hike was a policy error, but it would raise the importance of improving economic data to convince investors that economic growth will expand during this phase of policy “normalization.”

As it stands currently, the market is pricing in only one rate hike throughout 2016, based on fed-fund futures, while the Fed’s dot-plots suggest four rate increases by the year-end. The reality will likely be somewhere in the middle, but if the economic data continues to strengthen the market could be surprised by the pace of tightening.

Matthew S. Whitbread is the investment manager of multi-asset, North America for Barings in Boston.