Nomura has the pick of the sell side commentaries today:
We have been through a substantial market roller-coaster ride over the last few weeks. But the Fed barely blinked today. While the FOMC statement did note that market-based inflation expectations have declined and that near-term inflation will be depressed by lower energy prices, the broad message was that policy normalization is on track. First, QE ended. Second, there were no explicit comments on weak foreign growth, a strong dollar, or tension in financial markets. Third, the Fed toned down its language on labor market slack, now saying it is ‘gradually diminishing’. Fourth, it took out the sentence saying that ‘a highly accommodative stance of monetary policy remains appropriate’.
All told, there was not much for those in the market hoping for a dovish signal. And perhaps the easiest way to see this was that Plosser and Fisher did no longer dissent, while Kocherlakota did. The bottom line is that regardless of market volatility and concerns about global growth, the Fed remains on track for policy normalization.
Hence, the question is when the market will believe the Fed. Expectations for Fed lift-off have shifted somewhat after the FOMC statement. But we are still pricing lift-off only by October, and the implied probability of lift-off in H1 2015 is probably not more than 25%. Hence, these probabilities remain very different from where they were priced in September, when a June lift-off was closer to consensus. Hence, there is potential for these probabilities to shift higher.
We just need some data, which makes the Fed gain confidence in its central case and the market to believe in the Fed. The December 17 FOMC meeting will be crucial, as the DOTS may not shift much, and therefore question if the current gap to market pricing is sustainable. In the meanwhile, we will have to watch the usual labor market readings, the trend in retail sales, and perhaps more importantly, the fine print of each release relevant to the inflation outlook. On Friday, we have the Employment Cost Index, which will matter, even if it is less in the spotlight now than earlier this year when it suddenly became a fashionable indicator.
As I said this morning, there is still plenty of labour market slack to prevent any indigenous inflation breakout so the real question is about tradables and on that front the Chinese adjustment and European weakness should continue to apply upwards pressure to the US dollar and downwards pressure on commodity prices, meaning no imported inflation, either.
I had expected rate hikes by mid next year. That looks too early now, perhaps a year away, depending upon how the equity market handles the rejection. The Fed is in a little pincer. If the good data flows and its outlook firms then the equity market is more likely to slide, denting the outlook.
It should resolve in time as US unemployment falls further but it means rates rise later rather than sooner. I still reckon post taper tantrum 2.0 bond market pricing is right.
