AMERIPRISE FINANCIAL, INC. 08/25/2014 | David Joy
Investor attention was focused squarely on the Federal Reserve last week. The minutes from the July meeting of the Federal Open Market Committee (FOMC), which were released on Wednesday, seemed to indicate that the debate over when to first raise interest rates is beginning to intensify.
The Fed has taken note that the rate of unemployment has fallen faster than it expected. And although the unemployment rate is only one of a range of metrics the Fed employs to determine whether it has achieved its policy mandate of full employment, it has declined close enough to what is considered full employment to raise the voices of the FOMC hawks. The Fed is currently focused on the June 2015 timeframe for the likely date of the first rate hike. But the minutes revealed a growing debate about whether an earlier date might be appropriate.
Market reaction to the minutes was muted. Stocks dipped briefly just after the minutes were released, but recovered quickly to post a gain for the day. The S&P 500 maintained its strength on Thursday, closing at a record high. Partly explaining the market's equanimity was the fact that Fed Chair Janet Yellen was scheduled to speak on Friday, precisely on the subject of labor markets, making any reaction to the backward-looking minutes potentially counterproductive. As it turned out, Friday's speech broke little new ground, and although stocks slipped slightly on the day, they nevertheless rose strongly for the week, with the S&P 500 adding 1.7 percent for its third straight week of gains.
Investor sentiment was no doubt assisted by relative stability in Ukraine, in stark contrast to the jitters surrounding events in the region last Friday. In the bond market, yields on the short end of the curve moved steadily higher throughout the week. After ending the prior week at a yield of 0.41 percent, the two-year note climbed to 0.47 on Wednesday when the Fed minutes were released, and closed on Friday at 0.49 percent. After ending the prior week at a yield of 2.34 percent, the ten-year note yield rose sharply higher to begin the week, reaching 2.43 percent on Wednesday, before falling back to 2.40 percent on Friday.
Fed Hawks Grow More Vocal
The hawks at the Fed have stepped up their warnings that investors may be underestimating both the timing of the first rate hike, as well as the speed with which rates will rise subsequently. In an interview last week, Kansas City Fed President Esther George warned of complacency in the Fed Funds futures market, noting the gap between market expectations for the future path of interest rates, and those of the Fed. St. Louis Fed President James Bullard voiced similar concerns, and reiterated his view that rates will rise at the end of next year's first quarter.
An analysis published last week by research firm Cornerstone Macro points out that while the market is generally in agreement with the Fed that the first rate hike is likely to occur around June of next year, the real gap between the two concerns the speed at which rates will rise. Cornerstone points out that the futures market is pricing in 85 basis points of hikes per year in the two years after the first increase, while the Fed is expecting 140 basis points of rate hikes in each of the next two years.
In other words, by August 2017, investors expect the Fed Funds rate to be 2.0 percent, while the Fed's projections anticipate it being 3.25 percent, an appreciable difference that would require a meaningful adjustment in market yields of, by Cornerstone's estimate, 26 basis points in the two-year note and 59 basis points in the ten-year note.
There wasn't much on the economic calendar last week to divert attention away from the Fed, but that will change this week. After last week's bigger than expected jump in housing starts and building permits, as well as existing home sales, we will see how new home sales and pending sales performed in July, along with the June S&P/Case Shiller Home Price Index. Also scheduled are reports on durable goods, regional manufacturing, consumer confidence and flash purchasing manager indexes. We also get the latest reading on how well the Fed is doing with regard to the second of its two policy mandates, price stability. The July personal consumption expenditure deflator is expected to have risen 1.6 percent year-over-year, the same as last month. The core rate is expected to have risen 1.5 percent, also unchanged from last month.
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