Research US Fed on hold: uncertainty set to keep Fed sidelined

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1 Investment Research General Market Conditions 11 February 2016 Research US Fed on hold: uncertainty set to keep Fed sidelined In our view, the uncertainty in financial markets and rising risk of a systemic crisis is likely to keep the Fed from hiking before markets have settled down. We now expect the Fed to keep on hold until the September meeting, as we believe it will take some time before the current high uncertainty on the outlook will clear. Tighter financial conditions set to keep Fed on hold We anticipate the Fed will deliver three hikes in We think the Fed will use the upcoming March FOMC meeting to signal a lower trajectory for the Fed funds rate and state that it is on hold for now. No hike before the fog has cleared We believe the current financial market jitters will keep the Fed sidelined at the coming FOMC meetings. Although the US labour market is still in good shape, highlighted by the January employment report, the outlook is clouded by the recent tightening in financial conditions and the rising risk of a global systemic crisis (see also Market Turmoil, Policy Responses and Market Implications, 12 February). In the FOMC statement from the January policy meeting, the Fed chose to remove its risk bias and send a signal to the public that uncertainty on the outlook was unusually high. Since then, uncertainty has only risen. With core inflation running well below the Fed s 2% target, both survey-based and market inflation expectations trending lower and wage inflation only modestly higher, the Fed has room to be patient with the hiking cycle. We believe that the FOMC will use the coming FOMC meeting on 16 March to revise the dots lower, likely signalling two or three hikes this year, and state that it is on hold until the fog has cleared. Our base case is that the current panic in markets does not develop into a systemic financial crisis. However, risks have risen and we believe the current tightening of financial conditions will have negative spillover effects on global growth. Before moving along with the hiking cycle, we believe the Fed will need to be more confident that inflation is heading in the right direction and that GDP growth will run above potential. As a consequence and together with the subdued core inflation, inflation expectations trending down and weaker-than-expected data we have changed our Fed call and now expect only one hike this year, most likely in September (previously three hikes this year). In H2 16, when the headwind from tighter financial conditions is fading, we expect the Fed s focus to return to the fundamentals of the US economy and, in particular, the Phillips curve. We expect growth to pick up gradually, driven by solid private consumption growth and a turn in investments, which should give way to continued, although more moderate, job growth. The tighter labour market should lead to higher wage inflation supporting a continued hiking cycle with three additional in 2017 (previously four hikes next year). Source: Goldman Sachs, Bloomberg Survey based inflation expectations trending lower Source: NY Fed, Michigan, Federal Reserve Fed sees the world through the Phillips curve Senior Analyst Signe Roed-Frederiksen Analyst Mikael Olai Milhøj Important disclosures and certifications are contained from page 5 of this report.

2 Yellen did not want to jump to premature conclusions Fed Chair Janet Yellen was not as soft as expected yesterday when she testified before the Financial Services Committee and, in reality, we got only a little bit of news compared with the FOMC meeting statement from January. She confirmed that, although the Fed takes financial conditions into account, it sees the world mainly through the Phillips curve. She noticed that employment is increasing and wage growth has begun to pick up. On the financial market turmoil, she said that she does not want to jump to premature conclusions and that we will get more information when FOMC members update their projections in connection with the March meeting. Our interpretation of the January FOMC statement was that the Fed will skip March, as it will not risk tightening too much, too quickly. Since the January meeting, financial stress has increased and we expect the Fed to strike a much softer tone at the March FOMC meeting. Tighter financial conditions might do the job for the Fed As Yellen mentioned in her semi-annual testimony to Congress on Wednesday, the Fed is not insulated from the rest of the world. Global central banks are generally easing monetary policy, with the Swedish Riksbank the latest to cut the repo rate, by 15bp today, which is affecting financial conditions in the US as well. Relative to the rest of the world being on hold is actually quite hawkish, as other central banks are on an easing bias. The main channel of impact is through a stronger US dollar, which is restraining growth through lower exports and is putting downward pressure on inflation. In contrast, easier monetary policy globally is also keeping longer term interest rates in the US down, thereby stimulating economic growth. However, recent Fed speak suggests the first of these effects is dominant. If global monetary policy easing leads to a significantly stronger effective US dollar, this is likely to slow the pace of the US hiking cycle below what we forecast. Strong USD restraining growth Source: Federal Reserve See the next two pages for the Fed s chart book February

3 FOMC chart book Employment growth slowed in January but trend growth still seems solid Unemployment rate slightly below NAIRU Wage inflation is trending up but still subdued Fed puts much weight on the Phillips curve Unit labour costs indicate higher inflation Low market inflation expectations a reason to stay on hold Source: Federal Reserve of Philadelphia, Macrobond Financial, University of Michigan, Danske Bank Source: Federal Reserve of Philadelphia, Macrobond Financial, University of Michigan, Danske Bank Fed set to take the financial turmoil into account Strong USD puts a dampener on growth Source: Macrobond Financial Source: Federal Reserve, Bloomberg, Danske Bank 3 11 February

4 Large increase in high-yield bond spreads Financial conditions have tightened significantly Source: Bloomberg Source: Goldman Sachs, Federal Reserve, Danske Bank Historically, the Fed has not increased the target range when the ISM composite is at the current level Private consumption main growth driver Note: Dark (light) shading indicates periods of tightening (easing) Source: ISM, Danske Bank Source: BEA 4 11 February

5 Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S ( Danske Bank ). The authors of the research report are Signe Roed-Frederiksen, Senior Analyst and Mikael Olai Milhøj, Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of highquality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including a sensitivity analysis of relevant assumptions, are stated throughout the text. Date of first publication See the front page of this research report for the date of first publication. General disclaimer This research has been prepared by Danske Bank Markets (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) ( Relevant Financial Instruments ). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report February

6 The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These opinions are subject to change, and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related to the information provided in this research report. This research report is not intended for retail customers in the United Kingdom or the United States. This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank s prior written consent. Disclaimer related to distribution in the United States This research report is distributed in the United States by Danske Markets Inc., a U.S. registered broker-dealer and subsidiary of Danske Bank, pursuant to SEC Rule 15a-6 and related interpretations issued by the U.S. Securities and Exchange Commission. The research report is intended for distribution in the United States solely to U.S. institutional investors as defined in SEC Rule 15a-6. Danske Markets Inc. accepts responsibility for this research report in connection with distribution in the United States solely to U.S. institutional investors. Danske Bank is not subject to U.S. rules with regard to the preparation of research reports and the independence of research analysts. In addition, the research analysts of Danske Bank who have prepared this research report are not registered or qualified as research analysts with the NYSE or FINRA but satisfy the applicable requirements of a non-u.s. jurisdiction. Any U.S. investor recipient of this research report who wishes to purchase or sell any Relevant Financial Instrument may do so only by contacting Danske Markets Inc. directly and should be aware that investing in non- U.S. financial instruments may entail certain risks. Financial instruments of non-u.s. issuers may not be registered with the U.S. Securities and Exchange Commission and may not be subject to the reporting and auditing standards of the U.S. Securities and Exchange Commission February

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