An interest-rate hike in December is clearly in sight.
After months of guessing, Friday’s October jobs report jolted the market’s confidence that the Federal Reserve could — and perhaps would — raise rates next month.
The headline numbers were strong all around:
- The economy added 271,000 jobs in October, marking the fastest pace of growth this year, and crushing the expectation for 182,000.
- The unemployment rate fell to 5%, the lowest since April 2008, and a level most economists consider “full employment.”
- We even got wage growth, as average hourly earnings rose 2.5% year-on-year — the highest growth rate since the Great Recession.
- Manufacturing job growth was flat, beating the forecast for a drop by 4,000 as the sector flirts with recession.
This looked like the kind of data that the “data-dependent” Fed needed to argue that the labour market had shown “further improvement.”
And it all comes down to two reactions in the rates market following the jobs report that make December seem not just like a “live possibility,” but the real thing.
The yield on the two-year note — which is sensitive to interest-rate expectations and closely watched by investors — spiked to as high as 0.96%, the highest intraday level in five years.
And the Fed fund futures, which gauge traders’ expectations for future interest rates, jumped to show a 70% probability of a Fed hike in December, the highest reading yet ahead of a Fed decision.
And this reaction in the rates markets comes after a long period in which markets have underestimated — and the Fed itself has overestimated — how soon the Federal Reserve would end emergency measures that lifted the economy out of the Great Recession.
This chart shows that the Fed’s projections for interest rates have been higher than the market’s. It was recently highlighted by David Bloom, HSBC‘s global head of FX research, as the most important chart of the moment.
Bloom argued that the Fed and the market could not be right at the same time. And following Friday’s report, it looks like the market was catching up to the Fed.
Market participants were less bullish than the Fed because they did not believe rates could rise in imperfect conditions, according to Aaron Kohli, a director at BMO Capital Markets. And it isn’t that Friday’s jobs report was “perfect.” The labour-force participation rate, for instance, still languished at a 38-year low.
But even without “perfect” conditions, it seems that the market has been convinced, particularly after last month’s weak employment report.
As Kohli told Business Insider, “there are lots of reasons to say the economy is on the path to recovery.”
‘A live possibility’
Even before Friday’s jobs report, we had already gotten a clear indication from Fed officials about what the FOMC may do next month.
At a hearing before the House Financial Services Committee Wednesday, Fed chair Janet Yellen said the economy was “performing well,” and that a rate hike in December is “a live possibility.” And certainly a more “hawkish” — or aggressive — posture from the Fed has been corroborated by the most high-profile data yet.
“Even formerly dovish speakers have come out as hawkish,” Kohli said.
These “former doves” include FOMC vice-chairman William Dudley, who this week said he agreed with Yellen.
But what about year-end liquidity?
But with a December hike coming into view, there’s the nagging issue of bond-market liquidity.
Treasury-market liquidity tends to shrink in the final days of the year as traders, like everyone else, go on holiday. Additionally, many firms want to buy and hold on to government bonds to make their books more attractive at year-end reviews, as Bloomberg recently detailed.
And so were the Fed to raise rates in December, there could be particularly heightened market volatility. But Kohli thinks this is no excuse, as the Fed cannot postpone on this basis every year.
Moreover, there’s been more than enough time for markets to prepare. The Fed has “choreographed it very well,” Kohli said. “They have emphasised that ‘we aren’t joking here.'”
After the initial hike, though, markets will be set to grapple with the more substantive question of what does the full path of a Fed rate-hiking cycle look like.
“The bond market has been pricing in an extremely gradual path [of rate hikes],” Kohli said. “And whether it’s going to be quite as gradual as that, I think, is a completely different question.”
Said another way, the market is focused on December, but the really interesting part comes after the first move from the Fed.
Following Friday’s jobs report, shops across Wall Street were fine-tuning their predictions for when the Fed would first raise rates.
Barclays flipped, shifting its forecast for the first hike in nine years from March to December.
The firm wrote in a note to clients that it had assumed the recent market volatility would last longer than it did. But the fact that markets calmed, the Fed got more hawkish, and Friday’s jobs report was solid necessitated a change in its call.
And you’ve got to hand it to Goldman Sachs’ economists, who back in June pegged their rate-hike forecast on December, which now looks like a right call.
In an interview on CNBC Friday, chief economist Jan Hatzius said that it’s not too soon to start talking about a second rate hike in March.
This, it would seem, could become the real story.