If the US Federal Reserve is looking for a reason to slow the pace of rate hikes in the second half of the year, the chart below is not one of them.
From Bank of America Merrill Lynch (BAML), it shows two measures of US financial conditions at present.
Before we get into the mechanics of what both are saying, financial conditions, according to the St Louis Fed, “summarise different financial indicators and, because they measure financial stress, can serve as a barometer of the health of financial markets”.
While each financial conditions index (FCI) is constructed differently, most use short and long-term bond yields, credit spreads, the value of the US dollar and stock market valuations to evaluate the degree of stress in US financial markets.
Right now, and regardless of the measure, they’re all saying the same thing: there are few signs of stress, a somewhat remarkable outcome given some of the geopolitical headlines seen in recent months.
“On balance, financial conditions remain easy,” BAML says.
“Financial markets have taken both Fed tightening and geopolitical risks in stride. Concerns around Italy, trade, Iran and North Korea have caused brief, limited shocks to equity markets and have had little apparent impact on confidence.”
Importantly, BAML says easy financial conditions also signal to the Fed that the US economy can handle a “faster path of rate hikes”.
We’ll find out more on that front in just a few hours time as the FOMC delivers its June monetary policy decision.
A 25 basis point hike to the Fed funds rate is seen as a certainty by markets, meaning most interest will be on the Fed’s updated economic and interest rate forecasts for the years ahead.
In particular, there’ll be intense scrutiny on individual FOMC member forecasts for the year-end level of the Fed funds rate, known commonly across markets as “the dots”.
When the Fed last released the dots back in March this year, the median member forecast was for the funds rate to increase three times in 2018.
However, that was only by a slim margin with many individual FOMC members indicating that rates should increase four times this year.
Given how easy financial conditions are at present, particularly against a backdrop of ultra-low unemployment, faster economic growth, and building wage and inflationary pressures, it wouldn’t surprise if some FOMC members up their year-end forecasts for interest rates, something that would likely see the median rate hike forecast lift from three to four moves this year.
If such a scenario does eventuate, it could place renewed upward pressure on US bond yields and the dollar, two factors that contributed to increased financial market volatility earlier this year.
The Fed decision and updated economic projections will be released at 4am AEST.
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