For the past 26 days, investors have placed the post-Inauguration Day spotlight on Donald Trump. That's changing. The U.S. economy and inflationary data have been heating up of late and investors are justifiably wondering, will the Federal Reserve dial back its easy money policies and raise rates faster than is investors currently expect?
That's why investors watched in earnest yesterday as Fed head Janet Yellen took center stage to give her semiannual testimony before Senate Banking Committee. Unsurprisingly, Yellen declined to lay out a specific rate hike timeline but did sound ratchet up rate hike speculation. Here's the key statement:
“[W]aiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession."
Investor Rate Hike Expectations
Investors read Yellen's comments as hawkish (i.e. rate hike possibilities rising). Following Yellen's testimony, investor rate hike expectations rose, particularly for the back half of 2017. As you can see in the Chart of the Day below (from today's Early Look), here's what consensus considers probable on the rate hike front this year?
- Probability of a March 2017 rate hike = 34%
- Probability of a May 2017 rate hike = 53%
- Probability of a June 2017 rate hike = 74%
YELLEN: HAWKISH, DOVISH OR CHICKEN?
Here are some questions to consider. What if consensus is wrong? What if U.S. economic growth and inflation are accelerating faster than consensus (and the Fed) expects? Will the Fed raise interest rates faster than is currently expected?
We think so. Here are some stats:
- The U.S. economy is heating up: Fourth quarter U.S. GDP (year-over-year growth) came in at 1.9%, up from 1.7% in the third quarter (the second consecutive quarter of accelerating growth, since five quarters of decelerating growth to the 1.3% second quarter low.)
- Inflation is rising: The Consumer Price Index just accelerated for a 6th consecutive month, taking consumer price growth to its highest level since March 2012 at +2.54% in January.
The Fed risks falling behind the curve if they don't raise rates (and soon). As we wrote recently, our proprietary leading indicator on inflation suggests year-over-year CPI readings could hit three, even four, percent in the first quarter of 2017, as previously beleaguered commodity prices contribute to inflation growth in the coming months.
This would shock Yellen & Co. An inflation rate at or above 4% hasn't been seen since September of 2008.
We think investors don't yet appreciate how fast rates could rise in 2017. The Fed is falling behind and Janet Yellen is a Dead Dove Walking.