The easier monetary policy trajectories in the eurozone and Japan are taken for granted. The debate has been over the timing of the normalization in the US and the UK. Talk that had emerged recently that the Bank of England could hike rates before the Fed was never very compelling. Last week's developments increase the likelihood that the FOMC raises rates at least 5-6 months before the BOE.
The strength of US economic data, and especially the July jobs report, has prompted market participants to upgrade the risk of a September rate hike by the Federal Reserve. The implied yield on the September Fed funds futures contract is the highest since the mid-June FOMC meeting and dot plot, which the market read more dovish than ourselves.
One of the developments that make this cycle unique is that the Fed has adopted a target range instead of a fixed point. The Fed funds effective average has gravitated around the middle of the 0-25 bp target range. Our interpolation of the odds of a September rate hike priced into the Fed funds futures assumes that the effective rate, which is the key to the value of the contract, as opposed to the policy rate, continues to hang in the middle of the policy range.
We assume that the effective Fed funds rate will average 13 bp, as it has for the past hundred days, for the first 17 days of September. If the Fed hikes the target range by 25 bp, we assume that Fed funds will average 37 bp (a conservative assumption) for the remaining 13 days in September. That would produce an effective average of 23.4 bp.
Before the weekend, and after the jobs data, the September Fed funds futures contract implied 19.5 bp. This is the equivalent of a 62.5% chance of a hike, and this is likely to drift higher in the coming weeks. We subjectively assess an 80%-85% chance of a rate hike next month. A small decline in the JOLTS index that the consensus expected (5290 vs. 5363 in May) is unlikely to have much impact as it will still be the third highest on record (since 2000) after April and May.
Recent economic data (e.g., construction spending, inventories) has spurred economists to revise up expectations for Q2 GDP from 2.3% toward 3.0%. It appears that the favorable momentum carried into the start of Q3. Industrial output in July is likely to have risen for only the second time this year. Manufacturing output has fared better, but it slipped in June. July plays catch-up and a 0.4% rise the consensus expects would be the strongest since last November.
The July retail sales report should show that US consumption remains fairly stable, rising at about a 3% pace. This is faster that the increase in average hourly wages (2.1%), but there are other sources of income, including commissions, bonuses, dividend/interest, transfer payments and social security. The 4.8% savings rate in June matches the 24-month average and remains well above the 1.9% trough set ten years ago last month. Moreover, this consumption
Retail sales account for about 40% of personal consumption expenditures. They unexpectedly fell 0.3% in June but are expected to bounce back in July. Auto sales rose sequentially, and retail sales were likely boosted by more people working, a longer workweek, and earning a little more an hour. The scope for an upside surprise arises from the difficulty in assessing with any degree of confidence the impact of Amazon's Prime Day, which spurred a competitive response from other retailers, like Walmart. While some of the buying may have indeed been a substitute/replacement of purchases that would have been made in any event, and it might have brought forward some pre-school shopping, the impact could still be substantial.
