Despite somewhat mixed economic data, Fed officials are clearly prepping investors for a rate hike on March 15.
Fed Governor Lael Brainard is the latest official to signal that a rate hike in mid-March has a high probability. What makes Brainard’s hawkish comments particularly noteworthy is that she is well known to have very dovish leanings. She joins Fed Presidents Dudley and Williams, who also raised the prospect of raising rates this month earlier in the week.
The sudden hawkish shift to the Fed’s rhetoric is somewhat at odds with the recent data, which do not call for any increased urgency to raise interest rates. Although the core PCE deflator rose 0.3% m/m in January, our diffusion index fell below zero. This means that the price gains were narrow and it would not be a surprise to see softer price increases in the next few months. Moreover, the annual core PCE inflation rate remained steady at 1.7%, still below the Fed’s 2% target. Meanwhile, a divergence between the “hard” activity data and the “soft” survey data persists. Reflecting the former, real consumer spending contracted in January. Consequently, the Atlanta Fed’s GDPNow model slashed its Q1 growth forecast to just 1.8%. However, the ISM manufacturing survey rose to a boom-like 57.7 in February.
Nevertheless, in light of the recent Fed commentaries, our U.S. bond strategists now believe that a rate hike in March has a high likelihood. It will take a very dovish speech by Fed Chair Janet Yellen tomorrow or a very weak nonfarm payrolls report next Friday to stay the Fed’s hand on March 15.
The U.S. equity market has shrugged off the Fed’s hawkishness. It seems that investors see accelerated rate hikes as a confirmation that the economy is strong. Whether this interpretation is correct or not, investors should keep a close eye on the yield curve. A renewed flattening trend will warn that growth expectations are being marked down, which will make lofty equity valuations more difficult to sustain.