“We will do what we must…” – Mario Draghi, 20 November 2015

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Long-dated US Treasury yields were little changed on the week as a weaker report on retail sales, which recorded an increase of 0.1% month-on-month (MoM), was offset by a consensus report on consumer inflation with an increase of 0.2% MoM and a drop in weekly initial jobless claims to 271 000. The yield curve flattened as US two-year yields were up 8bp to 0.92%. Risk assets performed well, and the S&P 500 had its best week of the year, rising 3.3%.

On 18 November, the Federal Reserve (Fed) released the minutes of the 28 October Federal Open Market Committee (FOMC) meeting. Fed watchers saw no surprises in the minutes which reinforced the view that economic conditions in the US warrant a hike in the Fed’s policy rate following the 16 December FOMC meeting. More specifically, the minutes reflect that lift-off is contingent on further improvement in labour market conditions and the FOMC being “reasonably confident” that inflation will rise toward the targeted 2% over the medium term.

The minutes continue to maintain conditionality as they mention the Committee’s continuing concern about risks associated with global conditions and further US dollar appreciation. More recent communications from Fed officials have lent further support for the “most well-advertised” (NY Fed President William Dudley) rate hike in history for which markets should be well prepared. Atlanta Fed President Dennis Lockhart said this week that the rate hike, “when and if it comes”, should be seen as affirming the Fed’s positive economic outlook.

Just after the Fed’s October meeting, we received additional information about the labour market, with the addition of 271 000 jobs and a drop in the unemployment rate to 5.0%. Core CPI released on Tuesday, 17 November, showed a 0.2% MoM increase, so the more recent consumer inflation data also supports a hike (see Exhibit 1 below). Therefore, it would seem that as of right now, we are on our way to the first hike in the federal funds target rate in almost 10 years.

Exhibit 1: US CPI – Less Food & Energy, Not Seasonally Adjusted (NSA) (November 2009 – October 2015)

Source: Bloomberg, as of 20 November 2015

Meanwhile in Europe, German producer price inflation fell 0.4% in October, and the euro weakened to USD 1.067 versus the euro. Weaker European inflation data has set the stage for the ECB to provide further stimulus at its meeting on 3 December. Further cuts in the policy rate and additional asset purchases are likely. ECB President Mario Draghi’s statement on 20 November, which came before the release of the weaker German inflation data, was eerily reminiscent of his 2012 “whatever it takes” speech. Draghi said, “if we decide that the current trajectory of our policy is not sufficient to achieve that objective, we will do what we must to raise inflation as quickly as possible.” German 2-year yields fell to a historic low of -0.39%.

After nearly seven years of a 0% federal funds target rate and a nearly USD 4 trillion increase in the Fed’s balance sheet, it does now appear that the Fed is ready to take the first step toward normalising US monetary policy. Official policy rates in the US and Europe are now poised for divergence. The Fed seems finally willing to hand off the baton. The unconventional monetary policy race to the bottom has been fully joined and embraced by the ECB.

“We will do what we must.” ‑ What other choice is there?

 miqu77 / Shutterstock.com

John Carey

Head of structured Securities, CFA Charterholder

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