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The world and 'crazy circular logic' weigh on the Fed's next rate move

Lawrence Lewitinn
Lawrence Lewitinn

Janet Yellen gave the Fed a little wiggle room when it comes to raising rates.

Speaking before Congress on Wednesday, the Fed chief said that a rate cut was unlikely. But she also warned that the global economic situation could weaken demand for U.S. exports and “tighten” financial markets further.

The market is now more certain than before that there won’t be a hike in the federal funds rate – a major tool in the Fed’s monetary policy – any time this year. On Wednesday afternoon, the probability that a hike will even happen by February 2017 was calculated to be as low as 27% based on fed funds futures prices.

While Yellen didn’t confirm the market’s sentiment, Mark Sebastian, managing partner at Option Pit, sees some interesting points made in her testimony before Congress.

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“She finally admitted that other countries in the world affect our interest rates here,” said Sebastian. “Up until really this latest statement, she did not mention the fact that Europe was in the middle of its own QE [quantitative easing] and leaning toward negative rates, Japan was instituting negative rates, and China was weakening its currency. That acknowledgment points toward, maybe tacitly, at a minimum, far fewer rate hikes than they were planning and the real possibility that there are no more rate hikes in 2016.

Fears of a global slowdown may also be affecting the yield curve. The spread between the 2-year and 10-year Treasury Notes (^TNX) is close to 1 percentage point, the lowest it has been since 2007.

“It’s certainly a sign that globally, the economy is weakening,” said Sebastian of the flattening yield curve. “I'm not so certain it's a real sign of an upcoming recession in the U.S., but it's certainly troubling for economic growth worldwide.

Yet Sebastian doesn’t expect yields to fall all that much from here as long as the U.S. stocks don’t fall significantly and anticipates the yield on the U.S. 10-year to work its way back to 2% in the next few months.

However, he finds some fault in how the Fed may justify its next rate move.

“One of the things that was confusing to me was Yellen’s comment on the financial markets,” said Sebastian. “She mentioned she's watching the market. And if markets calm down, she may decide to raise rates. But the reason why markets sell off is because the possibility of raising rates. And it turns into this crazy circular logic.”


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