Huge letdown from the Fed

The Federal Reserve has decided to keep the rate at 0.25%, citing low inflation and the still-recovering labour market.

This came as a surprise to many.

“[Markets] thought that if the Fed didn’t raise rates, they’d at least talk hawkishly, but they didn’t,” says Tom O’Gorman, director of fixed income at Franklin Bissett Investment Management. “It’s surprised people how dovish the Fed is. People are probably scratching their heads and thinking, ‘What is it going to take get off [low rates]?’”

Read: Fed rate’s the same

An especially “dovish wrinkle” in the announcement came in the Federal Open Market Committee’s projections, notes Robert Spector, institutional portfolio manager, MFS Investment Management in Toronto. One member said the target for the federal funds rate should be in negative territory for 2015 and 2016.

Some experts speculate that member could be Narayana Kocherlakota, an American economist and the current president of the Federal Reserve Bank of Minneapolis. He joined FOMC in 2011.

Read: Let’s keep rates positive

In today’s press conference, Federal Reserve chair Janet Yellen said the committee had not discussed negative rates seriously, but conceded that they would be a tool if economic projections did not meet her and the committee’s expectations.

Her remarks made it clear that she is waiting for inflation to rise and the job market to improve, particularly the number of part-time workers.

“The Fed is still worried about long-term inflation—and rightfully so,” says O’Gorman. “The [inflation] number is well below their 2% target.”

The Fed also emphasized it wanted to see the effects of negative developments overseas before hiking.

“The key phrase in the policy statement was, ‘Recent global economic and financial developments may restrain economic activity somewhat and are likely to put downward pressure on inflation in the near term,’ ” says Michael McHugh, portfolio manager at Dynamic Funds in Toronto.

Impact on U.S. markets

Looking at U.S. markets, says O’Gorman, “We’re lower in yields, but we’ve been higher over the last two weeks. So [the announcement] is just taking some of that reaction back, and equities are up a bit. You could get some volatility, but I’m not sensing anything.”

That said, O’Gorman notes that the front-end of the U.S. yield curve has fallen. “Two-year Treasuries, which had priced in a hike happening, have rallied close to nine basis points, while 10-year Treasuries have rallied seven.”

Finally, “For fixed income, rates aren’t likely to move and there’s a bias for them to move lower. [The announcement] isn’t going to do anything to housing or hurt consumers. It’s also probably ok for credit markets, even if it’s not bullish for those markets. You’re not going to get risk out of emerging markets and currency markets. That’s saved for another day since it’s more of the same.”

Read: U.S. housing starts tumble

As an investor, says O’Gorman, “this puts us into the same mode as we’ve been in: U.S. at [near] zero rates and expectations about a Fed philosophy that continues to disappoint. The Fed has lowered its growth and inflation forecasts a little bit.”

That’s a problem, he explains, since “everyone wants to see something happen with the U.S. pulling ahead and helping global growth. But those hopes have been disappointed each step of the way.”

Impact on Canada

The Fed’s announcement will likely affect our currency.

“It wouldn’t be surprising to see the Canadian dollar rally a bit in the short term, but ultimately there’s a limit to how much strength the Canadian dollar can have,” says Spector. The ongoing slowdown in China puts pressure on commodities, and that’s going to hurt the loonie.

“And frankly, if the Canadian dollar strengthens too much, and the U.S. economy weakens […], it would increase the probability of a Bank of Canada rate cut this year or early next year, which would cap the Canadian dollar rally.”

Read: It’s a recession — now what?

For his part, O’Gorman says that despite energy weakness, “[Canadian] economic numbers have been good, and that probably takes BoC easing off of the table for now.” Even if the Fed had moved rates, the BoC likely wouldn’t have felt any pressure to make a move, he adds. “The U.S. dollar would be higher, and [Poloz] wants to see a weak loonie to help buy him time for the energy [crises] to play out.”

When will the hike happen?

Fed policymakers see just one rate hike likely to take place this year, down from two in their previous forecast, issued in June. The Fed also expects that its preferred measure of inflation will rise only 0.4% this year, down from 0.7% in June—both estimates are far from the Fed’s target of 2%.

“Most [Fed] participants continue to expect the first rate hike to occur this year,” says McHugh. “The FOMC also lowered the trajectory of the anticipated path of future rate hikes, presumably in an effort to contain financial market volatility when they do begin to raise rates.” (Check out the CME Group’s Fed Funds futures prices for probability of hikes in October onward.)

O’Gorman is pessimistic about a hike. “Interest rates probably aren’t going up significantly soon, especially longer rates, [considering] where inflation is.”

Even when the Fed does hike rates, it says it will take a measured approach. The FOMC release says, “Even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

But, says O’Gorman, “We wonder when good news will become bad news. For example, when does the equity market go down because economic news is too soft, versus going up because the Fed is going to be easy longer?”