Brexit derails Fed hiking cycle – RBC CM

Research Team at RBC Capital Markets, suggests that the Brexit vote outcome has derailed the Fed hiking cycle and the question now is for how long.

Key Quotes

“In that regard, one of the questions investors need to ask themselves is whether there is enough momentum in the US economic backdrop that will enable inflation to accelerate significantly from here–thus compelling the Fed to raise rates even in the face of the uncertainty taking place across the pond. It seems at present the answer to that is no. Thus on the heels on Brexit, it is low lying fruit to say the Fed is unlikely to hike this year.

We think the extent of the knock-ons from this development to the rest of Europe (i.e. the calls for similar referendums etc.) is going to be a significant factor impacting Fed policy beyond 2016. And the reality is there is no way to know how drawn-out that will be in the coming quarters. We will face a series of elections in Europe that will keep fear about additional countries exiting in the news.

Ultimately, Brexit has introduced the very real possibility that this morphs into a domino effect across the region. So it will be a very long time before all of the potential volatility in Europe is behind us, which means we are likely to be well into 2017 before the Fed has a clear path to continue tightening even if the economy remains solid. In fact, we have officially changed our Fed call and are now looking for the next hike to come in the middle of 2017 at the earliest.

It would seem that the Fed’s “every meeting is live” mantra has been decimated. The market has priced out a hike pretty well indefinitely thus moving the Fed’s forecasted policy path even further away from “reality.” So from here, they will either have to try to force market odds higher (regain the optionality and all of that business) or succumb to a much shallower path. After the debacle in talking up June/July odds, we think the latter is a more likely scenario. Again, they can rely on global “uncertainty” and a strong dollar (feeding back into lower US goods inflation) as lynchpins to their argument for lower for longer.

The one factor (maybe the only factor) we can see spooking the Fed into hiking rates at this point is an inflation scare. Though the extent to which inflation would need to rise to create such a scenario seems like a low probability event at present.”