Tags: greece | euro zone exit | federal reserve | rate hike

Here's How Fed Officials Will Probably Weigh Greek Fallout

Monday, 29 June 2015 09:25 PM

A Greek exit from the euro zone could give Federal Reserve policy makers reason to put off an interest-rate increase. Some investors are already betting on a delay.

Federal funds futures traders reduced the probability of a September increase to 35 percent on Monday in New York from 45 percent Friday. The yield on the 10-year Treasury note dropped by the most since October.

Whether those bets are correct will depend on how turmoil in the euro zone plays into Fed officials’ forecasts for growth, employment and interest-rate increases this year.

Chair Janet Yellen made it clear in her June 17 press conference that she needed to see “more decisive evidence” of sustainable economic momentum that supports labor markets and gradually firming prices. While economic data have improved since then, New York Fed President William C. Dudley called Greece a “huge wildcard” for the U.S. outlook in an interview with the Financial Times published Sunday.

Here’s what Fed officials will be watching in the weeks ahead:

Contagion: One immediate risk is a slump in business and consumer confidence in the euro zone that undermines the region’s economic recovery and increases risk-aversion elsewhere.

“The Fed is concerned because they see these problems in Europe and in the world economy as basically a drag,” said Joseph Gagnon, a former Fed economist and now a senior fellow at the Peterson Institute for International Economics in Washington. “The current turmoil in Greece may make people around the world even more reluctant to spend.”

U.S. central bankers next meet July 28-29. Yellen’s next two press conferences will follow the September and December meetings. She is also scheduled to give a speech on July 10 in Cleveland and will deliver semi-annual testimony to Congress on July 15 and July 16.

Dollar Drag

The exchange rate: One of the biggest surprises for economists in and outside the central bank was how swiftly the 18 percent rise in the dollar against major currencies for the year ending March sapped U.S. gross domestic product.

A stronger dollar cuts into exports by making U.S. goods more expensive abroad, while making imports cheaper. A ballooning trade deficit cut 1.9 percentage points from GDP in the first quarter of this year and about 1 percent in the fourth quarter of 2014, the biggest back-to-back drag since the first half of 1998.

Greece’s impact “will depend on the market reaction, especially the dollar,” said Mark Spindel, chief investment officer at Potomac River Capital, a hedge fund in Washington with $750 million under management. “We know how sensitive the Fed committee is to dollar strength.”

Spindel added that the Fed’s September meeting is months away, and the Greece situation “could change in heartbeat.”

Borrowing Costs

Financial conditions: Fed stimulus works through financial markets by lowering financing costs on everything from cars to homes. U.S. Treasury notes rallied Monday, pushing the yield on the 10-year note down to 2.33 percent at 3:05 p.m. in New York from 2.47 percent late Friday.

The question is whether mortgage and corporate financing become more expensive relative to Treasury yields as lenders grow more risk averse.

Fed officials “need to see where mortgage-backed security spreads and corporate spreads are to Treasuries” and what happens to stocks, which influence consumer confidence and spending, said Michael Gapen, chief U.S. economist at Barclays Capital Inc. “Those are your primary starting points” as a policy maker, Gapen added.

European Stocks

The Euro Stoxx 50 Index closed 4.2 percent lower on Monday while the Standard and Poor’s 500 Index ended 2.1 percent down in New York.

Yields on Fannie Mae-guaranteed mortgage bonds that guide home-loan rates climbed about 0.03 percentage point relative to an average of five- and 10-year Treasury yields, according to data compiled by Bloomberg.

The spread of about 1.11 percentage point as of 17:03 p.m. in New York would be the highest closing level since October.

“It wouldn’t be surprising if there is a sizeable, near- term reverberation in financial markets around the world,” said Laurence Meyer, senior managing director at Macroeconomic Advisers LLC and a former Fed governor. But “the big story for the U.S. continues to be what happens to the momentum in the economy.”

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A Greek exit from the euro zone could give Federal Reserve policy makers reason to put off an interest-rate increase. Some investors are already betting on a delay.
greece, euro zone exit, federal reserve, rate hike
Monday, 29 June 2015 09:25 PM
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