Don’t get too excited about interest rate rises in 2017, says CLSA’s Christopher Wood. Yes, Donald Trump’s fiscal stimulus could be a wild card that generates inflation, which, in turn, could lead to inflation and the three rate increases the Fed and even CLSA’s head of economic research Eric Fishwick is forecasting. But Wood, looking at recent employment numbers as just one example, is going to be “extremely surprised” if the Fed is as aggressive as is generally anticipated. But if interest rates are hiked, it will be due to wage growth.

Interest Rate Hikes Photo by Speaker resources

CLSA: Yellen  Interest Rate Hikes prove a point to Trump

There are several variables that might trigger an aggressive Federal Reserve policy response. One trigger for aggressive interest rate hikes could be that current Fed Chair Janet Yellen “may feel like making a point” to the Trump administration. Wood thinks that one probability path is that if it appears that Fed Chair Yellen going to lose her job she may send the Trump administration an outgoing message with a string of rate hikes.

The increasingly pragmatic probability, however,  is that Yellen is likely to raise rates if she gets the “feeling” the Trump administration, “enabled” by an eager to please Republican Congress, takes flight with an aggressive government spending spree generating inflation. Under such circumstances, this could generate the anticipated rate hikes.

But what is really like to move Yellen is wage pressures. Avoid the noise and pay attention primarily to wage growth. If it’s not there, rate hikes are unlikely. Wood, for his part, is waiting for wages to take off before drawing any conclusion regarding rate hikes. Looking at the potential for hikes, Wood, in part, looks back to last Friday for answers.

CSLA: Why didn’t the stock market sell off on strong wage growth numbers?

Looking at the most recent unemployment report, Wood shakes his head in disbelief. He doesn’t understand why the market is rising in the face of troubling numbers. It was not the not too hot, not too cold headline jobs number of 156,000 or the flat average weekly hours worked that mattered.

What was troubling was the average hourly earnings. Wage growth moved higher by 2.5% year over year, the highest since May 2009 and triggering concern over pending rate hikes.

After the strong wage growth numbers, Fed funds futures reflected an increased potential for rate hikes, pointing to three or more hikes in 2017 moving from 35.7% to 40.3% in one day.

Like hedge fund manager Crispin Odey, who can’t square the logic of how the UK stock market has been continually rising in the face of falling corporate earnings, CSLA’s Wood was surprised the stock market didn’t sell off.

Eyeing his 3% target on Treasury bonds, another component Wood is monitoring closely is credit and money supply growth. Bank loan growth has been slowing to 6.2% year over year in October. If money velocity picks up, that could be another sign inflation is around the corner.

Another factor to consider is the Trump impact on sentiment. Wood points to a mesmerizing “extraordinary psychological, and indeed seductive, impact” Trump is having on economic optimism. This can be seen in small business confidence.

The National Federation of Independent Business Small Business Optimism Index rocketed 7.4 points to 105.8 in December — its highest level since December 2004. In fact, since the Trump election the index has risen 10.4 points, significantly higher than the average move higher.

Sentiment and money velocity could be interesting to watch when considering rate hikes, but don’t bet on aggressive hikes unless you see strong wage growth.