FED IN FOCUS
Stéphane Monier, Chief Investment Officer of Lombard Odier (Europe) S.A. reviews the outlook for US interest rates after the Federal Reserve’s statement of 30 July 2015
MARKET FOCUS SHIFTS TO THE ‘FED’
With the Greek crisis likely kicked into the long grass for now, we think markets’ focus will return to economic fundamentals over the rest of the summer. This will include the all-important question of when the US Federal Reserve (Fed) will hike interest rates for the first time since 2006. Fed Chairwoman Janet Yellen has said that officials expect to raise rates this year. At its July meeting, the Fed kept rates on hold, but its statement on 30 July left all options open for its three remaining meetings this year - raising the prospect of one or more rate rises in September, October, or December of this year.
Unfortunately, the timing of the Fed’s move could become a source of volatility in itself in coming months. There is no precedent for a US interest rate rise after such a long period of ‘easy money’, including near-zero interest rates and quantitative easing.
WHAT ARE ECONOMIC TRENDS TELLING US?
While US first quarter gross domestic product (GDP) growth was weak, we expect the second quarter’s figure to be much stronger. Long-term unemployment is down, and there are signs of nascent wage growth. We think that should boost households’ real disposable income, confidence and consumption - the big driver of US growth.
Stronger economic growth, and in particular signs of wage growth point to rising inflation in coming months. The current 0.1% headline inflation rate (for June) is way below the Fed’s 2% target, and one of the main reasons why interest rates are still at a lowly 0.25%. But core inflation - excluding food and energy - is already creeping up - which should give the Fed some room for manoeuvre. A key variable here is the oil price: falling prices may slow the pace of rate rises. But should the oil price hold at around USD 60 per barrel, and should emerging wage pressures continue to build, we believe headline inflation could top 2% by year-end, as the base effect of lower oil prices from 2014 drops out after October.
WHEN DO WE THINK THE FED WILL HIKE RATES?
We think September is the likeliest time. While that is roughly in line with most economists’ predictions*, it could take fixed income markets by surprise. Futures markets are currently pricing in just one rate move by the end of the year, most likely at the December Fed meeting.
We believe economic fundamentals in the US warrant interest rates above current levels, and foresee further tightening taking the headline rate to around 2% in the first quarter of 2017. We believe the Fed will want to start tightening policy in part to give it more room to manoeuvre in the next downturn, since the economic cycle in the US is already quite mature.
WHAT DOES THIS MEAN FOR MARKETS AND INVESTOR PORTFOLIOS?
- Volatility - nervousness in equity, fixed income and currency markets, as investors try to second-guess the Fed’s moves, take stock of what they could mean for the global economy, and judge whether the Fed is ‘falling behind the curve’ on rate rises. We see a high probability of market volatility in the weeks ahead.
- USD strengthening - The US dollar could rise further against key currencies such as the euro, as monetary policy between the US and Europe diverges. We see further, but limited USD strengthening ahead.
- Negative repercussions for emerging market economies/currencies - as the effects of tighter monetary conditions in many dollar-dependent economies raise the cost of financing external deficits. We believe these repercussions could be less than in previous economic cycles, given the greater robustness of many emerging market economies.
- Fixed income liquidity crunch- taking as a precedent the ‘taper tantrum’ of bond markets in summer 2013. Since 2013, there has been a surge in fixed income assets and corporate debt, coupled with a change in regulation that has sharply cut banks’ bond inventories, removing a ‘cushion’ for the market. In a situation of market stress, some fear mass sales by asset managers, who now hold a much higher proportion of bonds than historically. We see this as an outlying possibility, but our baseline scenario is one of gradual market reassessment of Fed tightening ahead.
*Source: Wall Street Journal Survey July 2015 - 82% forecast a September rate hike, 15% a December rate hike
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