A major source of the market volatility in recent months has been the uncertainty around the outlook for interest rates in the US. This week will be eventful, with the US Federal Reserve holding their much anticipated monetary policy committee meeting, as market participants continue to fret about a possible rate hike. Expect the CNBC countdown clock on Thursday!
Janet Yellen, Chair of the US Federal Reserve, has done her best to telegraph a rate hike this year to avoid another ‘taper tantrum’, noting in July “I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy”. September was mooted as a possible “lift-off” date but the unfolding story in China and the disruption in financial markets over the last six weeks has many arguing for the Fed to hold off on raising rates.
In some ways the Fed obsession is bordering on the ridiculous, how material is a 25 basis points increase in interest rates after all? In a normal environment it would not garner such hype. However, in a world where financial markets have become conditioned to low interest rates and ever increasing monetary stimulus, any move, no matter how small it might seem, to reign in that party, is bound to have repercussions.
Remember, the US Federal Reserve has kept its benchmark interest rate – the federal funds rate – unchanged at the current 0 to ¼ percent target range since they first established it at their meeting on December 16th 2008, at the height of the global financial crisis. (The last time the Fed increased this rate was in June 2006, an increase of 25 basis points to 5-1/4 percent, driven by “inflation risks”!)
Seven years of near zero interest rates, that’s a long time! It’s also been a fruitful time for investors, as the major financial markets have rebounded sharply from the lows of March 2009. See figure 1 for the performance of the S&P 500 index, the most closely watched gauge of large-cap US equities. It is only a simple chart, adding no insight on current valuations and projected earnings etc., but even the most seasoned investor would be antsy looking at this chart, as a potential inflection point in US monetary policy nears.
Figure 1: S&P 500 Index: 20 Year Chart (Source: Reuters)
Approaching the meeting this week, the Fed face a delicate balancing act as they weigh up positive developments in the US economy against the downside risks associated with China and the ripple effects on the global economy. A rate hike would signal an improving US economic outlook, in line with Janet Yellen’s comments earlier in the year. It would be a positive reflection of past economic data but what has everyone scared is whether the economy can sustain higher interest rates. At the same time, a decision to delay rate hikes beyond this year would confirm the Fed’s real concerns about developments in China and the external environment.
However, even if the Fed consider the risk of a China inspired global recession to be overblown, they will also be concerned about rate hikes fueling a stronger US dollar, in the context of what the Fed’s central bank peers are doing, and the impact on the domestic US economy.
Whether the Fed raise rates or not at this meeting, they will be keen to reassure market participants that monetary policy will stay loose for the foreseeable future, reiterating that the pace of rate hikes will be “gradual”. Still, the issue is that from a market viewpoint any rate hike is perceived to set in motion a normalisation of monetary policy, at a time when other major central banks are closer to pursuing more aggressive easing measures, rather than following suit.
Overall, I suspect the Fed will hold off on raising rates at this meeting. In the press conference following the announcement Janet Yellen will talk up the improvement in the US economy and downplay the risks associated with China and the turmoil in financial markets, reiterating that they remain on track for a rate rise later this year but that any rate rise will be “data dependent”.
This will provide a further lead in for markets to get used to a rate hike and also give the Fed time to see how the global picture evolves. This would most likely be received well by markets as it would show the Fed is not bound to rate hikes this year, if external conditions deteriorate. Despite all the talk about rate hikes it would not be a surprise to see the US Fed resorting to QE4 in 2016, if we see a steeper slowdown in China for instance. One last hit!