Against the tide: The Fed is a macro risk
The US Federal Reserve has harmed its credibility by postponing a rate hike.
The decision of the US Federal Reserve to postpone its much-heralded hike in the funds rate is just that – a postponement.
The Fed will probably take the plunge in December. It seems to have held off because of the growing risk of a slowdown or even hard landing in China affecting the rest of the emerging economies and global growth.
The Fed shifted its forecast for short-term interest rates down by 16 basis points in 2015 (still a hike), by 27bp in 2016 and by 36bp in 2017. So the average long-term equilibrium or normalised rate is now also marginally lower (3.46% versus 3.64%).
Yet domestic US activity remains robust. While US headline inflation might face short-term pressure from lower oil prices, there is a gradual upward momentum in the core measure. With unemployment back to pre-global financial crash levels, the risks of acting too late are rising.
In its September statement, the Fed indicated that financial conditions had tightened (US dollar strength, wider risk spreads in fixed income markets and softer equities) but its expectations for positive US growth were unchanged. But Fed chair Janet Yellen alluded to labour slack not captured by the narrow unemployment rate of 5.1%.
In my view, the US labour market already has hit what should be the Fed trigger. And the improvement in the labour market is starting to generate first-round pricing pressures, which should become more visible once the transitory effects of declines in energy and import prices dissipate.
So I reckon that the Fed probably blew it at this meeting, leaving the market to yaw in the contrary winds of uncertainty for a few more months. This will do no good for markets or the economy, or the Fed’s credibility. Equity valuations are already lofty as a result of QE-driven asset-price inflation. The Fed’s negative global growth outlook will overwhelm the free-money-for-longer message. Nevertheless, the US economy will continue to be the strongest in the world. Therefore the Fed’s postponement is not a reversal of the ultimate outcome: namely US monetary tightening and global capital repricing.
So the dollar is likely to stay strong. First, there’s divergent monetary policy between the main economic blocs, with the Fed tightening and the Bank of Japan and European Central Bank easing. This divergence will continue to drive US dollar strength. If anything, the Fed’s procrastination adds pressure for further and earlier easing by BoJ and even the ECB. Expect the BoJ to undertake additional QE this year because of poor economic performance and little progress towards its inflation target. It is likely the ECB will also expand and extend its asset purchase programme beyond 2016. The eurozone recovery remains tepid and the ECB’s 2% inflation target is out of reach.
Second, China’s abandonment of its renminbi peg (as yet in theory rather than practice) removes the lynchpin for currency stability in emerging markets. So expect further big devaluations of Asian EM currencies, as well as Turkey’s, Brazil’s and Russia’s (among others). In Asia, the devaluations are to deal with potential debt-deflation and loss of export competitiveness. Asian domestic economies remain mired in low productivity, profitability and growth, while there is a pressing need for corporate deleveraging.
The triggers for the next step-down would be a 12% to 15% devaluation of the renminbi over the next year to reverse the real effective exchange rate gains seen over the past year as competitors devalued and the dollar rallied.
There is no sign that energy prices will reverse their steady fall. The oil glut will persist over the next 12 months as the Saudis continue to try to knock out competing supply. And there is a secular decline in growth of demand from emerging markets and disruptive technologies that replace fossil fuels. Agricultural commodities, such as corn and sugar, may be bottoming out, helped by El Nino damage to crops and, for corn, prices that have fallen far enough to affect planting.
The Fed has become a macro risk: it could continue to find reasons not to tighten when the economic conditions justify doing so. That would create more uncertainty in equity markets. Maybe the Fed is right to worry about weakening global growth. But if it is, then it suggests further weakening in emerging market currencies and a deep bear market in equities. And commodities would be for the birds.