Last night the US Fed released their carefully watched minutes from October’s meeting. Usually they are fairly vague about giving direction, but this time they made it quite clear they thought a December increase in rates was needed
This is completely in line with our expectations since the start of 2015, but more than 50% of the market was expecting them to wait until 2016. Strong recent data out of the US has caused many institutional investors to change their views to a December hike, but also to increase the longer term rates in the US. We think they have overreacted on this last point.
The Fed has to increase rates off their current level of zero*. That much has never been in doubt; if they don’t increase rates, they have no ability to reduce them again should there be economic weakness again in the future.
The only questions have been:
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When they start to increase rates.
- By how much will they increase rates over the coming cycle, i.e. the coming 2-3 years.
On the first question, we believe December this year, but as we’ve said throughout 2015, unless you are an institutional trader of fixed income futures under 12 months term, it doesn’t really matter if its December this year or January next year. Let the futures traders get excitable about the timing and put your energy into thinking about the next question, “How much will the Fed raise in the next few years?”
We believe this cycle will be much “flatter” than the market expects. The US economy is doing well, but not so well that the Fed will be forced to put up rates quickly. If inflation jumps to more than 2%pa, their hand will be forced. But at the moment, inflation remains either slightly below target or on target. New data out last night confirmed that.
So the Fed will put up rates to give themselves some flexibility to lower rates again in the future, but unless inflation jumps, they won’t put them up more than they need to.
The reason why is all about currency. The EU and Japan still have zero interest rates, are still undertaking QE (quantitative easing, or pumping of cash into the banking sector to stimulate lending and investment in the economy); and are still talking about extending their QE programs well into 2016 and 2017. China is reducing interest rates very quickly to combat its slowing economy. These are the three largest economies in the world after the US. If they are holding interest rates very low, and likely to be maintaining this strategy for the next few years, investors will favour currencies with a higher interest rate, ie the USD.
If investors flock to the USD, that will push up the USD’s value, making their exports less competitive, which in turn will hurt the US economy. That interconnectivity between the world’s major central bank strategies is what puts a ceiling on the Fed’s cycle of interest rate increases, in our view. We believe that rates are likely to be increased only as far as they need to be in order to keep a check on inflation and provide some flexibility for the Fed, ie six interest rate increases to around 1.5%p.a.. We also believe that 2016 will only see one to two more increases after the December 2015 hike.
Beyond this period, with the global economy facing significant headwinds from demographics (baby boomers retiring and therefore spending less) and fiscal constraints (major economies needing to pay down debt, and therefore spend less), we believe rates will remain much lower than historic levels, and as such when 10 year bond yields are over 2.0%p.a., this represents good value for long term investors.
*US rates are actually 0.13% rather than zero as the US Fed had to leave enough for money market funds to be able to charge their fees or the whole money market industry would be forced to change their products.