And the waiting is the hardest part
With a final solid payroll number under the belt, focus now turns squarely to the Fed’s
September 17th rate hike decision. Here we first describe the economic and policy
backdrop and then look at likely market responses to alternative Fed scenarios. Our main
economic and policy conclusions are as follows:
• The fundamental backdrop for growth has improved with healing from the financial
crisis and relative calm on the fiscal front.
• After a wobbly start to the New Year, the data now point to steady 3% or so GDP
growth and an even stronger recovery in the labor market.
• Inflation will likely remain weaker than both Fed and consensus forecasts, however,
the Fed seem willing to blame the weakness on temporary factors and focus on
upside pressure from a tightening labor market.
• There has been a regime shift at the Fed. Until 2013 the Fed was resolutely focused
in healing the economy and avoiding a “Japan Scenario.” With healing well
advanced, however, now they have shifted to “data dependent” mode. The Fed’s
“bias” is to act, all it needs is confirmation in the data.
• Three scenarios seem plausible for the Fed: our base case is that markets stabilize
and the Fed hikes this month, the second most likely scenario is that the Fed
remains uncomfortable with market fragility and delays hiking until October or
December; and the least likely scenario is that shocks to the economy worsen,
damaging growth and turning a temporary delay into a semi-permanent delay.
• What happens after the hike? We continue to expect rate hikes at every other
meeting, or at less than half the usual pace. Moreover, the risk is that that they
start out even slower, hiking every third meeting. We will revisit this question as
the Fed focus shifts and they drop more hints about the pace of hiking.
What does all this imply for capital markets?
• As this goes to press, a September move is only partially priced in. However, the
first hike will likely be seen by many as a “policy mistake” limiting pressure on the
rates market. The bigger shock will come if the Fed follows through with a
sequence of hikes.
• Rate hikes will not come as a big surprise to the currency market, but our work
suggests that the sharp move higher in the dollar in the last year was mainly due to
growth concerns and easings by other central banks. With Fed hikes not fully priced
in, we expect modest further upward pressure on the dollar versus a wide range of
currencies in the period ahead.
• Some volatility in Emerging Markets (EM) is likely, but the current situation differs
significantly from the 2013 “taper tantrum.” Taper talk was a surprise; a rate hike
now is not. Moreover, EM currencies are a lot cheaper and are undervalued
according to Compass FX, our valuation model. Also, there are only small external
imbalances in the Fragile Five. Finally, positioning is less extreme and institutional
investors dominate the market. These have proved to be more resilient than the
retail investors in 2013.
• In the near term credit should react favorably to liftoff as it is supported by US data
and market stability. However, further into the rate hiking cycle credit markets will
struggle as they were big beneficiaries of the Fed’s super easy policy in recent
years. This as retail and institutional investors “unreach from yield” and switch back
to safer fixed income assets and equities.
• For stocks, growth matters most, and the backdrop of a gradual tightening cycle
should be supportive of stocks, outperforming bonds and cash, as long as growth
improves. In our view, we have yet to see the highs in stock prices for this cycle, but
a delay in the Fed liftoff would prolong the uncertainty, overhang on the market,
thereby extending volatility.
• Higher US rates will impact commodities in a number of ways. As a first order
effect, higher US rates will likely drive up the US dollar further, likely impacting
commodity prices negatively in the short-run. A key second order effect, however,
will be reduced funding capacity across the commodity sector, a factor that should
ultimately lend support to commodity prices in 2016.
• Putting it all together, the Fed exit is good for the dollar and volatility, roughly
neutral for stocks and bearish for commodities and bonds, particularly for credit.
Overall, we see positive, but lower returns for a diversified investor.