Will the US ever raise interest rates again? http://on.ft.com/1Xd3N9O
Or, perhaps a more sensible question, will this be the first economic cycle — recovery followed by recession — in modern times where the US does not increase rates?
These may seem like odd questions, given the large number of leading strategists forecasting a rise in December.
But with a stream of disappointing data and the slowing Chinese economy hanging over markets, the Federal Reserve could hold fire at the end of the year as they did in September because of persisting worries over global growth and confidence.
In such a situation, the danger increases that the Fed waits too long and runs out of time to raise rates as economic recovery turns into recession, when monetary tightening would be out of the question and loosening through another round of quantitative easing would be back on the agenda instead.
At that point, the world economy would be on the precipice of disaster as the US, which has not raised rates for a decade, looks sure to follow Japan, where rates have not increased for more than two decades, down the road towards deflation and stagnation.
So, how seriously should we take this “nightmare” scenario?
First, it is an extreme or worst-case scenario and far from the most likely. But it is a possibility as markets keep pushing back rate rise expectations. They are now pricing them in for June. What the markets think matters because this is where the money is riding. A forecast is free, a market position is not.
Second, economic data has disappointed, not just in the US but in the UK too, the other industrialised economy where rate-rise expectations have been pushed back.
An activity heat map created by John Wraith, rates strategist at UBS, the bank, has turned decidedly cool. Purchasing manager surveys, manufacturing numbers and employment data have all come in lower than expectations in recent weeks.
Some key statistics, such as US non-farm payrolls, are more than one standard deviation below 12-month moving averages. In layman’s terms, this means they are significantly lower than where the Fed would like them to be before tightening policy.
Third, fund manager surveys show investors pushing back expectations of rate rises as worries over recession increase. This month’s Bank of America Merrill Lynch survey reported that 47 per cent of investors think the Fed will raise rates in 2015, down from 58 per cent in September, when fund managers warned of looming recession. A Citigroup report said a global recession in 2016 had become the most likely scenario.
Fourth, some of the most accurate forecasters in the bond markets are implicitly pointing to US rates remaining near to zero next year. Steven Major, global head of fixed income research at HSBC, the bank, expects US Treasury 10-year yields to end 2016 at 1.5 per cent, half a percentage point lower than today.
Mr Major has a strong record. He was one of the few strategists to correctly predict that US 10-year Treasuries would end 2014 at 2.1 per cent, when a large number of analysts were forecasting levels above 3 per cent.
If Mr Major is correct again, it suggests the next rate rise may not be until at least 2017 when the US recovery, assuming it lasts that long, will be in its seventh year. Data back to 1850 shows that a recovery rarely lasts longer than seven years.
Of course, data could strengthen to make a December rate rise more likely. Even without an improving backdrop, the Fed could still opt to tighten. Significantly, the house view of both UBS and HSBC is for a December rate increase.
But investors should prepare for the worst, however unlikely that may be. With billions of dollars in the markets riding on the decisions of the Fed, it would be foolish not to.