The Fed’s hawk­ish stance

Financial Mirror (Cyprus) - - FRONT PAGE - By Tan Kai Xian and Joyce Poon

For those who thought Janet Yellen a dyed-in-the-wool dove, her Jack­son Hole speech on Fri­day gave pause as she en­dorsed fel­low pol­i­cy­mak­ers’ re­cent state­ments that the US econ­omy was strong enough to war­rant in­ter­est rate rises. Mar­kets quickly ad­justed, with the chance of a hike in Septem­ber leap­ing from 32% to 42%, up from 22% a week ago. Ten year trea­sury yields jumped as much as 9bp, while the DXY dol­lar in­dex rose 0.8%. We think the mar­ket has cor­rectly re­set its ex­pec­ta­tions about the US eco­nomic out­look and likely Fed­eral Re­serve re­sponses. The im­pli­ca­tion for global as­set mar­kets is not al­to­gether en­cour­ag­ing.

The cur­rent US eco­nomic sit­u­a­tion sat­is­fies the Fed’s dual pol­icy man­date. The labour mar­ket is reach­ing full em­ploy­ment as judged by ris­ing wage pres­sure, high lev­els of job open­ings and grad­u­ally slow­ing em­ploy­ment growth. The Fed seems likely to achieve its 2% con­sumer price in­fla­tion tar­get in the com­ing few months as the year-on-year drag from col­lapsed oil prices fully wears off and prices are pres­sured higher by ro­bust do­mes­tic de­mand as sig­nalled by solid re­volv­ing con­sumer credit growth and sharply ris­ing res­i­den­tial rents.

What this in­du­bitably means is that a re­li­able global cen­tral bank “put” is no longer in place. The prob­lem is that a “lower for­ever” as­sump­tion by in­vestors drove the yield­chas­ing rally seen since the shock Brexit vote in late June. This rally was odd as prices of risk-on as­sets (eq­ui­ties) ral­lied in uni­son with risk-off as­sets (bonds, gold, and Ja­panese yen), while most in­vestors left them­selves short-volatil­ity. Such com­pla­cent po­si­tion­ing in­evitably leaves the mar­ket vul­ner­a­ble to in­fla­tion­ary sig­nals or state­ments of pol­icy in­tent such as Yellen of­fered on Fri­day.

The good news is that the US does not face an im­mi­nent re­ces­sion risk.

1) In­fla­tion­ary pres­sure maybe on the up, but it is not suf­fi­cient to make the Fed ac­tively fight price rises. De­spite re­cent hawk­ish talk from pol­i­cy­mak­ers, a slow and steady rate hike path re­mains most likely.

2) The cur­rent real cost of cap­i­tal is still sig­nif­i­cantly be­low our re­turn on in­vested cap­i­tal mea­sure. This means that US cor­po­ra­tions can still make prof­itable in­vest­ments dur­ing the ini­tial phase of rate hikes, which lim­its the chances of a wide­spread re­ces­sion.

3) While US cor­po­rate prof­its (as recorded in the na­tional ac­counts) for 2Q16 fell -2.4% on a se­quen­tial ba­sis, the out­look has slightly im­proved as the drag from the oil and gas sec­tor should lessen due to a sta­bil­i­sa­tion of hy­dro­car­bon prices. To be sure, a roar­ing prof­its re­cov­ery is un­likely due to slug­gish eco­nomic growth, ris­ing wages, a lin­ger­ing in­ven­tory over­hang is­sue and the strong US dol­lar. At best, the US cor­po­rate re­turn on in­vested cap­i­tal should re­main sta­ble at 5.4% (see chart).

Bring­ing things to­gether, US eco­nomic growth and prof­its are un­likely to crater, how­ever the econ­omy is tran­si­tion­ing to a phase when real in­ter­est rates are more likely to rise than to fall. As a re­sult, volatil­ity seems set to in­crease. Alas, very high lev­els of cross-as­set class cor­re­la­tion mean there are no ob­vi­ous sanc­tu­ar­ies where pos­i­tive ab­so­lute re­turns are likely to be earned. Look­ing ahead, we would ad­vise in­vestors to shorten du­ra­tion of fixed in­come po­si­tions and gen­er­ally lighten up on risky as­sets.

Newspapers in English

Newspapers from Cyprus

© PressReader. All rights reserved.