US Fed rate hike in sight

The Pak Banker - - OPINION - Ira Du­gal

It's now a vir­tual cer­tainty that the US Fed­eral Re­serve is on course to raise rates for the first time in nine years. Septem­ber seems the most likely tim­ing for the hike; which is about a month away. Yet there seems to be lit­tle move­ment in the in­ter­est rate mar­kets to sug­gest that this long awaited move to­wards nor­mal­iza­tion of mon­e­tary pol­icy in the US is around the cor­ner.

On a year-to-date ba­sis, the yield on the bench­mark 10-year US trea­sury bond is up just 9 ba­sis points (bps). (One ba­sis point is one­hun­dredth of a per­cent­age point.) The re­ac­tion across the shorter end of the yield curve has not been very dif­fer­ent, with the yield on the twoyear trea­sury bond up 6 bps, while the five-year bond yield has ac­tu­ally fallen by about 2 bps. No­tably, an in­crease in yields ear­lier in the year has al­most en­tirely been re­versed. Start­ing midApril, global bond yields had started to rise and many of us had won­dered whether the long feared global bond sell-off was be­gin­ning. Be­tween 17 April and 10 June, the US 10-year yield rose by about 60 bps-an in­crease that had fol­lowed a surge in bond yields in Euro­pean mar­kets such as Ger­many.

In hind­sight, that spike in yields proved to be tem­po­rary. The US 10-year yield, for in­stance, has fallen 22 bps and is cur­rently at about a two-month low. The ques­tion is-why are the bond mar­kets so quiet if an in­crease in in­ter­est rates is around the cor­ner? Here are some of the­o­ries do­ing the rounds. One rea­son for this is the ex­pected tra­jec­tory of in­ter­est rates in the US. While mar­kets are re­signed to the fact that the first rate hike will hap­pen this year, the view is that the pace of in­crease in in­ter­est rates from here on will be slow. The Fed has said as much. "The Com­mit­tee (Fed­eral Open Mar­ket Com­mit­tee) cur­rently an­tic­i­pates that, even af­ter em­ploy­ment and in­fla­tion are near man­date-con­sis­tent lev­els, eco­nomic con­di­tions may, for some time, war­rant keep­ing the tar­get fed­eral funds rate be­low lev­els the Com­mit­tee views as nor­mal in the longer run," said the Fed in its July state­ment.

An­a­lysts, too, be­lieve that eco­nomic con­di­tions (both global and do­mes­tic) will not al­low the Fed to raise rates too quickly and that's one rea­son why bond yields are not run­ning up de­spite the prospect of in­ter­est rate in­creases in the world's largest econ­omy.

The re­sump­tion of the global com­mod­ity slump is another rea­son why bond yields have been sub­dued. Af­ter a pe­riod of steadi­ness, com­mod­ity prices have started to fall again. Crude oil prices in the US are back at five­month lows, hav­ing slipped 20% since the be­gin­ning of July. Along with crude, me­tal prices are fall­ing, as are prices of agri­cul­tural com­modi­ties such as sugar and soy bean. The emerg­ing view is that the com­mod­ity cor­rec­tion may not be short lived. Ma­jor­ity views sug­gest that events such as the Iran nu­clear deal and the slump in China may keep com­mod­ity prices low for some time to come. All taken to­gether, this soft­ness in com­mod­ity prices could pre­vent in­fla­tion rates from hit­ting the Fed's tar­get lev­els of 2%, which, in turn, will pre­vent quick rate hikes.

A third fac­tor that is keep­ing US bond prices high and bond yields low is, very sim­ply, de­mand. The global en­vi­ron­ment re­mains volatile with most de­vel­oped and de­vel­op­ing economies (with a few ex­cep­tions) strug­gling. While the Greek cri­sis has blown over for now, the Euro­pean econ­omy re­mains weak. China, where the stock mar­ket slump con­tin­ues, is in­creas­ingly mak­ing global in­vestors ner­vous. While it was ear­lier thought that China's trou­bles would be lo­cal­ized, the re­ac­tion in the com­mod­ity mar­kets has proved oth­er­wise. In turn, the com­mod­ity price plunge has left a num­ber of com­mod­ity ex­port­ing emerg­ing economies in a mess. Brazil and Rus­sia are ex­am­ples of this. What this has done is keep the de­mand for safe haven as­sets high and most of this de­mand is be­ing routed to dol­laras­sets, in par­tic­u­lar US trea­suries.

All taken to­gether, what this means is that-con­trary to the long-held belief-bond yields may ac­tu­ally not surge in re­sponse to an in­crease in US in­ter­est rates. If it ac­tu­ally plays out this way, it won't be the first time that the in­ter­est rate mar­kets would have de­fied ex­pec­ta­tion and ex­pla­na­tion.

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