The Fed hike cycle: still guessing
Will markets have a tantrum when the US raises rates? Analysts are divided on the timing and pace but we’d better brace for it anyway,
Emerging markets have watched the sharp sell-off in global bonds in recent weeks with growing alarm, fearing that a second taper tantrum could be on the cards as the expected date of the first US Federal Reserve rate hike draws closer.
The first so-called taper tantrum occurred in May 2013 when the US Federal Reserve announced it would soon slow its bond purchasing programme. This caused US yields to move sharply higher and an exodus of capital from many emerging market assets. The rand was one of the many casualties.
Emerging market countries’ failure to accelerate structural reforms has eroded their long-term growth potential so they remain quite vulnerable to capital outflows at a time when the US is exhibiting growth at a lower risk, making it an attractive investment destination once again.
Former Fed chairman Alan Greenspan recently warned investors at a conference in Washington that markets would likely suffer another taper tantrum when the Fed took the next step in policy normalisation — lifting the policy rate off the current floor of 0%-0,25%.
It will be the first move upwards in US interest rates in about nine years.
“Normalisation is great, but the process of getting there is going to be very rocky,” the former Fed chief reportedly said.
Historically, the start of the Fed hiking cycle hasn’t generated large market moves, notes Rand Merchant Bank currency strategist John Cairns. Also, the markets have had years to prepare for this so, theoretically, it should already be priced in as long as the Fed moves when expected.
And that is precisely the problem. All global markets are moving in line with expectations of when the Fed will hike but the consensus date for lift-off is a moving target, making each data point a source of fresh volatility.
Until recently, the Fed’s upcoming September meeting was the consensus date for the first anticipated 25 basis point (bp) hike.
Initially, the markets shrugged off the US economy’s weak first quarter 0,2% GDP growth and dip in job creation numbers as
Doubts about whether the US recovery will be sustainable in the absence of a firmly growing global economy
being temporary and related to weather. This is also the reading the Fed took at its April meeting. However, the soft first quarter data has continued into the spring.
The fact that retail sales growth was 0% m/m in April compared to a rise of 1,1% m/m in March seems to have had a disproportionate effect on the markets’ expectation of Fed behaviour.
“It has changed a lot of people’s minds as to the timing of the first Fed hike because it brings into question whether the recent weakness in the US economy is just weather-related or something more structural,” explains Cairns. “This is not to say that the US recovery is faltering — US leading indicators are still strong — it’s just that the US economy is growing more slowly than most expected.”
At the time of writing in mid-May, this was reflected in a significant downward shift in the Bloomberg consensus forecast for 2015 US real GDP growth — from 2,8% to 2,5% — over the course of just one week. In January the consensus was for the US to grow by just over 3% for the year.
At the same time, the markets are now starting to reflect that the first Fed increase might come only next year.
The CME Fed Futures market at the time of writing was pricing in only a 17% probability that the Fed would hike at its September meeting, a 28% probability that it would hike in October, a 33% probability that it would hike in December but a 65% probability that it would have hiked at least once by the January 2016 meeting.
This differs from what analysts are saying. According to a Reuters survey of primary dealers after the May 8 US payroll numbers, 16 out of 18 dealers thought the Fed would hike in September by 25bp and again in December by 25bp. Only two dealers thought the first hike would come in December. However, the 16 who are expecting a September hike attach only a 50% probability to this actually happening.
“We had expected the Fed to move in September but are having to revise that view because of the weakness in the data,” says Cairns. “The problem is that the Fed says its decision will be data dependent so all you need is two strong payroll figures to change everything again.”
Renaissance Capital economist Thabi Leoka has pencilled in a 25bp hike in September but wouldn’t be surprised if the Fed didn’t hike at all this year, or if it hiked once only to pause for a considerable period. This is because she has doubts about whether the US recovery will be sustainable in the absence of a firmly growing global economy.
“They seem to be kicking the can down the road,” says Leoka. “The Fed has said its decision will be data dependent and we’re seeing signs that growth hasn’t been sustainable in the first quarter, plus China is slowing more than expected, and Europe is barely growing.”
Investec Asset Management economist and strategist Nazmeera Moola agrees that it is not a given that the Fed will hike this year and, if it does, feels that any upward moves are likely to be gradual. Writing in the Financial Mail, Moola points out that global GDP is on track for an annualised gain of just 1,2% in the first quarter — the second weakest reading during an expansion over the past quarter century.
“This means that both oil prices and US interest [rate] expectations should moderate in the coming months,” she writes. “While this is not good news for the growth expectations of emerging markets, including SA, it does ease concerns about a sudden exodus of foreign capital from our bond markets for international reasons.”
In recent weeks, the pushing out of the timing of Fed hiking fears on the back of a weaker dollar has allowed the rand to strengthen to a recent low of
Reserve Bank Governor Lesetja Kganyago has also said the Bank will only respond to a sustained breach in the 3%-6% inflation target
R11,66/$ (on April 3) from the year-to-date high of R12,50/$ reached on March 13.
But should the US economy perform better in the second half and the dollar resume its appreciating trend, it would be bad news for the rand. The latter is looking particularly vulnerable, given its relatively high inverse correlation with the greenback, coupled with SA’s deteriorating domestic fundamentals.
Both Nedbank Capital and Barclays Africa believe the US recovery is poised to pick up.
Nedbank Capital’s head of strategic research, Mohammed Nalla, finds evidence hidden in recent US jobs data that the labour market is slowly gaining momentum.
“What’s happening is that temporary, lower-paying jobs are building up and getting converted into higher-paying, more permanent jobs,” he explains. “The resultant wage growth should translate into higher disposable income over the next 12 months, which should result in faster GDP growth, since 70% of the US economy is consumer-driven.”
He expects the first hike in September, by which time he expects the Fed to have firmer evidence that the economy has picked up after what he believes was just a weather-related slump in the first quarter.
But while Nalla argues that the Fed will have to hike in September for credibility and financial stability reasons, he expects a gradual hiking cycle “because in the event that the Fed hikes too aggressively, it runs the risk of scuppering what has been a tentative recovery so far”.
For Nalla, two successive 25bp hikes by the Fed would constitute policy error since the resultant fall in emerging market (EM) currencies, including the rand, against the US dollar would push up EM inflation, slowing their growth. And since EMs count for 50% of global growth, it is inconceivable that this move wouldn’t rebound on the US economy in a negative feedback loop.
Though the Fed has itself voiced this concern at previous meetings, Nalla feels it is not central to the Fed’s deliberations.
“If they hike by 25bp in September I think you’re likely to see an adverse reaction in the rand and other EM currencies because the markets will automatically price in a succession of 25bp hikes.”
He’d ideally like the Fed to hike by just 10bp in its first move so that the markets would have to price in a much flatter hiking profile. This would reduce the negative spill-over effects on EMs. But he’s not holding his breath.
Barclays Currency strategist Mike Keen is also sticking to a lift-off date of September based on the Fed’s current view that the “soft patch” in the first quarter was temporary. He has another 25bp hike tentatively pencilled in for December but is also not expecting an aggressive hiking cycle, noting that any Fed moves will be highly data dependent.
“Any further downside surprises in growth and they’ll hold off and be very staggered in their approach,” he says.
SA’s Reserve Bank doesn’t pretend to know the extent to which US rate increases are already priced into the rand exchange rate, but has warned that the rand is likely to come under pressure once the US commences hiking.
Governor Lesetja Kganyago has also said the Bank will only respond to a sustained breach in the 3%-6% inflation target. In other words, it will hike only if first round exogenous shocks from the rand and oil price, coupled with electricity and food price increases, filter into second round effects such as an increase in inflation expectations or higher wage settlements.
Nalla, however, points out that the Reserve Bank’s inflation forecast — which assumes a 6,7% target breach in the first quarter of next year — doesn’t yet factor in the 25% hike in electricity tariffs being requested by Eskom.
Given the “toxic mix” of rising oil and food prices, outsize wage demands and a weaker rand, many economists are preparing for a sustained uptick in inflation. Nalla thinks that by the first quarter of 2016, CPI could well hit 7%, aided by low base effects at that time. “So even if the Fed has done nothing by then, the Reserve Bank will have to hike by the first quarter of next year for credibility reasons,” he says.
In such an environment where the dollar is strong, commodity prices are weak, the appetite for the carry trade is diminishing, and domestic SA inflation is trending higher, it will be very difficult for the rand to enjoy any sustained recovery, adds Mike Keenan, the currency strategist for Barclays. He expects the rand to end the year at R13/$.
Nalla expects a year-end figure of R12,50/$. Cairns’ forecast is for R11,75/$ based on the belief that the Fed’s views will be well telegraphed and that it will hike later than initially expected, limiting the fall-out for all global assets, including the rand.
Either way, it would be wise for South Africans to heed Greenspan’s warning and brace for more volatility. The rand and other SA assets are doubtless in for a rocky time.
The problem is that the Fed says its decision will be data dependent so all you need is two strong payroll figures to change everything again
US Federal Reserve chair Janet Yellen.