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,

Financial Mail - Investors Monthly - - Front Page - writes Claire Bisseker

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

Pic­ture: BLOOMBERG

US Fed­eral Re­serve chair Janet Yellen.

Pic­ture: THINKSTOCK

Pic­ture: THINKSTOCK

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