Sitting Tight

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It has been 81 months, and counting. The US Federal Reserve has missed another opportunity to raise interest rates. Instead, Janet Yellen and her fellow committee members cited global economic and financial uncertainty, sidelining Fed policy for at least another month. The problem with the Federal Reserve’s decision Thursday, and in turn their decision making process is that it paves way for greater uncertainty. Furthermore, investors are now right to question the outlook for the US economy, the ongoing impact of the slowdown in emerging markets, and what the path forward is for the US Fed as Yellen made clear a rate hike could come as soon as October, or perhaps not until 2016. It will now be difficult for the Fed to avoid something they’ve worked so hard not to do, and that’s not surprise the markets.

Without a doubt it was the recent financial market volatility, which emanated in Chinese stocks but spread all the way to US exchanges that kept the Fed on hold. Very succinctly, the FOMC statement read that they continue “to see the risks to the outlook for economic activity and the labor market as nearly balanced but [are] monitoring developments abroad.” What is meant by that statement is that with an employment rate approaching 5 per cent and GDP growth expected between 2.5 and 3 per cent, uncertainty from emerging markets is what has kept them on hold. This in turn revised their outlook lower for interest rates in the US in 2016.

This change from their most recent June meeting was their future forecasts for the federal funds rate and the path of liftoff became a lot more gradual. The projected timeline for higher interest rates will be a lot longer than previously anticipated. This is in part to do with weak domestic inflation, but also allows the Fed breathing room between rate hikes to ensure the economy does not see tightening occur too quickly. As many have cited, recent financial market activity has had a tightening effects on the economy already. Whether it’s higher interest rates, hits to market value of equity portfolios, or the rising dollar depreciating foreign revenues, American’s are being hit with the same deflationary pressures they put on their trading partners when they embarked on quantitative easing. This deflationary dilemma could remain a substantial issue for the Fed as it keeps a lid on US inflation.

Finally, it cannot be forgotten that the idea of a hike in interest rates is based on a strengthening outlook for the economy. September 17 of 2015 was the highly anticipated date for the Fed to raise interest rates because of labour market improvement, a recovering housing market, and a recovering economy. It seems we’ve hit a snag. There is an argument with the US economy at full employment as wage growth in the labour market could jump start inflation. As there is a shortage of workers to hire and productivity increases, firms compete for labour and pay skilled workers more to retain talent. The problem with this theory is the participation rate is at the lowest level since the 1970’s and accounting for underemployment (estimated at approximately 10 million American’s) means the employment rate may be more likely to go sideways than lower. The US labour market still has further to recover.

Whether or not the Federal Reserve was right to not raise interest rates is no longer the issue from Thursday’s policy announcement. The issue is that the Fed, after years of increased transparency and attempting to deliver a clear message to the market, just became a little less transparent. Janet Yellen and her team will be hard pressed to minimize the uncertainty they created from today’s inaction. The reason is not because they didn’t raise interest rates, but when the investors have been led to expect them to raise rates, the question is why not.

Will They or Wont They: A Cloud over the Markets

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August was the 80th successive month of the US Federal Reserve standing pat and not adjusting their key policy interest rate known as the federal funds rate. This Wednesday could mark the first rate move since December of 2008. As investors attempt to determine the actions of the US Federal Reserve, this “will they, or wont they” scenario has cast a cloud over the markets for the past few month as the US Fed readies themselves for liftoff. Investors have been essentially at a dead split in terms of their projection for whether the US Fed’s policy setting committee, known as the FOMC, would hike rates; moreover, consensus has now moved to being a little less likely as the market is currently pricing in a 25 per cent probability the Fed hikes this Thursday.

There is a very complex debate taking place for whether the fed should raise interest rates. For starters, the US Federal Reserve has never raised rates in a period when the global economic outlook has such a high level of uncertainty. Even though the argument is more globally based than the Fed’s domestic interests, it still might be the best reason for the Fed remaining on hold.

Harvard Economics Professor and former Director of the National Economic Council to President Obama, Larry Summers is arguably one of the most vocal advocates for why the US Federal Reserve should remain on hold. In a recent blog post he states five reasons for why the Fed should do what is potentially the hardest job for a policy maker, which is nothing. His strongest argument is that hiking rates for sake of doing so and not having a “commitment to a series of hikes is specious.” In his opinion the Fed sits in a role of guiding the more cyclical economic growth trajectory of the United States, versus acting in a reactionary fashion and adjusting rates as they see fit. Summers is also right to point out rate hikes shouldn’t come until there is a commitment of continued hikes.

The takeaway from all of this is really the bind US policy makers, and the global economy finds itself. Just this week Citibank’s Global Chief Economist stated there is a 55 per cent chance the global economy will slip into recession. And although the contraction and time horizon both are forecast to be moderate, it speaks to a level of uncertainty and fragility the financial markets are effectively displaying. At the same time, we have a US economy projected to grow between 2.5 and 3 per cent in 2015 with an employment rate moving near and soon below 5 per cent, which indicates a rate hike from the Fed.

As it is clear Wall Street is no longer predominantly bullish on US stocks, the question is whether the outlook for US growth can look past the uncertainty elsewhere in the world. As notable economists like Larry Summers, and many others have pointed out, a ‘one and done’ is not what the Fed intends to achieve when they raise rates. Should they decide to hike this Wednesday, it would likely imply a level of confidence in the US to navigate the perils of a China and emerging market slow down. From similar logic, if a threat of a global slowdown will substantially affect US growth, the beginning of higher interest rates may be delayed a little longer. Will they or wont they carries deeper implications than the simplicity of “global uncertainty,” and investors have to be cautious to the consequences.

September Arrived Early for the Markets this Year

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There is no shortage of stories for what is affecting global financial markets.

On the 10th of August we witnessed the Peoples Bank of China decision to allow the yuan to depreciate for the first time in two decades. Brazil, the “B” in the sensation that was the BRIC economies tabled a budget this week that roiled the real, its currency, and sparked fears among investors that its debt would be relegated to junk status by credit rating agencies. The North American continent sees investors debating what level of immunity our domestic economies have to slowdowns elsewhere in the world, and the US Fed has to determine whether September 17 would be an appropriate day to raise interest rates for the first time since the financial crisis amidst all of the global instability. August was quite the month. It ended earlier this week, but this saga for the markets is only getting started.

As the US dollar continues its bull market, the pressure on emerging market (EM) economies can only continue. China’s story of a depreciating currency should slowly lose interest as in this period of US dollar strength all other major trading partners of the US have seen their currencies tumble. Other explanations of the move by Chinese regulators have been attributed to internationalizing their currency to gain currency reserve status. As the action by the bank of China seemed to shock markets at the time, it fits in a long list of reforms as they look to liberalize their financial markets. Frankly, the bigger concern for those linked to China’s economy is establishing the magnitude of the link between the financial markets and their economy.

China’s equities continue to be the catalyst for North American equity weakness, and the downside volatility we have witnessed with a greater than 10 per cent correction in the S&P 500. The notion that weakness in Chinese equities will continue to cast a cloud over North American stocks seems stretched; moreover, as the exuberant run in China began last October, it didn’t see our markets participate in the same upside. What is likely though is the souring sentiment in emerging markets could continue to elevate risk premiums worldwide, and Canada and the US are not completely immune.

Former PIMCO CEO Mohammed El-Erian makes a very sound argument that because these catalysts are emanating from overseas, and EM policy makers don’t have the same tools or “circuit breakers” that say the Bank of England, Japan, ECB or Fed has, downside volatility could continue for some time. The most recognizable example of what he is referring to is ‘quantitative easing’. What has to be recognized is that countries like Brazil still have a hard price to play for failing to reform and diversify their economy through their commodity boom years. Running an austerity filled budget that still leads to a deficit of 9 per cent of GDP will see a dark recessionary period with huge social costs.

What does this mean for North America? Well, as one economist put it, it risks making the US Fed look like a kid stuck on a diving board who’s too scared to jump. One threat could be runaway inflation for the US if they don’t stay ahead of it. GDP growth in the US this year is nearing 3 per cent. Inflation is approximately half a percent under target, but on an upward trajectory. The jobless rate, although understated from displacement from the Great Recession, is at 5 per cent, which is what the Fed defines as full employment. That warrants a Fed move. If or when the Fed raises interest rates, they will use every voice they have to let investors and market participants know that they remain highly accommodative. Even with a hike in September and the fed funds rate still below 1 per cent, the punch bowl isn’t going from the party just yet.