Monday, 17 August 2015

US Fed Rate Hike

Investor Expectations

Dennis Lockhart, president of the Fed Reserve Bank of Atlanta, mentioned economic data would have to greatly deteriorate to avoid a rate hike. His statements contrast investor sentiment who have predicted rate rises much later in the year.  The implied futures contract rates points to a rise of 1% by next year, which contrasts the latest median projection of 1.6% from the Reserve Board.  Valuations are inflated, the bull market has reached its seventh year with investors being optimistic and EPS growth is slowing- all factors which have previously seen large losses. This is especially because margins are driven by a small cluster of stocks.
Historically, it takes three rate hikes to ultimately eliminate bubbles.

September Rate Hike

However, labour and retail spending figures support a rate hike- claims for state welfare have remained below 300,000 mark for over 5 months, which suggests strengthening job market. The four week moving average of claims which eliminates weekly volatility is at its lowest since 2000. Associated increase in retail spending particularly in automobiles implies a solid third quarter growth. With factors supporting wage growth, US stocks must keep rising against rate hikes and reduction in profit margins. 

Effects on Bonds & Reasons

Analysts at QIC report that a US rate hike will result in losses on long bonds if major central banks raise rates faster than what investors expected for the past few months. The premium that investors required for taking on interest rate risk will revert back to normal as the drivers that previously lead to low yields are reversed. Foreign ownership in bond markets has reached a 25-year peak, and central banks have begun to liquidate their foreign currency reserve holdings. The excess supply results in higher yields. Such accumulation has been due to a number of factors. Firstly, the 90s Asian currency crisis increased investment in foreign currencies to act as a future buffer. Secondly, oil-producing economies are drawing on such holdings to maintain their expenditure levels given the decline in oil prices. Most of the accumulation is accredited to China’s growing export economy, which means China has invested foreign currencies from their export market into US treasury bonds to limit Chinese currency appreciation. Clearly this has helped Chinese export competitiveness. However, economic data demonstrates China has been easing capital controls- their foreign currency reserves peaked at $US 4 trillion last year in June but this number has steadily declined to $US 3.7 trillion in June 2015. This could imply China has been using its reserves to short US treasury bonds. If China is developing a floating currency governed by demand and supply, there will be positive and negative effects on Australia. Previously low bond yields correlated with quantitative easing in the US meant investors flocked to other economies such as Australia for higher yielding currencies, increasing the supply in the Australian bond market. As a result, our currency appreciated and was limited in its stabilization role during declines in terms of trade. The increase in the premium and yields in US will assist in the RBA’s current focus on $A depreciation, allowing it to focus on calming the property price bubble.

Other economies

The price yield curve means bond prices fall with increased yields. Britain’s ten-year bond yield increased six basis points to 1.93%, Germany’s increased four basis points to 0.68%, Australia’s increased seven basis points to 2.8%. Treasuries ten-year note yields increased nine basis points to 2.24%. Sliding oil prices were responsible for the increase in Germand ten year bunds as it supported speculation that slow inflation will remain.

However RBI Governor Raghuram Rajan is not worried about the effects on the Indian economy, arguing the impact of the action has already been factored in by global markets as one of the “most awaited things in history in recent times”. To offset potential volatility post Fed hike, the RBI has been increasing its forex currency reserves since the beginning of 2014 by $105.8 billion to $354 billion.

Delay? China’s Devaluation

Further delay could even be expected with China’s recent move. China’s central bank devaluing its previously tightly controlled currency drive speculation that such action could delay the interest rate hike as it added volatility to global forex markets. China’s growth had previously been weak from capacity excess, larger than expected drop in exports in July and over valuation of the yuan. The yuan devalued by 1.9%, which was stressed as a one-off that allowed its currency to be appreciated by market factors. However, some economists believe that if the Chinese economy joined other economies who have a large propensity to save (e.g. Japan) in the global currency war could trigger another crisis.  If other central banks follow and devalue their own currencies to boost their export markets, which is likely given deflationary pressures from low commodity prices, this would further damage US companies who are already struggling due to the strong US dollar buying from talks of a rate hike. Albert Edwards at Societe Generale stated the devaluation will change investor perceptions over the US economy’s resilience, and the currency war will eventually mean the US starts to import deflation.

However, others argue this action will not substantially impact the Fed’s decision making given the fact that China’s Real exchange rate has increased by approximately 14% in the past year and a decrease of 2% is too little to spark major change. Moreover, the Fed has no obligation to any economies outside the US and hence the importance of emerging markets is being overstated- unless the move creates economic mayhem, it is unlikely such a move will influence the Fed. In fact there are speculation over the reasoning of this devaluation was du to anticipation of the Fed’s close rate hike as it would hinder China’s goal of getting ahead of the curve.  

With boosted export competitiveness from China, demand and prices for iron ore and commodities should increase. With how stocks in the mining sector have acted previously to interest rate hikes, there is little need for concern for adverse effects from US monetary tightening.  July experienced the lowest commodity prices in four years. Performance correlation with US interest rate movements has historically been positive. However, the other side of the story is that the rate hike will obviously cause appreciation which has always been a negative sign for commodity exports. Investors must look at the relative side of things- appreciation will only happen if the rate hike is greater than the appreciation in other currencies from their respective rate hikes.  

Commodity safe haven Gold reached almost a five and a half year record low following comments from the Board regarding next month’s interest rate hikes. Bullion has remained below the $1100 threshold after overreaching its support level in July this year which pulled gold down to its weakest since Feb 2010. 

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