23 April 2015

When the Federal Reserve (Fed) raises rates, it will be the first of the major central banks since the 2008 financial crisis to do so. Many central banks are moving in the other direction, either through quantitative easing programmes (for instance, the European Central Bank and the Bank of Japan) or rate cuts (the Reserve Bank of Australia, the Swiss National Bank, the Reserve Bank of India and many more).

Quite naturally, markets are laser-focused on the statements and minutes coming out of Federal Open Market Committee (FOMC) meetings, as well as US economic data, to get a read on when the Fed might ‘lift-off’. The Fed itself wants to avoid uncertainty and market turmoil around a policy decision, and as such is being deliberately transparent in its language.

State of confusion

However, despite the Fed’s best efforts, markets have appeared somewhat-confused over the last few weeks about the timing of a rate rise. Ahead of the FOMC meeting in March, consensus expectations were for a June 2015 rate rise. The statement following that meeting was a mixed bag, featuring a removal of the ‘patient’ watch word, an indication that the Fed would be ‘data dependant’ and lowered growth expectations for the US economy. Rate rise expectations were pushed out.

Then came the much-scrutinised non-farm payrolls report (a leading US labour market indicator), released on 3 April. The report came in much weaker than expected. The minutes from the March FOMC meeting were subsequently-released, revealing that Fed officials were divided on whether to raise rates in June (meaning a June rise was still effectively on the table at the time of the meeting). Markets are currently pricing in a US rate rise in early 2016.

We expect a September hike

We believe the Fed is still on course to raise rates year, most likely in September. Here’s why: there is a seasonality to US Q1 economic data, a trend that has played out over the past five years. The economic outlook for this year is shaping up to be similar to last year, with a difficult first quarter followed by incremental growth in subsequent quarters. A combination of extreme weather conditions, a surprisingly-strong move higher for the dollar and shutdowns of ports over labour disputes are more likely to blame for weaker Q1 2015 data than any kind of persistent slow growth trend in the US. Markets appear to be over-reacting.

What does this mean for UK rates?

It’s a similar situation in the UK, where a rate rise is priced in for Q3 2016. We believe this is too extreme – UK economic growth is strong. For instance, retail sales volumes are very healthy, with ‘big ticket’ items, such as automobiles, selling well. Given the upcoming election, there is some political risk in trying to predict when UK rates will rise, but if the Fed does move in September, it will make it easier for the Bank of England to follow suit, possibly this year.

Investment implications

Even if the Fed does raise rates this year, a marginal increase is unlikely to change the fundamental dynamic at play in markets: monetary policy around the world is creating distortions, particularly in rates, and there is uncertainty about the trajectory of that policy.

In such an environment, there may be opportunities to tactically take advantage of those distortions for short-term returns, but it requires a fixed income portfolio nimble enough to do so while offering some protection against bouts of volatility – particularly if US data remains weak over the next few weeks.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of 23/04/15 and may change as subsequent conditions vary.
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We believe the Fed is still on course to raise rates year, most likely in September.