That coming Fed hike? Take it easy

FOR much of this year, the big debate (or obsession) for investors has been about when the US Federal Reserve would start raising interest rates after keeping them near zero for almost seven years.

After delays in June and September, attention is now focused on the Dec 15-16 meeting following the Fed's indication at its October meeting that it would consider a hike then and much- stronger-than-expected jobs data for October.

US money markets are pricing in a 66 per cent chance of a move in December.

The Fed's inclination to start hiking is understandable. The extraordinary monetary easing since the global financial crisis (zero interest rates and three rounds of quantitative easing, or QE) have done their job in restoring US growth.

Jobs are well up on 2008 levels, unemployment is down to 5 per cent, confidence is up, the housing sector has recovered, and business is investing again. And since inflation normally turns up only with a lag, the Fed feels there is an argument to get going.

However, heightened expectations of a hike in December have seen a return to the sort of worries that drove share markets lower in August/September with investors fearful that a Fed hike would put upwards pressure on the US$, which in turn would drive commodity prices lower, accentuate the risk of problems in the emerging world, and adversely affect US economic growth.

As a result, shares, commodity prices and emerging-market (EM) currencies have seen some renewed volatility or outright falls so far this month.

More broadly, it's understandable for investors to be wary as they have become used to zero interest rates, and the fragile state of US and global growth along with deflationary risks suggest that there is a risk that the Fed may make a mistake in hiking.

There is a long list of countries that have raised interest rates since the crisis only to cut them again.

This includes Australia, Canada, Norway, New Zealand, Sweden and the eurozone. Japan had a similar experience in the 2000s. So there is a risk that the Fed could make a similar mistake.

Given all this, Fed-related uncertainty and nervousness could continue at least until the Fed's December decision is out of the way. However, there are several reasons not to be too concerned about the Fed.

Fed hikes conditional on a stronger US economy

The Fed has clearly made its first interest rate hike conditional on the US economy moving in line with its relatively upbeat expectations - specifically "that unanticipated shocks do not adversely affect the economic outlook and that incoming data supports the expectation that labour market conditions will continue to improve and that inflation will return to the (Fed's) 2 per cent objective over the medium term".

By delaying in September, the Fed clearly indicated that its conditionality was serious and that the conditions had not yet been met.

This all means that if the Fed does hike in December or whenever, it will only be because the US economy is stronger and the Fed is confident that this will continue - in other words, it will be a "good hike".

And subsequent moves will also be conditional on further improvement in the US economy. Given ongoing constraints on growth and inflation, I expect that rate hikes will be very gradual - that is, below Fed members' expectations for the Fed Funds rate (commonly called the "dot plot") to reach 1.5 per cent by end-2016 and 2.6 per cent by end-2017.

In fact, the Fed's December meeting is likely to see these expectations revised down again.

Periodic growth scares - like bad weather, China worries, and terrorist attacks - only add to this.


US economic downturns/recessions have historically come only three years after the first Fed rate hike in a cycle. In fact, recession did not come until seven years after the February 1994 first hike and for three- and-a-half years after the June 2004 first hike.

This is because the first rate hike only takes monetary policy from very easy to a bit less easy, and it's only when monetary policy becomes tight after several rate hikes that the economy gets hit. This is often signalled by long-term bond yields falling below short-term interest rates (that is, an inverted yield curve).

And we are a long way from that.

Flowing from this, while there can be share market wobbles around the first Fed rate hike after major easing cycles, sustained problems usually set in only when interest rates/monetary policy become tight. This can be seen in the first chart (Chart 1).

Shares had wobbles when interest rates first started to move up in February 1994 (US shares had a 9 per cent correction at the time) and in June 2004 (US shares had an 8 per cent correction then). But bear markets did not set in till 2000 and 2007, after multiple hikes and with recessions around the corner.

Other major countries are still easing

Although the US may start raising interest rates, other major central banks are still moving in the direction of monetary easing or at least are a long way from hiking.

These include the People's Bank of China (which is expected to cut interest rates further), the European Central Bank, the Bank of Japan (which is biased towards expanding its quantitative easing programme), and the Reserve Bank of Australia (which still has a bias to cutting interest rates further). In other words, even when the Fed moves, global monetary policy will remain easy.

This divergence is very different from the period before the financial crisis.

The US$ will constrain the Fed

Since the start of last year, the US$ has risen just over 20 per cent against a trade- weighted basket of currencies. This has largely reflected expectations that the US is moving towards monetary tightening at a time when other key central banks are still easing, which in turn has made the US$ relatively more attractive.

A rising currency is a form of monetary tightening because it bears down on economic growth (by making the US less competitive) and inflation (by reducing import prices).

According to a Fed model of the US economy, the 20 per cent rise in the value of the US$ since January 2014 is equivalent to around 150 basis points of rate hikes.

In other words, the rise in the US dollar has done much of the Fed's job for it.

A rising US$ also puts downwards pressure on commodity prices because most commodities are priced in US dollars, which in turn weighs on US inflation.

So with US growth still being relatively fragile (it has averaged just 2 per cent since the crisis ended whereas a period of much stronger growth would normally have been seen after such a severe recession) and its preferred measure of inflation still running well below target (the private final consumption deflator is running at 1.3 per cent year-on-year versus a target of 2 per cent), the Fed is unlikely to want to see a further sharp increase in the US$.

As a result, with other major central banks still easing, upwards pressure on the value of the US$ will act as a brake on how much the Fed can raise interest rates. And in order to stop the US$ rising too much, the Fed is likely to talk dovish in stressing a gradual tightening cycle.

This has indeed been seen in recent Fed comments and is likely to remain the case.

Non-US shares are cheap

While US shares are expensive on some measures - particularly if low bond yields are not allowed for - this is not the case for non-US share markets, which are cheap whether low bond yields are allowed for or not.

For example, while the so-called Shiller price-to-earnings multiple or cyclically adjusted PE - which compares share prices to a rolling 10-year moving average of earnings to smooth out the earnings cycle - puts US shares at 26 times, global shares excluding the US are trading at only 15 times (see Chart 2).

In fact, global shares excluding the US are about as cheap as they ever get on this measure. This includes Australian shares. This is very different from 2000 or 2007, when most share markets were expensive on this measure.

This tells us that there are still plenty of opportunities in global shares for investors (even if Fed hikes continue to put a brake on US shares).

The anticipation of and worries about the Fed's first interest rate hike in seven years have been a major driver of investment markets for at least the last year. These worries could have further to go. But it may be overkill to take this too far.

Because when it does hike (with December looking likely), it will be the most anticipated Fed rate hike in history. When it comes, it will hardly be a shock to anyone.

And to summarise the points made above, there are several fundamental reasons not to be too concerned about the Fed: the first and subsequent rate hikes will be conditional on the US economy continuing to improve, and given constrained growth and deflationary pressures, the process is likely to be very gradual; history tells us that it's only when monetary policy becomes tight that it becomes a real problem, and that is a long way off; global monetary conditions will remain easy as other major countries are still easing; the strength of the US$ will constrain how much US rates will go up; and, finally, while US shares are expensive on some measures, shares outside the US are cheap - indicating that there are still plenty of opportunities for investors.

The writer is head of investment strategy and chief economist at AMP Capital.

This article was first published on November 21, 2015.
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