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Guy Stephens: Why investors don’t have to worry about a Fed rate rise until Christmas (at least)

15 September 2015

Rowan Dartington Signature’s Guy Stephens explains the reasons why the US Federal Reserve is unlikely to make its first interest rate hike this week.

By Guy Stephens,

Rowan Dartington Signature

Thursday evening this week sees the outcome from the two day Federal Open Market Committee (FOMC) meeting in Washington which decides the future direction of interest rates.

The focus on this has become very intense as earlier in the summer, subject to continuing robust US economic data before the developments in the Chinese markets, it was looking very likely that the Fed would indeed implement the first increase in rates since 2006.

US economic data has been very robust with GDP upgraded from 2.3 per cent for the second quarter to 3.7 per cent at the end of August, and unemployment is now down at 5.1 per cent. The level of 5 per cent is regularly referred to as the level at which full employment can be claimed due to all the aberrations and long-term unemployed from sickness & disability that always exist in a developed economy with a welfare state.

The balance of economic commentators, and us, are not expecting the Fed to move as they have jumped on every excuse not to ever since QE tapering ended in October 2014. They can now quote concerns regarding the global slowdown and the impact of China, equity and bond market volatility and the on-going strength of the US dollar for reasons to not pull the trigger.

Performance of indices over 5yrs

 

Source: FE Analytics

When one also considers that the World Bank chief economist has now followed the IMF and warned that the Fed should delay, it would be a brave Fed governor that flew in the face of the clamour of official statements from the world’s major institutions.

That said, the Fed needs to start the process soon as wages are starting to rise and core inflation is bottoming out, and whenever the oil price begins to tick up, pressure will build as CPI rises.

The Fed needs to be ahead of the curve and also needs to be able to cut rates when the current economic cycle slows and needs some stimulus. The only tool they have at the moment is to restart QE and that needs to be a one-off tool of the history books, not a recurring theme.


 

 The main reason the IMF and World Bank are upping the ante against a Fed rate rise is through concern for emerging markets. The combination of a strong dollar and weak commodity prices is challenging many of these economies as their US dollar denominated debt becomes more expensive to service and renew, whilst their national income from commodity exports has fallen sharply.

More recently, the scare over the Chinese economic situation has battered the peripheral currencies of those economies that depend on exports into China but also those where some contagion risk is seen.

 To quote some numbers for the two weeks to the end of August, the Chinese yuan has fallen by 2.2 per cent as the regime has widened its trading bands. As a consequence, the Japanese yen has fallen by 3.6 per cent, the Australia dollar has lost 5 per cent and the Indian rupee has lost 3.6 per cent.

Performance of currencies vs US dollar over 1yr

 

Source: FE Analytics

Whichever way you look at it, investors have been divesting their emerging market exposure as it continues to be the asset class of 2015 to be avoided.

We hear that the price of iron ore and copper is now approaching the marginal cost of production. This means that the supply side will start contracting but this can take some time to occur, as we have seen with the oil market, as it takes significant time for facilities to wind down and inventories to reduce.


 

Current forecasts with regard to the oil industry suggest that supply will have reduced to the level of demand by the middle of 2016. However, this assumes that OPEC continues to produce at current levels and doesn’t go for more market share, and supposes that Iran doesn’t increase supply significantly.

The commodity market is far less influenced by political factors or a swing producer such as OPEC and should therefore behave more rationally. However, for some states, it is a significant part of their income and economies such as Brazil, Venezuela, Nigeria, Canada, Australia and of course, Russia, are really feeling the pain.

That said, it is quite possible that prices can fall below the marginal cost of production before supply reductions catch up, and so trying to call the bottom of the cycle in the face of global growth headwinds is probably foolish at best if not irresponsible as an investment adviser.

Imagine the scenario that the Fed raises rates, the US dollar strengthens further and an emerging market state defaults on its debt? Not something that Janet Yellen would want to be held accountable for.

And that means we push forward to Christmas, if not into 2016, for the first rise. This means that market volatility remains and, as investors, we continue to try to work out exactly how bad things are going to get in China and whether this is priced into the markets.

Challenging times where the professional investor really needs to be very careful indeed.

Guy Stephens is a director at Rowan Dartington Signature. The views expressed are his own and should not be taken as investment advice.

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