So there we have it. 
After nine years of rate slashing, emergency stimulus measures, quantitative easing and leading investors on the merry-go-round, the Federal Reserve has finally decided to put up interest rates last night.
In fact, with delightful symmetry, it was seven years to the day since the Fed slashed rates to basically nothing, in an attempt to ward off financial Armageddon.
A lot has happened since then and I think we can all breathe a mighty sigh of relief that the nonsense is over, although doubtless investors and commentators alike will now immediately start to focus on when the next hike will be.
Performance of indices over 7yrs
Source: FE Analytics
Well, it can’t be as boring as the last eighteen months or so and we suspect that much of the debate will focus on inflation, where there might be a few surprises ahead.
In fairness to Janet Yellen, she has had a thankless task over her tenure as Federal Reserve Chairwoman, which is easily evident in the pushes and pulls she faced over this latest decision. Yellen has had to weigh up the fact that the US economy is growing solidly (but unspectacularly) at the same time as global growth slowed (temporarily) during the summer.
I am sure the Fed, like we have been, have been soothed to a certain extent by recent data out of China, Europe and Japan which shows that growth is OK and most data points have at least stabilised, with some notable improvements, since the summer lull.
Our forecast is for global growth to be at or around trend levels of 3.5 per cent next year, which justifies the Fed putting up rates.
Based upon our current forecasts for both global and US growth, we would agree with the Fed that a further four hikes next year, in effect one a quarter/at alternate meetings, is most likely.
Yellen was probably less concerned about the outlook for growth than she was about recent distortions and gyrations in corporate credit markets. Putting up rates at a time when there had been an indiscriminate sell-off plaguing credit markets, most evident in the US high yield market, took courage.
One wonders how close a call the decision to raise rates was in the light of the ill-behaviour that there has been in some markets.
My simple “the morning after the night before” view is that this is a positive sign; to have delayed might have led investors to believe there was something nasty they hadn’t thought about lurking in the shadows, most likely in the credit markets.
Another major factor weighing on the mind of poor Janet was the US dollar, which has been unhelpfully strong over the last eighteen months, acting as a suppressant upon inflation, a destroyer of commodity prices and an axe upon growth in US manufacturing.
Relative performance of currencies over 18 months
Source: FE Analytics
Indeed, latest economic data and anecdotal evidence shows a US manufacturing industry barely growing at all. Yellen and her garrulous cohorts at the Fed will be doing all they can to keep the dollar’s strength contained in the coming months.
The Fed’s life is made much more difficult because they are effectively setting the risk free rate for the world and influencing the world’s omnipotent currency.
Yellen and her mates recognise the influence they therefore have upon commodities, whose latest bout of weakness she had seen as a surprise.
Linked to my above comments on the dollar, Yellen will recognise that some soothing of commodity markets would be welcome, not least as it will aid the Fed in the previously futile attempts to get inflation back to 2 per cent.
Whilst the inflationary push has so far been a failure, despite some of the most extraordinary monetary policy experiments in history and a tidal wave of money printing, the Fed should be congratulated to a certain extent for creating an economic recovery in the US.
Of course, the sceptics (and I am one of them) could retort that economies tend to have life cycles of their own and the Fed’s meddling could have been counter-productive at times, but the Fed is raising rates with housing starts at a seven year high, auto sales at a ten year high and employment approaching the mark denoted by the Fed themselves as “full employment”.
This last point is vital for us all and should be considered further. The Fed’s hyperactive tendencies have tried mostly in vain to boost inflation, but we might well now be at the pinch-point for price rises.
There are much-welcome (and certainly long overdue) signs of a virtuous wage price growth cycle appearing in parts of the US economy. Without wanting to come across all “galaxy, far, far away” on you all, but the inflationary force has awakened in the US and this will have ramifications for financial markets.
It is fair to say that our primary focus upon inflation has been unhelpful over the last eighteen months.
The world has suffered a rare disinflationary shock, which we believe we are seeing the closing stages of at this very moment. Over the recent past inflation has been suppressed due to significant slack in many global economies, a lack of wage pressure due to persistent levels of unemployment from the financial crisis and a collapse in commodity prices.
We believe that we are at the inflection point for each of these factors.
Firstly, we are approaching what we would consider to be “full employment” in countries such as the UK, Japan and Germany, as well as the aforementioned US, meaning that both the slack in the labour force has been evaporated and there will be rising pressure upon wages.
Our belief that commodities are approaching their low points is perhaps more controversial, but we can envisage prices rising next year, as demand stabilises and grows, the efforts to curtail supply by the resources industry take effect and evidence that China is enjoying a moderate economic improvement.
Performance of indices over 3yrs
Source: FE Analytics
As described already, we expect the Fed to use this as one of their key guides to future rate hikes and they will try to ensure that price falls are contained.
As we discussed at length at our quarterly investment committee meeting last week, our forecast is for US inflation to start to rise more quickly than investors anticipate and markets are pricing in.
In simple numerical terms, we expect US inflation to rise to 2 per cent by the end of 2016, driven by a stabilisation in commodities (who knows there might be an upside surprise), acceleration in wage growth, persistently evident core inflation (as seen in medical costs and housing) and low base effects.
Even the latest el Nino wildcard could add to our forecasts, which are currently 50bps higher than market forecasts (priced in to TIPs) and 10 year consumer inflationary expectations.
This gives us great confidence that the inflation-proofing philosophy we have held at the core of our process since we started our business in 2002 will once again prove to be a positive driver behind investment performance.
The fact that the Fed have raised rates, despite the challenging and duplicitous economic and market environment, suggests it agrees with us.
Tom Becket is chief investment officer at Psigma Investment Management. All the views expressed above are his own and shouldn’t be taken as investment advice.
