Investment Clock insights

Dovish Fed means no repeat of 94


Ian Kernohan 

22 March 2017

Earlier this month, the US Federal Reserve (Fed) lifted rates for only the third time in this current policy cycle. The decision came as a reaction to better economic data, in particular strong labour market data, which suggested that the US economy had achieved greater momentum in recent months. With the decision well telegraphed in advance, global data turning more positive, and Fed Chair Yellen sticking to the script that the pace of policy tightening would be gradual, equity markets responded well, and emerging markets in particular. Markets later sold off on concerns that Mr Trump would find it hard to pass any significant tax legislation, despite the fact that both the White House and Congressional Republicans have publically committed to introducing reform.
Higher US interest rates need not always be a barrier to equity markets: much depends on how well the Federal Open Market Committee have signalled their intentions, why they are raising rates, and how quickly. In this case, the market was well prepared, the economic data have given some cause for optimism, and the Fed delivered a “dovish hike”: rates will rise further, but slowly. In my view, markets would have been even more worried had the Fed not hiked, returning to an old narrative that central banks had run out of ammunition and were policy constrained. With the scale, mix and timing of any fiscal stimulus still very unclear, the Fed is right to be cautious with the pace of tightening, despite some robust economic data in recent weeks.  
The cyclical peak in Fed Funds (in both real and nominal terms) has been falling for decades, and this time should be no exception: last time Fed Funds peaked at 5.25%, and we expect a lower peak in this policy cycle. The economy has become more sensitive to rises in the cost of debt, while trend GDP growth has fallen, thanks to slower labour force and productivity growth. Even if productivity picks up a bit, it’s hard to see potential growth much in excess of 2%, thanks to the ongoing demographic drag. 

Earlier this month, the US Federal Reserve (Fed) lifted rates for only the third time in this current policy cycle. The decision came as a reaction to better economic data, in particular strong labour market data, which suggested that the US economy had achieved greater momentum in recent months. With the decision well telegraphed in advance, global data turning more positive, and Fed Chair Yellen sticking to the script that the pace of policy tightening would be gradual, equity markets responded well, and emerging markets in particular. Markets later sold off on concerns that Mr Trump would find it hard to pass any significant tax legislation, despite the fact that both the White House and Congressional Republicans have publically committed to introducing reform.

Higher US interest rates need not always be a barrier to equity markets: much depends on how well the Federal Open Market Committee have signalled their intentions, why they are raising rates, and how quickly. In this case, the market was well prepared, the economic data have given some cause for optimism, and the Fed delivered a “dovish hike”: rates will rise further, but slowly. In my view, markets would have been even more worried had the Fed not hiked, returning to an old narrative that central banks had run out of ammunition and were policy constrained. With the scale, mix and timing of any fiscal stimulus still very unclear, the Fed is right to be cautious with the pace of tightening, despite some robust economic data in recent weeks.  

The cyclical peak in Fed Funds (in both real and nominal terms) has been falling for decades, and this time should be no exception: last time Fed Funds peaked at 5.25%, and we expect a lower peak in this policy cycle. The economy has become more sensitive to rises in the cost of debt, while trend GDP growth has fallen, thanks to slower labour force and productivity growth. Even if productivity picks up a bit, it’s hard to see potential growth much in excess of 2%, thanks to the ongoing demographic drag. 

The current size of the Fed’s balance sheet also offers an alternative source of “tightening”, which reduces the need for aggressive rate hikes. Most importantly, wage cost growth suggests that underlying inflationary pressures are still contained, so we do not expect a repeat of the 1994 style sell-off in bond markets, when the Fed surprised the market with a series of rate hikes.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.