The Fed could well be about to end its policy of patience.
The US economy’s ability to create astonishing numbers of jobs is showing little sign of changing. On Friday, the US Bureau of Labor Statistics (BLS) reported that total US non-farm payroll employment rose by 295,000 in February, exceeding expectations of 240,000. The US unemployment rate edged down to 5.5 per cent, its lowest rate since May 2008.
This sparked a sell-off in equity markets and US government bonds. On Friday, the Dow Jones Industrial Average slid 1.5 per cent, while 10-year US Treasury yields rose to 2.24 per cent (see chart). The dollar, meanwhile, hit an 11-year high against the euro. All of this was widely interpreted as a sign that many investors expect the Federal Reserve to raise interest rates sooner than previously expected.
But will it? “It’s generally accepted by most in the markets that the first rate hike will come in June or September”, says Craig Erlam, market analyst at Oanda. Indeed, in January, a regular survey of money managers, investment strategists and economists carried out by CNBC suggested that the first hike will take place in September. Further, the Fed reiterated last month that it would be “patient” on interest rates, saying that they would be held near zero as long as inflation remains depressed, even if the jobs picture improves. But ahead of the Federal Open Market Committee’s 17 to 18 March meeting, and as the US economy reaches “full employment” territory, there is a chance that this patience will come to an end.
AN UNCERTAIN RECOVERY?
The bull market in US stocks celebrated its sixth anniversary yesterday, with the S&P 500 now up 200 per cent since its low on 9 March 2009. A combined policy of near-zero interest rates and three rounds of quantitative easing has certainly helped. According to Leuthold Group, this is the fourth longest of the 23 bull markets the Dow Jones Industrial Average has experienced since 1900.
With a host of records recently broken, equity markets have certainly seen the benefits of easy money. But although some are warning of asset price bubbles, this is not what is guiding Fed policy. While job creation has been extremely impressive for almost a year now, notes Erlam, “the bigger frustration [for the Fed] has been a lack of wage growth which would bring with it inflationary pressures, thereby warranting a rate hike”. Indeed, says eToro chief market analyst James Hughes, “average earnings are not playing the game like the unemployment rate, which could be one thing that holds back Fed chair Janet Yellen from acting”.
Given the Fed’s stated reluctance to rush into a rate hike, two important releases this week could point to interest rates rising sooner than many currently anticipate.
First, the US Census Bureau is set to release retail sales figures on Thursday morning. This will be an important opportunity to discover whether Friday’s strong jobs numbers have a connection with actual consumer spending. Marshall Gittler, head of global FX strategy at IronFX, says that February sales “are forecast to have rebounded after falling in January, while the core figure (which excludes auto and gasoline) is forecast to have accelerated”. A better than expected figure could be market moving.
Second, Friday sees the release of consumer sentiment data from the University of Michigan. Forecasts expect sentiment to have inched higher, and yet again this could give a crucial steer as to whether strong employment is feeding through into wage gains and spending.
This could nevertheless prove to be mere noise. Alasdair Cavalla, economist at the Centre for Economics and Business Research, maintains a central estimate of October for the first rate hike. Friday’s report “could add weight to the view that it could happen around mid-year,” he says. But inflation will not take off without an expansion in wage growth.
And wage data “is still failing to show the take-off which has been predicted for some time and which is necessary for the Federal Reserve to judge the recovery as entrenched,” he says. The critical variable is productivity growth. Last Wednesday, “the BLS reported that productivity for 2014 stood only 0.7 per cent higher than it did in 2013, while a quarter four on quarter four comparison revealed a 0.1 per cent decline.”
While there is clearly very little consensus about the precise timing, when it does happen, many expect the Fed to raise interest rates gradually. Mohamed El-Erian of Allianz, for example, recently told CNBC that a rate rise will coincide with “a very aggressive forward guidance policy.”
Nevertheless,“investors are beginning to fret that the reality of higher US rates will stymie the relatively free ride that the market has come to expect from today’s global low-rate environment”, says Dean Popplewell, director of currency analysis and research at MarketPulse.
If interest rates rise in the US, “there is a fear that the rally in stock and bond markets will grind to a halt and move into correction mode”, says Erlam. This would be a natural way for investors to protect their capital, “unless we see better earnings from companies which makes current prices more acceptable,” he adds.
And how the Fed revises its benchmark rates will also have ripple effects across the Atlantic. “The US will be seen as the trend setters, and once this does happen, the talk around a Bank of England rate hike will be relentless,” says Hughes.