Overnight, the Fed’s decision not to move rates at its meeting was in line with our view that the committee will hold rates until December this year. We review the key points for investors
As we expected, the US Federal Reserve did not increase rates after this month’s Federal Open Markets Committee (FOMC) meeting. This was one of the most watched Fed meetings since the GFC as it is the first time that US economic data could justify an increase in rates since 2006.
49% of market traders surveyed just prior to the meeting expected an increase. So when the Fed came out with no increase, long term US bond yields fell. The 10 year bond yield is now back to around 2.20% p.a.
There was lots of noise from the usual market players. But the more relevant points for investors are:
- Janet Yellen, the FOMC Chairperson, discussed the strength of the USD throughout her announcement of the committee’s decision. This is consistent with our view that long term rates are too high as the Fed is clearly cognisant of the risk that the US being the only economy increasing interest rates leaves the USD vulnerable to large increases in value. For the US economy, this weakens exporters and puts downward pressure on inflation. Weaker exporters is completely counter to the Fed’s purpose, namely maximising employment without exceeding 2% inflation growth. And downward pressure on inflation simply means less pressure on the Fed to increase rates, i.e. it can leave rates lower for longer, stimulating more jobs growth.
- Some market participants have now pushed their bets for the first rate rise into 2016. Given the Fed “promised” that it would increase in 2015, we believe that unless financial markets deteriorate, it will increase in December.
- Yellen also referred to the issues with the unemployment rate saying that it underestimated the slack in the economy because of the “underemployed”. This is why we prefer to watch the “U-6” rate of unemployment which includes underemployed (e.g. those working less hours than they want to) rather than the headline “U-3” rate which excludes anyone that has any job of any type. The U-3 rate is below long-term averages, which would justify higher rates, but the U-6 rate is well above long-term averages, meaning rates should stay lower for longer.
- The Fed has increased its 2015 GDP growth forecast from 1.8% at its June meeting to 2.15%, but lowered its 2016 and 2017 GDP forecasts. Again this points to interest rates only being increased 1 to 1.5% p.a. over this cycle, meaning 5, 10 and 30 year bond yields are too high at the moment.
The next major piece of data out of the US is the Q3 GDP growth estimate. This will be late October. The Fed seems to be forecasting a 2 to 2.2% p.a. growth figure for that quarter. If it undershoots this figure dramatically, it could push the Fed into 2016, but despite our GDP forecast of 1.8% p.a. or lower we don’t think this will be disappointing enough to leave rates. It will, however, be disappointing enough to push bond yields lower over the next few months.
See our update from before the rate decision where Craig explains the scenario that has played out to date. View here.