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So much depends upon US interest rates

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Stock markets continue to climb a wall of worry. Some have described this bull run as ‘the most unpopular rally ever’ (since it has been driven by tech stocks which many have avoided). Last week, markets were concerned that Trump’s tax cuts would either be watered down or would arrive in 2019 – a year later than previously expected. This, however, is mere detail. What would really hurt stock and other asset markets would be an unexpected rise in US interest rates.
On this subject, there remains a difference of opinion between members of the FOMC and market participants. The latest ‘dot plot’ chart of the interest rate expectations of the rate-setting FOMC members, produced in September, shows median expectations for the Fed funds level to be between 2.00 and 2.25% by the end of next year (compared to 2.0% for the market), rising to just under 2.75% by the end of 2019 (compared to 2.10% for the market) and stabilising at 2.75% beyond that – whereas the market does not see 2.75% until August 2029. Although the FOMC’s expected levels are about 25 basis points lower for 2019 and beyond compared to the dot plot in June, the FOMC members are still expecting rates to rise more quickly than the market.
Perhaps the FOMC members are mindful of the mid-sixties when the Fed was kept under political pressure to keep rates unnaturally low – and did so. For several years, even with excessively accommodative monetary policy, inflation failed to rear its head. Then, towards the end of the decade, the inflation rate breached 5% and really took off with the collapse, in 1971, of the Bretton Woods agreement which had kept the price of gold fixed at USD 35 per ounce since 1944. By 1980, gold was USD 850 per ounce.
In light of the events of the sixties and seventies, perhaps the markets are correct in assuming only minimal rate rises. With core CPE inflation, the Fed’s preferred measure, still languishing at just 1.3% despite almost full employment, there is arguably no urgency to normalise rates, particularly since doing so would raise the government’s debt-servicing costs. However, we shall only know once core CPE approaches or breaches its 2% target. At that point, the Fed’s actions will be crucial. Either the FOMC will react to the inflationary threat through tighter policy, or the committee will come up with myriad excuses as to why ‘this time it’s different’.
Back in the seventies, the ruinous inflation was blamed squarely at the feet of Opec, following the Arab oil embargo of 1973/74. While the quadrupling of the oil price certainly did not help, the seeds of inflation had nonetheless been set several years before, with the abovementioned political pressure on the Fed in the sixties and the realisation at the turn of the decade that the US’s Vietnam War debt would only ever be repayable if its real value was slashed by inflation – hence the end of Bretton Woods under Nixon. It is entirely possible that the current FOMC members are just ‘talking the talk’, with no intention of raising rates meaningfully should inflation pick up. If that were the case, their response would be consistent with the seventies, when central banks (independent or not) chose to preserve jobs rather than the real value of money.   
Whatever the Fed’s intentions vis à vis monetary policy, the path of UK interest rates will be influenced by what happens in the States. With interest costs on UK government debt around £56 billion per annum and the average maturity of a UK gilt being 15 years, it follows that, very roughly, a doubling of 15 year yields would increase debt servicing costs by another £56 billion – or by almost 7% of the total government expenditure of about £815 billion – and 15 year yields are a mere 1.63%. While some households would certainly be stretched by such an upward movement in rates, the government would come under immense pressure – with the only politically acceptable solution being an increase in borrowing to pay the extra interest. It is for this reason that the independence of central bankers will increasingly come under threat. Although it is unlikely that the Bank of England’s position of independence will be officially changed any time soon, political pressure on the MPC to run ‘behind the curve’ when it comes to Bank Rate will be hard to resist. This political pressure to keep rates low will only increase if the current generational imbalances in the housing market and pension provision threaten to worsen.
This would all make a good case for selling sterling were the situation not as bad in the US, Japan and the eurozone. In truth, no-one wants inflation to be controlled by higher interest rates, with the exception of savers. However, they tend to be older, law-abiding and less inclined to violence – which is why their concerns are so routinely ignored.
There was better news on the UK inflation front last week, as CPI for October came in unchanged at 3.0%, while RPI only rose a notch (rather than the expected two) to 4.0%. In the three months to September, average earnings rose a slightly-better-than-expected 2.2% compared with the same period last year. Nonetheless, real wage growth remains at -0.8% or -1.8%, depending whether one uses CPI or RPI to convert nominal to real.
This week is a rather light one for data. Thursday should provide confirmation that the UK economy grew at a rate of 1.5% year on year in Q3. There are also mortgage approvals data on Friday, though only the GDP figures are likely to move the markets – and only if they are meaningfully revised. The minutes of the FOMC meeting are released on Wednesday and these should provide further insight into the FOMC’s thought processes. Arguably the most important data releases are on Thursday in the form of PMI data for the eurozone, with manufacturing, services and composite expected to come in at 58.2, 55.2 and 56.0 respectively, continuing the eurozone’s run of better economic health.

Finally, Wednesday will see Philip Hammond deliver a fairly bland Budget in which he, like his predecessors, will fail to deliver on the required massive simplification of the tax rules, with which even tax professional struggle. Instead we shall see a stamp duty sop for the young, a promise to build many more houses and, if we are unlucky, another raid on pensions. What we shall not see is anything ‘big’. The government’s DUP-backed majority is, sadly, simply too small for boldness.



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