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Deja vu in interest rate expectations

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1 st June 2016
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Interest rate expectations are in danger of becoming repetitive. Over the last few years we have seen the expectation for rate hikes collapse during the first half of the year, then rebound in the second half to the extent where rate increases are ”imminent”… only for the turn of the year to come and the cycle continue. Data and comments over the course of the last week would suggest that the coming months could follow suit.

There is a growing expectation that the Fed will sanction another rate increase by the end of July. The markets are now putting the probability of a rate increase by that time at 54%, having given it only a 17% chance at the beginning of May. This change in expectation was supported by Janet Yellen’s comments on Friday that a rate increase would be appropriate in the “coming months” as there were signs that the economy was “continuing to improve”. This applied in particular to the strength of the labour, retail and housing markets which all continue to produce robust data. Furthermore, a rate increase will be easier to justify now that inflation shows signs of returning to the Fed’s 2% target. Yet Yellen’s comments come even though growth in Q1 was a sluggish 0.8%, albeit slightly better than expected.

One major concern for policy makers remains the lack of productivity growth, with data released on Thursday pointing to US productivity actually shrinking for the first time in 3 decades. There are concerns that traditional measures of productivity are failing to fully account for increasingly rapid technological advancements, a concern not just restricted to the US. However, if productivity growth fails to materialise soon and hiring remains strong then we could witness a spike in inflation that could result in interest rates rising faster than expected, a potential problem shared by both the Fed and the Bank of England.

What was clear from Yellen’s comments is that the Fed is keen to control an orderly and gradual normalisation of monetary policy rather than have its hand forced by a spike in inflation. Manufacturing surveys data today along with the US employment report on Friday, and Yellen’s speech on June 6th will provide further clarity on the specific timing of the next rate hike. However, we would expect the Fed to be keen to increase rates well in advance of the presidential election in order to remove it as a political factor. International markets certainly appear more comfortable with a rate increase by the Fed in the coming months. This is a reflection of the relative strength of the US economy as well as a sign that the concern over external factors such as the state of the Chinese economy and collapsing oil prices are alleviating, the latter breaching $50 a barrel for the first time this year. Whilst this increase in price is largely driven by supply factors rather than an increase in global demand and is, therefore, still likely to result in volatile price movements, the markets appear more content that such a price strikes a balance between having a positive impact on consumer spending whilst alleviating fears of large defaults in the oil sector, as well as pressurising emerging debt markets. Importantly, it also undermines deflationary fears, giving central banks greater headroom in looking to normalise monetary policy.

On Wednesday the Chinese renminbi was set at the lowest fix for five years, reflecting a strengthening dollar as expectations increase around a further increase by the Fed. Whilst a sliding renminbi in August 2015 and January 2016 sent shockwaves through the global economy, last week’s fixing passed without so much as a tremble, suggesting that fears surrounding a slowing Chinese economy and the deflationary forces surrounding that have been largely overdone. It will be interesting to see if the May Purchasing Managers’ Index (PMI) manufacturing survey released on Wednesday manages to reverse back into positive territory.

We even had positive news, with Europe successfully completing another Greek debt deal ensuring that the struggling economy can fund itself until the end of the year, thereby avoiding another summer of protracted and destabilising negotiations. Can-kicking has become an area of EU expertise. Whilst such a deal will only push the inevitable discussions surrounding debt relief to a later date, it has been welcomed by the markets: out of sight and out of mind!

However, we expect tomorrow's European Central Bank (ECB) meeting to be relatively dovish even though there were signs last week of strong German economic growth in Q1. Data releases this week will support this optimistic wave with positive figures for inflation (Tue), unemployment (Tue) and retail sales (Fri).

Sterling also had a positive week as the latest opinion polls on the EU referendum - a topic I have been instructed to avoid - appear to have momentum behind the remain campaign. However, we expect continued volatility as we approach the June 23rd date. Such swings could be significant if liquidity in the market deteriorates over the coming weeks. Whether there is enough weight behind this growing optimism on the state of the global economy to result in a significant increase in interest rate expectations is yet to be seen, but we suggest, particularly with the UK and US economies at close to full employment, it won’t take a lot of momentum to move the US and UK yield curves substantially steeper. Whether any momentum is sustainable in the long term is a far harder question to answer!

All views expressed here are the author's own and are based on information and data available at the time of writing.

 

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