16th September 2015
Eric Chaney, Head of Research, and Laurent Clavel, Senior International Economist, at AXA Investment Managers (AXA IM), discuss the potential for and implications of a possible Federal Reserve (Fed) interest rate hike being announced today.
The market’s and our baseline scenario is for no Fed interest rate hike this week and a lot of focus on the communication. Yet, if the Fed were to hike, the market reaction would be negative in our view, with risky assets and emerging markets (EM) suffering the most. If, as we believe, the Fed does not hike this week, there will still be a modest market reaction, gently positive for global equity, although EM underperformance would likely persist under the ongoing sword of Damocles of Fed rate ‘normalisation’.
· Our baseline scenario is for the Fed rate lift off in December, despite unemployment now at a seven-year low and in line with the Fed’s view of long-run unemployment. This view is primarily driven by the marked deterioration in the inflation outlook (too low), but also heightened uncertainty about the health of global economic activity. This view is largely shared in the market, as probabilities inferred from the Fed fund futures suggest a 30% chance of a September hike.
· Yet we acknowledge that September’s decision is likely to be a close call. In our view, the risk associated with an early hike is on the downside (think taper tantrum for a blueprint). US bond yields would probably overshoot in the short-run, and we do not discount the possibility of 10 year yields touching 3%. Any yield overshoot is likely to be met with Fed communication that a more gradual pace of long-term yield increase is more appropriate. By the end of 2015, we believe 10 year yields would only have risen by 30-40 basis points (bps), only marginally higher than what we expect with a December hike.
· Even though a September hike could be interpreted as the Fed being surprisingly confident in the US economy, we think global equity, and more generally risky assets (e.g. high yield), would suffer from this negative surprise in the short-run. We think that this could provide a good opportunity to buy developed market (DM) equity, as a hike would not jeopardise the structural tailwinds supporting earnings growth (outside of the US where dollar appreciation would likely crimp dollar earnings more). The (short-run) pick-up in US yields would be reflected in other DM bond markets, almost one-to-one for gilts, less so (β≈0.5) for eurozone bonds (especially for peripheral countries), which would therefore outperform on a relative basis, as markets would believe in the European Central Bank’s (ECB) friendly policy.
· Emerging markets would be the worst impacted region by a September Fed hike. As a side effect of the US accommodative monetary policy, EMs saw large capital inflows starting early 2009 for equity and mid-2009 for debt portfolio flows, partly reversing during the taper tantrum (mainly as far as debt is concerned) then again recently (this time mainly with equity portfolio outflows) as a financial spill over effect of market fears over China. On a cumulative basis, “hot money” in EMs remains very large and, based on an event study of the taper tantrum, we estimate that net capital outflows, especially bond (net) flows to EMs, would quickly and sharply deteriorate. Even though most EM currencies have already depreciated significantly and are now undervalued on a real-exchange-rate basis, these capital flows would put further pressure on EM foreign exchange (FX) rates. Most central banks are unlikely to intervene (by increasing rates), as the currency depreciation would be seen as a necessary (if not welcome) pressure to reduce imbalances. The urge not to do anything would be especially clear in countries running current account deficits and/or where the debt overhang is too important. We believe that the introduction of capital controls is a credible risk, particularly for Malaysia (in our view, the weak link among EMs with a current account deficit and short-term external debt that we estimate to exceed FX reserves), Indonesia and Brazil (next-in-lines in our view).
· In our baseline scenario, with the Fed not hiking this week, communication will be of the essence. An on hold decision will have an immediate impact (reducing September’s hike probability to 0% from 30%). On top of that, the market-implied probability of a December hike (currently close to 60%) would likely decrease, even if the Fed dots are likely to provide implicit guidance of such an outcome. We expect US 10 year yields going down to 2% in the short-run. Such an outcome would also be gently positive for global equity, although we expect a neutral impact for China and for broader EM, the ongoing sword of Damocles of the Fed’s normalisation should see EM equities continuing to underperform.
· What about other scenarios? First, we discard the eventuality of a “half hike” (10-15 bps) both as a historical unprecedented event and as a movement which would spark greater uncertainty in US monetary policy. Second, we consider the possibility of a rate hike in October as unlikely. October does not deliver much by way of additional information for the Fed to act upon (Q3 GDP and wage data are due only after the October meeting), although we do not see the absence of a scheduled press conference as an unsurpassable hurdle as Fed Chair Yellen has explained on several occasions.