Waiting for the Fed ?

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  • Most market participants anticipate no change in the policy rate following the upcoming FOMC meeting in the week commencing 07/11/16
  • Growth has been helped by an increase in exports and consumer spending
  • New home sales have recently shown strength due to still-low mortgage rates and an improving labor market
  • The US dollar has firmed and reported corporate earnings have surprised to the upside, supporting equity valuations

US interest rates moved higher on the week commencing 24/10/16 and the yield curve steepened

US 10-year yields closed at 1.85%, the highest level since late May. The 10-year was up 11 basis points on the week commencing 24/10/16 with two-year yields up three basis points. Stronger economic data and a Federal Reserve (Fed) rate hike coming closer into view were the primary drivers for the move higher in yields. Most market participants anticipate no change in the policy rate following next week’s Federal Open Market Committee (FOMC) meeting (week commencing 07/11/16) but most do expect a hike at the December meeting. Across either meeting fully 85% of the market expects a rate hike before year end.

Recent US economic data support a rate hike. Today’s third quarter GDP came in stronger than expected at 2.9%. That was the fastest growth rate in two years and up from the 1.4% reported in the second quarter. Growth was helped by increases in exports and in inventories. The report showed consumer spending was also solid.

New home sales reported earlier in the week (24/10/16) also showed some strength

Sales were up 3.1% versus August to a 593,000 annualized rate. Improving labor markets – with both job and wage growth coupled with still very low mortgage rates – are helping home sales. In fact, recent new home sales are the highest they have been since 2007. The Case-Shiller home price index for August was also released this week and showed an increase of 5.1% versus a year ago with prices supported by stronger wages, low rates and limited housing supply.

So, much like last year, the stage is set for a Fed rate hike in December

The question is whether markets will face the same kind of melt down we saw last time around. Risk assets did very poorly in the weeks following the last FOMC rate increase. US equities fell by over 10% and US high yield was down by over 6%. Indeed, oil prices moved sharply lower in January but who expected that a well-telegraphed 25 basis points hike in the fed funds rate would be responsible for all that volatility?

Risk assets have since recovered that underperformance – and then some. After falling by more than 10%, US equities are up by 4% year-to-date and the excess return for US high yield so far in 2016 is an astonishing 12.9%. Ten-year yields at 1.85% are a full 40 basis points lower than they were at the start of the year. Meanwhile, measures of volatility including the MOVE index and the VIX continue to trend lower.

What this means of course is that the reward for risk-taking are lower now than they have been in some time. Yield advantages for taking credit risk and duration risk are quite low. At the same time, the markets see the Fed moving toward hiking the policy rate and reducing the level of unconventional policy accommodation. We hear increased chatter about the need for additional fiscal policy measures as we approach the limitations of monetary policy measures. We see potential for volatility around the presidential election in the US, as both candidates are advocating measures which will increase government spending.

In our view, things are different now than they were last December…

…when the Fed hiked with the US economy expanding and oil prices stable. The US dollar has firmed and reported corporate earnings have surprised to the upside supporting equity valuations. We seem to have made it through the historically scary month of October without an issue. But given tight valuations, low implied volatilities, and potentially market-moving events on the calendar, we would exercise caution. After all it has been Hallow’een and things should be at least a little scary!

Exhibit 1: GDP US chained 2009 Dollars Q.o.Q SAAR

jjSource: Bloomberg as of 30/09/16

John Carey

Head of structured Securities, CFA Charterholder

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