Investors moved into the summer expecting the US central bank to finally raise interest rates in the autumn, for the first time in nearly a decade. But come September, the Federal Reserve (Fed) once again decided to hold back, despite still healthy growth in the US economy, with chair Janet Yellen making clear that concerns over emerging markets were a key reason for the delay. This increased the level of uncertainty around the timing of rate rises but, for long-term investors, the pace of tightening matters more than the exact date. With a recovery continuing in the developed world and wage growth finally picking up, investors should expect policy rates to rise in the US and UK in the near future. But we would expect both long and short-term rates to remain at historically low levels for a long time to come.
Domestic conditions are not quite there
Why has the Fed held off so far, and what needs to change for it to finally pull the trigger? Like most central banks, the Fed aims to keep inflation low and stable. It set a target in 2012 of a 2 per cent increase per year in the cost of personal consumption expenditure. At present, the level of inflation is well below the 2 per cent target. Although much of that weakness is due to the price falls in energy, so-called “core” inflation (which excludes volatile food and energy prices) is also the lowest it has been in years. Stronger evidence that underlying domestic price pressures are building is needed for the Fed to act.
Unlike most other central banks, the Fed also has a target of full employment, which represents the other half of its “dual mandate.” Unemployment has fallen significantly and other measures of the labour market have also improved as this expansion has continued, but obtaining full employment – the definition of which is often subjective and differs between analysts – has so far eluded the Fed. Wages are relevant to both sides of the mandate. They are a key driver of inflation and also the main indicator of the proximity of full employment. All eyes will continue to be trained on those indictors in the months ahead.
Both markets and policy makers expect rates to rise, but when, how fast and where they end up are all subject for debate.
Falling unemployment is a sign of how far the economy has come, but further declines are necessary to see wages accelerate.
International concerns unlikely to fade on schedule
2015 has seen significant turbulence in the economies and markets of the emerging world, most notably China. That the Fed is concerned about market conditions is no surprise: the central bank manipulates markets as a course of its policy. But in our view, the focus on the emerging world does not reflect a general concern for global stability, but rather concern about the direct and indirect implications for US inflation and growth of a severe slowdown in emerging markets. The question marks over China will not lift any time soon. But stabilisation in emerging market growth and commodity prices would provide an easier environment for the Fed to raise interest rates than the environment that was presented at the last meeting.
Investors need to prepare for the eventual lift off for US policy rates, whether it occurs this quarter or next year:
- Core bonds may well be challenged in a rising policy rate environment and diversification will be essential within fixed income portfolios.
- That diversification can come by including credit alongside core bonds. The recent sell off has created opportunities, but selectivity is key given the pockets of stress that exist in the asset class.
- Ultimately, rising short-term interest rates is a sign of economic strength and should provide a positive environment for equities, which have historically done well over the course of a tightening cycle by the Fed.