By David Absolon, Investment Director at Heartwood Investment Management
When most central banks across developed and emerging economies are in easing mode, the assumption that the Federal Reserve will raise rates this year is starting to look questionable.
There was little to digest from the Federal Open Market Committee (FOMC) monetary policy statement following its first meeting in 2015 last week. A few tweaks of the language here and there – “modest” replaced by “solid”, when referring to the current economic expansion, and lower inflation “largely” reflecting declines in energy prices rather than “partly”, but the Fed remains broadly sanguine about the US economy, notwithstanding worries across the rest of the world.
On the basis of its current outlook, the Fed is a central bank standing in splendid isolation. Global macro policy over recent months has been led by the monetary stimulus actions of the European Central Bank and the Bank of Japan. Central banks in Canada, Singapore and New Zealand have all surprised the markets by either cutting interest rates, attempting to ease policy through the currency or, in the case of New Zealand, removing its tightening bias. The Reserve Bank of Australia is expected to join the choral of easing policies this week with a rate cut.
What is emerging and was most clearly demonstrated by the Swiss National Bank’s reaction to a weakening euro is central bank forays into competitive currency devaluations, which increase the risk of unintended consequences. Denmark is the latest candidate to respond to the repercussions of the ECB’s quantitative easing programme. The Danish central bank’s attempts to defend its currency peg against the euro has led to the temporary suspension of sovereign bond issuance (with the aim of lowering longer-dated rates), following three reductions to the deposit rate in January. Alongside the eurozone and Japan, Denmark enters the world of negative shorter-dated yield curves, becoming the first country to offer a negative interest rate mortgage!
For Fed policymakers, the external environment and the actions of other central banks are becoming increasingly hard to ignore. Reductions in energy capital expenditure, overseas threats to US growth and US dollar strength are already starting to weigh on US manufacturing data, as well as company earnings results. Caterpillar, Microsoft and Proctor and Gamble are some of the high profile casualties to report disappointing results last week, blaming a strong US dollar.
However, US data trends are also bifurcated. Strong household and employment data (the fourth quarter saw the strongest consumer spending since 2006) argue for higher rates. Even the housing sector, where the recovery has been slow, is showing improvements, while the oil price windfall will continue to support consumer-related sectors.
Moreover, if the Fed doesn’t act this year, its credibility would be on the line given how carefully it has prepared the markets for rate hikes through forward guidance. That said, although a Fed rate hike continues to be priced for later this year, markets are probably not prepared for the reality of an ending to the zero interest rate policy. The focus has shifted away from the Fed in recent weeks. However, as we move towards midyear when there is greater anticipation about higher US rates, the Fed is likely to regain the spotlight whether it takes action or not. We expect 2015 to be punctured by bouts of market volatility across asset classes, as central bank policies become less predictable.