In early October, market expectations of a 2015 US interest rate rise were low. This reflected the FOMC’s cautious stance at its September meeting, which it had justified on the basis of events in China and the negative effect they would have on global growth, inflation and market stability. However, this soon changed following rhetoric from a number of prominent FOMC members that signposted an imminent rate hike, as well as a series of positive economic data releases.
Figure 1: US interest rates have risen for the first time in over nine years, signalling the beginning of the end of the unprecedented period of extremely accommodative monetary policy that has been in place since 2008.
(Source: Thomson Reuters Datastream)
Ultimately, the Fed did implement a much-publicised 0.25% interest rate rise in December, thereby removing any lingering uncertainty as to when the process of monetary policy normalisation would begin. In communication accompanying the decision, the FOMC made a point to recognise its confidence in the US economy and the fact that it considered overseas risks to have diminished.
In our view, forward guidance regarding the longer-term pace of monetary policy tightening has always been more important than the timing of the first hike. In this regard, the FOMC’s economic expectations remain more optimistic than those of the market, as they have been for some time (it expects to implement four 0.25% rises in 2016, while the market has priced in only two). However, it has also caveated its position by stating that policy changes will be contingent on its economic forecasts being met and, implicitly, market stability being maintained.
Eventually, the views of the FOMC and market should converge. The former has been unambiguous in stating that there remains further room for improvement in the labour market and that recent softness in inflation has been due to transitory factors, although it has also noted that longer-term inflation expectations have edged down. Overall, it considers the risks to its economic outlook as balanced. With these comments in mind, employment (specifically in regard to wage growth) and inflation data will be watched closely to see whether the current balance of interest rate risk moves to the upside or downside.
An example of the varying state of the US economy can be seen in the relative strength of its service and manufacturing sectors (Figure 2). The former is growing strongly, backed by buoyant consumer confidence, while the latter has come under pressure as a result of two primary headwinds. The first of these is the strength of the US dollar, which is damaging US firms’ international competitiveness, and second is a fall in oil production activity that has accompanied the large declines in oil prices.
Figure 2: The performance of the US manufacturing sector, as measured by the Institute for Supply Management’s Purchasing Managers Index, has declined in line with an appreciation of the US dollar and a decline in oil prices. Conversely, the US service sector is performing well.
(Source: Thomson Reuters Datastream)
The market’s initial reaction to the US rate rise was generally positive. We believe this reflects a bolstering of the Fed’s credibility and an improvement in investor sentiment driven by greater clarity in the monetary policy outlook. Given these favourable macroeconomic developments, and together with the continued growth of US corporate earnings (excluding the energy sector), US equities ultimately ended the quarter higher and in positive territory for 2015 as a whole.
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