The market impact of a slower US rate tightening

The Federal Reserve (Fed) maintains a bias towards tightening monetary policy this year, but remains sensitive to how the financial markets and global economy are performing.

Janet Yellen
Source: Bloomberg

At the heart of the debate is the pace of future interest rate increases, because falling behind the rate tightening cycle amid improving economic environment and rising inflation may create other problems later on, such as excessive debt burdens.

While fostering full employment and price stability are the dual mandates of the Fed, it is increasingly difficult to gauge how global developments may affect these two objectives. The collapse in world energy prices due to a supply-demand imbalance has dampen inflationary pressures across the world, including in the US.

The Fed expects inflation to remain low in the near term, but to pick up to its 2% target in the medium term, as energy prices stabilise. Nonetheless, the complexity in stoking price increases is making Fed policy makers cautious about prematurely tightening interest rates.

At the recent Federal Open Market Committee (FOMC) meeting in March, changes to the quarterly economic projections were perceived by the market as more dovish. In the so-called dot plot graph, the median FOMC member predicted that rates will remain below 1% at the end of 2016, which suggests two more 25 basis-point (bps) hikes this year.

Comparing this to the summary of economic projections in December, which suggested four 25 bps in 2016, the new plot is somewhat more dovish.

It was also a surprise to the market because recent economic data pointed towards resilience in the labour market, as well as a sharp pickup in inflation. Fed chair Janet Yellen asserted that temporary factors were behind the recent jump in inflation.

In my view, the Fed is less hawkish, not more dovish. They are more cautious because they continue to see global economic and financial developments posing risks to US economic activity.

Although Yellen stressed that the April FOMC is a ‘live’ meeting, the less hawkish stance adopted at the March meeting means it is increasingly unlikely that any rate increase will come before June. According to the Federal Funds Futures, odds for a June hike was taken down from 50% on 11 March to 39% on 18 March.

Generally, the market is pushing out their pricing of additional rate hikes in the second half of 2016. It makes sense because more clarity on global economic growth and inflation is needed before investors are confident that conditions are ripe to bump up US interest rates.

Higher rates, in general, favour the banking stocks. A slower pace of rate hike, or worse, no increases this year would be a negative for US banks, and to a certain extent, Singapore banks. Ultra-low interest rates would curb the profitability of banks. According to Barron’s[1], US bank profits rose just 1.3% in 2015, and that is expected to slow to 1% this year. The uncertainty of the US economy also puts pressure on bank stocks.

Gold prices rallied following the March FOMC, but short covering orders may be behind the rebound, as short sellers took gold down prior to the Fed meeting. Despite the speculative nature of the move, gold prices may still benefit in the coming months as there was a fundamental shift in the financial markets.

The USD is now much weaker and there seems to be more uncertainty in the equity markets. Unless global conditions improve in the near future, gold could be seen as a hedge against global and policy uncertainties.


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