Aaron Lewis, Research Analyst, Macquarie
Thursday 10 December 2015
Monthly economic commentary: November 2015
Aaron Lewis, Research Analyst, Macquarie
Economic and market highlights
In a further attempt to ensure that the Federal Reserve and the market are on the same page in relation to the approaching interest rate rise, the Federal Open Market Committee (FOMC) minutes for October were released containing clear and deliberate attempts to align market expectations and FOMC thinking ahead of the 16 December meeting.
US real GDP was revised from 1.5 per cent to 2.1 per cent due to a smaller investment in private inventory (which is a drag on growth) than previously estimated. Nominal disposable income rose 0.4 per cent for the month on advances in wages and salaries. Real disposable income, which is adjusted for inflation, also posted a solid 0.4 per cent gain, and accelerated to 3.9 per cent year-on-year.
Eurozone data has been less compelling, with weak industrial production. GDP growth for the third quarter was a modest 0.3 per cent and below consensus estimates, with the fourth quarter also expected to be weak despite renewed declines in the euro.
Domestically, the job market has been a bright spot, with an average 17,500 jobs a month generated in the third quarter. The unemployment rate has fallen from 6.3 per cent in July to 5.9 per cent in October, which is its lowest level for 18 months.
Bond yields in developed markets have been mixed, with 10-year yields in Europe falling in response to a weaker growth outlook for the region relative to the US and UK. Mario Draghi, President of the European Central Bank, fanned the flames with a dovish address to the European Parliament by announcing core inflation measures were weakening and further stimulus would likely be required if downside risks to global growth and trade materialise. Core Europe lost between five and seven basis points while yields in periphery nations fell somewhat further, with Italian and Spanish rates down 16 and 12 basis points respectively.
US yields have responded to healthy employment data and deliberate references by the Federal Reserve that they expect conditions for a rate rise will be met by December's Federal Open Market Committee meeting. The rebasing of expectations indicated by the sharp lift in short term yields since October has seen 2-year yields lift 20 basis points while 10-year yields have only moved slightly higher.
In Australia, positive employment data diminished prospects of a December cash rate cut considerably, leading to a 23 basis point rally in two-year yields and a 21 basis point rally in 10-year yields. As widely anticipated, the RBA left rates on hold in December.
The MSCI World Index of developed market equities was broadly flat for November, despite a mid-month swoon of 3 per cent. The S&P500 finished up in November, but only just, gaining 0.1 per cent, while UK's FTSE100 lost 0.1 per cent. Europe and Japan, the QE regions, performed well with the Japanese Nikkei 225 gaining 4.3 per cent and Germany's DAX rallied 4.9 per cent. Equity markets in commodity economies struggled with continued weakness across the commodities complex- Australia and Canada both losing 0.9 and 0.4 per cent respectively.
The Australian dollar has been quite resilient, gaining 1.3 per cent over the course of the month. This is due largely to a perceived improvement in Australia's economic fortunes. With no rate cut delivered in November or December given the strong employment data, the currency has responded with surprising strength. This is in spite of the outlook for commodities, in particular iron ore, which continues to set new multi-year lows.
The US dollar trade-weighted index gained 3.0 per cent. Against the US dollar, the euro fell 3.9 percent, pound sterling lost 2.2 per cent, while the yen has shed 1.7 per cent.
The First US Rate Hike Since June 2006
Global growth in 2015 is forecast to be around 3.2 per cent, with a slight improvement to 3.5 per cent in 2016, while economic growth in the United States this year is expected to be around 2.5 per cent.
Source: MWM Research, Oxford Economics, December 2015
A couple of questions pondered by economists ad nauseum since the Federal Funds rate flat-lined have been:
No. 1: "When will the Federal Reserve lift interest rates?"
Source: MWM Research, DataStream, December 2015
It looks increasingly likely that the outcome of the December Federal Open Market Committee (FOMC) meeting will be an increase of some sort, most likely a standard 25 basis-point increment. In recent weeks, US economic data has strengthened the case for a December move in interest rates with most members of FOMC holding the view that conditions around economic activity, the labour market and inflation will likely be met by the time the December meeting rolls around, precipitating a tightening of monetary policy.
As for the rate of increase, Fed members agree that a gradual removal of policy accommodation would be appropriate. Macquarie is forecasting a peak interest rate in this cycle of 2.00 per cent, which will be reached by late 2017.
The Fed has been telegraphing their intentions for some time now using an alternative policy tool called "forward guidance". This approach was adopted in the wake of the Global Financial Crisis to highlight the FOMC's intention to maintain highly accommodative monetary policy while the economic recovery strengthened. Lately, in press releases, statements and minutes, they have gone to great lengths with this technique to ensure that the markets are not surprised when rates are finally lifted. A key line used in the latest set of meeting minutes has been:
"Most (FOMC meeting) participants anticipated that, based on their assessment of the current economic situation and their outlook for economic activity, the labour market, and inflation, these conditions could well be met by the time of the next meeting."
This particular line has been deliberately used to align market expectations with the FOMC's assessment of the economy to make sure there are no surprises. Judging by the response of short-term interest rate markets, the forward guidance appears to be working. Examining thirty-day interest rate futures prices tells us the market is placing a probability of around 80 per cent on a December rate rise. While the decision might therefore appear to be a foregone conclusion, unanticipated shocks, exceptionally weak economic data, and a dramatic increase in market volatility, could derail any intentions the Fed has, as was the case in September.
The pace at which interest rates are normalised was also referenced in the minutes of the latest meeting:
"During their discussion of the likely path for the federal funds rate after the time of the first increase in the target range, participants generally agreed that it would probably be appropriate to remove policy accommodation gradually. Participants also indicated that the expected path of policy, rather than the timing of the initial increase, would be the more important influence on financial conditions and thus on the outlook for the economy and inflation, and they noted the importance of underscoring this view at the time of lift-off."
No. 2: "What will happen to US and global growth when they do lift rates?"
While advanced economies continue to grow at a moderate pace, this is somewhat offset by a marked weakness in emerging economies and commodity exporters. With monetary policy in the US diverging from the rest of the world, and the US dollar strengthening in anticipation, this growth divide is only likely to widen as the tightening cycle commences.
The United Kingdom appeared to be on a similar monetary policy trajectory to the US. A strong currency, weak business investment and energy price declines have seen both headline and underlying inflation continue to fall. This has been noted by the Bank of England (BoE) in their Inflation Report to explain their continued dovish stance.
Emerging markets (EMs) are likely to suffer depressed growth as capital becomes scarce due to higher US interest rates drawing funds from relatively more risky EMs back to the US. EM central banks can stem the tide by increasing interest rates, making it more attractive for capital to stay put, but this tightens financial conditions when local businesses can least tolerate it. As the capital flows, a stronger USD means weaker EM currencies. EM sovereigns and corporations that borrowed US dollar debt when the going was good will find their interest payments becoming increasingly burdensome as they struggle to make USD repayments. To a large extent, this is already taking place. There are solutions to this problem but they are far from optimal. In instances where a currency is weakening rapidly, intervention by central banks can neutralise the impact of capital outflows by buying excess supply of local currency and selling foreign currency reserves. However, this places enormous pressure on central bank holdings of foreign currency and reduces the domestic money supply, potentially creating deflationary forces and exacerbating any current account deficit. Sterilised currency intervention can be used to correct for this, by buying back local currency bonds and other qualifying financial assets in exchange for local currency. This is a short term solution and can only continue while the central bank has sufficient foreign currency reserves with which to intervene, and history shows a financial turmoil of some sort follows when the original cause of the capital flight is not addressed.
At present, US economic activity is driven by robust consumer spending, improving residential construction, and strong services activity supported by large falls in energy prices. If global growth does slow, these major contributors to US final demand should prove to be relatively resilient. Employment continues to grow and wages are creeping higher- now only 55,000 to 100,000 new jobs are required each month to keep pace with labour force growth, according to our US economist, when over the past six months, an average of 215,000 per month have been created. Supporting this view of the robust consumer are housing indicators which are strong, with rates of household formation accelerating over the past year and mortgage growth rates turning upwards. However, a question mark remains over the ability of the US to tolerate an increasingly strong dollar, given the impact it will have on their export competitiveness - on a trade-weighted basis the currency has gained 13.3 per cent over the past year. This is already filtering through in subdued external demand and weakening export growth. So far this year, the US has exported US$1.88 trillion worth of goods and services, down from US$1.95 trillion this time last year.
Source: MWM Research, FactSet, December 2015
Although the Fed is yet to adjust the fed funds rate, some tightening in financial conditions can be observed by examining the interest rates at which banks, corporations and individuals borrow money. These borrowings can be accessed via banks or bond markets. In the US, most large companies tend to borrow money by issuing bonds, rather than using bank financing. Generally, the lower the creditworthiness of the borrower, the higher the interest rate they must pay. Amongst some of the high yield corporate borrowers, interest rates have been creeping up since mid 2014 (for example, the US energy sector), while at the high quality end, interest rates are little changed. These rates are determined daily by market forces and are not priced off the Fed funds rate. This makes the argument that an increase in the Fed funds rate is serious cause for concern somewhat moot when many large borrowers have been facing higher rates for some time.
Source: MWM Research, FactSet, December 2015
As for home loans, many new borrowers in the US have been facing higher rates for some time. The basis for fixed-rate mortgages, that is, the 10, and 30-year bond rates, bottomed in mid 2012. So, anyone taking on a fixed-rate mortgage pays (approximately) the prevailing bond rate for the loan term plus a margin. Existing borrowers are not affected.
Source: MWM Research, DataStream, December 2015
Adjustable-rate mortgages are a different story as increasing interest rates will transmit financial pressure to existing borrowers almost immediately, but this is only a small proportion of household debt. Fixed rate loans have always been popular in the US, and since the global financial crisis, the preference has shifted even more dramatically away from adjustable rate mortgages to fixed rates. While it is difficult to determine precisely how much of the outstanding household debt stock is variable, we know that almost all of new mortgage origination is on a fixed rate. So, a 25 basis-point increase in interest rates is likely to be symbolic as far as many in the US and other advanced economies are concerned, while potentially amplifying existing economic woes in emerging markets. We expect the US economic recovery to continue, with other advanced economies running a little further behind in the business cycle. Emerging markets will remain volatile, with only those that are economically sound and not reliant on commodity and energy exports able to weather the capital outflows.