John Bilton, Head of the Global Multi-Asset Team Strategy Team at J.P. Morgan Asset Management
At last week’s Federal Open Market Committee (FOMC) meeting, the Federal Reserve (Fed) removed the word “patient” from the statement it uses to indicate when it will start normalising monetary policy. This decision was widely expected. In addition, the Fed lowered its forecasts for growth, inflation and unemployment for the 2015/17 period. The set of forecasts, known as the “dots”, imply a softer profile for the rise in U.S. interest rates, with a median Fed funds rate of 0.625% at the end of 2015 rising to 1.875% in 2016 and 3.125% in 2017. The market is pricing in rates of 0.4%, 1.2% and 1.7% respectively. Yet within these averages, there is a wide variation regarding the direction of interest rates among FOMC members. In contrast, the range of estimates around economic growth and inflation projections are much smaller!.
At Fed chairwoman Janet Yellen’s press conference, she was clear that any decision to raise interest rates would be a function of “reasonable confidence” in the Fed’s inflation outlook. In other words, the Fed would need reasonable confidence that the rate of core inflation would move back to the 2% target over the medium term. She cited four factors to inform a sense of reasonable confidence: a further reduction in labour market slack; realised inflation; wage growth; and (rising) inflation expectations. With renewed emphasis on the dots, it is clear that monetary policy has become data dependent once more.
Yet “reasonable confidence” is also an elegant way of keeping your options open. To give it more room for manoeuvre, the Fed reduced its estimate for the equilibrium mid rate of unemployment from 5.35% to 5.1%, implying there is more slack in the U.S. labour market than previously thought. This compares to a current jobless rate of 5.5%, below the average of the last 20 years of 6% and the lowest reading since June 2008. While the labour market is arguably tight, and unit labour costs have started to accelerate, it is worth observing that these are lagging indicators of activity. The other reasons for keeping its options open is that the current quarter has been very weak, perhaps more than suggested by very cold weather and the West Coast port strike. Indeed, the Atlanta Fed’s latest “nowcast” estimates that first-quarter 2015 real GDP growth is tracking at only 0.3% saar.
Despite changing little, the impact on markets was significant last week, with equities rising strongly, bond yields falling and the dollar weakening. Indeed, one of the largest reactions was in the FX market, where the European currencies rallied strongly, with the euro having an intraday trading range of 4.4% (the second largest in the lifetime of the single currency) while sterling was equally volatile, recording an outside day reversal, seen by some as a technical signal of trend exhaustion and a possible change in direction.
A move to data dependency, combined with the shift from stable to gradually rising rates, suggests scope for greater market volatility. This seems particularly likely to hold true at the short end of the yield curve, where the sensitivity of 2-year yields to economic data surprises was unusually muted between 2012 and 2014. Indeed, uncertainty about the Fed seems apt to persist for a while, beyond the (ultimately) minor issue of the timing of the first rate hike, as the debate shifts first toward the pace of tightening and then to the terminal funds rate and the size of the balance sheet, questions that have yet to receive a full airing in market discussions.
The UK’s pre-election budget masks longer-term structural problems. The UK government delivered its last Budget prior to the general election on 7 May. Usually, pre-election Budgets in the UK have been an institutional form of bribery, to incentivise the electorate to vote in favour of the incumbent government. However, Chancellor of the Exchequer George Osborne’s room for manoeuvre was constrained by fiscal reality and his Liberal Democrat coalition partners. Instead, a broadly neutral budget was delivered, though it was laced with some modest electoral goodies in the form of savings tax relief for older votes and incentives for first time home buyers. The headline arithmetic had the UK budget moving back into balance by the 2019/20 financial year, with expenditure falling as a percentage of GDP to 2000 levels.
Despite the relatively upbeat tone of the Budget, the UK faces sizeable structural challenges over the next five years. As has been noted, the UK faces a productivity problem, where average output per head lags that of France by a fifth. This has probably been the single biggest reason as to why UK living standards have been slow to recover after the crisis.
Some of these challenges are obscured by the official forecasts. Lurking in the projections made by the Office for Budget Responsibility was a rise in household gross debt, which is projected to rise from a current level of 146% of household income to 171% by the end of 2019—above the pre crisis peak of 169% in 2008. This suggests that household debt will grow at around 7% per annum and outstrip nominal GDP growth by approx 3% p.a. Assuming that most of this growth in debt will be bank financed (with a considerable chunk being mortgages), bank credit is likely to grow much faster than forecast by bank analysts or by the banks’ own capital positions. If this forecast is achieved, it could bring further pressure on the current account – and potentially the currency – given a current shortfall of 6% of GDP. Alternatively, if household releveraging undershoots this forecast, then the growth outlook – and the UK’s fiscal profile – will deteriorate.
All this sits uneasily with the looming general election, which promises to be inconclusive. At present, it appears to be a contest between the unacceptable and the unelectable, with no clear winner in sight given present polling trends. A period of uncertainty therefore awaits until a new coalition is formed. History suggests that a combination of deteriorating external fundamentals coupled with political risk tends to take a toll on sterling, which looks overvalued on a real effective basis. So, the next 50 days of campaigning threatens to be volatile and could be bruising for UK assets.
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