A fed funds hike in 2015, come hell or high water

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Bastien Drut and Valentine Ainouz, from the Strategy and Economic Research team at Amundi, highlight Fed funds possible hike in 2015.

All it took was a speech for Janet Yellen to revive anticipations of a fed funds hike as soon as this year.

Judging that the labour market is getting close to the full employment target and reasserting her belief (what else can we call it?) that inflation will return to its 2% target in the medium term, Yellen said that the Fed could begin normalising its rate policy beginning in 2015 if “the economy continues to improve as she expects.”

Now, it would take very bad numbers for the Fed to give up on its plans for monetary normalisation.

She said that the “pace of normalisation is likely to be gradual” and that “it will be several years before the federal funds rate would be back to its normal, longer-run level.”

Interestingly, Yellen ended her speech by stressing the weak productivity gains by the US economy these past few years and the possibility that US growth potential could be much weaker than before.

Inevitably, the greater credibility of a first fed funds hike in 2015 after very mediocre economic numbers at the start of the year stirred up the fixed-income and foreign exchange market. The US dollar headed upward against the developed currencies and will continue to appreciate for some time.

Meanwhile, the US yield curve resumed its bear flattening : for developed countries, the two-year yield is generally around 110 bp above key interest rates the first time in a cycle that those rates are raised.

By the way, it should be stressed that the markets still do not believe fed funds will be raised in 2015. However the rise in US long-term rates can only be very limited, because

1) the US dollar’s appreciation is weighing down oil, which in turn is weighing down inflationary expectations,

2) the terminal fed funds rate is much lower than before, because, as Yellen suggests, growth potential is much weaker than before,

and 3) the US dollar’s appreciation and the low yield environment in Europe and in Japan could accelerate inflows on the US bond market.

The divergence in monetary policies that seems to be accelerating convinces us to prefer euro credit to dollar credit. The ECB’s QE should maintain a technical configuration over the coming quarters that is favourable to euro credit.

  • Any raising of key interest rates by the Fed that is not expected by the market would have a negative impact on risky US assets (specifically equity and HY credit), which have been boosted in recent years by the extremely accommodating monetary policies.
  • Given the very limited rise in long rates, the IG segment seems to us to be less sensitive to this risk. Moreover, long-maturity securities get better protection against the risk of bear flattening, while offering the advantage of yield.

Underperformance of dollar credit after a rise in key interest rates would be an interesting buying opportunity : the valuations on offer are more attractive than those in the Eurozone.

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