Fed in focus

Stéphane Monier, Chief Investment Officer of Lombard Odier (Europe) S.A. reviews the outlook for US interest rates after the Federal Reserve’s statement of 30 Jul

MARKET FOCUS SHIFTS TO THE ‘FED’

With the Greek crisis likely kicked into the long grass for now, we think markets’ focus will return to economic fundamentals over the rest of the summer. This will include the all-important question of when the US Federal Reserve (Fed) will hike interest rates for the first time since 2006. Fed Chairwoman Janet Yellen has said that officials expect to raise rates this year. At its July meeting, the Fed kept rates on hold, but its statement on 30 July left all options open for its three remaining meetings this year – raising the prospect of one or more rate rises in September, October, or December.

Unfortunately, the timing of the Fed’s move could become a source of volatility in itself in coming months. There is no precedent for a US interest rate rise after such a long period of ‘easy money’, including near-zero interest rates and quantitative easing.

WHAT ARE ECONOMIC TRENDS TELLING US?

While US first quarter gross domestic product (GDP) growth was weak, we expect the second quarter’s figure to be much stronger. Long-term unemployment is down, and there are signs of nascent wage growth. We think that should boost households’ real disposable income, confidence and consumption – the big driver of US growth.

Stronger economic growth, and in particular signs of wage growth point to rising inflation in coming months. The current 0.1% headline inflation rate (for June) is way below the Fed’s 2% target, and one of the main reasons why interest rates are still at a lowly 0.25%. But core inflation – excluding food and energy – is already creeping up – which should give the Fed some room for manoeuvre. A key variable here is the oil price: falling prices may slow the pace of rate rises. But should the oil price hold at around USD 60 per barrel, and should emerging wage pressures continue to build, we believe headline inflation could top 2% by year-end, as the base effect of lower oil prices from 2014 drops out after October.

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