David Scammell, fund manager at Santander Asset Management, comments on the Fed’s decision to leave interest rates unchanged and what this means for fixed income markets.
What we learnt
This was a challenging meeting for the Fed. The mixed messages sent from various speakers ahead of the meeting highlighted the uncertainty of policymakers, and this lack of conviction in reaching a decision will not be lost on investors.
In the event, the Fed opted for the course of least resistance and left rates unchanged. This may be seen by some as a sensible precaution given recent market turbulence and the low cost of waiting to learn a little more in the coming weeks. However, it does show that, after almost seven years of zero interest rates, policy makers are still of the mind-set that the economy is fragile and growth may not be sustainable if subject to external shocks.
With regard to the latter, China is clearly a cause for concern and is deemed a major source of downward risk. This is a disappointing conclusion, especially given the fact that US domestic growth has been solid and the unemployment rate has fallen to 5.1%, reasonably close to the Fed’s current estimate of full employment (or NAIRU using economic jargon).
In other words, there would appear to be little slack left in the economy and, according to traditional models built along the lines of the Philips Curve, wages and inflation should move higher over the medium-term. It would thus appear that this time the Fed are less convinced by their models and have placed more emphasis on the very subdued levels of current inflation.
Implications for Fixed Income Markets
From a procedural perspective, the uncertainty ahead of the decision underlined the limitations of forward guidance. The Fed has itself become a source of volatility, and the market is likely to be very data dependent in upcoming months. There can be no doubt that the Fed is still biased to hike, but the anticipated pace of tightening seems set to be slow and gradual – the latest Fed forecasts indicate 0.25% of tightening this year, followed by a further 1% in 2016.
The market is much less convinced, with the money-markets pricing in an even gentler and flatter hiking cycle and bond yields back at the lower end of defined ranges. If, in the absence of an accelerated emerging market crisis, the Fed chooses to raise at the December meeting, valuations look rich and a moderate grind higher in yields should be anticipated. The risk to this viewpoint is that the bond markets will decide that the underlying story is one of secular stagnation.
In other words, we live in a new world in which the global economy cannot generate enough growth to be sustainable without zero interest rates, permanent QE, higher inflation targets and financial repression. In this scenario, bonds will be well supported and the bond vigilantes will have a long wait.