Markets vulnerable to US rates news

Recent weeks have seen important updates from some of the key central banks in the context of global monetary policy.

First up, we had the ECB surprising markets by giving a strong signal that it is working on providing additional monetary stimulus sooner rather than later, including a possible cut to the deposit rate.

Then, last week, it was the turn of the US Federal Reserve.

As expected, there was no change to policy at the October Fed meeting. Nonetheless, the meeting statement did enough to grab the market’s attention, with indications that a rate hike could be on the cards next month.

In a key change to the previous meeting’s statement, the Fed amended the language from “in determining how long to maintain its target range” for rates to “in determining whether it will be appropriate to raise the target range at its next meeting”.

The statement also indicated that the Fed is now less concerned about risks to the US economy from external developments compared to its September meeting.

Meanwhile, the committee’s description of the economy contained only minor tweaks. It continued to be of the view that the economy is expanding at a moderate pace.

The most recent GDP data, which were also released last week, corroborate this viewpoint.

While growth for the third quarter showed a deceleration to 1.5% annualised from 3.9% in the previous quarter, the underlying details were more upbeat than the headline number suggests.

Consumption was a key driver of growth, increasing by a robust 3.2%. Business investment remained somewhat soft though, adding just 0.3 percentage points to GDP.

The contribution from net trade was neutral, meaning the expected negative impact from the stronger dollar and slower growth in developing economies was not apparent in the data.

The only significant drag came from inventories, which took a 1.4 point off GDP growth in the quarter, the largest negative impact in three years.

Thus, excluding the inventory change, the economy grew by 3%.

This drag from inventories is unlikely to be sustained, so GDP growth should rebound in the fourth quarter.

Meanwhile, the pace of recovery in the labour market has slowed to some extent in recent months.

Non-farm payrolls averaged monthly gains of 167,000 in the third quarter, a decline from the 231,000 average in quarter two.

The unemployment rate, though, has fallen to 5.1%. On the inflation front, lower oil prices have seen CPI inflation remain very subdued, coming in at zero in September.

Markets continue to expect a less aggressive path of interest rate hikes than the Federal Reserve is currently suggesting.

Market pricing indicates that the first full quarter point rate hike is not expected until April 2016.

The market is looking for the Fed funds rate to rise to 0.75% by the end of 2016, below the Fed’s current projection of 1.375%.

Therefore, this leaves markets vulnerable to any unfavourable news on US interest rates.

Overall, it is apparent that the Fed used its October meeting statement to put markets on notice that a rate hike at “its next meeting” — on December 15 and 16 — is under serious consideration.

Hence, the chances of a Fed rate hike in December have increased following last week’s meeting.

At the same time though, the Fed statement was worded so as to allow it flexibility on when it decides to start to increase interest rates.

Any policy tightening remains dependent on the Fed being content with what it sees from the incoming data, including the labour market, as well as “readings on financial and international developments”.

In that context, the market will be paying close attention to data on the US economy over the coming weeks, along with speeches and comments from Federal Reserve members in order to try and ascertain the likelihood of a Fed rate hike in December.

John Fahey is a senior economist at AIB.