After some minor, but quite important changes to the Fed’s post meeting statement, the market is increasingly of the view that a December rate hike is back in play. Perhaps markets had got slightly ahead of themselves in pricing out a December hike, as the official Fed line had always been that every meeting was "live". That said, there was justification for expecting the Fed to delay further. The data has generally been soft (and the Fed have told us they are data dependent) and two board governors declared two weeks ago that they were against a December hike.
The problem is that the Fed simply has its policy on the wrong setting. With real growth of 2% and nominal growth of nearly 3%, interest rates should not be near zero (along with a bloated balance sheet from past QE). The Fed have been far too easy for too long, petrified of what may happen when they begin to normalise. In our opinion, they should never have embarked on QE2 and QE3, and having allowed markets to become addicted to stimulus, they are having a real tough time beginning the normalisation process, never mind getting interest rates to where they should be, which is somewhere in the 2% range.
That said, we all have to deal in the here and now, and as noted above, the majority now seem to think a December hike is on the cards. We can see the sense in starting the process, however evidence is building that the economic cycle is now very mature. Indeed, there are a number of indicators that not only show a real deceleration in the economy, but are positioned as they have been near the start of a recession. In isolation, it seems strange that the Fed would want to start hiking rates now given how mature the post crisis recovery appears to be. Let’s have a look at a few indicators.
Chart 1 below shows the year on year growth in US Nominal GDP along with the Federal Funds Rate. There are a few points to make. First, growth post the financial crisis is the lowest it’s been in post WWII history despite unprecedented stimulus. Second, there is a loose connection between nominal growth and interest rates. Historically, the Fed have allowed nominal growth to track some way above interest rates after the end of recessions to allow the recovery to gain traction. The disparity between the two has never been this wide for this long, indicating that rates need to be higher already. Third, nominal growth has already slowed from 4.7% to 2.9% in the last 12 months. Although this is not recessionary, the Fed usually starts raising rates when growth is accelerating.
Chart 1 – U.S. nominal GDP growth versus the Federal Funds Rate
The second chart below shows the year on year per cent change in US Non-Farm Payrolls plotted with the Federal Funds Rate. The rate of jobs growth has already begun to slow (from a high of +2.34% in February this year to 1.97% in September) and is likely to slow further into year end. For example, the average monthly jobs gain so far this year is nearly +200k. If the US can generate 200k jobs each month in the fourth quarter, then the year on year rate drops to +1.70% in December. However, the last three months has seen an average of only +167k new jobs per month. If this lower pace is sustained in Q4, then the year on year rate of jobs growth drops to +1.6% by year end.
As with the broad economy, although the deceleration in jobs growth is not necessarily indicative of a pending recessionary, the Fed usually cuts interest rates as this metric declines, and usually only raises rates when jobs growth is accelerating.
Chart 2 – Year on Year % growth in U. S. Non Farm Payrolls versus the Federal Funds Rate
The message is similar in wages for non-supervisory workers as shown in chart 3 below. Although we have no doubt that there are pockets of wage pressure, the fact is that, for the vast majority of workers, wages never recovered to normal levels during the post crisis recovery. Wage growth peaked at 2.5% last year and has since declined to 1.9%. Typically, the Fed only raises interest rates when wage growth is accelerating. We suspect that both jobs growth and employment growth have peaked for this cycle already and we are not expecting any meaningful improvement in the months ahead.
Chart 3 – Growth in average earnings (for production and non-supervisory jobs) versus the Federal Funds Rate
Let’s look at one more chart. Below, we show industrial production and the year on year growth (lower panel). The main point to make here is that industrial production is already declining (having peaked last December) and the year on year rate is on the verge of moving into negative territory. This is recession territory for this particular part of the US economy, and clearly not something associated with the Fed raising rates.
Chart 4 – U.S. Industrial Production is indicative of a recession
We could show more charts, but we think our point is made. The indicators above, along with modest growth in retail sales, falling corporate profits and revenues and declining core capex (exc’l aircraft) are more indicative of a Federal Reserve about to ease policy rather than tighten policy. So what happens if they do raise rates in December, perhaps followed up with another rise in March?
We believe that this would risk a policy error. We think that the Fed have been right to worry about the global economy slowing and the strength of the US Dollar. If the Fed are going to raise rates, especially at a time when most other major central banks are looking to ease policy, then the Dollar probably strengthens further. Assuming this is the case, then we believe that Emerging Markets will struggle further, and the whole cocktail could be enough to push a sluggish and slowing US economy into recession next year. This is clearly not consensus, and is still a lowish probability. However, we believe that recession risks do increase quite a bit if the Fed raises rates two or three times by next Spring/Summer.
As for a December rate rise, despite the market moving quickly to price in a December hike, we would still point out that they claim to be data dependent, and there are clearly divisions on the committee. We do not believe a hike is inevitable given data that is indicative of a slow/slowing economy.
In terms of our current market views, we remain neutral on equities overall (having bought European equities post ECB), we are long the Dollar and we also believe that bonds and interest rates markets are offering some value here, despite a tough week last week. Clearly, the last five weeks have been “risk on”, however developed equities have outperformed EM equities and US equities have been strong relative to many developed markets. As well as EM underperforming, credit spreads remain relatively wide and advance/decline data has been much more pedestrian than headline indices. This all signals that the rally is not on the most solid of foundations, and we need economic growth to accelerate again to support risky assets across the board.
Without an acceleration in growth (likely in our view), the risk on rally is at risk of petering out quite quickly. At best, gains are likely to be harder to come by in the weeks ahead. Although we had to become more constructive post ECB, we are on the lookout for market signals to get more bearish of risk assets in the near future. We have to say that a U.S. recession next year would be a disaster for risk assets, and Fed rate hikes increase recession odds.