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Broadgate: Weekly Briefing 29/9

29 September 2014 

The past week can best be summarised as the week when the dogs did not bark. In the run up to the Federal Reserve (Fed) meeting and the referendum on Scottish independence markets were poised for a period of material turbulence, which stood in contrast to the low-volatility environment that has prevailed for much of this year. Scotland, however, opted to remain part of the United Kingdom, and the Fed’s meeting indicated no great change in US policy. In response, equity markets moved higher, with bond yields drifting up slightly, along with the dollar. Credit spreads remained range-bound, commodities were weak, and there was some underperformance from emerging-market assets.

In this discussion, we’ll focus in on current Fed thinking and put this into a broader global context by considering the actions that other central banks are likely to take over the coming months. So where does the Fed now stand in terms of potential policy tightening? Well, in many respects, the board remains where it has been for much of this year – although the post-meeting statement shows that this stance will change. It maintained its language around the timing of potential policy tightening and referred to the significant underutilisation of economic resources, while recognising that inflation is still running below target.

US policy: will the data force the issue?

There were, however, some interesting new outcomes, particularly with regards to the slight rise in the median policy-rate projection for the end of 2016, and a further material rise expected by board members in 2017. One interpretation of these events is that, while the case for an immediate rate rise has yet to be established, when rates do begin to increase, they may do so significantly. Fed Chairwoman Janet Yellen reinforced the point that the board’s policy decisions will remain data dependent, but if the US economy does continue to strengthen to the extent that the unemployment rate declines more materially, the data will, at some stage, force the issue.

The best guess is that any interest rate rise will occur sometime in mid-2015, but there are risks on both sides of this expectation.

The UK turns from politics to economics

Now that the Scottish referendum is out of the way, economics rather than politics will once again dominate the UK rate debate. The Bank of England (BoE)’s position is similar to the Fed’s: The UK unemployment rate has continued to decline. At this stage, it is difficult to point to much in the UK inflation data that suggests that rates need to rise soon; but, as in the US, ongoing recovery does point to the potential for a base-rate increase in mid-2015 and potentially even earlier.

It’s important to stress, however, that the Fed and the BoE are atypical of many other developed-economy central banks. The Bank of Japan is still strongly committed to a loose-policy stance until there has been a more material increase in inflation. And the European Central Bank (ECB) is clearly moving in the opposite direction from the BoE and the Fed. Its weak, and somewhat faltering, recovery combined with inflation falling close to zero suggests the need for additional monetary stimulus, including more aggressive use of the central bank’s balance sheet. In the eurozone, last week’s take-up of longer-term refinancing operations was lower than expected. While there are a number of reasons why this could have been the case, it does increase the possibility that quantitative easing by the ECB may have to be extended beyond refinancing operations and asset-backed security purchases, potentially to include sovereign bonds. This had previously seemed a low-probability outcome, but it’s now on the market’s radar.

And finally, China: recent data suggests that the economy lost momentum over the summer and there has been a response from the People’s Bank of China, which in recent days has injected additional liquidity into the banking system. The main conclusion from this is that the divergence in business-cycle conditions is delivering a divergence in central-bank policies, potentially to a much greater extent than we have seen in recent years. This could well become a market theme over the rest of the year.

If the Fed and the BoE do raise policy rates next year, it is highly unlikely that such moves will be followed by other large economies. This raises the potential for the recent phase of dollar strength to persist. But there is also an interesting longer-term implication: if business cycles and policy responses do remain divergent across the large global economies, there is a lower likelihood of global overheating, which in turn reduces global recession risk, and means that the current global expansion could persist for some time. If low economic growth does allow for lower recession risk over time, and a longer economic cycle, this could provide a more fundamentally bullish environment for many growth assets.

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The information set out herein has been obtained from various public sources and is by way of information only. Broadgate Financial can accept no liability of any sort in relation thereto and readers should obtain their own verification of any statement before making any decision which may have any financial or other impact.

Neither the information nor the opinions herein constitute, or are they to be construed as, an offer or a solicitation of an offer to buy or sell investments.

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