Financial Daily from THE HINDU group of publications
Monday, Apr 26, 2004
Money & Banking - Insight
Columns - Global Finance & Overview
When will Fed raise rates?
V. Anantha Nageswaran
EVER SINCE the US Labour Department reported that the economy added more than 300,000 jobs in March, financial markets have been on a heightened sense of alert for the Federal Reserve to raise interest rates. The Federal funds rate in the US is at a historical low of 1.0 per cent. Anticipating the rate increase, the dollar had strengthened against most currencies. The hardest hit has been the euro.
The interest rate futures market is pricing in a 50 basis point tightening in the three-month euro-dollar deposit rate. September futures of the 90-day euro-dollar rate now prices in 1.64 per cent up from just 1.2 per cent a month ago. Wall Street is swaying with the market. Economists have begun to forecast the first Federal Reserve rate hike in June or August. Hardly a month ago, after the February employment report, Wall Street consensus was beginning to rule out any rate hike in 2004. Their forecasts are proportional to the relative strength of the economic data. How realistic are these expectations?
Some select remarks of the Fed chief, Dr Alan Greenspan,:
(1) Mr Greenspan said the fiscal implications of a rising level of retiring US workers are a "very significant problem" for the US budget in the long term. "It hasn't impacted yet on the short-term markets," he said. "Clearly, you cannot find footprints of either the immediate deficit or the long-term deficit in long-term Treasury yields as yet." Yields are rising because "the news is good" on the U.S. economy, he said.
(2) "It is fairly apparent that pricing power is gradually being restored," Dr Greenspan said in response to a question on the economy from Senator Richard Shelby, an Alabama Republican, at a Senate Banking Committee hearing on the banking industry. "Threats of deflation that were a significant concern last year by all indications are no longer an issue before us. Clearly it is a change that has occurred in the last number of weeks."
Dr Greenspan dismissed rising commodity prices as an inflation threat, saying they are a small part of total costs for companies. Inflation pressures are "reasonably contained," and labour productivity, which helps companies hold down prices because they can produce more goods in an hour, is "still impressive".
While commodity prices are rising, labour costs, which account for more than two-thirds of the final cost of goods and services, are still declining, he said. Non-farm unit labour costs fell 0.4 per cent in the fourth quarter after a 5.6 percent decline in the prior three months, Labour Department data show.
(3) All told, the available data, industry and supervisory judgments, and the long and successful experience of the US commercial banking system in dealing with changing rates suggest that, in general, the industry is adequately managing its interest rate exposure. Many banks indicate that they now either are interest-rate neutral or are positioned to benefit from rising rates.
Greenspan in no hurry to push the rate button
The preceding paragraphs have three pertinent observations from Dr Greenspan when he spoke to the Senate Banking Committee on the State of the US Banking industry. His remarks on the bond market were and are far more significant than the comments he made about deflation or inflation.
To be sure, he said that deflation was no longer an issue but he also added that inflation was not a risk. He said that labour productivity was strong and that labour costs make up around two-thirds of the overall cost of production and dismissed the impact of rising commodity prices on inflation and correctly so, in our view. Therefore, to expect Dr Greenspan to raise interest rates when he views the state of the inflation as a state of nirvana implies considerable confidence in the sustainability of the American economic upswing and the extent of available spare capacity.
As expected, Dr Greenspan used his appearance before the Joint Economic Committee on Wednesday to suggest that he is in no rush to pass judgement on the sustainability of the upswing or on inflation. Data, barring the March payroll report, have been mixed. Factory orders have been tepid in the first two months of February. Industrial production was weak in March. Despite record hiring in March, overall wage bill came down and hours worked too contracted in March.
Therefore, our view remains that much of the flag-waving on the US economy would stop in the second quarter. Hence, the current revisions to forecasts of the Federal funds rate would need to be put back into the bottle in the second quarter. We expect the Federal funds rate to remain unchanged at 1.0 per cent for the year.
What if we are wrong?
Of course, we should consider the possibility of being wrong. If the US economy continues to show strength, then the Federal Reserve has a lot of catching up to do. Before it actually begins to do so, the bond market will begin to price that possibility in. The 10-year US Treasury Note Yield should then climb to around 5.5 per cent. The US dollar will start to correct. Last time the Federal Reserve was in a catch-up mode with growth and inflation back in 1994, the US dollar weakened during the tightening phase.
There will be other reasons for dollar to weaken
Faster US economic growth relative to the rest of the world would eventually see its trade deficit begin to rise. We continue to view the muted increase in trade deficits in the last two quarters as an aberration. Thus, if the US economy were to strengthen, the rise in bond yield would be accompanied by a falling dollar. Together, they would ensure that the valuation-challenged US equity market corrects.
Before long, the market would start speculating on a rate cut by the Federal Reserve and a rally in the bond market. The US economy is trapped in high debt and it cannot take higher rates for too long.
The fatal attraction of the US dollar...
However, for now, markets are romancing the dollar as they did in the latter half of the 1990s. They will soon realise that the America of 2004 caught in the Iraq quagmire and backing Ariel Sharon is not the America of the 1990s that was experiencing a partially genuine technology and entrepreneurial boom. For now, the dollar strengthened across the board; precious metals fell; silver and gold are down sharply and US equities slid as well. The 10-year US Treasury Note shot up to a yield of 4.45 per cent
In reality, the dollar strength further complicates the long-term adjustment that the US economy is yet to make. The American economy, if it were growing on a sustained basis, would need more foreign capital than foreigners would be willing to supply. In our view, the belief that a growing US economy would be able to attract the capital it requires easily is too simplistic and optimistic. Neither the stock nor the bond market is cheap.
... fails to see long-term risks of Treasuries
Dr Greenspan's remarks on the bond market are quite pertinent. He believes that the US bond market has not priced in either the immediate budget deficit or the long-term deficit.
According to Prof Paul Krugman's latest column (23rd April 2004) in The New York Times, military expenses in Iraq are now $4.7 billions per month. He cites Mr Cordesman of the Centre for Strategic and International Studies on the funding requirement in Iraq: "in excess of $50-70 billion a year for probably two fiscal years". In the first six months of the fiscal year 2004-05 (the American fiscal year runs from October to September), cumulative budget deficit is $300 billion against the $253 billion of 2003-04.
Hence, bonds appear far more problematic at this stage. The bond market is unlikely to stabilise, therefore, at current yield levels. Indeed, more than the risk of a rate hike, Dr Greenspan's remarks on the absence of any `footprint of either the immediate or the long-term deficit' are bound to prove problematic for the US stock market, the economy and the dollar in the months ahead. Purchases of US Treasury could conceivably slow and if yields continue to rise, then the stock market would be likely hit, as would the mortgage refinancing market.
The dollar has probably peaked
Therefore, I believe that the strength of the dollar against the euro, the pound-sterling and the Canadian dollar sets up excellent long-term buy opportunities. Indeed, the market action on Friday suggests that the US dollar might have peaked. Orders for durable goods in March rose 3.4 per cent over February. It was five times the median estimate of economists. Yet, the dollar finished the day marginally weaker against the euro, the pound and the Japanese yen.
In my view, the same goes for gold as well. Indeed, the view on gold follows the view on the US dollar in the above paragraph. Simply put and at the risk of repeating myself ad nauseam, I would add that strong US economic growth is either unlikely and if likely, then it is not going to be nirvana for either the US or for the world.
(The author is Director, Global Economics and Asset Allocation, Credit Suisse, Singapore. The views are personal. Address feedback to email@example.com)
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