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Markets cheer US interest rate hike

Cape Town – The US Federal Reserve’s decision to increase its policy interest rate is a vote of confidence in the US economy, say Dave Mohr, Chief Investment Strategist, and Izak Odendaal, Investment Strategist at Old Mutual Multi-Managers (OMMM) in a company note. 

“Last week, the Federal Reserve (the Fed), increased its policy interest rate as expected. The Fed funds rate target range increased by 25 basis points to a range of 0.75% to 1%. This is only the third time US interest rates were increased since rates were slashed to near zero in December 2008.”

A month ago, the market still thought a rate hike in March was unlikely, but the probability increased quickly as a series of speeches by key officials of the US Federal Reserve (the Fed) officials made it clear that their thinking had shifted. 

READ: Rand rallies as US Fed raises interest rates 

In 2015 and 2016, the Fed promised that it would hike rates three or four times each year. Yet it only hiked twice. It is therefore unusual in terms of its own recent history for the Fed to bring forward the timing of its rate increases for this year. 

One of the reasons why the Fed could not deliver its planned hikes previously was that some financial or economic calamity would occur to put it off course (or would loom over the immediate horizon). 

“Therefore, last week’s move is a vote of confidence in the US and global economy, and the relative stability on financial markets. In what has been termed a “dovish hike”, the tone of the statement also reinforced the gradual nature of expected future rate increases, supporting equities, and pushing bond yields down somewhat. The dollar also pulled back (with the euro supported by the success of pro-European Union parties in the Dutch election),” Mohr and Odendaal say.

Getting dotty

The quarterly summary of Fed officials’ economic projections (called the “dot plot” because each participating official plots his or her expected path of interest rates on a chart) was largely unchanged from December. This suggests two further hikes this year and three hikes in each of the following years. If the Fed funds rate settles at 3% as projected, it would still amount to a historically gradual hiking cycle, ending in the lowest plateau on record (in the previous cycle, the Fed funds rate briefly peaked at 5.25%).

“Monetary policy is therefore still supportive of economic activity. At current levels, it has only been lower 19% of the time in its 46-year history. Therefore, this is a case of returning rates to a more normal level rather than tightening policy to choke off inflation. Inflation is gradually moving up to the Fed’s 2% target. Inflation expectations have increased, but not dramatically so,” say Mohr and Odendaal.  

Labour market key

The labour market is key to the interest rate outlook. A “tight” jobs market is one where employees have bargaining power to drive up wages, which feeds into inflation. A jobs market with “slack” is one where employers are spoiled for choice and do not have to offer higher wages to attract or retain staff.

READ: US jobs, wages show solid gains in Trump's first months 

The labour market has certainly tightened, and at 4.7% unemployment is now very close to its “natural” rate. Further declines in the unemployment rate are perceived to be inflationary.

The most important interest rate in the world

Why do we care so much about US interest rates? 

“Firstly, it’s because of the potential impact on activity in the world’s largest economy,” say Mohr and Odendaal. 

“Higher borrowing costs put consumers under pressure, but interest payments relative to household income are still historically low as households have been borrowing at a slower pace than their income growth (called deleveraging).”

Historically rate hikes have been seen as mostly bad for equity markets, because they were designed to reduce demand to contain inflation – and company profits suffered as a result. However, rate increases now reflect a stronger and healthier US economy and equities have risen alongside interest rates (this also happened in the 2004 to 2006 hiking cycle).

Secondly, the US accounts for around half the weighting in the main equity and bond benchmarks. Almost all commodities and a fair portion of global trade are priced in dollars. According to the Bank of International Settlements (BIS), most currency transactions are also in US dollars. The BIS estimates that $9trn of debt denominated in US dollars has been issued outside the US. Therefore, when the Fed hikes rates for the US, it effectively hikes rates for the rest of the world and financial markets around the globe. 

The dollar rallied strongly from 2011 onwards, partly on expectations that US interest rates would diverge from the rest of the developed world (it will still be quite a while before European and Japanese rates are hiked). 

The rand collapsed over this period. It has been a constant fear of local investors and the SA Reserve Bank (SARB) that when US rates finally start rising, global investors would dump emerging market assets and the rand would fall further. In early 2013, the mere suggestion that the Fed might consider easing up on (or tapering) stimulus caused a massive sell-off that became known as the “taper tantrum”.

Rand resilient

However, the rand took the rate hike in its stride, and fell below R13 per dollar after the US rate decision (and dot plot) was announced. Local bonds have also held up well despite higher US short and long-term rates. Again, the widespread fear was that higher US rates could draw capital from markets such as our own.

The benchmark R186 government bond yield fell to 8.53%. However, South African bond yields remain among the highest of the major economies once adjusted for inflation.

Conditions still tough

The rand remains resilient supporting a better inflation and interest rate outlook, especially since the oil price has pulled back from its recent peak, say Mohr and Odendaal. 

“The current over-recovery of 54c/l should therefore offset the planned fuel levy increase next month.” 

The economy still needs all the good news it can get since the latest local economic data highlights that conditions on the ground are still tough. Business confidence increased marginally in the first quarter. 

The RMB/BER Business Confidence Index increased by two index points, but at a level of 40 indicates that most businesses are still pessimistic. The survey, which gauges sentiment in five cyclically sensitive sectors in the domestic economy, has been hovering around its long-term average since 2010, making it the most sluggish cycle on record. 

READ: Business confidence: No reason for optimism 

Although wholesalers were confident on balance, new vehicle dealers, construction firms, retailers and manufacturers were pessimistic. Other data sources confirm the headwinds these sectors face. 

Statistics SA announced last week that real retail sales fell 2.3% year-on-year in January and by 1.2% between December and January (seasonally-adjusted). Lower inflation should, however, help in future.

Manufacturing production was marginally positive in January compared to a year ago, but the overall level of production is lower than mid-2016. Since 2013, manufacturing output has been volatile from month-to-month, but the underlying trend has been sideways. Improved global economic activity should lift this trend. 

Similarly, mining production was slightly higher than a year ago, but there has been little improvement in the underlying trend.

READ: Manufacturing continues to underperform 

"However, investors should also remember that with more than half of the JSE’s earnings coming from outside South Africa, equity returns are not as closely linked to the economy as commonly thought.

"Bond investors should benefit from the improved inflation outlook. The local listed property sector is also increasingly global, and should benefit from lower inflation and interest rates,” according to Mohr and Odendaal. 

Nonetheless, there is still reason for increased economic optimism. 

As a small open economy, South Africa depends largely on favourable global trends to do well. These trends – commodity prices, global growth, sentiment towards emerging markets, and a benign US interest rate outlook – are much more supportive than a year ago. 

“What we need now is to avoid any further political and policy-own goals to improve confidence in the economy and ensure that businesses start investing here again,” Mohr and Odendaal say.

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