After seven years of the most accommodative monetary policy in the history of the US, on the 16th of December last year, the Fed decided to raise interest rates from 0.25% to 0.5%. During the last few months, investors have reacted positively on the Yellen's comments about the future interest rate raise. The Fed does not look to be determined to go ahead with raising interest rates or at least not four times until the end of 2016 (guidance in the beginning of 2016). Yellen seems to be more than eager to raise rates. Last Monday she said: "I see good reasons to expect that the positive forces supporting employment growth and higher inflation will continue to outweigh the negative ones." Yellen, also mentioned that the recent disappointing data in the last month's job report would not influence the decisions as the medium/long term economic outlook is what matters. Nevertheless, the short-rate expectations according to OECD for 2017 now stand at 1.4% from 1.7% two months ago. The FOMC (the committee which decides US monetary policy) is meeting on Wednesday the 15 th of June and we believe that it may lower the expectation for rate hikes this year.
There has been a debate among economists about the effect a Brexit could have in the global economic growth. However the answer to that is not clear. The Brexit consequences seem to be more obvious for Europe the country itself, but not the US. We believe that a Brexit can have a detrimental effect on the US economy. A first and more direct impact could be the operations of US banks in UK. During the last few years London has been a European hub for US banks and a Brexit could change that. However, a Brexit could affect the global economy indirectly too. UK could become the first country leaving the European bloc and this could raise fears that other countries may follow constituting a danger for the continent's safety. This fear could spread into the markets rapidly leading to higher risk aversion and less investments.
The odds for a Brexit have been increased dramatically during the last few weeks. The most recent poll conducted by ORM on behalf of Independent shows a 10% lead for leave while the previous polls were giving a 50-50 vote.
Interest rate Expectations (source: OECD)
Source: Bureau of Labor Statistics
According to Bureau of Labor Statistics, total nonfarm payroll employment increased by 38K in May which is the lowest increase is 5 years (average 203K) mainly due to a 35K workers from the telecommunications industry being on strike. But still, even without taking the 35K workers into consideration, it is clear that there is a downward trend in the employment creation since the last quarter of 2015. We believe that the Fed will be eager to go ahead with a rates hike after seeing an increase close to the average of 203K in nonfarm payrolls.
The delay in raising interest rates may not be supportive for the stock market.
While the delay in raising interest rates has been perceived as a good sign by many investors, we believe that the reasons of that decision and the turnaround of the Fed's stance does not seem to be supportive.
Historically, rate cuts or the delay in raising interest rates have been good signs for stocks because the "free" or "cheaper" money which was drained in the economy. In addition lower Central Banks' interest rates mean lower bond yields which makes equities more attractive due to the yield differential as well as because the yield of bonds is indirectly influencing stock prices as it is used in most of the equity valuation models making stock prices to look "cheaper".
But is that the case with US at the moment?
Central Banks raise interest rates to prevent inflation, when the economy seems to have stabilized. The dramatic fall in unemployment rates (unemployment rates fell to 4.7% compared to 10% in Oct 2009) should have raised inflation expectations; But it didn't. This was also Fed's view a few weeks ago but why isn't this the case anymore?
The global economy risks are mentioned as a reason to the sudden change in Fed's stance. The level of global investments remain low, China growth slows down, terrorist attacks in Europe (along with a debt crisis which remains and the fears of Grexit & Brexit) and the political turmoil in Middle East constitute dangers which impede Fed from rising interest rates.
But there are signs we see which go beyond that. Advanced economies around the world including the US are set to face a long-term stagnation. A few of the most powerful global economies will be trapped in low (if any) growth rates, low (or even negative) inflation and monetary policy has no power to stimulate the economy by increasing the productivity or prices. This relates to fisher effect and the liquidity trap. Providing "cheap financing" at low rates in the long term will make investors indifferent.
All in all, a change in Fed's stance will mean that equities can offer higher yields, increasing stock prices but on the other hand it can also be translated into a serious warning about the stability of the economy.
Consumer confidence, a leading growth indicator, has been growing steadily from the mid 2011 when it fell below 97 to reach its 5 years high in Feb 2015 (101.1). However since Feb 2015 Consumer Confidence Index fell to reach 100.8 in May 2016. Consumer Confidence in US seems to have improved by a faster pace than the average of the OECD countries and it's far above the 5 year average which is a positive sign.
However, the US Business Confidence Index has seen a taken a more dreadful path. The Index has reached to a four-year high in Oct 2014 when it stood at 100.82 and has been falling since then to reach 99.6 in May 2016. More importantly, the despite the fact that the US BCI has been closely tracking the average BCI of OECD countries, it has started falling significantly since 2015, losing track of the OECD average, which constitutes a warning sign for the US economy.
The aforementioned signs start being obvious; at least as far as the US growth (expected growth for 2016 was 2.8% in Jan 2015 but the current economists' estimates have set US growth at 1.7%), inflation, productivity, confidence and investments are concerned. In our view, this suggest that we may not only see rates rising at a slower pace, but may also see rates staying at historical low levels for a longer than expected period of time. We expect that the Fed will have to review its strategy soon and lower the expectations of much higher interest rates in the next two years. We also see a high probability of keeping interest rates below 1.5% for 2017 too if the worst case scenarios (Brexit & Grexit) take place and fear is spread into the markets. All in all, we believe that the Fed will go ahead with rising interest rates (we estimate just one rate hike), but not before the end of the summer. The policy which will be followed after June will be heavily dependent to the economic developments across the globe and mainly the result of the UK referendum.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.