On Wednesday 14 June, we believe the US Fed is highly likely to raise the target range for the federal funds rate by a further 0.25%. We believe the opportunity the move policy rates further away from the zero "lower bound" will not easily be passed-up as US unemployment figures improve and as importantly without spooking markets, which have priced this move in.
However, a signal of "one and done" for 2017 - or at least "one and wait and see" will be critical to keep markets buoyant. In addition, investors will be watching for benign comments in respect of any adjustments to the Fed's balance sheet policy.
Exhibit 1: Fed fund futures for 2018 slipping away from Fed dot-plot in 2018
In particular, if Fed policymakers do not address the increasing divergence between their dot-plot guidance and market-implied rates for 2018 and beyond, Exhibit 1, there could be repercussions for US financing costs, the US dollar and consequently equity markets.
We can certainly understand why inflation expectations have been falling. Commodity price inflation has been absent, as oil has stuttered at a little over marginal costs for US shale. Within basic industries iron ore prices have also been declining in recent weeks and we note that interbank rates in China continue to rise, cooling animal spirits.
In the US, six months after Trump's election there appears to be little visible progress in terms of a substantive fiscal stimulus or infrastructure spending. Furthermore, US economic surprise indices have now moved even lower than we would have predicted from seasonal and mean-reversion factors, Exhibit 2. Based on 5 year forward markets, US inflation is forecast to be 2.2% in 5 years, down from 2.4% in April and is indicative of declining inflation pressure.
Exhibit 2: US economic surprise index has fallen sharply in Q2 17
As a result of this ebbing of inflation and growth expectations, long-term interest rates have been moving lower, flattening the yield curve, even as equity markets have in many cases been making new highs. There is, in the circumstances, no change to our cautious view on equities.
However, even if the very recent data points to something of a slowing of US activity, we believe the Fed will on Wednesday proceed to raise US rates by 25bps. This is in our view a situation where the data remains equivocal and the decision will be more calendar dependent, to avoid the Fed falling behind its previous guidance of a period of gradually increasing rates. This should not come as a surprise to markets.
Nevertheless, Fed guidance for H2 17 will be critical in terms of the market reaction. In the event of the Fed adopting a "wait and see" approach, we believe the market reaction would be modestly positive following such reassurance that US rates are not on a monotonically increasing trajectory and are also data-dependent. This is our base case.
Exhibit 3: Chicago Fed US financial conditions index easing in 2017, even as US rates increase
However, should the Fed emphasise financial stability concerns or the net loosening of financial conditions since the start of the year, Exhibit 3 (as the decline in the US dollar and risk premia in financial markets have offset the tightening from earlier US rate increases), this would be good reason to be wary of a potential increase in market volatility over the summer.
Furthermore, investors are already becoming nervous in respect to the potentially dwindling level of support from central banks for asset prices as QE programs in developed markets peak or are scaled back, Exhibit 4. In the US, we expect more questions in respect of the likely trajectory of the Fed's balance sheet on Wednesday.
In this decade, equity investors have benefited from a triple whammy of initially depressed valuations, stronger than expected corporate profitability and continuous downward pressure on long-term interest rates from quantitative easing, factors which have arguably driven equity markets to records in many cases.
We view the situation rather differently in 2017 to five years ago. Forecast corporate profits growth may indeed remain strong in 2017, but valuations are high and there has been no period post the 2009 financial crisis when central banks have not, in aggregate, been intervening aggressively in asset markets. With equity valuations relatively high, we still see good reasons to position portfolios cautiously and be focused on company-specific situations rather than on macroeconomic factors.