The Global AnAlyst | SEPTEMBER 201548 |

INTERNATIONAL

In these late summer days of 2015 a peak of volatility is spreading in the global mar-kets triggered mainly by a combination of catalysts.

These factors notably include - the potential decision by the Federal Reserve (Federal Open Market Com-mittee), at their Sept. 16-17 meeting, to undertake either in 2015 or in early 2016 the first rate lift-off since 2006 (monetary tightening); the Chinese economy slowdown, its highly lever-aged stock-market bubble and free-fall (Shanghai Composite Index in June 2015 was over 5,000 points from approximately 3000 points in De-

FEDERAL RESERVE’S RATE RISE Coming Soon?

cember 2014 and now it is back at the same level it was in December 2014, that is the index fell by 43 per cent); and, the impact of the sharp stock market correction, currency devalua-tion and massive capital flight (with potential liquidity risks or currency wars), the interest-rate cuts and re-serve ratio cuts, and the below target GDP growth on the global financial markets and real economy (i.e., com-modities, equities, foreign exchange, credit, financial markets, etc). Additional catalysts to the current level of volatility include the sharp oil prices decline (below $40 a bar-rel), geopolitical and economic risks

affecting the emerging markets; the uncertainty about the unravelling of the Greek crisis (third bail-out in five years and a new election on the way), and the ability of China to effective-ly implement structural reforms to liberalize its economy and to rebal-ance its economic model from an export-led growth (driven by a long-held investment-and-infrastructure growth strategy) to a consumption-led growth. Lastly, other catalysts are the inves-tors’ concerns over falling inflation expectations, and the health of the global economy (risk of global slow-down or recession).

In spite of the solid improvement of the US economy fundamentals, it is still unlikely that a rate rise will occur in September 2015 (unless the Fed aims to make just a minor symbolic hike), the first one in more than nine years, since it might not be fully consistent with the current inflation expectations and the latest turbulent international developments.

- Dr. IVO PEZZUTOGlobal Markets Analyst, Management Consultant, Economics and

Management ProfessorAuthor of the Book “Predictable and Avoidable” ISTUD Business School and

Catholic University of the Sacred Heart. Milan, Italy

49The Global AnAlyst | SEPTEMBER 2015 |

Challenges remainIn spite of the above facts, the Fed, like other central banks, should re-main independent from political influence and global externalities, and it should be mainly focused on the health of the US economy when setting its monetary policy, there is no doubt that in today’s complex, high interconnected, and globalized world, it would be difficult for any central bank not to consider in their global economic outlook and data dependent analyses economic and financial shocks of leading global economies. The collapsing Chinese stock markets, the plunging com-modity prices, and the global slow-down, geopolitical risks, and the intensifying currency war will in-evitably affect, directly or indirectly, all central banks policies and global economic growth expectations. The stock market and credit bubbles in China, the strength of the dol-lar relative to th`e emerging market currencies, (i.e. since 2008 dollar denominated corporate bonds have sharply increased in the emerging markets fueled by massive QEs and a weak dollar), and the commodity rout could all affect global earnings growth. Given the current scenario, it would be impossible to imagine a complete decoupling of the Chinese crisis on the US economy.

The US economy, sooner or later, would not be able to avoid the de-flationary forces sparked by the Chi-nese bubble. In spite of the improving fundamentals (i.e., economic growth) in the US economy, the emerging glob-al risks (i.e., Chinese crisis) are likely to pose significant challenges to the economic recovery, sooner or later, even in the United States, due also to the strengthening of the dollar against other currencies which start-ed in January 2014, when the Fed signalled that it would raise interest rates. Moody’s forecast is that the US growth will be at 2.4% in 2015, before rising to 2.8% in 2016. Robust job cre-ation, high corporate profits, favour-able financing conditions and pent-up demand all point to higher GDP growth. (Moody’s, 2015).

The Fed’s recent statement suggests it expects to raise interest rates some-time soon and that their monetary policy tightening will be extremely gradual. The level of uncertainty about the Fed’s policy decisions is contributing to increased volatility in the markets even though many sophisticated institutional inves-tors reported that they have already priced in the impact of a potential rate hike (monetary policy normal-ization) by the end of 2015 or in early 2016. Futures markets indicate that there is now just a 24 per cent chance of a rate increase in September 2015. Since the market currently attach a 24 per cent probability of a rate hike in September 2015, it is quite likely that an unexpected decision to start the first rate lift-off next month might generate some additional turmoil in the markets.

Rate rise & its repercussionsHigher rates would raise borrowing costs for consumers and companies, possibly hurting spending and eco-nomic growth. Nevertheless, cur-rently a large number of economists expect the Federal Open Market Committee (FOMC) to raise its target for the federal funds rate before the end of 2015. The minutes from the Fed’s July meeting indicated that the conditions necessary for an increase in the federal funds rate “were ap-proaching” but had not yet been achieved. A rebound in headline in-flation and continued solid employ-ment and overall economic data, suggest that the Fed might opt for a first rate hike before end of 2015.

The appreciation of the dollar, the devaluation of the Chinese currency, and the further decline of oil prices are complicating factors in predict-ing the pace of growth and Fed’s rate hike decision. The underlying trends in falling oil prices and falling com-modity prices have affected infla-tion rates leading to lower headline rate of inflation low, while core rate of inflation (which does not include food and energy) remains higher. Household wealth is increasing thus economists expect that in the coming

months they should choose to spend instead of saving. In the US economy, currently, the combination of a low and on target unemployment rate and low and below target inflation rate seem to be related to the par-ticular national and global economic cycle highly influenced by falling oil and other commodity prices, lower salaries, some structural changes in the labor market, higher savings rates, and probably even tightened lending market conditions.

In light of the most recent interna-tional developments and increased volatility on financial markets, many investors and analysts believe that it is unlikely that the Federal Reserve will pursue a rate hike plan in Sep-tember 2015. Volatility (measured by the CBOE’s Vix) in the past few days has surged as high as 53 in intraday trading (the last time the Vix was above 20), the highest since February 2009, indicating rising tension across markets. The S&P 500 nearly dropped 10 per cent. Economists at Barclays Capital have recently predicted that rate hike will occur March 2016, stat-ing that “it is unlikely to begin a hik-ing cycle in this environment for fear that such a move may further desta-bilize markets.” However, given the fact that FOMC seem to have posed significant attention on financial sta-bility considerations, it might still be possible to effect a first rate hike ei-ther in September or December 2015 in order to signal confidence to the markets in reaching the Fed inflation target in the medium term and the strength of the recovery.

What the fundaments suggest Recent data on the US unemployment rate (at 5.3 per cent) suggests a poten-tial fall below 5 per cent this year and a likely need for tighter monetary policy. Reports show that consumer confidence rose to its second-highest level in eight years while new home sales climbed 5.4 percent, the most in 2015. Good news also came from the US durable goods orders report. The New orders for U.S. manufactured durable goods climbed 2 per cent in July after jumping by an upwardly

Federal Reserve

The Global AnAlyst | SEPTEMBER 201550 |

revised 4.1 percent in June. Orders for transportation equipment led the increase once again, surging up by 4.7 in July after soaring by 10.7 percent in June. The orders for mo-tor vehicles and parts jumped by 4.0 percent, while orders for aircraft and parts gave back ground after spiking higher in the previous month. Or-ders for non-defense capital goods excluding aircraft, a closely watched indicator of capital spending, surged up by 2.2 percent in July after climb-ing by 1.4 percent in June. Shipments in the same category rose by 0.6 per-cent in July following a 0.9 percent increase in the previous month.Crude inventories fell 5.5 million barrels in the week to Aug. 21, the biggest one-week decline since early June, according to government data that countered analysts’ expectations for an increase of 1 million barrels. Treasuries prices rose after a top Federal Reserve official scaled back his view of a rate increase in Septem-ber in the wake of market turbulence stemming from worries about Chi-na’s economy. The Fed seems not to be in a hurry to raise rates even though it wants to get off to zero-bound rates. With the latest international developments (the turmoil and volatility spreading from China to global financial mar-kets), apparently, the window of opportunity is rapidly closing for a Fed’s tightening decision in Septem-ber 2015. According to the Mortgage Bankers Association’s (MBA) Weekly Mortgage Applications Survey for the week ending August 14, 2015, mortgage applications increased 3.6 percent from one week earlier. Re-cent financial market turmoil and lower price of commodities includ-ing energy has made it tougher for US central bankers to go ahead with a rate hike in immediate policy meeting scheduled for September 16th/17th.While survey based inflation expec-tation has remained stable, market bases measure has dropped to low-est level not seen since August 2010, when financial market was on its recovery from 2008/09 slump. Infla-

tion expectations as measured by 5 year- 5 year (5y/5y) forward inflation expectation calculated using swap dropped to 1.87%, a level not seen in 5 years.Markit Economics recently released its preliminary manufacturing pur-chasing managers’ index (PMI) for the U.S. The U.S. preliminary manu-facturing purchasing managers’ in-dex (PMI) declined to 52.9 in August from 53.8 in July, missing expecta-tions for an increase to 54.0. It was the lowest level since October 2013. According to survey respondents, the strong dollar continued to put pressure on export sales and com-petitiveness, while heightened glob-al economic uncertainty appeared to have dampened client spending both at home and abroad. Alongside this, manufacturers of investment goods widely cited growth headwinds from the slump in capital spend-ing across the energy sector. Rise in global volatility has pushed inves-tors to the safety of treasuries, which has pushed expectations of inflation down.Fed policymakers are still concerned about the weakness of the global economy, but they are also more con-fident about US growth prospects. Developments in the world economy and commodity markets have in-creased the downside risk in achiev-ing the sustainable inflation path to-wards 2 percent, thus an immediate

monetary policy tightening by the Fed might probably affect markets across the world and might cause more pain for emerging market as-sets, already being hit by China’s woes. If US tighten their monetary in such timing, a correction in the stock market probably can’t be avoided.

Rate rise can waitTo conclude, in spite of the solid im-provement of the US economy fun-damentals, it is still unlikely that a rate rise will occur in September 2015 (unless the Fed aims to make just a minor symbolic hike), the first one in more than nine years, since it might not be fully consistent with the lat-est turbulent international develop-ments. It is more likely, instead, that it will occur at the end of 2015 or in 2016 if the emergency phase of the Chinese crisis will soon resume and if the US economy will not have an unexpected overheating in the com-ing quarters.

Naturally, the S&P 500 index would be highly energized, at least in the short-term, by a decision of the Fed-eral Reserve to delay the Fed’s inter-est rates lift-off in September 2015 and by a firm commitment and a coordinated effort of central banks to continue to flood the markets with further monetary stimulus (i.e. stir-ring markets’ QE addiction) in order to avoid deflationary trends and fur-ther global economic slowdown.

Federal Reserve

TGA