A Rocky Reaction to a Fed Hike

23 Dec 2015 | Author: | No comments yet »

A Rocky Reaction to a Fed Hike.

At first it seemed as if markets were taking the Federal Reserve’s first interest-rate hike in nine years in stride. Mexico City • Mexico raised borrowing costs for the first time since 2008 following Wednesday’s increase by the Federal Reserve amid concern a smaller rate advantage versus the U.S. could lead investors to pull funds from Latin America’s second- largest economy. Banco de Mexico’s board, led by Governor Agustin Carstens, boosted the overnight rate 0.25 percentage point to 3.25 percent Thursday from a record-low 3 percent, as forecast by 21 of the 26 economists surveyed by Bloomberg. Agustín Carstens, who also chairs the policy advisory committee of the International Monetary Fund, said Thursday the orderly reaction so far in emerging markets to the U.S.

Federal Reserve’s rate increase could be sustained, noting that the coming moves will likely be less transcendental. “A very important thing is that this first step taken by the Fed had taken on a mystical quality, but I think that in subsequent actions taken by the Fed that characterization won’t apply,” said Mr. Crucially for Carney, it allows him to assess how the U.S. economy and markets react to costlier borrowing before making what will be a sensitive move of his own. The British economy is likely to be among the world’s fastest-growing for a third year in a row next year and, just as in the United States, it has seen a drop in unemployment. But faced with near non-existent inflation, sluggish wage growth and ultra-loose monetary policy in Britain’s main euro zone trading partners, Carney has already stressed he would not necessarily move in step with his Fed counterpart Janet Yellen. The latest signals from the Bank of England’s Monetary Policy Committee (MPC) have indicated that we should not expect a rate rise in the near future.

Carstens said the Fed managed quite well its first rate increase in almost a decade, explaining ahead of time and in detail what it intended to do, which contributed to an orderly reaction in many emerging market currencies. The yield on the benchmark 10-year note (which moves inversely to prices) closed the week at 2.2%, down from a high of 2.33% on Fed day, according to Tradeweb. The central bank has spent about $24 billion in 2015 on intervention programs to support the currency. “The central bank has been watching the Fed very closely and preparing the market for this.

The peso, the world’s eighth most-traded currency with a daily volume of $135 billion, strengthened after the widely anticipated Fed decision and closed little changed Thursday at 17.06 per dollar. Recent statements from Mark Carney and his deputy, Minouche Shafik, have reinforced the view that the UK will not be in a hurry to follow the lead of the US Fed.

Other Latin American currencies, such as the Brazilian real, have also strengthened. “I think that for the time being the solid response can be sustained, but there is constant news that could have an impact on markets,” Mr. The not-so-obvious answer to the riddle of lower Treasury yields following liftoff is that bond investors aren’t buying a lot of what the Fed is selling.

Aside from the inflation outlook, there are plenty of other reasons Carney might be cautious – not least Britain’s in-out referendum on its EU membership due by the end of 2017, and finance minister George Osborne’s plans for further spending cuts as part of his mission to run a budget surplus. Thursday’s rate increase brings to an end an almost seven-year period beginning with Carstens’s predecessor, Guillermo Ortiz, in which Banxico cut rates 11 times as the economy struggled with the global financial crisis and its aftermath. Fed Chair Janet Yellen has repeatedly said—and echoed again on Wednesday—that the pace of rate hikes would be gradual and dependent on incoming data. The latest Reuters poll of economists indicated that the first UK interest rate rise would take place in the second quarter of 2016 (April to June) – so could be only a few months away. Many economists anticipated that Mexico would follow the Fed after Banxico in July changed its meeting schedule for the rest of 2015 to be able to better react to U.S. moves.

But she also said she is confident that the job market is improving and inflation is heading to her 2% target (she believes that current low inflation and moderate U.S. economic growth are transitory). But as his predecessor Mervyn King – who was criticised for responding too slowly to the 2007-9 crisis – found out, the exact timing of any move is a delicate balancing act. The Fed’s dot plot, a chart released on Wednesday that displays Fed officials’ predictions for future rate increases, shows about four hikes next year. Carney’s previous hints of a British rate rise have been knocked off course by the twists and turns of the world economy, including the plunge in global oil prices which at one point sent British inflation tumbling to below zero.

The Federal Open Market Committee unanimously voted Wednesday to set the new target range for the federal funds rate at 0.25 percent to 0.5 percent, up from zero to 0.25 percent. Carstens, who ran unsuccessfully in 2011 to head the IMF and has left the door open to try again next year when Christine Lagarde’s term ends, praised the Fed’s handling of a process of monetary normalization that will gradually end the age of easy money that started after the 2008 financial crash. “The Fed is acting in a way that’s congruent with its mandate and with the communications it has been carrying out for many months. Given its latest communications and lingering credibility questions, “our own view is it will be difficult for them to reverse course in the next three months or so,” says John Bellows, portfolio manager at Western Asset Management.

Peter Boockvar of The Lindsey Group says headline inflation could rise and unemployment could fall to some 4% as the U.S. and global economies soften. The bank raised rates in a bid to keep the peso competitive, but annual inflation is at 2.2%, the lowest level in 45 years, and economic growth remains moderate.

Investors are left to react to each new data point. “In a way, it’s business as usual,” says Francis Rodilosso, who oversees fixed-income exchange-traded funds at Van Eck Global. “But that’s a fair amount of volatility.” With liftoff just days old, it’s early to read too much into the reaction. Plus, he adds, “In terms of the real economy, interest rates are not higher; they’re lower.” THE BEST-PERFORMING fixed-income sector in 2015 was municipal bonds, recommended in this column repeatedly this year. Growth and inflation in both the UK and US are also projected at similar rates, with GDP rising by between 2pc and 2.5pc and inflation moving back up to 2pc as the impact of lower oil prices drops out of the calculation. Muni bonds returned about 3% in 2015, and many closed-end muni funds, which use leverage, as well as ones that buy lower-rated high-yield muni bonds—both highlighted here— did far better. Muni returns shine even brighter on an after-tax basis. “Munis had a good year in 2015,” says Jim Kochan, chief fixed-income strategist at Wells Fargo Funds.

France continues to be a drag on European growth, but this is offset by better performance in other countries in northern Europe, such as Poland and Sweden. And there are signs that these are feeding through into wage increases – for example, pay rates are now increasing by over 6pc in the construction sector.

So UK borrowers and savers should keep a close eye on monetary policy on the other side of the Atlantic if they want to know what is going to happen here.

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