Fed takes a step towards normalisation

Nicholas Wall, portfolio manager, Old Mutual Global Strategic Bond Fund, Old Mutual Global Investors

The US Federal Reserve (Fed) hiked interest rates for the first time this year while economic projections were not changed meaningfully - however, the big surprise was that the central bank now projects three interest rate hikes in 2017 (to a 1.25-1.50% range). The Federal Reserve pointed to “considerably” higher market-based inflation expectations and highlighted a “strengthening” labour market as the main reasons behind the move.

Our view has long been that global central banks overreacted to the news that the UK voted to leave the European Union and, arguably, overplayed the so-called ‘secular stagnation’ view of the world.

Against that backdrop not only did the Fed postpone raising rates in July, but it lowered its projections for the terminal Fed Funds rate and potential US growth. In recent months, however, there has been largely growth- and inflation-friendly news flow in the US and globally (the unemployment rate is close to an eight-year low at 4.9%, the participation rate has stopped declining and average hourly earnings have picked up). What’s more, these trends existed before the promise of president-elect Trump’s fiscal boon and that’s why the Fed were prepared to move before his inauguration.

The initial move has seen curves bear flatten and the dollar strengthen as you would expect. However, longer term, we would expect curves to steepen due to the large amount of ‘search for yield’ trades that still need to be unwound in the market and due to the prospect of the US running higher fiscal deficits, boosting nominal GDP growth that tends to influence the long end of the curve to a greater degree. This is a modest change, but a further step towards policy normalisation.