There are many market pundits and economists who now believe that today’s employment report has given the Federal Reserve enough rationale to embark on a path of increasing interest rates. Some are even calling for them to begin the process during their upcoming meeting later this month. Others, including the International Monetary Fund Christine Lagarde are calling for them to wait until 2016. So what will happen?
While the economic data is beginning to look like the negative GDP from the first quarter was a “one off”, there are many global headwinds which could make the good news on the economy a temporary condition. Some are watching to see if Greece will default on their debt and subsequently leave the Euro. Others are watching the rapid decline in the value of the German 10 Year Bund (“bond”) which inversely means their rates are rising.
You also have an apparent slowdown in economic activity in China and continuing tensions in the Middle East. I find it kind of interesting that the US economy appears to be gaining steam in the second quarter while the Chinese economy is sputtering or decelerating. Conventional wisdom would lead you to believe that if the US is improving, then so should China and other countries that are exporting to the United States. So it will be interesting to watch and see if the Chinese and Emerging Market economies begin to pick up along with the United States.
The issues in the Middle East are very unpredictable. There are so many cross currents that a positive development today doesn’t necessarily translate into a turning point or a trend. What would happen to the oil market if the Iranians disclose that they have developed a nuclear bomb? This could have a ripple effect across the globe and any trends in rising interest rates could be abruptly reversed due to the risk to the global economic structure.
Despite all of the outside issues, the Federal Reserve will have some tough decisions to make going forward. The odds favor that they will wait until September and even possibly into December to raise rates despite the possibility of being behind the curve. If the US economy continues to accelerate and most, if not all, of the issues discussed as a headwind subside, there is a great fear by many economists that they will have to raise rates in a draconian fashion. Instead of baby steps, 0.25% increases, they may become more aggressive and increase rates by 0.50% to slow down the specter of inflation. Some think that a draconian policy decision will create a shock to the bond markets which could spill over into the economy and stock market causing an across the board decline in all asset classes.
Right now since we do not know what policy the Fed will pursue, it is prudent to watch the US dollar versus other currencies, 5 and 10 year US Treasuries and the German 10 Year Bund. They are approaching levels which could force their hand sooner than they may want in order to show the market that they are serious about controlling rates. Obviously, time will tell……………….
Tom is the Founder of TRG and has been the President and Chief Investment Officer since 2008.