At the closely watched September meeting of the U.S. Federal Open Market Committee, Chair Janet Yellen and the Committee kept interest rates on hold. Russell Investments’ strategists delve into what this record run of near-zero U.S. official interest rates means for New Zealand investors.
What does the announcement signal?
OK, so we’ll wait a little longer for the U.S. Federal Reserve (the Fed) to finally raise interest rates. In hindsight, the delay wasn’t all that surprising: The U.S. equity market decline in August and ongoing volatility—prompted in large part by worries about China and the emerging markets, plus continued concerns about stubbornly low U.S. inflation rates—made caution a good choice for the time being.
One thing that’s clear as a result of the announcement: We certainly know what the Fed is thinking. Yellen and others at the Fed have been exceptionally transparent about what will drive them to hike rates. Even though September was widely seen as a potential time for rate “lift-off,” minutes from the Fed’s July meeting made it obvious that it was not a done deal. Rather, the choice about a rate increase would depend on economic data. That’s a good thing. We still remember what happened in 1994 when the Fed surprised markets with a rate hike that didn’t seem to be based on available data: it sent bonds and equities tumbling.
Should New Zealand investors be worried?
Keeping interest rates at zero after several years of U.S. economic recovery is an eye-catching example of non-action. The commentary from the Fed suggests that “Recent global economic and financial developments” (that is, the slowdown in many emerging economies such as China and Brazil, and related currency and sharemarket turbulence), “may restrain economic activity” – potentially a problem for a commodity exporting country like New Zealand.
Despite this Fed caution, we remain optimistic about the outlook for the U.S. economy in particular and, ultimately, the world as a whole. Cheap oil is helping to drive down inflation (and hammering energy producers) but we see that as largely transitory, and lower energy prices act as a tailwind for the consumer. Recent U.S. economic data reports have remained solid; vehicle sales in August were the strongest since 20051 and, as the U.S. Bureau of Labour Statistics notes, the unemployment rate has fallen all the way from 10% during the Great Recession crisis to 5.1% today.
A second key effect of U.S. rates being “lower for longer” is the potential impact on New Zealand official cash rates and, relatedly, the New Zealand dollar. Ongoing Fed inaction is on the face of it a positive for the New Zealand dollar, and the currency initially staged a rally on the back of the Fed announcement. But we still believe that U.S. rates will be in an uptrend over the coming 6 months whereas Graeme Wheeler at the Reserve Bank of New Zealand has recently reiterated an ongoing easing bias. That means that the New Zealand dollar will likely continue to be undermined by differential U.S. versus New Zealand rate policy in the medium term.
When are rates likely to move?
With some upbeat language from the Fed, in the latest statement, about the U.S. economy now being “notably stronger”, we still think the Fed will move on raising interest rates this year. They just need a bit more time to assess the recent market volatility in financial markets and feel absolutely confident that the economy is still chugging along. The initial hike will be modest – probably 25 basis points in December. But our expectations are a bit more aggressive than others in how we see rates rising from there. Our forecasts are for the Fed funds rate to increase by about one percentage point per year. That’s higher than the 0.5% rate that the bond market is pricing2, and so we expect U.S. interest rates to move higher. But in a historical context, this is likely to be an extremely gradual rate-hiking cycle which is a positive for both the U.S. economy and financial markets.
What should you do with your investments—and what is Russell Investments doing?
Given our continued expectation of moderate economic growth in the developed markets, we viewed the equity market sell-off last month as a potential buying opportunity. But for global investors, we see better opportunities in regions such as continental Europe, where the European Central Bank is pursuing an aggressive asset purchase program along the lines of the Fed’s quantitative easing from several years back. We made note of this in our most recent Global Market Outlook – Q3 Update. Europe appears to be in the earlier stages of its growth cycle which could potentially yield rewards for careful investors.
As always, Russell Investments is continually monitoring its funds and seeks to help clients manage risks through diversification. Our investment team has been anticipating and preparing our portfolios for the eventual divergence in global central bank policies. For example, in recent periods, we have moderated portfolio exposures to interest rate sensitive assets and focused on alternative sources of returns that are less dependent on the direction of markets.
After seven years of essentially zero interest rates, we’re close to entering a new world. Investors will want to be ready to consult with their financial advisers and understand when (and when not to) move as markets do.
There are a lot of shifting and diverging parts in the global economy these days.
The Fed is just one of them.
1 “U.S. auto sales surge in August to highest level since 2005”, MarketWatch.com September 1, 2015
2 According to Bloomberg Bond Trader data as of September 2015.
The information contained in this publication was prepared by Russell Investment Group Limited on the basis of information available at the time of preparation. This publication provides general information only and should not be relied upon in making an investment decision.