Memo from Federal Reserve: 2015 Interest Rate Hikes are a Myth

January 27, 2015 • Analysis • Tags: , ,

This article was written by Patrick Brik

According to economic data, as translated by the Federal Reserve, the US economy is no longer struggling. During 2014, 1.7 million jobs were added and GDP is expected to expand by 2.6%. In contrast to the rest of the developed world, the US is the belle of the ball. However this is only because the party goers are ugly as sin. The European Central Bank decided to embark on quantitative easing two years too late and Japan has been faced with consistent deflationary pressures. As a result, the Federal Reserve is considering making the US economy the only one to normalize interest rate policy in 2015. Does the Fed actually believe the US is sheltered from the global economy? If so, then why do the structures of the yield curve, credit spreads and the current level of volatility paint a different picture?

Yields Indicate Deflation and Sub-par Growth

Global bond yields are all dropping and racing towards 0% (below). US 10-Year Treasury has collapsed below 2% thus far in 2015, while German and Japanese bonds are sub 0.5%. This significantly caps central banks as there aren’t many alternative options to encourage economic growth.

[level-free]

global yields

Yields are driven down and flattened when investors seek risk-free assets ahead of an economic downturn.  Oil’s decline and the fact that economies overseas are struggling to find their footing have fueled bets that inflation will slow even more than it already has. Eurozone is nearing deflation and the US is circling the same result.

The gap between 2yr and 30yr Treasury yields flattened to 186 basis points, down from around 329 basis points a year ago. Treasury yield curve is at the flattest levels in six years due to global growth concerns and the perceived rate hike.

Even more concerning is that rates are running below mandated central bank targets.  The Federal Reserve has a policy of stable pricing, which constitutes inflation targeting at 2%. If the Fed stays true to its word and raise rates, then that indicates that inflation should be nearing the mandated 2%.  However, recent data (below) shows inflation moving away from the 2% target, rather than towards it.

us inflation

With US treasury yields at ~1.8% and inflation, by Fed’s expectations, to hit 2%, investors are purchasing US bonds with negative real rates.  Nowhere does this acknowledges any type of stable pricing & global growth.  Yields driving towards zero are a result of deflationary pressures and a slowing global economy. The appetite to drive rates lower has yet to abate and is a cause for concern.

Widening Credit Spreads a Sign of Economic Struggles

Theoretically, during economic expansion, credit spreads narrow and in economic downturns credit spreads widen. Currently, spreads between high yield corporate bonds (white) and treasury (blue) are widening as government bonds are making new highs, but high yield corporate bonds are under performing (below).

credit spread

 

The credit widening began in late 2014 as oil’s price drop applied pressures to high yield notes. Oil fracking is approximately 15% of the corporate high yield debt index. With oil prices down over 50% in the last year, the probability of producer defaults has sky rocketed. Credit is becoming more costly to acquire in the midst of this market’s weaknesses.

 Volatility
Central banks are devaluing their currencies in a hope to spur economic growth. The race to depreciation was ramped up with Mario Draghi’s bond purchasing announcement. Equity markets have benefited from such policies, but at the cost of currency valuations. The $US dollar has risen for seven straight months as the Yen, Euro and other major currencies have dropped (below).

currencies

Currency fluctuations increase uncertainty and interrupt global trade. US corporate earning abroad will suffer from currency volatility as certain American giants like Coca-Cola, McDonald’s and Philip Morris generate approximately 40% of sales from overseas.  This exposure to foreign currencies will affect corporate earnings once results are translated back to USD.

With many commodities being priced in USD, volatility of copper and oil prices has added to the selling. Additionally, unforeseen events have caused unstable markets reactions. Take the Swiss’ decision to abandon the Euro peg, for example. The subsequent 20 point move in the franc caused carry trades to unwind in a fashion that led to the bailout of currency broker FXCM.

This volatility in currencies will spill into the equity markets. According to the VIX, 2014 was indeed a year of low volatility. While under QE3, the VIX index remained subdued below $22.

Since the Fed ended the bond buying program in late October, the VIX index has breached $22 four times in as many months (below).  Volatilty creates uncertainty and uncertainty can lead to corrections.

vix

What Does This All Mean?

Though the US has shown some economic traction as of late, the global economy is slowing and succumbing to deflationary pressures. Globalization will not permit the US economy to be unaffected by the recent rise in volatility.  A rate hike could further accelerate deflationary pressures, which isn’t in anyone’s best interest. Due to this, I believe that rate hikes are out of the question for 2015.

Interest Rate Hike
Do you see Fed raising rates in 2015?
[/level-free]

Tags: , ,

Comments are closed.