The Two Things That Will Drive US Interest Rates

As it turns out, the decision by the Federal Reserve in the US not to raise rates last week was a pretty close call. Over the weekend, four of the 10 voting members that make up the Federal Open Market Committee (FOMC) said they still expect the cash rate to rise before the end of the year.

Chair Janet Yellen gave 2 main reasons for the delay within ‘liftoff’, as they’re calling it right now. Firstly, the massive market volatility that hit global markets in August. And next, the potential impact on the US through the slowdown in the Chinese economic climate.

How these two factors flow in to growth in the US economy, and the inflation rate, will determine what the Fed will do from here.

We witnessed much of this market volatility in the huge daily swings within the Chinese stock market over the last month or two. This affected all the major search engine spiders worldwide.

Similar to the role that the RBA plays here in Australia, the Federal Reserve seeks full employment as one of its primary goals. The unemployment rate in america is currently 5.1% — a level that the Fed considers close to complete employment.

This satisfies one of the requirements for lifting rates back to more ‘normalised’ levels.

By the way, if you are wondering what the ‘normalised’ interest rate level is, officials at the Given put it at 3.75%. Even though Yellen is softening the market up by saying that it might take ‘several years’ to reach this goal.

Another primary goal of the Fed is to acquire a desired inflation target around 2% per annum. Again much like the RBA within Australia. Currently this sits at around 0.3% in the US — well below their target degree.

Typically central banks lower the cash rate to spur development in the economy. This can may also increase inflation as extra money bids up the costs of goods as well as services. To curb extreme growth and inflation, main banks do the opposite and increase the cash rate.

Increasing rates right now in the US seems to go against this particular economic theory. It could further dampen inflation just as they need it to get back to their focus on level.

However, the four dissenting members of the FOMC see the labour market because the biggest contributor to fixing the inflation problem.

The cost of labour impacts all goods and services throughout an economy. While joblessness is high there is little in the way of wages growth that will drive up these costs. The employee offers little bargaining power.

With full employment, though, this balance starts to move back into their own favour. With a tight work market, employers need to pay more to stop staff leaving with regard to better paying jobs.

It’s this rationale that those governors in favour of raising rates this year are financial on. That is, an increase in labour costs should help pump the inflation rate back up to the desired 2% level.

Of course, any downturn in the labour marketplace puts a hole in the theory. That’s why, according to Bloomberg, the commodity market only points to the 20% probability that they’ll raise rates in October.

This number increase to just under 50% for the December meeting. Although, this is the exact same number who thought they might raise the cash rate last week.

In the meantime, the US offers plenty of others giving them free advice. Among them, the IMF and the World Bank.

They’re worried that the increase in US rates may drag yield hungry funds out of emerging markets and back into the US. This will further exacerbate the huge sell-offs that have smashed these markets and will pull the world economy down additional.

Regardless, I still think they will raise rates. Maybe not by October. Maybe it will be in December or early the coming year.

Again though, I won’t believe it till I see it.

The problem is this particular. If they didn’t raise the money rate will full work and the markets trading continually highs, how will they raise rates if the markets still tumble or unemployment starts ticking up?

Maybe they’ve missed their chance.

One thing the markets loathe is uncertainty. Jesse Yellen is scheduled to speak within Massachusetts on 24 Sept. Needless to say, the markets all over again will be hanging off the woman’s every word. So we’ve got that to look forward to.

Chinese investors don’t want to play

While Janet Yellen and her posse of Federal Reserve officials try to guess what’s happening in China, it seems even those on the ground there are still trying to work out what’s going on.

The Chinese language government has been very active in trying to stem the rout that hit their markets after they peaked in June. You can see the run up within the following chart:

Shanghai Composite Index

Source: Google finance

The government is desperately attempting to avoid the huge swings and volatility from the stock market flowing into the rest of the economy. It’s been pumping what seems like an endless way to obtain money into the market to originate the flows.

The problem right now, though, is that nobody seems to have any idea how much the market is being propped up by the federal government, or how much comes from real demand from long term investors.

The measures undertaken by the federal government were designed to lower volatility and restore liquidity to the market. However, it might now be getting the opposite effect as traders’ time frames become even shorter.

There appears to be one trade in town the most nimble investors are trying to profit from. It’s trying to guess a level where the Chinese government purchasing will enter the market, and slip in ahead of all of them.

As the buying might only last a day or two, of course, short term traders try to jump away before the buying stops. It might be a vicious circle, and all it will is scare more traders away from the market.

Bloomberg puts the entire trading volume in gives down by a staggering 75% over the last four months. At the same time, volatility offers more than doubled. And the quantity of new investors entering the marketplace has dropped by over 80%.

The government has also intervened in the futures marketplace, just about bringing it to a stop. Short selling as well as margin lending have been severely restricted as authorities search out those deemed accountable for bringing the market to its legs.

30 day volatility chart from the major markets

Source: Bloomberg

The above 30 day volatility chart highlights just how crazy the ride has been in China. It’s certainly quite serious when you compare it to our experience here. I’m not too sure I’d have the stomach to be wading into their market in the near future.

When will it all settle down? That’s what Yellen and her officials is going to be trying to work out. While speculators may dominate a market temporarily, the weight of real money — money focussing on the fundamentals — will determine once the market has bottomed.

Right now, still it seems like it has further to go.

Regards

Matt Hibbard,

Editor, Total Income

Editor’s note: The above article is definitely an edited extract from Complete Income. To find out more about Matt’s strategy for income investing in a low-interest rate world, click here.

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