The Two Things That Will Drive US Interest Rates

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

Chair Janet Yellen gave two main reasons for the delay within liftoff, as theyre calling it right now. Firstly, the massive market unpredictability that hit global financial markets in August. And secondly, the potential impact on the US through the slowdown in the Chinese economy.

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

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

Similar to the role 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 the Fed considers close to complete employment.

This satisfies one of the criteria for lifting rates back to more normalised levels.

By the way, if youre wondering what the normalised interest rate degree is, officials at the Fed put it at 3.75%. Although Yellen is softening the market upward by saying that it might take several years to reach this goal.

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

Typically central banks lower the money rate to spur development in the economy. This can 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 at this time in the US seems to go against this 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 actual FOMC see the labour market because the biggest contributor to fixing the actual 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 increase these costs. The employee offers little bargaining power.

With complete 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 for better paying jobs.

Its this particular rationale that those governors in favour of raising rates this year are banking on. That is, an increase in work costs should help pump motor the inflation rate back up to the desired 2% level.

Of course, any kind of downturn in the labour marketplace puts a hole in the theory. Thats why, according to Bloomberg, the futures market only points to a 20% probability that theyll raise rates in October.

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

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

Theyre worried that an increase in US rates will drag yield hungry capital from emerging markets and back into the US. This will further worsen the huge sell-offs that have smashed these types of markets and will drag the world economy down further.

Regardless, We still think theyll raise prices. Maybe not by October. Perhaps it will be in December or early next year.

Again though, I wont believe it until I see it.

The problem is this. If they didnt enhance the cash rate will complete employment and the markets buying and selling at all time highs, how will these people raise rates if the markets continue to tumble or unemployment starts ticking up?

Maybe theyve missed their own 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 weve obtained that to look forward to.

Chinese traders dont want to play

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

The Chinese language government has been very energetic 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 trying to avoid the huge swings as well as volatility from the stock market flowing into the rest of the economy. It has been pumping what seems like an endless supply of money into the market to stem the flows.

The problem now, though, is that nobody has any idea how much the marketplace is being propped up by the government, or how much comes from real demand from long term traders.

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

There appears to be one trade in town that the most nimble investors are trying to profit from. Its trying to guess a level in which the Chinese government buying may enter the market, and slide in ahead of them.

As the buying might only last a day or two, of course, the short term investors try to jump out prior to the buying stops. It becomes a vicious circle, and all it does is scare more investors from the market.

Bloomberg puts the total trading volume in shares down by a staggering 75% over the last 4 months. At the same time, volatility has more than doubled. And the number of new investors entering the market offers dropped by over 80%.

The government has also intervened in the futures market, nearly bringing it to a stop. Short selling and margin lending have been severely limited as authorities hunt away those deemed responsible for getting the market to its knees.

30 day volatility chart of the main markets

Source: Bloomberg

The above 30 day volatility graph highlights just how wild the actual ride has been in China. Its certainly quite sobering when you compare it to our experience here. Im much less sure Id have the stomach to become wading into their market in the near future.

When will it all settle down? Thats what Yellen and her officials will be trying to work out. While speculators might dominate a market temporarily, the weight of real money money focussing on the fundamentals will determine when the market has bottomed.

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

Regards

Matt Hibbard,

Editor, Total Income

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

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