Lift-off postponed

The September FOMC decision was highly contentious and reasonable arguments could be made for either staying pat or starting to hike cautiously. Markets clearly favoured the status quo while economists were more evenly split. By deciding not to hike, the Fed has clearly proven the markets right.

Why has the Fed decided not to hike this time?

China’s economic troubles and the slower growth in other foreign economies were apparently crucial reasons. The argument was mentioned both in the FOMC release (“recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term”) and during Yellen’s press conference.

The Fed, however, did not only choose to delay raising interest rates, it also revised downwards its path of expected interest rates going forward. Three participants now favour lift-off in 2016 and one even favours a cut to negative rates and lift-off … in 2017! Of course, as underlined by J. Yellen, a “substantial plurality” of FOMC participants continues to expect that a rate hike by year-end will be appropriate. Still, it might sound slightly intriguing to see more participants being reluctant to hike while getting closer to the end of the year, which almost all Fed officials had repeatedly signalled as a deadline for lift-off.

Despite those rather dovish revisions, yesterday’s decision might, however, have been a closer call than perceived. As mentioned in the press conference, “The recovery from the Great Recession has advanced sufficiently far and domestic spending has been sufficiently robust that an argument can be made for a rise in interest rates at this time.” But, “heightened uncertainness abroad” and “a slightly softer expected path for inflation” had convinced the committee to wait for more evidence, including further improvement in the labour market. Yellen went even further, adding that the Committee wants to take “a little more time” to bolster confidence in its medium-term forecast.

What will happen next ?

Unless external conditions deteriorate much further, the Fed will, as planned, hike before the end of the year. Could that be October? While Yellen acknowledged that October was a “live meeting” (the Fed could decide to convene a press conference), it looks rather unlikely at this juncture. Inflation will soften further in the coming months before bottoming around the end of the year. Moreover, by that time the Committee will still not have much useful information about the Chinese economy and, more generally, about emerging market risk. A December move might thus be more likely as further improvement in the labour market and confidence that inflation is moving back to its long-term objective should by then have made the Committee more comfortable.

The importance of the initial timing of the increase should, however, not be overstated.

While uncertainty about the “L-Day” might linger, an October or December hike will not make a big difference to the economy. Of course, markets will remain more volatile trying to guess the exact timing of the lift-off (but this is an inescapable side effect of weaker forward guidance). What matters more than the date the Fed will opt for is that the tightening will be very gradual and monetary policy will remain accommodative for quite some time to come …

Our cross-asset strategy: we reduced our overweight on the USD

Given that the Fed will now take into account the global economic context and lower inflation expectations, any action from the US central bank in October, as mentioned above, looks rather unlikely. This is having an impact on the USD and will delay any further appreciation of the greenback.We therefore decided to reduce our overweight on the USD.

Beyond that, we think that the Fed’s decision should reduce the pressure on emerging markets and commodities, making the context more accommodating for a rate hike in the next few months. Therefore, for the moment, this status quo decision does not call into question our global economic scenario: it should end up being supportive to risky assets. Nevertheless, this lack of visibility on monetary policy should lead to a more volatile environment.

In consequence, we maintained a slight overweight in equities, especially in the euro zone, and wait for better entry points to increase our exposure to equities. We also retained diversification away from government bonds on our fixed income allocation.