Will the Fed shift?

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The coming week will see three big events. The FOMC (Federal Open Market Committee) meets and its projection for US interest rates for next year could move up a bit further. However, we expect the Fed to stick to its overall guidance that rates will remain low for a 'considerable period'.

In addition, Scotland votes in a referendum on independence, which will be a close call. Nick Kounis Nick Kounis Head of Macro Research

In the eurozone, the ECB will conduct the first TLTRO (Targeted Long-Term Refinancing) operation. It seems likely that the take-up will eventually be large, but banks may wait until the December one. In addition, Scotland votes in a referendum on independence, which will be a close call. A vote in favour will likely mean uncertainty in the near term, which will be negative for the UK economy and sterling for a time. Meanwhile, last week’s data were positive, suggesting the eurozone returned to growth in Q3.

All eyes will be on the Fed

The FOMC meets in the coming week. These meetings are usually big events, but this one will be particularly closely watched. The minutes of the last meeting suggested that a number of Committee members feel that interest rates may need to rise somewhat earlier than they are currently signalling if the trends seen in the economy and labour market persist going forward. Even Fed Chair Janet Yellen sounded a little more open to raising interest rates earlier in the face of better economic data. Finally, last week, researchers from the San Francisco Fed published a paper suggesting that financial markets were expecting ‘a more accommodative policy than FOMC participants’. Against this background, financial markets have started to price in higher short-term interest rates in the US for next year. According for futures markets, the fed funds rate is now expected to rise to 0.8% by December. This compares to lows of around 0.65% in the middle of August. This means investors now expect a little more than 50bp of policy rate increases next year, which is still below the guidance of the Fed (see below).

US fed funds rate expectations

Watching the dots and the guidance

Three elements will be watched particularly carefully. The first is the projections of individual FOMC members, which are published once a quarter. There is a particular focus on their expectations for future short-term interest rates, which are displayed in a dot chart. The last projections, published in June showed that officials expected a median target for the fed funds rate of 1.1% at the end of next year. Given the recent remarks from officials, the dots could well creep up a bit further, to signal a somewhat higher expectation for the fed funds rate.┬áThe second element is the forward guidance in the FOMC statement. In recent times, the Fed has asserted that it would be 'appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends'. The Fed is likely to taper its asset purchases again at the September meeting (to a monthly pace of USD 15bn from USD 25bn) and end the programme altogether in October. What a 'considerable time' after that means, is anyone's guess. There has been some discussion among Fed officials that the guidance should change to be made 'data dependent'. However, we do not expect this at this meeting. The latest month of the broad range of labour market data the Fed watches has shown little progress. This might be due to special factors, but we think it is probably too early for the Fed to make a major shift in its communication. The final element to watch will be Fed Chair Yellen’s remarks during the press conference. We expect a relatively balanced approach.

Exit like to be at a pace that suits the economy

Our base case is that the Fed will raise rates in June of next year, and raise interest rates in small steps at each subsequent FOMC meeting in 2015. With inflation under control, the Fed can afford to raise interest rates at a pace consistent with the economy continuing to grow at a healthy pace. Signs that less accommodative monetary policy is threatening economic growth would see an adjustment in the pace of rate of hikes. As such, we do not see the Fed’s exit as a threat. During past rate hike cycles, economic growth and the performance of growth-related assets has remained positive on average. We see no reason to think this time will be different.

TLTRO take-up could start slowly

The other big event next week will be the first of the ECB’s TLTROs in which it will lend money to banks for up to 4-years. The maximum take-up in the September and December TLTROs is around EUR 400bn, while the central bank has indicated that taking all eight operations together, there could be a take-up of a trillion euro. There probably will be ample demand. The cost of the operations compared to other sources of funding is favourable for banks. However, it is conceivable that banks will start relatively slowly, with the bulk of the early take-up coming in December. Banks that are still using LTRO funds will hang on to them a little longer as they are cheaper. A reasonable assumption for September borrowing is EUR 100bn. Although the TLTROs on their own will not make the difference for the outlook for bank lending, they are part of a comprehensive package of measures by the ECB, including the comprehensive assessment of banks and the covered bond and ABS purchase programme. All these measures together are starting to look formidable. In addition, demand for bank loans is starting to recover. We expect a gradual recovery in eurozone bank lending in the coming quarters. (please also see our Fixed Income Watch publication: 'TLTRO: bazooka or peashooter', for more).

Scotland takes centre stage

The final big event of the week will be Scotland’s vote in the referendum on independence from the UK. Last weekend, an opinion poll showed that the Yes vote for Scottish independence had taken the lead. However, towards the end of last week, the polls turned to show that the No campaign once again had the upper hand. Either way, it looks to be a close call. A Yes vote could lead to a sterling currency area break-up as the UK government has ruled out a currency union with an independent Scotland. This in turn raises questions about the division of assets and liabilities and the possible re-domination of the balance sheets of Scottish entities. In the case of a Yes vote, the two governments have pledged to work constructively together to reach separation agreements, while the BoE has prepared a contingency plan to ensure financial stability in the interim period. Nevertheless, the uncertainty would likely hit investment and trade, especially in Scotland itself, which makes up around 8% of the UK economy. Sterling would likely fall significantly as markets scaled back BoE rate hike expectations and factored in a significant risk premium.

Economic data last week generally positive

Turning back to recent economic reports, these were generally rather encouraging. In the eurozone, there were signs that Q2’s flat GDP reading was not the beginning of a trend, but rather that a moderate recovery is continuing. Industrial production jumped by 1% mom in July, up from a 0.3% decline in June. A stronger global economy and the fall in the euro should underpin growth in the eurozone industrial sector in the coming months. Meanwhile, employment rose by 0.2% qoq in the second quarter, up from a 0.1% gain in the first. In the US, the story of continued strong economic growth was underlined by an upbeat retail sales report. Retail sales were up by 0.6% mom in August, while the July number was revised up to 0.3% from 0% previously. It was particularly encouraging that the growth in sales did not rely on volatile auto or gas sales, with the core measures also strong. US households are benefiting from an improving labour market and strong balance sheets.

Eurozone employement growth

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