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A Wake Up Call from the Fed

The US and, to a large extent, the world economy are finally coming to terms with the somewhat perplexing reality of resilient growth and persistent inflation. While markets have long wished for interest rates to decline, the Fed has found little room to manoeuvre in the face of rebounding growth and an improving unemployment situation. Last week, the US central bank once again had to reiterate that it was not ruling out another increase this year and that interest rates would remain elevated for an extended period.

Policy Makers Still Hard at Work

The Federal Reserve is unlikely to announce a further rate increase at its Wednesday meeting. However, the release of a fresh round of economic projections from the central bank will shape the mood of the market. We expect the Fed to signal that a further rate hike in the near future cannot be ruled out. Inflation is still well above target, and economic data has suggested that the economy, unlike projections, is in a mini cycle of re-acceleration.

Still robust growth and more inflation

Week after week, economic data out of the US has continued to signal that US economy remains on a firm footing. Last week was no different. Pragmatism would have one believe that in a scenario such as this, the market would move to discount a slightly higher risk of a further Fed funds rate hike. However, in our view, the market is taking a rather sanguine view of the need to reverse the ongoing significant stimulus that continues to prop up the economy but one that also somewhat distorts the inflation story.

Central Bankers Attempt to Climb Out of a Hole

Few surprises emerged from the foothills of the Teton Range in Jackson Hole last week. For some time now, it has been evident that policymakers are still concerned about the persisting inflation and the signs of a re-acceleration in growth in the United States. Thus, while central bankers in the US remain biased – perhaps reluctantly – towards further rate hikes, the markets believe differently, ascribing just a 40% probability of a Fed rate hike by year-end. ECB President Lagarde, speaking at the annual symposium, was rather candid in her admission of the goings-on, articulating that "there is no pre-existing playbook for the situation we are facing today – and so our task is to draw up a new one". Roughly translated, central bankers are living from meeting to meeting. The Fed has admitted as much with its focus on data watching.

Maybe we should talk about 5%

The “shock” of a reacceleration in global growth even as core inflation persists and remains sticky is pushing investors – and economists – to consider levels of long-term interest rates that were previously unthinkable. We believe that there are good arguments for why a 5% US 10-year bond yield is quite possible. Despite many a market commentator being in denial, US growth is running at a pace far quicker than consensus expectations, and inflation is not necessarily trending back to the Fed’s long-term target range.

Testing Times

Some economists drew comfort from last week’s US inflation report, but we believe it still does not paint a rosy picture. Core inflation, which peaked at 6.6% year-on-year last September, is still at 4.7%, indicating it remains sticky and high. We continue to be sceptical that the US Federal Reserve will be in a position to cut interest rates through much of the next year absent a global event that brings about a marked slowdown in growth.