The Fed minutes and the unclear rate hike path

On Wednesday the Federal Reserve (Fed) released its minutes for the meeting held in mid-June. The minutes highlighted that committee participants were surprised by the slowdown in job growth and the potential threat of Britain leaving the European Union. But was the former truly their major concern?

Let’s face it, over the past twelve months, May’s non-farm payroll figure was the first remarkable disappointment. A figure below 100,000 was last seen in March 2015. The 38,000 number was the fewest monthly total in five years, and it followed a tepid gain of 123,000 in April. Thus from an economic perspective, a strong pattern of jobs growth was undoubtedly noted over the past months.

In my view the major concern was more related to the negative implications of Brexit. Now that both the outcome and market reaction are crystal clear, the Fed is re-assured that investors will flock to safer havens (sovereigns) and the dollar will appreciate strongly.

Moving forward following Brexit, the dilemma for the Fed is once again the appropriateness with regards to the next rate hike. In my view, the Fed will now re-shift its focus on the sustainability of positive domestic economic data.

Yesterday ADP employment in the private sector rose more than expected in June, led by gains in small-business jobs, while economists’ expectations for this afternoon’s job report are close to 180,000, thus a significantly upward revision from May’s numbers. Surely a solid jobs report could help ease anxieties about the U.S. economy and renew speculation about when the Fed might resume raising rates. That said, the Brexit vote certainly eased the timing pace of a rate hike as market participants witnessed turbulence over the past days.

This time round the market is pricing in a 17 per cent probability of a hike in December. That said many economists think the Fed will raise rates at best just once in 2016, probably near year's end. As stated in my previous write-ups the current interest rate levels are surely unsustainable for the U.S. economy and possibly could going forward hinder economic expansion, while a worst case scenario would be a recessionary phase. Thus in all fairness, a rate hike this year is surely a healthy move for the economy, but first and foremost a healthy move for the U.S. banking sector which now seems to be struggling to gain momentum.

On the flip site of the positive employment figures (with May’s exception), in my view the Fed failed to reckon in more detail the softness in U.S. business investment spending and its plans to address the said situation. Despite the fact it seems that the weakness is brought about by slowdown in corporate profits and concerns about prospects for economic growth, other factors such as consumer risk-averseness should fit into the Fed’s equation in combating sluggish economic growth. Thus the real question investors should pose is, in which point of the economic cycle is the U.S. economy?

For the fixed-income investor, the slower pace of a rate hike offered further comfort. A comfort which was witnessed over the past two days whereby spreads continued their recent tightening phase. The lack of yield due to the said tightness pushed investors to fetch yields into riskier assets. This is now visible in the strong performance registered in U.S. High yield and mostly Emerging Market hard currency debt, which registered just over 8 per cent and 11 per cent respectively on a year-to-date basis.

Going forward from an asset allocation perspective, despite Brexit might have posed opportunistic valuations, investors’ should opt for a cautious approach, as headwinds from other geographical areas might still be on the cards.