By Dan Denbow, CFA
Any doubts about a Federal Reserve interest rate increase this month went away when the latest jobs report came out Friday – the pace of hiring accelerated in August, and wage growth was at its highest since the economic recovery began in 2009.
Add these data points to soaring consumer confidence, manufacturing gains and robust earnings growth expectations for third and fourth quarters, and the Fed has no reason to hold back on rates when it meets in late September. The thriving U.S. economy has the market pricing in another rate increase in December, but conditions overseas raise the question of whether the Fed should perhaps be a little more cautious.
One key reason is the flattening Treasury yield curve – the yield spread between 2-year and 10-year Treasuries was a mere 24 basis points (0.24%) on Friday. A year ago, that spread was 76 bp. A flatter yield curve is worrisome because it could lead to an inverted curve in which shorter maturities have higher yields than longer maturities. An inverted yield curve has historically been a recession predictor.
The Fed’s rate hikes and its efforts to reduce the size of its balance sheet have helped push up yields on short-term Treasuries to their highest level in a decade, while solid demand from investors concerned about a slowing economy is holding down yields on longer-dated Treasuries.
Too much pushing up at the short end via rate hikes raises the risk of an inversion, which at least one top Fed official fears could occur before year-end. This risk should give the Fed at least some pause on moving forward with a December rate increase.
Given all of the good news on jobs, wages, earnings growth and the like, it may be hard to see economic troubles ahead in the U.S. But conditions are not as rosy abroad, especially in emerging markets, and this could adversely affect the U.S.
Higher U.S. interest rates, a strong U.S. dollar and trade uncertainties are presenting a stiff headwind for EM countries, which can be seen in both their equity and credit markets. The MSCI Emerging Markets Index fell into bear-market territory last week, meaning it was down more than 20% from a recent peak. And EM debt – much of it denominated in dollars – is among the worst-performing asset classes so far in 2018. Currencies of some key EMs have dropped more than 20% against the dollar so far this year, and a few (notably Argentina and Turkey) have fallen much further.
Dollar strength and trade turmoil is also taking a toll on commodity demand (mostly from China, the world’s largest consumer) and thus on prices – this compounds the troubles for those EM nations dependent on commodity exports. Oil slipped more than 3% last week, while copper dipped to its lowest price in more than a year in Shanghai.
If only the state of the U.S. economy mattered, it probably makes sense for the Fed to implement rate hikes both in September and December. But we don’t exist in a vacuum – our economy is woven into the wider global economy, so significant events that occur outside our borders often can be felt here to some degree as well.
The Fed typically does not consider overseas factors when deciding how to proceed on rates, but now could be one of those rare instances when it should. EMs are already vulnerable, and a Fed that’s too aggressive on rates could heighten that vulnerability and in turn raise economic risks at home.
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