Economic Review 3Q 2015
US Federal Reserve
At the September 17, 2015 FOMC meeting, the Fed left rates unchanged after the much anticipated rate hike that the market had long awaited. The rationale was that it would restrain US economic activity.
The Fed cited recent global financial and economic developments that could impact and restrain US economic growth and keep inflation low. The Fed focused on the adverse impact of global economic and market developments and lowered its inflation forecast. The Fed lowered its long term projection of the rate from 3.8% to 3.5%.
European Central Bank
The ECB kept the main policy rate unchanged in August, 2015 as growth and inflation expectations were revised downward. The inflation rate is expected to be negative in 4Q2015 due to low oil prices. Eurozone inflation fell below zero in September for the first time in six months, potentially bolstering the argument for the European Central Bank (ECB) to stave off deflationary concerns with additional stimulus. The Euro area’s consumer price index fell 0.1% from a year ago. The previous negative reading came in March, when the ECB launched its bond-buying program.
US employers added a disappointing 142,000 jobs in September, raising questions over whether slowing global growth is taking a toll on the US expansion and if the Fed will raise rates this year.
August monthly figures were revised lower and wages were sluggish, adding to the downbeat tenor of the report. While the unemployment rate held at 5.1%, the labor force participation rate fell further, remaining near its lowest level since the 1970s.
The jobs report for August was 173,000 lower than the average 200,000 per month required. The economy added less jobs than anticipated. The unemployment rate dropped to 5.1% and the U6 underemployment rate dropped to 10.3%. The labor force participation rate was 62.6% and 2Q GDP was revised to 2.7% which is below the median forecast of 3.2%.
In September, US manufacturing activity expanded at the slowest pace since May 2013, according to the Institute for Supply Management (ISM), a sign that the strong US Dollar and tepid overseas demand is weighing on manufacturers. The ISM index fell to 50.2 in September, down from 51.1 a month earlier, dragged lower by production, new orders, and employment indicators. However, readings have remained above 50—which separates expanding from contracting activity—for nearly three years.
In September the investment grade, corporate bond market totaled $21 billion in new supply across 14 issuers including Gilead, Marriott, and Lowe’s. Corporates outperformed Treasuries as a result of strong demand.
Liquidity in the US bond market has changed dramatically from the period before the financial crisis. Historically, broker-dealers carried securities inventories on their balance sheets and were willing to make markets in securities and take market risk. The change in making markets, and the record corporate issuances and low interest rate environment have made it difficult for broker-dealers to make markets and inventory securities. Fixed income trading has become less liquid.
Fixed income investors face longer holding periods than they would have considered in the past. Lower turnover strategies have a lower impact on transaction costs on portfolio especially when there are changes in market liquidity. Trading now requires a more deliberate approach to minimize transaction costs. Conversely, there are attractive prices for buyers when there are forced sellers in the market.
The liquidity in fixed income markets has changed across all sectors including Treasuries. The ability to trade in large blocks has changed. Primary dealers that purchase directly from the Fed have been buying fewer Treasures and volume has fallen. The size of the Treasury market has doubled since 2008. US and foreign investors have purchased a higher percentage of Treasuries sold by the Fed than the dealer community.
They released a 5-year plan to restructure and reduce the $28 billion financing gap. This involves losses on $72B in Puerto Rican debt.
Global financial markets were volatile in August following China’s devaluation of its Yuan currency that triggered fears of a Chinese and global economic slowdown. Chinese economic weakness impacted commodity demand, emerging markets that are commodity based, and drove fears of deflation. Crude oil fell below $40 per barrel. Global growth concerns highlighted by continued weakness in China weighed on global markets in September.
China is at an inflection point as the services sector overtakes industrials as the largest part of its economy. Countries ranging from Brazil to Indonesia to South Africa saw their currencies plunge either to multi-decade or record lows, underscoring the tumult facing emerging-market currencies.
The Fed’s new focus on non-US developments underscored China’s far-reaching implications. The volatility in Chinese equities, an unexpected depreciation of the Renminbi, and another round of disappointing activity data.
The Fed’s decision to postpone a rate hike may put downward pressure on the USD at first. Higher US yields may support a trend to a stronger USD against global currencies. US companies with international sales have usually not benefited from stronger USD although US consumers have with lower prices. If the USD weakens, commodity prices may rise temporarily. The excess crude oil supply and weaker Chinese demand for commodities, prices will continue to trend downward, regardless of the Fed action.