Ilike how Although these risks are not new, they are taking on a greater urgency given investors are facing the first tightening by the Fed since 2006. With the U.S. economy on solid footing, we think the Fed should start to move sooner rather than later, possibly by June. More evidence to support that came from December’s labor market report. While wage growth unexpectedly fell and the participation rate is still stuck at a multi-decade low, job creation continues to accelerate and previous numbers were revised upward.
Market Realist – The Federal Reserve introduced quantitative easing involving the purchase of U.S. Treasuries (TLT) (IEF) and mortgage-backed securities (VNQ) (IYR) and reduced the federal funds rate to near-zero levels in order to combat the recession set off by the US financial crisis (XLF) of 2008. The bond-buying program concluded in October 2014.
It’s only a matter of time before the Fed starts tightening policy and hiking rates. The impending rate hike is likely to affect not just fixed-income instruments but equities as well. The accommodative monetary policy of the Fed has been widely touted as one of the reasons for the two-year period of low volatility (VXX) in the US equity markets (SPY) (IVV). With an impending rate hike in sight, markets are expected to become more volatile going ahead.
Although the Fed has indicated patience in regard to a potential rate hike, rates could lift off as early as June. The following are the headwinds and tailwinds for the impending rate hike by the Fed.
- The US economy has gained speed over the last two reported quarters. The economy grew by 4.6% and 5%, respectively, as you can see in the above graph.
- The unemployment rate for December has come down from 5.8% in the past month to 5.6%. This is well in line with the Fed’s target range of 5.2 to 5.5%, as you can see in the next graph.
- The labor market continues to look strong. December is the 11th consecutive month with more than 200,000 job additions to the non-farm payrolls. Total additions to non-farm payrolls in December amounted to 252,000. Private payrolls increased by 228,000, while manufacturing payrolls rose by 17,000. Almost 48,000 jobs were added in construction, a significant increase.
- Though hiring strengthened in December, the labor force participation rate of 62.7% was its lowest since the 1970s. Wage growth actually declined by 0.2% in December, bringing the annual wage growth to 1.7% for 2014. Wage inflation is one of the most important barometers of economic growth. Its absence indicates a slack in the labor market.
- Inflation continues to stay at low levels. The Fed uses the Personal Consumption Expenditure (or PCE) Price Index as a measure for inflation. The core PCE, which excludes the volatile food and energy price segments, continues to hover around 1.4%, much below the Fed’s target of 2%.
- U.S. retail sales fell by 0.9% in December, making it the steepest fall in the last 11 months. This could mean cutting of GDP (gross domestic product) growth estimates for the fourth quarter of 2014.
Read on to the next part of the series to understand how you can prepare for the impending rate hike.