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What keeps Yellen awake at Night?

It has been more than six years since the historic collapse of Lehman Brothers and ever since, investors have been living in a world of financial repression, categorized by extremely low interest rates. The impacts of this financial repression are profound and have been covered extensively in a previous article on Foresight Investor. A summary of the massive effects due to central bank financial repression is provided in Figure 1.

Figure 1: Effects of financial repression (Source: Bank of America Merrill Lynch)

As one can see, zero-interest rates have far-reaching effects. Therefore, 2015 will be a momentous year as it is the first time that the US Federal Reserve (FED) is expected to increase interest rates in over six years (Figure 2).

Figure 2: FED hiking cycle, market expectations vs FED guidance (Source: Deutsche Bank)

As one can deduce from Figure 2, the market expects the hiking cycle to start somewhere in mid-2015. However, it is striking that market participants are expecting an extremely slow hiking cycle, which is significantly below the FED’s own guidance and the FED’s terminal rate guidance. This opens the serious risk that market participants are underestimating the speed of a possible FED hiking cycle.

The risk that investors are underestimating the speed of a future hiking cycle is quite significant, as there are various indicators that argue that the FED is already far behind with its current hiking cycle. Firstly, the US unemployment rate has always been one of the most important catalysts for FED rate hikes. Looking at the current state of the US job market, we can come to the conclusion that the FED is a full hiking cycle behind, compared with historical standards (Figure 3). Because of this massive historic divergence between US interest rates and unemployment, it can be argued that the FED might choose to hike rates at a faster speed than currently anticipated by the market.

Figure 3: FED hiking cycles and US unemployment rates (Source: Deutsche Bank)

Another important argument for faster FED rate hikes, stems from the Taylor Rule equation. The Taylor Rule has served as a gold standard for central banks when determining interest rates in response to macro-economic conditions. If we look at the US interest rates implied by the Taylor Rule, we can conclude that the FED is behind on the rate hiking cycle according to this metric as well. It is noteworthy that the Taylor Rule equation has been arguing for higher US interest rates for some time now. Furthermore, the gap between the Taylor Rule implied interest rates and the current market pricing is quite large, which further increases the risk that the market is anticipating an overly dovish FED.

Figure 4: FED funds rate implied by the Taylor Rule vs market pricing (Source: Citigroup Research)

In short, it seems that the FED is quite late with the start of the hiking cycle in 2015, as various indicators suggest that interest rates should already be higher than is the case today. These indicators also argue that the FED hiking cycle should be faster than what the market is currently pricing in, which creates the possibility that the FED could surprise investors with faster rate hikes than is currently expected. This could in turn lead to increased market volatility and unexpected market sell-offs, if investors where to readjust their expectations of FED rate hikes.  

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Simon Waslander

Simon is the CEO and Editor-in-Chief of Foresight Investor. He has been following the markets passionately for over 7 years.

This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.

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