The US Federal Reserve has kept its key interest rate on hold at 0 – 0.25%. Global economic uncertainty (read China) was the headline; this consideration appears to have played a greater role than in the past. The potential for the financial market turmoil in August to contribute further to the persistent low US inflation rate, already influenced by low energy prices and the stronger dollar, was perhaps the main motivating force. However, the Fed chair, Janet Yellen, was keen to emphasise that the US economy continued to make solid progress. ‘Domestic spending would justify a rate rise’ was one quote. The Fed continues to hold its hand until it is confident that inflation is heading back towards target.
The Fed has a dual mandate of 2% inflation and full employment; the latter is on track, but the former is currently way below target. Two market moves were clear during the Yellen’s press conference this evening when she outlined the Fed’s thinking :
- Equity markets were volatile – the S&P was up over 1% at one point but when Yellen had finished, it was down c. 0.2%. Equity investors can’t decide whether to be pleased at continued cheap money or worried that the US economy isn’t strong enough to withstand a very small rise in rates.
- Short term bond markets (the two year US government bond in particular) saw prices rise quite significantly, ie. expectations for the level of future interest rates fell.
In a sense, we are left very much as we were. The Fed continues to assess data in the US economy and will react accordingly. However, the betting on US interest rates remaining at current levels through to 2016 will have strengthened. Whilst there may be some equity investors who welcome even lower short term interest rates, there will be others who dislike the ongoing uncertainty about when rates will rise and fear that deflation may become embedded.
We should therefore expect equity markets to continue to be volatile. Our view remains that the slow recovery from the great financial crisis remains on track, albeit the US domestic economy seems weaker than we would have hoped; but the Fed will remain extremely accommodative, at least in its current make up. We don’t see any reason to change our core asset allocation for long term investors favouring equities.