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Putting the “Control” back in “Optimal Control”

The key event for the week, if not the balance of the year will be the meeting of the Federal Reserve Open Markets Committee (FOMC) on Wednesday, New York time. 

These meetings are always important to market direction – but given the wide dispersion in market views on when, or even if, interest rates may rise and the fact that this is the last meeting with a press conference until March – this one may be especially so.

The first issue the market is looking at is whether there will be any change to the “Considerable Time” language with regard to how long before the Fed will raise the fed funds rate.

Our view is that as a prelude to rate rises from June next year – the statement that these are a considerable way off will be removed. To make such a change without a press conference would be unlikely. To wait until March (when the next meeting combined with a press conference occurs) will be too long, based on other recent Fed commentary. Further, this meeting is the updating of the Governors views on economic and market data, which, all together, would seem the right time to do it.

The market remains sceptical, however, and short term market rates in the US could rise more than a quarter of a per cent, if the Fed does remove the Considerable Time reference. This may not sound much, but is equivalent to an equity market move of three to five percent, in terms of sharpness.

Even if the “Considerable Period” language changes, the second question, once rates start to rise, concerns how much, and how many times they will go up.

Our view again is a little divergent from the market. We expect rate rises to be at 25bps a time and continue apace over H2 2015 and 2016. This is based on Janet Yellen’s “Optimal Control” philosophy, which favours holding back on monetary policy changes until you are convinced you need to act, then moving like a machine to implement the intended change of path. Even so we expect rates to peak well below where they have in previous cycles.

The reason for our confidence is that we think that continuous job growth, incipient tightening labour conditions, in the form of lower sackings, increased willingness of workers to change jobs, and greater difficulties filling vacancies; will trump low reported inflation.

We don’t expect lower short term inflation from falling oil prices to have much impact. If anything this will be increasing consumption elsewhere.

Why does this matter to a global equity fund manager like Morphic and our investors?

The first reason is that we are not sure US or global equity markets are fully prepared for rate rises in the US. In fact it would be amazing if they had more prescience on this than rates markets themselves. There is therefore a risk that there might be sharp stock market sell-off in this context.

The second is that US dollar strength could intensify, as the implication of rising rates in the US when the Bank of Japan is in fully fledged money printing and the European Central Bank is itching to join the game, is that the relative attraction of parking money in US assets will increase.

Thirdly, and in a more local context, Australian rate cuts, which the market is now increasingly expecting, may be deferred if the U.S. does move decisively. This is especially likely if the Australian dollar weakens in the aftermath.