US rates unchanged…for now

Instreet market & economic commentary and opinion

The decision by the US Federal Reserve (Fed) on Wednesday to keep interest rates unchanged was expected by the market, as was the formal announcement of its balance sheet normalisation process. At just $10 billion per month (initially), the pace of run-down will be so gradual that the latter is unlikely to have a major impact on the economy or financial markets.

The bigger news, of course, was that Fed officials continued to indicate that there will be one more 25 basis point rate hike by the end of the year. This comes despite the weakness of core inflation in recent months.

These more hawkish comments were also reflected in the rise in treasury yields and the US dollar.

Nonetheless, FOMC participants continued to signal that the long-term federal funds rate was likely to settle eventually at a lower level than in the past. The long-term median projection is now 2.75%, which is the lowest level since projections for the rate were first published in 2012. It is also nearly 50 basis points below the longer-term level that appears to be discounted in the bond market.

Of course, a lower long-term rate not only affects the value of bonds but also equities as they use the long-term risk-free rate to discount earnings in order to come up with valuations. Thus, we also believe this change in expectations will lend support to US equities.

A look at the Australian property market

Following several years of rapid house price inflation in Australia, the house price to earnings (HPE) ratio of Australia's eight capital cities has risen to 5.8 – well above the average of 3.6 from 1980 to 2016. For the HPE ratio to revert to its historical average, house prices would need to decline by 38%.

In our opinion this is not going to happen in the near-term, given the employment market is strong and improving. There is a lot of focus in the media about the impact of interest rates on housing demand, but it will be weakness in the employment market that is more likely to cause stress in housing.

The comparisons of today’s HPE ratio with long-run averages ignore the structural change in the employment market and the decline in equilibrium interest rates which has occurred in recent decades. Lower interest rates have reduced the returns available from "safe" assets like developed market government bonds, which in turn has reduced the returns investors require from riskier assets, including housing.

Although the housing market may be slowing down there are no signs that house prices are about to slump. It’s more likely that national prices may stagnate over the next two years or continue to rise, albeit at a slower pace, on the back of improving employment.

Brussels applauds Theresa May

UK Prime Minister, Theresa May, has been applauded by Brussels for her "constructive spirit" after she set out plans to keep Britain in the EU in all but name until 2021. Although Britain will formally leave the EU in March 2019, under May's model it would still be covered by all EU rules, European court judgments, the free movement of EU workers and budgetary contributions to Brussels until the transition ends in 2021.

The good news for May was tainted, however, by a decision by credit ratings agency Moody’s to downgrade the UK. This prompted a dispute with the government over the health of Britain's public finances. The timing of the downgrade couldn’t have been more wounding for May, who hoped that her speech in Florence would kick life back into the Brexit negotiations.


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