Fed Hike in June Unclear - But USD Will Strengthen Either Way

Market Views And Insights | May 16, 2016

The US jobs data released on 6 May, 2016 might be weaker than expected, but our Chief Economist Megan Greene believes it is no reason to write off chances of a US interest rate hike in June. More importantly, she points out that the US dollar is likely to strengthen again after the recent pause – a development that could have deep significance for the financial markets.

Towards the end of this note, Manulife Asset Management’s fixed income teams will discuss their views and portfolio positioning.

Commenting the US April job report released on 6 May, 2016, Manulife Asset Management’s Chief Economist Megan Greene thought the number of jobs added, at 160,000, was well below expectations (around 200,000)1, but this headline figure is one of the least important indicators in the jobs report. Digging into the details, the news was not all bad.

Megan added, this jobs report will certainly not light a fire under the Federal Reserve’s (Fed) feet to hike rates at their next meeting in June, nor does it rule June out for a rate hike. Investors are breathing a sigh of relief that the Fed may wait to tighten monetary policy further, as this has driven a reversal of US dollar strength in the first four months of the year, stabilizing oil prices and easing financial conditions in emerging markets (EM).

But they shouldn’t get used to it.

US dollar strength depends just as much on the Fed’s moves as on those of other central banks. Even if the Fed stays put, we expect significant easing from the Bank of Japan (BoJ) and the European Central (ECB) to push the dollar up again, reversing the recent trend.

Jobs Report: Something for Everyone

There was something for everyone in the April jobs report. The headline figure was lower than expected, but more importantly the labor force participation rate fell from 63% to 62.8%. More people gave up looking for work than found employment. Unemployment remained steady at 5%. But the news was not all disappointing - the number of people working part-time for economic reasons fell in April after jumping in March. After plummeting for two months, jobs were actually added in manufacturing—a high wage industry—last month. Low wage sectors (retail, administration and waste, social assistance and leisure) comprised around 26% of new jobs in the private sector— the lowest level in a year. Average hourly earnings growth was slightly stronger in April at 0.3% month-on-month, but is still nothing to write home about.

Impact on the Fed

The latest Non-Farm Payroll (NFP) report had enough negative and positive indicators to have little impact on the Fed’s likely actions in June. Combined with incredibly weak first quarter GDP data and a potentially close Brexit referendum in the UK one week after the June Federal Open Market Committee (FOMC) meeting, this NFP report could suggest the Fed will stay on hold next month. But given that growth should accelerate slightly in the second quarter, and we will have a lot more US economic data as well as Brexit opinion poll results by June, a Fed rate hike at the next meeting is not entirely off the table.

Ever Weaker US dollar?

A June rate hike is not at all priced in at this point, so unless the Fed starts signposting a rate hike more clearly the markets will be caught out and we would expect the US dollar to strengthen. If the Fed remains on hold in June, however, do not assume that US dollar weakness will continue for the rest of the year.

In trying to gauge what will happen with the US dollar, a lot of analysts have looked to the Fed. After all, dollar weakness this year was largely driven by the Fed’s revision of its own forecasts from four rate hikes for 2016 at the beginning of the year to only two rate hikes2. This is only half of the equation though. It is just as important to look at other currencies—starting with the renminbi.

The renminbi is down slightly against the US dollar, but is significantly down versus a basket of currencies (including the euro and the yen) since the beginning of the year. In addition to suffering from an appreciation of their currencies relative to the US dollar, Japan and the eurozone are suffering from an appreciation relative to the renminbi as well. This will provide a headwind for 2 Federal Reserve: Economic Projections, March 16, 2016 For professional investors / investment advisors only 16 May 2016 3 growth that Japan and the Eurozone can hardly afford given their already lackluster growth prospects (we expect growth of 1% at best in Japan and 1.5% in the eurozone this year). Furthermore, inflation expectations in Japan and the eurozone remain well below the BoJ and ECB’s target of 2% (close to but below 2% for the ECB) despite both central banks recently announcing a raft of easing measures.

Inflation Expectations in Japan and the eurozone Remain Below Target

It is therefore a question of when and how, not if, the BoJ and ECB will significantly ease further. The BoJ may follow in the ECB’s footsteps and announce a TLTRO-like program3 to pay banks to lend. We expect that, like in Europe, this could help along the margins but is hardly a silver bullet. The BoJ and the ECB are likely to also try doing more of the same: cutting rates further into negative territory and expanding and extending their quantitative easing programs.

The verdict on negative rates is mixed at best, and negative rates bite into bank profits, which is of particular concern in parts of the eurozone where some bank balance sheets leave a lot to be desired. More quantitative easing could have an impact on inflation expectations if the basket of purchased assets is expanded to include equities. There is likely to be more resistance to this in the eurozone than in Japan, but we expect both central banks will eventually have to implement this measure.

If the Fed hikes rates in June, we expect the US dollar to strengthen given that markets are only pricing in one Fed hike in 2016. If the Fed is more dovish and waits to hike, this will put even more pressure on the BoJ and ECB to ease aggressively, which in turn will push the US dollar up. Investors should therefore not get too comfortable with the recent market rally we have been enjoying, as a stronger US dollar will have negative implications for oil and for financial conditions in EM. The volatility we experienced at the beginning of the year may feel like a distant memory, but we are likely to be reminded of what it felt like later this year.

Our fixed income positioning

Looking ahead, Asian fixed income investors should not be over complacent as some Asian economies are showing signs of slowing down, said Endre Pedersen, Chief Investment Officer, Fixed Income, Asia ex-Japan of Manulife Asset Management. Endre and his team believe that it is not an environment for investors to take aggressive positions, but rather an opportunity to consolidate gains while actively managing risks.

Endre added, “We remain biased towards holding US dollar against Asian currencies. While our view on Asian currencies remains defensive, we have a preference for South Asia over North Asia currencies. We are more cautious on Asian currencies following the broad strong Asian currency performance, and so the portfolio has a more defensive currency positioning with a bias towards US dollar denominated Asian bonds."

In addition, Manulife Asset Management’s Global Multi-Sector Fixed Income Team believes that growth differentials, diverging central bank policies, and structural positives will continue to be supportive for the US dollar, but given the large move over the past 18 to 24 months, Global Multi- Sector Fixed Income Team would expect further appreciation of the dollar to be at a slower pace and of a smaller magnitude, and continue to hedge the majority of the portfolio back to the US dollar.

1 Bureau of Labor Statistics: Employment Situation Summary, May 6, 2016
2 Federal Reserve: Economic Projections, March 16, 2016
3 European Central Bank: ECB announces new series of Targeted Longer-Term Refinancing Operations (TLTRO II), 10 March, 2016

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