The Global AnAlyst | JANUARY 201626 |

INTERNATIONAL / BANKING

FED BITES THE BULLET Implements First Rate Hike in Nearly a Decade The US Federal Reserve finally bites the bullet, increasing the FFR – a key short-term interest rate – by quarter of a per cent. With this, the regulator has clearly signaled that it might take similar actions in future, if need arises, to take the economy towards full recovery.

- Dr. IVO PEZZUTOGlobal Markets Analyst, Management Consultant, Economics and

Management ProfessorAuthor of the Book “Predictable and Avoidable” ISTUD Business School and

Catholic University of the Sacred Heart. Milan, Italy

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In the absence of unexpected severe externali-ties, tail-risks, or new unexpected negative data, it seems quite likely that the US Federal Reserve (Fed) Bank will continue its monetary policy tight-ening in the coming months and years after the

first lift-off (since 2006) of the benchmark interest rate on December 16th, 2015. The banking sector regulator has increased interest rates (technically known, FFR or Federal Funds Rate - the benchmark short-term financing cost for banks that influences a wide range of borrowing rates for households and businesses) by 25 bps or quar-ter of a per cent. As a result, its target rate now stands revised to 0.25-0.50 per cent, from 0-0.25 per cent range. “Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic out-comes, the Committee decided to raise the target range for the federal funds rate 1/4 to 1/2 percent,” the regulator said in a press release justifying its action, which comes after nearly a year of speculations on part of the market participants and much dilly dallying by the Board itself.

In spite of the modest pace of expansion of the US econ-omy in October and November recently reported by the Fed’s Beige Book, and the opinions of some skepti-cal analysts about the future economic growth of the US economy, Federal Reserve Chair Janet Yellen is optimistic about her country’s substantial recovery from the Great Recession.

A positive moveThe US third quarter 2015 GDP was at 2.1 per cent while the second quarter 2015 GDP was at 3.9 per cent. The slowdown in the third-quarter real GDP primarily re-flected a downturn in inventory investment and slow-downs in exports. The Bureau of Labor Statistics recently reported that nonfarm payrolls increased in November 2015 by 211,000 jobs (based on seasonally adjusted data). The recent jobs growth data which is lower than previ-ous month (298,000 jobs), however, it is exceeding econo-mists’ expectations of 200,000 jobs. According to Janet Yellen, the 12-month average job gain after the Novem-ber jobs report was 220,000, while the participation rate increased slightly to 62.5 per cent. She believes that the US still remains below full employment even though for the majority of analysts and economists the Fed’s interest rate lift-off decision was already priced in by the finan-cial markets weeks before the FOMC’s December meet-ing. In early December 2015, in fact, futures markets at-tached roughly an 80 per cent probability to a possible short-term interest rates hike at the policy-setting Federal Open Market Committee meeting of December 15-16.

At the beginning of December 2015, she had expressed a firm optimism about the improved labor market con-ditions (i.e., unemployment rate remains at 5 percent, down from the 10% peak of October 2009) which boost a rise in wages and consumer spending (i.e., average hour-ly earnings rose 0.2 per cent from October and 2.3 per

cent on an annual basis), and overall, should allow the US economy to withstand the rise in the central bank’s official interest rate.

In fact, Janet Yellen believes that, in spite of the current subdued inflation, price levels will soon move back to the 2 percent objective over the medium-term. Headline in-flation is very close to the 2 percent inflation target, while core inflation (stripping out the volatile unprocessed food and energy prices) still remains well below target. Yet, according to Janet Yellen, moves in the energy mar-ket prices are transitory in nature and affected by pres-sures from low oil prices and a stronger dollar, thus most of the effect should taper off after a few quarters. She also expects that the headline inflation target will be eventu-ally reached as further improvements in the labor market conditions will probably fuel additional growth, inflation expectations, and consumer spending.

Yet, inflation remains below the Fed’s stated 2 percent target and core PCE (personal consumption expendi-tures) in the third quarter rose below the Fed’s stated tar-get, nevertheless, it is quite evident that the Fed Reserve in December 2015 was eager to get off the zero lower bound, as interest rates close to zero per cent evoke an emergency policy setting that has been in place since the depths of the financial crisis. Furthermore, zero lower bound interest rates encourage liquidity traps and may contribute to generate asset prices’ bubbles and potential ‘boom-bust’ market scenarios (i.e. massive leverage strat-egies facilitated by excess of liquidity and cheap funding guaranteed by central banks which allow corporations to lever up their balance sheet and to conduct stockholder-friendly actions, like buying back stock or paying divi-dends, thus artificially inflating the profitability of their businesses – earnings per share).

End to monetary stimulus? Since the 2008 financial crisis, the massive injections of liquidity and cheap funding by the central banks have contributed to the unusual expansion, growth, and prof-itability of the financial sector (i.e., the Fed’s non-conven-tional expansionary monetary policy helped fuel a surge in the stock market), more than to the recovery of the real economy, as investments in firms’ capital expenditures have grown proportionally less than those in the stock markets, financial sector, and shadow banking business. In the US, the Fed has undertaken massive unconvention-al measures to drive down long-term interest rates and to encourage more borrowing and investments. These mea-sures have significantly inflated the Fed’s balance sheet over the years. Thanks to the quantitative easing (“QE”) programs, the Fed has increased its balance sheet to over $4 trillion — five times its pre-crisis size.The austerity measures undertaken by several countries after the global financial crisis to restore economic and financial stability, combined with higher tax burden, budget discipline and fiscal consolidation programs, re-

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duced public spending and private firms’ investments, and the “Great Recession,” have further enhanced the divergence between the pace of expansion of the financial sector ver-sus the real economy. Furthermore, structural changes in the technologi-cal environment, innovative produc-tion processes and business models (i.e. smart technologies, disruptive technological innovations, robots, digital business models), and the dominance of the service sector over manufacturing and other sectors have also partially contributed to the reduction of investments in the more traditional labor-intensive sectors. Christine Lagarde, the managing di-rector of the International Monetary Fund, made the following remark at the annual IMF and World Bank meeting in Washington on Octo-ber 12, 2014: “With regards to the disconnect between economics and markets, there is “too little economic risk-taking (e.g. capital expenditures and lending), and too much financial risk-taking.” (Lagarde, 2014)The scenario for future oil prices, which has an important impact on inflation expectations, however, at the beginning of December 2015, remains still quite complex and un-certain since the OPEC aims to stick with its year-old policy, as the largest oil exporter, Saudi Arabia, remains committed to maintaining crude production to retain market share in order to compete with big produc-ers outside OPEC. This strategy will probably continue to put pressure on the commodity and energy markets and on cash-strapped oil exporting countries such as, Venezuela, Ec-uador, and Algeria and other weak economies with unpredictable geo-political consequences. Furthermore, leading oil exporting countries face the growing competition from Rus-sia, Iraq, and quite soon also Iran, as the embargo might soon be lifted. Even the US might soon pursue an oil exporting strategy as a conse-quence of the lifting of the US ban on oil exports. For all these major factors in the early days of December 2015 (the US crude) oil was trading below

$40 per barrel. Furthermore, recently emerging geopolitical risks have also put additional pressures on the oil exporting countries.

A smooth ride ahead for the US economy!Janet Yellen also aims to pursue a ‘gradual and smooth monetary pol-icy’ normalization (although it is not guaranteed that it will be gradual and smooth for the global markets!) before significantly overshooting the Fed’s dual mandate goals, that is, of full employment and price stability. She believes that the pace of mon-etary tightening is more important than the timing, and that it is critical to avoid disrupting financial markets through delayed and abrupt policy tightening decisions. She expects that a pickup in demand in many advanced economies; the easing monetary and fiscal policies in the emerging-market economies, and a stabilization in commodity prices, should boost growth pros-pects of emerging market economies. One major concern for the Fed has been the strong dollar, which keeps inflation low by pressuring on com-modities prices. Apparently the US economy seems to be ready for a gradual tightening of its monetary policy (i.e., raising the federal funds rate), and in the absence of unexpected externalities and black swan events, it should be

moving forward on a solid footing towards a full recovery, as indicated also by the improving economic fun-damentals and investors’ expecta-tions. Yet, a number of analysts ex-pect that the Fed’s monetary policy tightening might contribute to the flattening of the yield curve, and if the current trend of contraction continues in 2016, the US Economy might be faced with the risk of a po-tential price stagnation which could eventually lead to a downturn in out-put and inflation.

In fact, the manufacturing contrac-tion in November 2015 reported by the Institute for Supply Manage-ment’s headline index of manufac-turing activity (ISM), which fell to 48.6 from 50.1 in October (below the 50 mark — which nominally divides expansion from contraction), indi-cates that the strong dollar might be contributing to the disappointing manufacturing data even though the services sector continues to per-form well and the auto sales have remained robust driven by low gaso-line prices. Recently, a number of analysts and prominent institutions (i.e., IMF, Fitch Ratings, Moody’s, BIS, the ECB Financial Stability Review) have warned about vulnerabilities and po-tential downside risks for the finan-cial system stemming from emerging markets and China which relate to geopolitical risks, emerging market

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corporate debt and private compa-nies’ debt sustainability challenges, slowdown in GDP and secular stag-nation, rising inequality, significant amounts of non-performing loans of banks, growing size of the shadow banking and off-balance sheet in-vestment vehicles’ perimeter, firms’ interconnectedness, a widespread use of synthetic leverage, declining profit margins, massive corporate debt downgrades (i.e., more than $1tn in US corporate debt has been down-graded this year as defaults climb to post-crisis highs - Analysts with Stan-dard & Poor’s, Moody’s and Fitch ex-pect default rates to increase over the next 12 months) (Platt, 2015), the fall of commodity prices, potential rise in currency volatility, current account imbalances, and problems in corporate credit markets. All these factors com-bined together add up to a substantial level of uncertainty and potential insta-bility in the global markets.The Switzerland-based BIS (the Bank for International Settlements), in fact, has recently raised warnings about potential ‘taper tantrum’ risks for the emerging markets associated to the Fed’s monetary policy normaliza-tion path. Infact, the BIS has reported the following statement: “Weaker fi-nancial market conditions combined with an increased sensitivity to U.S. rates may heighten the risk of nega-tive spill overs to emerging market economies (EMEs) when U.S. policy is normalized” (BIS, 2015). Gavin Jackson and Eric Platt of the Finan-cial Times recently reported that in the US the “number of companies defaulting on their obligations is set to reach the century mark, driven largely by struggling US shale gas providers” (Jackson and Platt, 2015). Joe Rennison and Eric Platt of the same newspaper also reported that “the sales of global corporate bonds have eclipsed $2tn this year, for the fourth consecutive year” (Rennison and Platt, 2015).

As the author of this article has stated in previous publications and in the book titled “Predictable and Avoid-able: Repairing Economic Disloca-tion and Preventing the Recurrence of Crisis”, the aggressive quantitative

easing policies of the past years have been valuable and necessary non-conventional monetary measures for emergency situations, but over a pro-longed period of time, they have also contributed to inflating asset prices and encouraged unrealistic expecta-tions in the financial markets about a potential never-ending availability of cheap money and unlimited liquid-ity. In fact, these policies have helped to take advantage of lower interest rates and have also encouraged ex-cessive risk-taking on part of inves-tors in search for attractive yields in the financial markets (i.e., sover-eign bonds, high-yield bonds, ETFs, synthetic products), due also to the widespread expansion of negative interest rates.

More hikes in offing?After all, in spite of the very generous and accommodative non-conven-tional monetary policies of the past years, there is a limit to what central banks can do to offset global disin-flationary pressures triggered also by structural global macroeconomic forces such as the global slowdown, falling commodity prices, demo-graphic differences, the shrinking of the middle class in a number of west-ern economies, weak productivity growth in some countries, reduced investments in the real economy (i.e., capital investments and lending), and macroeconomic imbalances.

Furthermore, it seems that the ag-gressive quantitative easing poli-cies of the past years have also de-layed the restructuring of distressed credits and non-performing loans (NPLs). In addition, as some analysts argue, massive QEs without proper macro-prudential policy making, co-ordinated ad hoc fiscal policies, and structural reforms, can also contrib-ute to create a false impression of liquidity and they may sustain fake alpha (market outperformance based on capturing risk premia on hidden fat-tails). As it is well known, un-fortunately, too much of good thing cannot last forever.

Portfolio managers, fund manag-ers, credit managers, and investors should remain watchful of these developments, early warnings, and potential systemic risks, despite the improving fundamentals of the US economy and other economies, since in a worst case scenario they might be faced with a sharp and sudden risk aversion in the markets, higher levels of volatility, market liquidity problems, increased capital require-ments, and strong corrections in as-set valuations due to these potential market dislocations.

Let’s hope that the new year 2016 will be a peaceful, prosperous, finan-cially sound and sustainable one for the global economy and the financial markets and that the worst case sce-nario just described and warned by

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many analysts and commentators will remain only a fat-tail risk event, that is, an extreme, infrequent, and rare event, since for most countries the level of SOVEREIGN DEBT and corporate debt in 2016 will be signifi-cantly higher than those preceding the 2008 global financial crisis (i.e., approximately 94 per cent in the Eu-rozone).

The US national debt, for example, should soon be approaching $19 tril-lion, thus the leading global econo-my, just like other economies with even higher levels of sovereign debt as a percentage of GDP, seems to have no choice but to keep interest rates low for quite a long period of time. The combination of this condi-tion (i.e., low interest rates), with the ongoing accommodative monetary policies of other central banks, and a massive recourse to complex and innovative financial engineering so-lutions (derivatives and off-balance sheet investment vehicles) may po-tentially reduce the perception of the debt-burden risk in the corporate world and they may encourage addi-tional excessive risk-taking practices.

OutlookTo conclude, an energizing wave of optimism is definitely in the air (es-pecially following the first interest rate hike by the Fed in almost a de-cade) making the financial markets very excited about the positive eco-nomic outlook of the US economy and the future outlook of many as-set classes in 2016 as a consequence of the divergent monetary policies of the Federal Reserve, the ECB, and other leading central banks and the impact of structural reforms.

Thus, in the short run things should move forward quite smoothly, un-less there will be unanticipated nega-tive shocks. Yet, with a longer-term perspective, in spite of the robust ongoing US economy data improve-ments, the general optimism in the financial markets, and a strong inten-tion of the Fed to start its monetary policy normalization, some concerns remain related to the level of global

imbalances, the global slowdown, the rising levels of debt, low inflation rates, and the po-tential downside risks for the emerg-ing markets, cur-rency markets, and global economy.

Looking forward, complexity and uncertainty seems to be rising in the global markets and

capital requirements (as the author of this article has already warned in the paper titled “Predictable and Avoidable: What’s Next?” of Septem-ber 2014); the high unemployment rates in some geographical areas; the structural macroeconomic imbalanc-es; the bigger global output gap and the below target inflation rates; the global divergence; the potential cur-rency wars; and in some economies also the gloomy recessionary trends.

Thus, there is room to be optimistic about the New Year 2016, at least for a part of the banking business, since even with tiny increases in interest rates over the coming months and years they expect a real boost to their revenues on loans and other busi-ness lines. Markets, however, should not underestimate the risk of a sud-den and unexpected rise in volatility due to a potential turbulence in oth-er parts of the banking and finance business or in other geographical areas of the global markets. Potential adverse macroeconomic scenarios and sharp corrections should not be easily overlooked.

Investors should remain alert of po-tential unexpected downside risks and they should engage, as much as possible, in highly diversified as-set allocation, security selection, and portfolio rebalancing strategies. They should also try to reduce exces-sive emotional reactions to market investing and they should try man-aging their portfolios by adopting a longer-term investment approach.

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economies in the coming years. The global business environment will probably face more complexity, in-terconnectedness, and vulnerability due to the increased use of innova-tive digital technologies, innovative business models, and complex finan-cial engineering solutions and mar-kets, which will generate many new exciting business and employment opportunities but, one way or anoth-er, they might also inevitably affect our countries’ social, economic, and sustainability models.

In the coming years probably the ma-jor concerns for the global markets will be the following: the ability and commitment of the countries with high levels of sovereign debt, and stagnant, and anemic GDP growth rates to effectively complete the re-quired structural changes and adjust-ments in order to achieve sustainable growth; the challenges of political and social integration in a number of countries due to rising nationalist forces; the international geopolitical challenges and tensions; the large number of firms with heavy debt burden; the rising shadow banking sector (i.e., Over-the-Counter trading of derivatives and off-balance invest-ment sheet vehicles); the potential threat of highly leveraged invest-ment funds; the high yield market; the high levels of banks’ NPLs; the ‘illiquid’ and distressed credit mar-kets and the high levels of volatility; the potential risk to financial stability of reviving the asset-backed securi-ties markets with lower standards in