Is the US Economy Ready for Another Rate Hike?

   Schwaben Blog

June 06, 2016

 

Monthly Statistics:

  Today Month Ago Year Ago
  06-June-16 06-May-16 06-June-15
       
S&P TSX 14,226 13,690 14,743
S&P 500 2,099 2,046 2,079
DJIA 17,807 17,632 17,766
OIL $48.70 $42.68  $62.66
USD vs CAD 0.7742 0.7728 0.8303
Gold $1,246 $1,266  $1,172

 

During the latest Federal Open Market Committee (FOMC) meeting, some of the Fed governors discussed about the possibility of a rate hike in June. The FOMC is keen to further increase the interest rates because they believe that the US economy is showing more signs of sustainable growth with inflation hovering around their 2% target. The unemployment rate has also dropped to 4.7% (lowest in eight years) in May from 5% in April. But this drop in unemployment rate was primarily a result of people dropping out of labor force rather than finding new jobs. 458,000 people dropped out of labor force, either because they don’t want to work or they don’t think that they can land a job. Employers added only 38,000 jobs in the month of May, lowest monthly growth since September 2010.  The unemployment rate is calculated by comparing the number of people who are out of work and looking against the total number in the labor force. If someone is out of the labor force, he isn’t counted.  The dismal unemployment report in May will certainly push back the Fed’s plan for a rate hike soon. According to the CME Fed watch tool, there is only 4% probability of a rate hike during the FOMC meeting in June, compared with 31% in July and 44% in September.

At this juncture, the US economy might be strong enough to tolerate the normalization of monetary policy but the global economy is much more vulnerable to the Fed’s moves. The tightening of the US monetary policy and the liberal monetary policy in Europe and Japan have certainly contributed to the strength of USD and weakness in Euro and Yen. The recent weakness in Euro and Yen hasn’t had a very noticeable effect on the Europe’s and Japan’s exports, but the strength of USD certainly had a negative effect on the earnings of US corporations. Roughly half of S&P 500 revenues comes from abroad and any further appreciation in the USD will dampen the prospects of near term growth in the index EPS. For Q1 2016, 72% of the companies have reported earnings above the mean estimate and 53% have reported sales above mean estimate. The earnings declined by 6.7% on a year-over-year basis. This marks the first time the index has seen four consecutive quarters of year-over-year declines in earnings since Q4 2008. Profits for the S&P 500 also declined by 8.3% (2.9%, if excluding the Energy sector).  Now that the oil prices have recovered by more than 70% from their February lows, the majority of equity analysts believe in a brighter outlook for the index and recommend an average increase of around 6% in the S&P 500 EPS over the next 12 months, with growth in all sectors but Energy. With additional stimulus expected from the European Central Bank (ECB) and the Bank of Japan (BoJ), a rate hike by the Fed will push the USD toward record highs and this will hurt the profitability of US corporations.

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