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Fed may consider 6% rate target for 2007: JP Morgan
Moneycontrol.com | June 28, 2006
David G Fernandez, head, Asia Economic Research of JPMorgan says that Ben S Bernanke has an option of a 50 bps hike, but may not go for it.
Fernandez feels that it is not the time to buy emerging markets on dips due to the uncertainty that looms. He also says that the Fed may consider a rate target of 6 per cent for 2007.
He expects that Fed would keep stock and money markets in mind in case of a big fall. He sees a low chance of Fed cutting rates in 2007 or 2008.
Excerpts from CNBC - TV18's exclusive interview with David G Fernandez:
We heard somebody from Deutsche Bank saying that the Fed is already over shot, it is 5. 25% and no more. Do you think it will be quite as good as that?
Unfortunately I don't think so. I think the Fed is going to be on the move. In fact, one of the options he didn't lay out for this week's meeting is the possibility of the Fed doing a 50 bps hike. There is quite a bit of market chatter about that occurring at this week's meeting. I don't think that is going to happen.
However, even if they have a 25 bps hike, I think we are going to see some alterations in the statement indicating once again that they find inflation trends unwelcome, as so many of the Fed governors have said over the past several weeks.
In terms of guidance, I think they are very much going to leave the door open, as they have done since the May statement for more rate hikes. If one looks at the Fed fund futures right now, they are almost entirely pricing in another move in the August meeting. That is a JP Morgan call but I want to see if the other forecasters catch up to it. I don't think it is over.
Do you think he will stop at 5.50? Do you think in this Fed meeting, he will say something, which will indicate with some degree of certainty that he will move again in August?
Unfortunately I don't think so. All of the correction that we have seen in the emerging markets has been centered on Fed's uncertainty. If that is the case, then if our view is correct that Fed continues to leave the door open for further rate hikes even after the August meeting, then I think emerging markets are going to continue to be in a tough situation.
Our view is that we have to deal with that uncertainty with at least until the August meeting; in which case, in emerging markets, the risk aversion is still at play. Stay cautious, this is not the time to buy on dips.
Like you said it is an 80% chance in the Fed futures that they will hike in August, is that some thing the global markets have adjusted though?
I don't think so entirely. The fixed income markets have moved there. There is still a lot of hope especially in equity markets that somehow they will signal firmly that it is over.
In fact, I heard some people say that if they do 50 bps hike this week, it will be good sign because it will signal that the rate hike cycle is over. But I don't believe that. I think if they hiked 50 bps, I would actually see it as quite terrible signal. With the hawks really taken over the Fed, they would keep moving higher.
I think we are going to see a Fed meeting, which is going to see growth that hasn't tipped over in the US. We have seen the housing data so far for this week; they were bad but not terrible.
So it looks like housing correction in the US is happening in a controlled way. If the growth doesn't fall over completely, our view is that we could see the Fed back as early as December this year pushing Fed fund targets to 6% by early 2007.
How do you read that 6%? Does it look like they are over shooting or do you think they are in line with what can be expected with the inflation concerns?
I think the Fed is going to continue to keep an eye on growth. There are concerns that they seem to be neglecting on the growth side and are focussing more on inflation. I don't think the Fed is going to run US economy into a brick wall and create a recession situation as we get into 2007.
They need to see some signs that the growth is not tipping over, as we go further into the third quarter and later into the fourth quarter. If they see the signs of growth slow down and housing market as orderly, yet inflation continues to drift higher, I think they will have to move.
How much of an eye do you think Fed has on markets? There is an argument that the Bank of Japan held its move because of what was happening in the stock market and Fed may also not want to spook the market too much. Do you think the market is one of its top 2 or 3 priorities to keep the window open or not?
I think so. I think the financial conditions are what the Fed is looking to have an impact on and that has an impact on growth and inflation. If one looks at what is happening in the markets so far, in the US, I don't think anything in terms of bond markets or equity moves in the US is going to stop the Fed.
If we had a severe sell-off both in fixed income and equities, then I think that would give Fed some food for the thought. But right now, it has been a bear market, a soft market but it hasn't been a terrible market. I think the Fed is actually quite pleased with the financial markets' reactions to their moves and to their talk.
On a scale of 10 how would you rate the chances of Fed not stopping at 5.50 and maybe going on to something like 5.75 or so at this point?
I would say that there is a 70 per cent chance that you see the Fed keeping this hike moving. It could get you to 5.75 or in our call it is 6 per cent by early next year. That is a bullish call on growth. It is a call that says growth is not tipped over.
It gives a reason for Fed to say that it is fine for us to continue because inflation is still drifting out of the comfort zone. We keep repeating that 1 or 2 per cent comfort zone for core PCE. We will get the core Personal Consumption Expenditures numbers the day after the Fed announces on Friday.
Last time you told us that fund interests were still high in markets like India. If indeed the Fed does make these moves, how much of a liquidity squeeze do emerging markets like us have to start facing?
It is important to cite the type of structural flows, which is what I am seeing coming out of places like Japan into India. That kind of a structural flow believes that a long return story is not going to turn just because of the global liquidity squeeze. They still need to find places to put their cash, and in a place like Japan, if we are right, where the growth continues to be strong, those flows are going to continue to come to places like India.
It is simply a matter of timing. It is not an overall call where you want to allocate and in that score, India is going to be high on every investor's card. It is a matter of timing and if you are still in a world where you are uncertain about the Fed outlook, then the timing is wrong for investors to come in now in a large way. That is what you are going to continue to see. As long as the Fed is uncertain, even for a good story like India, you are going to see investors staying on the sidelines.
If your call is that we will have tight liquidity across the world for the next six months, what exactly is your call on how long this tight liquidity conditions might actually prevail? When do you think this whole liquidity squeeze cycle might actually get over leading to the resumption of the bull trend in equities in emerging markets?
I don't think we are going to see the return of the kind of liquidity conditions we have enjoyed for the past several years. I would qualify, in terms of characterizing my view, that we will see tighter liquidity conditions. But I don't think we will see tight liquidity to the degree that the central banks think they have overdone it. I think they see a world where inflation continues to creep higher, be it in the US or in Japan.
So I believe that they think it is just no longer time to have this extra ordinarily low interest rate environment and they have taken that back. I don't think they will be in a rush to cut. If we get into a recession situation in the US, which is a 20-30 per cent probability; then they might contemplate cuts. But I don't see the Fed taking it back, even if they go to 6 per cent rate hikes that they put into place. I don't see them taking them back in the next year or even in the year after that.
As an asset class, is it time to give bond markets a notch up?
I still think the underlying driver of our view where the Fed and other Central Banks continue to hike rates gradually is that growth is still strong. Growth is still a driver that should lead you to move towards risky asset classes. So I think equities will eventually make a good comeback when people realize that the tightening hasn't gone too far. The tightening was appropriate to take the inflation steam out but it hasn't knocked growth over. So I think till this smoke clears on such Central bank calls, which unfortunately may take several months, equity markets would recover.
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