Shift In Monetary Policy Expectations Supports Risk Assets by OFR
Risk assets such as equities, corporate bonds, and emerging market currencies appreciated notably in October, recovering somewhat from the sharp losses in recent months. The catalyst for the rally appeared to be weaker U.S. labor market data, which delayed the expected start of monetary tightening by the Federal Reserve. Extraordinarily accommodative monetary policy has supported risk asset prices since the global financial crisis and this month’s market reaction suggests that these prices may still be contingent on accommodative policy. It remains to be seen whether current U.S. asset price ranges can be sustained once the Federal Reserve begins to raise interest rates, broadly expected to occur between December and June.
Developments during the last month
- The market-implied path of the Federal Reserve’s policy rate increase shifted further into the future, with the highest probabilities for liftoff now in the first half of 2016.
- Global risk assets rebounded, driven by the shift in expectations for a Federal Reserve rate hike.
- Oil prices also rebounded at the start of October, but remain highly volatile.
- At the end of September, U.S. money markets followed the pattern of recent quarter-ends: Overnight secured funding rates spiked and utilization of the Federal Reserve’s reverse repurchase agreement facility hit new highs.
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Weaker U.S. economic data have pushed back market expectations for a Fed rate increase.
The market-implied path of the Federal Reserve’s policy rate flattened further in October (Figure 1). The downward shift reflected a weak U.S. labor market report and the release of minutes from the September meeting of the Federal Open Market Committee (FOMC). These same concerns contributed to pronounced declines in market-based U.S. inflation compensation, which reached its lowest levels since 2009 (Figure 2). The market-implied probability of a Federal Reserve rate hike in 2015 is now down to approximately 25 percent to 35 percent, with an implied probability of a rate hike at the October 27-28 FOMC meeting of less than 10 percent.
Global risk assets advanced on expectations for continued or additional accommodative policy among central banks in advanced economies …
U.S. equities have rebounded strongly in October, although fundamentals remain weak. The S&P 500 index has rallied since the start of October and is up 10 percent from its August low (Figure 3). As with the broader rally in risk assets, this rebound has been attributed to the delay in an expected Federal Reserve rate hike. The rebound has occurred in the face of weaker U.S. equity fundamentals, such as the slowdown in global growth, negative effects of a stronger U.S. dollar on earnings, and continued weakness in the energy sector. For the third quarter, analysts continue to expect negative revenues and earnings for energy stocks, with modestly positive growth for non-energy S&P 500 stocks.
Emerging market assets have rebounded, following months of deterioration. Emerging market currencies have rallied since the start of October (Figure 4), led by a 5 percent to 8 percent appreciation in commodity-sensitive currencies. Emerging market equities and credit have also advanced. Despite the rebound in emerging market assets, some of the recent gains also represent a technical recovery driven by covering of short positions and moderation of excessively bearish sentiment. Overall, emerging market economic fundamentals remain very weak. In its latest World Economic Outlook, the International Monetary Fund (IMF) downgraded its forecast for emerging market growth.
…despite ongoing concerns over spillovers from deteriorating Chinese growth.
Chinese currency and equity market prices and volatility have stabilized since the August devaluation. The difference between onshore and offshore yuan exchange rates has diminished significantly, a potential sign that the People’s Bank of China continues its effort toward inclusion in the IMF SDR (special drawing rights) basket. Volatility in Chinese equity markets has also moderated over the last month, with major indices higher in October, following consecutive monthly declines since June(Figure 5).
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