Australia | Oct 31 2006
By Chris Shaw
Since taking over as Chairman of the US Federal Reserve Ben Bernanke has been at pains to point out future changes to interest rates will be data dependent. But as Merrill Lynch points out, how you interpret the data can produce a vastly different outcome in terms of future expectations for US rates.
The broker has adjusted its expectations for the US interest rate cycle, with recent weakness in energy prices leading it to push back its timetable for the first cut to interest rates to March next year from January. It also now sees a slower pace of future cuts, possibly extending into 2008.
This reflects the change in conditions, as lower energy prices have turned a headwind into a tailwind in terms of the outlook for consumption, which the broker suggests will prove supportive for growth in the shorter term. As a result the broker has lifted its GDP growth forecast for the first quarter next year to 2.2% from 1.7% previously, while it expects growth of 2.5% annualised in the current quarter, up from 2.0%.
In the broker’s view the Federal Reserve is likely to follow a two-stage process in reducing rates with the first being a return to a neutral rate, which would entail reversing the three rate hikes in 2006 and possibly the last increase from Greenspan’s tenure as Fed chief, all of which were moves made to provide insurance against inflation.
This would see rates back in a range of 4.25-4.75%, roughly equal to a neutral rate in the broker’s view though below the Fed’s implied neutral level now with rates at 5.25%.
Such moves are unlikely in the broker’s view to be enough to restore the housing sector to full health, so it expects stage two will see rates possibly moving below 4.0% either late in 2007 or early in 2008.
The broker admits there are differences between its interpretation of the economic data currently available and that of the Fed policy makers, as while both expect growth to be below trend in 2007 it suggests a harder landing in the housing sector is more likely than the soft-landing the Fed anticipates.
Estimates with respect to other data are also different, as for example it notes Fed forecasts are for the unemployment rate to move to around 5% late next year from around 4.6% now and for capacity utilisation to reach 81% from almost 82%, while over the same time it expects inflation to ease to around 2% from 2.5% now. The broker in contrast expects unemployment to reach 5.8% near the end of next year, while it sees potential for inflation to return sooner to levels of 2% or lower.
If its outlook proves correct the broker suggests the bond market is being too conservative currently as it is only pricing in a 6% chance of a 0.25% rate cut next March and a 28% chance of a cut in May. As a result it suggests investors look at buying the June 2007 eurodollar futures contract, as it is cheap given the lack of pricing in of future rate cuts.