• US rate hike liftoff in December, followed by a slow pace of rate hikes
• EUR/USD likely to reach parity in the first half of 2016
• China data confirm gradual slowdown, divergence industry and services
Liftoff from Fed’s zero interest rate policy
We think that after the liftoff in December, the pace for rate hikes will be slow. We expect the Fed policy rate to reach 0.5% in December 2015. Then the next hike will be in June, giving the Fed a bit more time to assess the impact for the US economy and thereafter hikes every other meeting reaching 1.25% at year-end 2016. If this scenario plays out as we expect, US 10Y yields will reach 2.5% at year-end 2015 and 3% at year-end 2016. We think that the EUR/USD will reach parity in the first half of 2016. More analysis of the implications of this will follow in the FX and Precious Metals Special to be released this week.
Slow pace of rate hikes after liftoff
Although the US economy is on the right path to full employment and a return for 2% inflation, we think that a gradual pace of normalisation of interest rates allows several elements of the monetary policy debate to be taken on board. To begin with, there is still dispersion among FOMC participant’s projections for the federal funds rate. In October, a couple of the more dovish FOMC policymakers had mentioned their preference for a rate hike in 2016. This setup requires more caution than normal in order to reduce the probability of dissenters when voting for a rate hike. Moreover, the divergence in policies across central banks and financial tightening in the US requires a cautious approach to ensure that the actions do not result in unnecessary tensions. Finally, the more dovish members are concerned about the risks of tightening when there is still uncertainty around foreign growth. Much of the focus of investors and policymakers has been on China, where most concerns have been raised. We think that most of the issues mentioned above will gradually improve in the coming time, but they support a slow rate hike.
China: activity data confirm shift from industry/investment to consumption/services
While the high-frequency activity data for October published on Wednesday did not bring large surprises, they confirmed China’s ongoing shift from industry and investment towards consumption and services. For the third month in a row, growth of retail sales accelerated in October, albeit marginally to 11% yoy (September: 10.9%). Car sales also showed a recovery in the past two months, supported by tax cuts. This suggests that confidence effects of the sharp stock market correction in the summer months on consumption have been limited. This is also illustrated by recent anecdotal evidence, such as record online sales reported by Alibaba for ‘Singles Day’ (the largest online shopping event). Meanwhile, the data show an ongoing gradual slowdown in industrial activity. Industrial production cooled marginally to 5.6% yoy (September: 5.7%), while fixed asset investment slowed to 10.2% yoy (September: 10.3%). Whereas overcapacity in the industrial and real estate sectors continue to be a drag on growth, higher infrastructure spending as part of a fiscal stimulus programme partly compensates for this.
Trade data still weak in annual terms
Earlier this week, China’s trade data continued to disappoint. Merchandise exports contracted by -6.9% yoy in October (September: -3.7%). In terms of export destination, the weakness was rather broad based, in line with overall weakness in global trade. We expect the authorities to allow more moderate weakening of the Chinese yuan to facilitate exports. Meanwhile, merchandise imports contracted by -18.8% yoy in October, slightly better than the September number (-20.4%), but worse than market consensus (-15.2%). Import values dropped sharply in early 2015, on the back of a drop in investment, and this is still affecting the year-on-year numbers. Our (rough) estimates suggest that China’s goods imports have contracted by on average around 6% in volume terms (compared to around 16% in value terms) so far this year. This shows that the sharp drop in import prices, particularly commodity prices, has been an important factor in explaining China’s weak imports this year. Looking forward, we expect China’s (annual) trade data to improve next year, as we expect China’s slowdown to remain gradual and negative base effects to gradually fade out.
Data in line with our view of an ongoing moderate economic slowdown
Adding everything up, Bloomberg’s monthly GDP estimate remained virtually unchanged at around 6.6% yoy. Hence, the economy shows signs of stabilisation on the back of previous easing measures, with solid services growth compensating for the industrial slowdown. All this confirms our view that China is undergoing a gradual slowdown, not a hard landing, with further monetary and fiscal easing expected to continue into 2016. We expect overall economic growth to slow from 7.3% in 2014 to 7% in 2015 and to 6.5% in 2016.