US Fed to hike in summer: prepare for higher rates in the Middle East

The April payroll data released on Friday has given the market confirmation that the strong March payroll results were not an aberration, and the last step of a strong economy (i.e. new jobs) is swiftly falling into place. Then add to that the FOMC statement from Tuesday of last week which removed all obstacles for the FOMC to begin raising the fed funds rate from the current 1.0%, and you have a strong market reaction. Those developments also substantially increased the case for near term monetary tightening, and even the final holdouts who had been calling for no change in fed funds until 2005 have capitulated.

That does not mean that a rate hike in June is a done deal, but it is certainly on the table. In fact, the market is pricing in a high probability of such a move. For some time now, our call has been that the first rate hike would be 25bps in August. Prior to that, we expected June would be the month of the first hike. After the FOMC statement and the payrolls data last week, it is fair to say that the probability of a June rate hike has increased, and is not much below the likelihood that the first move will come in August.

Why not change the call for the first hike to June meeting then? Before the June FOMC meeting, the market will get the payrolls and price data for May. (Recall that the next FOMC meeting is June 30, and the following one is August 10.) We would prefer to see those May numbers come in strong before changing the view. We note that the market has swung quickly from the majority expecting no rate hikes before late-2004 or 2005 to now expecting the first hike in June. Expectations could thus shift rapidly again in the fact of a good but not great number. We have no reason to think that the next set of data will be anything but strong, but we are comfortable waiting to see what the data print before putting emotion ahead of the numbers. After all, we have said all along that the data will dictate the first move by the Fed.

Equally important to the timing of the first hike is the pace and magnitude of further hikes. Our view has been and continues to be that we will see a series of steady, 25bps hikes in August, September, November, and December for a year-end fed funds target rate of 2.0%. That steady trajectory will continue into 2005, with fed funds of 2.50% in Q1-05. Looking at our rate trajectory for 2004, keep in mind that is a long way from neutral fed funds. For example, real fed funds (i.e. nominal - core CPI) ended 2003 at -0.1%, and our forecast that core CPI will be 1.4% y/y in December 2004 implies real fed funds of 0.6%. That is hardly a significant tightening of monetary policy. Using our forecast of headline CPI (2.2% y/y in December), real fed funds would be -0.2% at the end of this year. The bottom line: watch the inflation data closely. Even if prices rise in a slow, predictable manner, fed funds will have to rise significantly in the next two years to approach a neutral rate.

Higher rates in the US means that interest rates will have to rise in the Middle East. Since the majority of currencies in the region are pegged to, or follow, the US dollar, interest rates need to mirror those set by the US Federal Reserve. Local interest rates in the UAE and wider Gulf, Egypt, Lebanon and the Levant will begin to rise over the next six months. The current high levels of regional liquidity may mean that interest rates do not need rise at the same pace as those in the US, but the next move in local rates will be up. Corporates and individuals need to begin thinking about hedging, or even scaling back, their borrowing and preparing for higher debt service costs.

Doug Smith, Chief US Economist, Standard Chartered
Daniel Hanna, Regional Middle Eastern Economist, Standard Chartered