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Economic Update

2016/06/07

The path of U.S. Fed rate hike and its implications to Hong Kong

Ahead of the Federal Open Market Committee (FOMC) meeting on 14-15 June, Fed Chairman Janet Yellen addressed the World Affairs Council of Philadelphia on 6 June and talked about the economic outlook and monetary policies. In her speech, the Fed Chair gave indications that while the pace of interest rate increase will be slow given the lingering uncertainties in the U.S. and abroad, the Fed is likely to bring interest rates upward in one of its upcoming meetings.

In the U.S., while labour market conditions appear to have continued a recovery from the global financial crisis, the sluggish pace of recovery is leading to renewed concerns. In hindsight, the unemployment rate edged downward in May to reach 4.7%, the lowest since November 2007. On the other hand, nonfarm payrolls (NFP) merely increased by 38,000 reaching 143.894 million in May (see Chart 1). While the continuing trend of labour market expansion was extended to 68 months, the paltry increase – compared to the full year average of 228,700 in 2015 – was the lowest since October 2010. 

We believe a relatively high comparable base (i.e. U.S. total employment number at a historical high of 151.6 million in May) is part of the reason for the slower pace of job market expansion. That being said, as this is the slowest pace of job creation on a three-month basis since July 2012, the moderation of such dynamics could be a source of concern for some Fed officials, which should likely keep the low interest rate environment intact for the moment.

Yellen commented that “gradual increases in the federal funds rate are likely to be appropriate,” if incoming data suggests acceleration in inflation and continuous improvement in labour market conditions. With crude price (WTI) currently at around the US$49.6/barrel level (representing a 33.6% increase from end-2015) and unemployment rate improving to 4.7% (lower than the projected 4.87% natural rate of unemployment adopted by the Congressional Budget Office), we believe the Fed will look to raise the federal funds rate again in the second half of the year.

Nonetheless, this expectation could change rapidly (see Table 1). At the time of publication of this article, the probability of a June or July rate hike (as implied by fed funds futures) had fallen to 2% and 21.6%, respectively, which suggests that the market now expects the next rate hike to come in September ( 42% probability).

As expected, many sectors in Hong Kong will be hurt if the interest rate goes up. According to the Bank for International Settlements, the debt servicing ratio of Hong Kong’s private non-financial sector was 24.425% in 2015, the highest since 1999 when such data was made available. Higher interest rates will add pressure to the ability of businesses to finance their debt, which should, in turn, hurt banks’ asset portfolio (see Chart 2). Although banks in Hong Kong did not bring interest rates up in December 2015 as a result of the abundant liquidity in the system (e.g. capital adequacy ratio at 18.3%), any upward movement of interest rates would likely dent the already aching investment and consumer sentiment even further.

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