June timing of the Federal Funds rate increase: Many areas to draw conclusions from

The prevailing Federal Fund rate in U.S. does not bode well for an economy that is almost operating at full employment.

The housing sector shows a trend in price increase that speaks volumes about its health.

The fixed income investment sector, including re-insurance and banking have much to gain from this change and could be the primary driver of the rate change.

This article will show how the June rate rise is no more a distant conjecture and how the fortunes of the commercial banking and the insurance (including reinsurance) are so strongly correlated positively with this rate rise.

The employment numbers in the last four quarters have shown a trend that can hardly be ignored that the economy is achieving full employment status, something that can hardly be equated with an interest rate environment which is stuck at zero lower bound. If that be so then the economy has moved into a Japanese style economic trap that allows no respite from deflation. But the sign of the economy is far from a deflationary spiral as is the case for Japan; in fact we have enough evidence to prove otherwise.

1. Inflation: Let me start with inflation itself. The latest inflation rate for the United States is 1.1% through the 12 months ended April 2016, as published by the US government on May 17, 2016. The most interesting observation is that April saw the uptick that was most significant. In the headline monthly figure, consumer prices jumped 0.4% in April, something that had not happened in the last three years.

In rounding out the Labor Department’s report, core US inflation moved 2.1% quicker on an annual basis after running at 2.2% pace in the 12 months ended March. This is on the back of 11% drop in oil prices year on year, although the same did start to move up in April.

2. Unemployment

Moving on to unemployment statistics, the situation looks far better than the original mandate that Fed had set out to do. On the other hand there was a continuous improvement in the labor force participation rate that improved to 63% and climbed down just a shade in April alone to 62.8%.

3. Housing

The housing sector has the biggest of the uptick that one would have expected as there are three reports to draw conclusions from:

Firstly S&P/Case-Shiller U.S. National Home Price Index, which seeks to measure changes in the total value of all existing single-family housing stock on a monthly basis. This shows a distinct trend of a warm up one can hardly miss and the index at 175.61 is inching towards its highest point.

The Press Release went on to say, “The S&P/Case-Shiller U.S. National Home Price Index, covering all nine U.S. census divisions, recorded a slightly higher year-over-year gain with a 5.4% annual increase in January 2016. The 10-City Composite is up slightly at 5.1% for the year. The 20-City Composite’s year-over-year gain is 5.7%. After seasonal adjustment, the National, 10-City Composite, and 20-City Composite rose 0.5%, 0.8%, and 0.7%, respectively, from the prior month.”

Secondly the dramatic turnaround of home prices is better to be seen in the Federal Reserve of St. Louis chart called, All-Transactions House Price Index for the United States. The data reached almost its highest point at the end of 2015.

Thirdly one should see the data on the housing starts itself for the last three years, which shows a steady but certain improvement taking the starts to the highest level in five years at the rate of 1200000 per month. The data as furnished by U.S. Census Bureau goes on to say, “Housing starts in the Unites States rose 6.6 percent to a seasonally adjusted annual rate of 1172 thousand in April 2016, compared to an upwardly revised 1099 thousand in the previous month. The figure came in above market expectations of 1127 thousand, boosted by single-family housing starts. Meanwhile, building permits went up 3.6 percent, following a 7.3 percent drop in March, but lower than an expected 4.3 percent gain. Housing Starts in the United States averaged 1441.61 thousand from 1959 until 2016, reaching an all-time high of 2494 Thousand in January of 1972 and a record low of 478 Thousand in April of 2009.”

4. Banking, Life and Reinsurance Sector

 

The Fed’s quantitative easing (QE) program, or large-scale purchases of long-term government bonds and other securities, in 2008, 2010 and 2012—often called QE1, QE2 and QE3, pushed the benchmark 10-year Treasury yield down from fell from 4.7% at the start of 2007 to 1.9% at the end of 2011. Following the gradual phasing out of the bond-buying program by the Fed, the benchmark rate moved up to 3.03% at the end of 2013, before slowly declining back to 2.27 % at the end of 2015. As of the end of January 2016, the rate had slid even lower to 1.94%.

This benchmark treasury yield today stands at 1.821%, which has consequences for all fixed income portfolios.

Taking this to the re-insurance sector and banking, we would find more than the usual reason why the current interest regime is now proving to be a drag on the bank finances; as also the re-insurance industry this comes as a negative for the fixed income segment. The ‘float’ for this industry ends up earning very little due to prevailing low interest rates on fixed income products. The top five commercial banking stocks have shown some reason for concern as well, especially when some like Bank of America and Citi are still hovering around 0.7 times the book value.

The impact on the life-insurance industry holds a strong proxy to the entire re-insurance business, which has to take the brunt of the low interest rate environment. Life insurance companies face considerable interest rate risk given their investments in fixed-income securities and their unique liabilities as their assets and liabilities are heavily exposed to interest rate movements. Interest rate risk can materialize in various ways, impacting life insurers’ earnings, capital and reserves, liquidity and competitiveness. Moreover, the impact of a low interest rate environment depends on the level and type of guarantees offered. Life insurers’ earnings are typically derived from the spread between their investment returns and what they credit as interest on insurance policies and products. During times of persistent low interest rates, life insurers’ income from investments might be insufficient to meet contractually guaranteed obligations to policyholders which cannot be lowered. Life-Insurers typically invest in a mix of portfolios, all of which cannot be predicated on high risk high return part of the portfolio.

Persistent low interest rates can also affect earnings and life insurers’ liquidity, which works through the float and the ability to earn return with the float becomes limited with such low interest rate products.

The financial industry is inter-connected and the fortunes of the fixed income portfolio can hardly be ignored for such a long time.

In Sum: It is most timely that looking at all these four factors, the June rate rise is worth a real look.