'Markets will price in a US Fed rate hike before it happens'

Fears of a slowing global economy, especially in China, has rattled financial markets. Paul Donovan (pictured below), senior global economist & managing director, UBS Investment Bank, tells Puneet Wadhwa that China's decision to allow market forces a greater role in determining the value of its currency prompted an overreaction.

The US Federal Reserve (Fed), he believes, will make its intention of raising rates clear at its meeting this month. Excerpts:  

Do you think the US Fed should have raised the rates in September review, which in turn would have taken out the element of uncertainty?  

I believe the Fed erred in its September policy meeting, in particular in seeming to give financial markets power over its decisions. The Fed conspicuously failed to raise interest rates in September.

It did everything else it was supposed to do. The failure to raise rates was bad enough but the language used to communicate the 'logic' of its decision was more troubling. It implied market volatility had helped to prevent a rate increase. Markets should not dictate to economists, ever.

Economists should lead and markets should follow, at a respectful, reverential distance.

The recent US employment report has the market believing the lift-off could be postponed to 2016. Do you agree? What is the road ahead for the US economy?

The next stage in the US economic cycle is for headline inflation to leap up. This is a global issue.

The impact of oil prices has been to reduce headline inflation in most major economies since last October.

That impact is going to fade, and fade fast, from the headline consumer price data.

Essentially, headline inflation rates are likely to converge with core inflation rates, which exclude some energy prices, as the oil effect disappears.

This implies annual headline inflation will rise by 0.8 per cent or more in most major economies. Indeed, core inflation could also rise, because those rates do include some energy (it is just buried away in things like air fares and transport costs).  

So, the fears of a deflationary trend will abate?  

Investors still seem to have a disinflation bias to their thinking. However, as headline inflation rates suddenly jump up, between October and January, this disinflation bias should fade away.

While it seems unlikely that investors will start to look for high inflation, and while it is unlikely that inflation is likely to rise too rapidly, a US headline inflation number closer to two per cent is likely to mean investors stop looking for downside risks to inflation when data is released or policy makers speak.

This move will also give the Fed the opportunity to free itself from the perceived influence of financial markets, and allow it to exert its independence properly.  

Are the global financial markets already factoring in a rate rise this year?  

I think the financial markets will price in a rate hike by the Fed before it happens (December, in our view). However, there might still be some reaction before then.

I think the October FOMC (Federal Open Market Committee) might make the intention to raise the rate in December clear, and that will lead to some reaction in bond and currency markets.

What are your views on China? What key points/data points are the markets looking at to believe the worst could be getting over?

The Chinese economic policy measures have not had time to act. Policy works with a lag. Late October/early November is the earliest we could expect a reaction. We should see some improvement in economic data from then.

Is there is a possibility that the yuan could be devalued further?

China's decision to allow market forces to play a greater role in determining the value of its currency prompted an over-reaction in financial markets.

The renminbi might weaken a little further but we do not expect substantial moves.

The move was primarily about bringing market and government fixings together as a prelude to joining the IMF-SDR basket.

It was not aimed at gaining competitive advantage and, by and large, we have not seen exporters from China react to the move with dollar price changes.

What are the likely implications of this for global financial markets?  

Exposure to Chinese domestic demand is mainly about commodity producers. Non-commodity producers are not likely to be affected.

However, it is important to note that China's economy could demand more commodities. It is moving from financial services - led growth to more traditional - led growth so, it could be more commodity intensive, even if slower, growth.  

What is the road ahead for the global bond market? There were some views that bond markets could be the next bubble to burst. Do you agree?  

Bond markets remain distorted by 'captive' investors - central banks, plus financial institutions that are required to hold bonds for regulatory reasons.

This will not stop bonds from weakening but should prevent a collapse. 

As regards commodities, oil and base metals, do you think we were overly optimistic about global growth earlier and misread the demand? Are we in for a prolonged slump in prices given that the drivers of global growth could themselves be slowing?

I do not think we face a prolonged slump for commodities. Markets underestimated supply and misread some emerging market trends, but commodity prices are likely to slowly increase in absolute if not relative terms over the next couple of years.