Chart of the Week: Brexit and the Fed: are all bets really off?

In response to last week’s UK referendum result, investors have slashed the already low probabilities previously assigned to the prospect of US interest rate increases. Currently, the chances of a hike even by the end of next year are seen as just 26%. In our view, investors would be wise to consider the possibility that the US labour market is close to full employment.

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After last week’s UK referendum, a tightening of US interest rates next month is all but impossible, even if the next nonfarm payrolls report confirms our belief that US job creation rebounded in June. Nevertheless, we think that markets are significantly underestimating the possibility of US rate increases both this year and next.

Last week’s result poses a number of uncertainties, which are unlikely to be resolved any time soon. Financial markets are likely to remain volatile over the summer and global economic growth will probably slow as long as these uncertainties remain. November’s US presidential election will add a further element of unpredictability into the mix.

But federal funds futures prices seem to be implying that the US economy is heading into a recession. We disagree. In fact, we still believe that the domestic economy is relatively strong and that the labour market is close to full employment. Indeed, although US labour market participation has fallen, we estimate that around two thirds of the decline since 2008 is due to demographics and the ageing of the US workforce.

The participation rate of prime age workers (those aged 25 to 54 years) has also declined. We suspect that this is also due to structural factors — such as globalisation, technology and inequality — and not cyclical factors, as widely believed. Looking ahead, we anticipate a pick-up in wage growth, pushing both core and headline inflation higher this year and next. On that basis, we still believe that there is a realistic prospect of one US rate rise this year, probably in December, with several more to come next year.