Asking the Right Questions
US Fed Policy: A Much More ‘Gradual’ Path
Global equity markets sold off sharply last week, as weak economic data outweighed the recent positivity generated by the prospect of more easing from the Bank of Japan (BOJ) and the European Central Bank (ECB).
Much of the focus was on the US, as weaker than expected reports on manufacturing and services raised concerns about the trajectory of the US economy. Comments from Bill Dudley, President of the New York Federal Reserve, on the ‘tightening of financial conditions since December’ have added to speculation that the US Federal Reserve may be forced to abandon planned rate hikes this year.
The Fed’s most recent “dot plot” – a chart that is part of the FOMC’s Summary of Economic Projections which plots the predictions of the committee members for the target fed funds rate over various time periods – signaled four rate hikes in 2016. A lot has changed since then and indeed many in the markets are now ruing the Fed’s decision in December to start raising rates.
Figure 1: Fed Dot Plot, US Federal Reserve, December 2015
US interest rate futures, used to infer what the market expects the Fed to do in terms of rate hikes, suggests little chance of four rate hikes this year. One rate hike might be the extent of it based on prices last week, but a more aggressive reversal of policy by the Fed could be necessary.
It will be increasingly difficult for the US Federal Reserve to continue down a path that materially diverges from the other major central banks. Despite claiming that negative interest rates would not be necessary in Japan, the BOJ changed tact the week before last and joined other central banks in introducing a negative deposit rate on cash balances at the Bank. The ECB are intimating at more aggressive measures to be announced in March.
Also, last week we saw the Bank of England (BOE) confirm that they are firmly back on the extended easing path with the BOJ and the ECB. This is something I highlighted following the BOE’s meeting in November (see link: Super-Thursday: BOE blare the lower for longer tune) and we have since seen a sharp fall in Sterling as market participants have woken up to the fact that the BOE have no intention of raising rates in 2016. Ian McCafferty, the sole member of the BOE’s monetary policy committee who had been voting to raise rates, has become concerned enough about a slowdown to change his vote, with the committee last week voting unanimously to keep their main interest rate at the record low of 0.50%.
One could be forgiven for thinking that the prospect of ‘lower for longer’ would be received well by equity markets. However, right now market participants are more focused on the fragility of the economic recovery, which still remains heavily reliant on record low interest rates. The sharp drop in core government bond yields this year is a worrying development, an ominous signal of global economic weakness and a financial world defined by negative interest rates. The reality is that if the Western world had emerged from the crisis then interest rates would not be at emergency levels, and possibly going lower.
The Fed are now left with a difficult balancing act. Delaying rate hikes and backtracking on their previous statements would signal real concern about the global economic outlook, triggering a market selloff that could feed back on itself, in turn causing a sharper slowdown. At the same time, maintaining their stance in the face of the current turmoil would depict a Fed out of touch with reality.The next meeting of the Fed is not until March 15th/16th so we are sure to see continued volatility over the coming months. If precedent holds, the Fed and the ECB will likely come to the rescue for equity markets in March. At some point, this precedent will no longer hold, and that is when equity investors will really need to worry!
The truth is that we are still emerging from the last crisis. Michael Burry, head of Scion Asset Management, the real life character portrayed by Christian Bale in the movie The Big Short, sums up well our current situation:
“This crisis was such a bona fide 100-year flood that the entire world is still trying to dig out of the mud seven years later.”
End
Vincent McCarthy, CFA
*Full Interview with Michael Bury via DailyIntelligencer is worth a read:
