Why investors should keep an eye on the Fed « ROGER MONTGOMERY
Why investors should keep an eye on the Fed
How quickly the tables have turned. Although equity markets are in the doldrums, they’ve bounced strongly since a few U.S. Federal Reserve officials intimated that the pace of rate rises could soon moderate. But there’s another issue that’s possibly even more important for long-term investors: quantitative tightening. Since the Fed began to shrink the size of its balance sheet, share markets have collapsed and demand for ‘safe’ assets such as long dated treasuries has surged.
While I pen this article, the Nasdaq index is up by 5.9% since the intraday lows of Friday a week ago, and over the same period, the S&P500 is up 5.6 per cent and the S&P/ASX200 is 2.1 per cent higher. So, is the bear market over? Not by a long way. High quality Australian and global companies remain miles below their highs.
All expectations are for the Federal Reserve to impose another interest rate rise of 0.75 percentage points at their meeting this Wednesday (Thursday our time) but also expected is a debate by Fed members on whether a smaller increase is warranted in December, and if so, how to signal that to investors without triggering a new bull market.
This Wednesday (Thursday our time), the Fed will have raised rates again and possibly provided a clearer indication about its plans for forthcoming moves. Meanwhile, global liquidity measures, reflected in the turbulence in UK Gilts recently and U.S. Term premia, have slumped. Crashing global central bank liquidity has ended the most recent bull market, exposing, as it has in past episodes, those with leverage. Sadly, as the Gilt troubles revealed, the leverage appears concentrated in safe and sovereign, rather than speculative, assets.
Term premia is the difference between the return received for locking up money for an extended period and the return received from rolling over short-term instruments for the same amount of time. It’s a measure of the extra return demanded by investors to hold a long horizon bond above rolling a short-term interest rate contract over the same period. Negative Term Premia – such as we see today in some measures at the 10-year tenor – suggests excess demand of government bonds as ‘safe’ assets.
Additionally, negative term premia at the 10-year tenor (long-horizon bond yields are moving less than shorter-term yields), is at all-time lows according to some macro-economic researchers, and suggests the demand for ‘safe’ assets is extreme.
That just might have something to do with U.S. Treasury Secretary, Janet Yellen, voicing concerns about the functioning of the U.S. Treasury market, at the U.S. Securities Industry and Financial Markets Association’s Annual Meeting. Indeed, Yellen listed financial market concerns alongside inflation, stating “Two immediate priorities are to tackle inflation and to monitor potential vulnerabilities in the financial system.”
Perhaps surprisingly, nobody in the financial media is discussing this issue. Could it therefore be a non-issue? I think not.
Investors are, instead, still focused on predicting whether the Fed will raise rates or pause. The futility of this focus by investors is best highlighted by the fact even members of the Fed disagree on what the right path for interest rates should be.
On one side of the fence are the Fed officials who have flagged their preference to adopt the RBA’s policy of waiting and assessing the impact of rate hikes to date, by slowing the velocity of rate rises and even refraining from further increases by early next year. The ‘doves’ understandably want to reduce the risk of a hard economic landing.
One of the doves is Fed Vice Chairwoman Lael Brainard who, in a speech on October 10, disclosed personal disquiet about raising rates by 75 basis points beyond November’s meeting, noting their lagged influence on the economy.
Another dove is Chicago Fed President Charles Evans who is reported to have expressed concern about the assumption the Fed could easily reverse course on rates if they proved to be too high.
One of the problems for the doves is they number among those who argued most vehemently for a delay to the removal of stimulus policies. With inflation now at near 40-year highs, they have lost some credibility.
On the other side of the Federal Reserve’s fence are the ‘hawks’ who believe persistent and broadly high rates of inflation means it is too early to start talking about stepping off the gas, so to speak.
On October 6, Cleveland Fed President Loretta Mester, cited no progress on inflation as the reason for her preference for 75 basis-point rate increases at each of the Fed’s next two meetings.
Philadelphia Fed President Patrick Harker has a similar view. Wanting proof inflation is falling before easing up on rate increases Harker said recently, “Given our frankly disappointing lack of progress on curtailing inflation, I expect we will be well above four per cent by the end of the year”.
And finally, there are those in Federal Reserve officialdom who can’t decide. In a speech earlier this month, Fed governor Christopher Waller sat on the fence pontificating: “We will have a very thoughtful discussion about the pace of tightening at our next meeting”.
Focusing on what the Fed does next is at best a guess. While a dovish pivot would be bullish, a hawkish tone will disappoint and erase all of the market’s most recent gains. Nevertheless, long-term investors should look at the data. Since the Fed commenced its program of reducing the size of its balance sheet, equities have declined and demand for ‘safe’ assets such as long dated treasuries has surged.
Markets rallied in July and August when central banks stopped shrinking their balance sheets, and that needs to happen again if investors want equities to rise. It could happen next year, if the economy starts to slow, and especially if the hawks win and a hard landing follows. And so, investors should be watching what the Fed does with its balance sheet and what investors do with their appetite for safe assets, rather than what rates do in the short term.