Perceived shift in US Fed's monetary policy causes uncertainty
A perceived shift in US Federal Reserve's monetary policy has caused uncertainty in markets fearing swifter and sharper tightening measures
As the dust begins to settle around the latest perceived shift in policy on the part of the United States Federal Reserve, uncomfortable questions are being asked about the credibility of US monetary policy and the communication skills of the world's most closely watched central bankers.
First, what explains the sudden discrepancy between the relatively minor change in the Fed's economic forecasts - which anticipate no change in its outlook for inflation and only a minor downward revision to its estimate for the unemployment rate - and the fairly significant one in its interest rate projections?
Second, was there more to last week's off-the-cuff remark from Janet Yellen, the new Fed chairman, that there is likely to be a six-month interval between the end of the central bank's programme of quantitative easing and the beginning of interest rate rises than meets the eye?
Third, and most worryingly, given that this is the third time in just 10 months that the Fed has startled markets, what are the odds of the US central bank being able to keep treasury yields anchored at low levels prior to and after the first increases in rates?
What is clear is that markets are as confused as the Fed has once again allowed itself to be perceived.
If this confusion persists, last summer's sell-off in "risk assets" could prove relatively mild compared with the financial turmoil that may lie ahead - particularly when it comes to emerging markets, which have already borne the brunt of market uncertainty about the direction of US monetary policy.
Indeed, there were already signs in January that bond traders were bringing forward their expectations of US rate increases. The yield on two-year treasuries, the most reliable gauge of future rate increases, rose to 43 basis points or 0.43 per cent - its highest level since September last year, when the Fed was forced to put off "tapering" its asset purchases because of a sharp tightening in financial conditions.
The yield dropped to 29 basis points early last month but began rising again this month. In just 10 days or so, it surged 13 basis points to 47 basis points, as bond investors fear the ground is shifting in favour of earlier and sharper rate increases despite Yellen's insistence that there has been no change in policy since she replaced Ben Bernanke as Fed chairman last month.
The winding down of QE, the catalyst for a brutal sell-off last year, has almost become something of a sideshow. Markets are now focused on the timing and pace of US rate rises - a far more sensitive and consequential shift in monetary policy.
Are bond investors reading too much into Yellen's inadvertent remark about a six-month interval between the end of QE and the first rate increase? Shouldn't they be reassured by the fact that she immediately caveated it by saying that "it depends what [economic] conditions are like"?
Possibly - but this makes the release of every important piece of US economic data in the coming weeks and months an even more nerve-racking event for markets.
The bigger worry, however, is that the credibility of US monetary policy - the most important determinant of market sentiment along with China's attempts to tame its credit boom and, more recently, geopolitical tensions over Ukraine - is being undermined.
For a central bank that insists its policy stance remains steadfastly dovish, the Fed's hawkish signals are becoming more pronounced with each passing month.
The Fed is on very shaky policymaking ground now - and at a time of increasing nervousness in the markets to boot.
While it is still unlikely it will start raising interest rates as early as March or April next year - the most likely timeframe for rate increases if one attaches importance to Yellen's "six-month" remark - the Fed is injecting a lot of uncertainty into the outlook for interest rates.
Indeed, one could be forgiven for thinking that the Fed, whose rate-setting Federal Open Market Committee has become noticeably more hawkish over the past several months, is preparing the ground for a swifter and sharper tightening in policy.
If bond investors start to believe that this is in fact the case - and there are signs that this may already be happening to some extent - market rates could rise sharply in the face of relatively soft economic data (employment and inflation are likely to remain extremely low for a considerable time), leading to an even more disorderly normalisation of US monetary policy.
The stakes are very high - particularly for emerging markets, which, over the past several months, have been enjoying a period of diminished sensitivity to the once-dreaded "tapering" of the Fed's asset purchases.
Emerging market policymakers will now be nervously eyeing the yield on two-year treasuries in the hope that investors do not lose confidence in the Fed.
Nicholas Spiro is the managing director of Spiro Sovereign Strategy