Investors, second-guess a hawkish Fed at your peril
The world’s leading central bank has developed a well-earned reputation for dithering – but after three-and-a-half years of persistent uncertainty it finally appears to mean business
International financial investors could be forgiven for doubting the resolve of the US Federal Reserve.
Ever since the Fed surprised markets in May 2013 by announcing its plans to wind down, or “taper”, its programme of quantitative easing (QE), the world’s leading central bank has developed a well-earned reputation for dithering.
Investors and market commentators have lost count of the number of times the Fed signalled a tighter monetary stance only to back off because of concerns about the weakness of the US economy or, more controversially, the adverse effects on markets.
When the Fed did finally raise interest rates in December 2015 – the first hike in a decade – it was criticised for exacerbating a sharp sell-off the following month stemming mainly from fears about China’s economy.
The risks surrounding Britain’s unexpected decision in June to vote to leave the European Union (EU) and, more importantly, the upset victory of Donald Trump in the US presidential election in November contributed to the Fed’s decision to wait another year to increase rates for a second time.
Yet after three-and-a-half years of persistent uncertainty over the trajectory of US monetary policy, the Fed finally appears to mean business.
In one of the most striking developments in markets in recent years, the victory of Trump – an unabashedly populist president whose reflationary economic agenda could be imperilled by a faster pace of monetary tightening – has narrowed the gap between the expectations of investors and those of the Fed.
For the first time since the “taper tantrum”, bond investors are no longer instinctively second-guessing the Fed, or at least not to the extent they were before the US election.
According to the closely watched Fed funds futures market, investors now believe there is a roughly 50 per cent chance that the Fed will fulfil its pledge to increase rates three times this year, with the odds of a rate increase as early as next month climbing to 42 per cent on Wednesday.
This represents a significant increase in confidence in the credibility of the Fed. Part of the credit goes to Janet Yellen, the Fed chair, who has struck a distinctly more hawkish tone of late, underpinned by growing inflationary pressures in the US economy.
Testifying before the US Congress on Tuesday, Yellen said that “waiting too long to remove accommodation would be unwise, potentially requiring the [Fed] to eventually raise rates rapidly, which would risk disrupting financial markets and pushing the economy into recession.”
Just as importantly, while she admitted that Trump’s eagerly awaited fiscal stimulus programme was a source of “considerable uncertainty” for the economic outlook, she made it clear that rates would rise irrespective of changes in fiscal policy, implying that hefty tax cuts could increase the scope for more aggressive tightening.
Some analysts are even fretting that the Fed has allowed itself to fall behind the curve and that markets are underestimating the degree of policy tightening required over the next few years. Prominent asset managers such as Blackrock and Pimco are cautioning that the Fed may end up raising rates faster than investors anticipate.
Yellen’s testimony this week has provided renewed impetus to the so-called “Trumpflation trade”: a repositioning of investors’ portfolios out of bonds and into equities in anticipation of a faster pace of monetary tightening. The yield on benchmark 10-year Treasury bonds rose a further 6 basis points following Yellen’s remarks to just under 2.5 per cent, up 16 basis points since February 8.
The dollar index, a gauge of the greenback’s performance against a basket of its peers, has shot up 1.6 per cent since January 31.
Still, not everyone is convinced that the Fed will follow through on its plans to raise rates three times this year.
Some analysts, notably HSBC’s fixed income research team, believe that structural forces will keep bond yields anchored at low levels and, crucially, that the Fed will not be able to raise rates significantly without endangering economic growth.
Trump himself will also be able to appoint at least three new Fed governors within the next year and may seek a more pliant (in other words dovish) Fed in order to help implement his fiscal stimulus plans and counter the strength of the dollar.
The betting, however, is that, this time round, the Fed is serious about raising rates.
Investors who continue to second-guess the US central bank do so at their peril.