Fed losing market power; taking not making prices
The Federal Reserve appears to be reacting to events outside its control rather than setting the agenda in financial markets.
The Fed’s decision to delay raising interest rates at its September meeting, tied in part to concerns over China, unsettled investors, leading some to conclude that not only was the world’s most powerful rate setter hard to predict but that it was far less able to counter changes in market sentiment.
In past years the Fed, whatever its other struggles in balancing employment and inflation, has been a reliable power, dampening down anxiety when markets become jumpy.
That reputation, won by its heroic efforts during and after the 2008 financial crisis, was predicated on the faith of investors that, though economies are messy and don’t always respond directly to policy, markets on the other hand will more or less do the Fed’s bidding.
That was probably always naive, though as it proved time and again to be a profitable strategy, the axiom among market participants was "don’t fight the Fed".
By acknowledging that it is being steered by opaque and often bizarre events in China, the central bank tipped the weakness of its own hand.
"We reckon that the Fed has lost control of risk sentiment," analysts at bank Societe Generale led by Vincent Chaigneau wrote in a note to clients.
"Indeed, we argue that risk sentiment now has a strong impact on Fed expectations, but the Fed itself has a limited impact on risk."
If true, and market prices appear to bear it out, this will mark not only a significant change in global markets, but one which is, by definition, self perpetuating.
Credit, at the bank or in the stock exchange, is no more than belief. Once investors stop believing the Fed can inspire optimism, the tendency will be towards pessimism. As the rest of the world is a lot scarier and harder to predict than the US central bank, the implication may be higher risk premia and lower market prices.
Societe Generale notes that previous stress in the market has been self-correcting, in part due to expectations that the Fed would keep policy more generous for longer. That helped to support asset prices when stress ensued, and also short-circuited that stress.
Yet the Fed’s decision to leave interest rates unchanged on September 17 led to a selloff in global stock markets.
Similarly, when Fed chair Janet Yellen sounded more ready to raise rates last week there was only a very temporary respite for financial markets. So while it was upsetting to learn that they wouldn’t, we didn’t feel much better when they said they probably would after all.
New York Federal Reserve President William Dudley, who usually has quite a good touch with markets, illustrated the issue well when on Monday this week he said that if the economy keeps to its current trajectory there is a strong case for hiking before the end of 2015.
Stock markets sold off strongly on Monday, with the S&P 500 index losing 2.5 per cent, but it did not appear to be because people suddenly became convinced that the Fed would indeed raise interest rates.
Fed funds futures, derivatives which allow betting on policy rate changes, fell on Monday and now predict only a 37 per cent chance of an increase by year’s end.
The market, therefore, is not listening to what the Fed is saying but drawing its own conclusions based on what is happening elsewhere. Dudley and Yellen may wish to appear that they are on course, and in control, but that is now increasingly hard to square with past policy decisions.
Far more likely that the stock market sold off not because it fears a Fed hike but because it sees a growing threat to global economic growth from China.
Chinese industrial company profits fell by 8.8 per cent in August compared to a year ago, the most since records began in 2011, as demand dropped and prices fell, data showed on Monday. That news in turn helped to fuel another 2.0 per cent fall in the price of oil, adding to unease on global markets.
China is the price maker and the Fed, facing diminished power is more of a price taker, more acted upon than acting, and less powerful than we’ve believed. Perhaps its policies are achieving diminishing results. That will take some getting used to.