Note that the Fed just pulled the plug on a 35-year trend
‘Bottom line for the markets is that the days of plenty are over’
You have been warned. The US Federal Reserve is making it clear as punch that the days of easy money are over and tougher monetary medicine is on the way. With the US economy on a firm footing, the markets are on full notice that the cost of US money is going up. And it is not just in the US where the effects will be felt. The aftershocks will be felt globally.
Right now, with US job creation and economic growth heating up, the last thing the Fed wants to be accused of is over-cooking the pot. The Fed needs to wind in the excess stimulus fast, before its critics in the US Republican party pile in. The Fed took a huge gamble ramping up the US economy after the 2008 crash and probably wants to avoid a damaging run-in with the government about state over-intervention.
So, it is no surprise to hear a growing chorus of key Fed officials laying the groundwork for higher rates this year, coupled with pledges to start running down the Fed’s US$4.5 trillion quantitative easing (QE) asset pile. Over the last few weeks Fed whispers have been turning into more of a shouting match. The writing is on the wall for tighter money and there will be consequences all round.
The Fed is adamant interest rates are going higher this year after last month’s quarter-point rise. The key is by how much. Most Wall Street banks now see the Fed targeting the key funds rate up to at least 1.25-1.5 per cent by the end of the year. But it is not going to stop there.
The Fed’s long term objective is to normalise monetary policy as quickly as the economy allows. Long term, this implies the Fed funds rates should be heading back towards its post-war average of just below 5 per cent, probably into an initial range of 2-4 per cent, after making some allowances for the economy recovering from the after-effects of the 2008 financial crash.
The cost of money will be going up and there’s likely to be a sharp squeeze on the supply of cheap credit as the Fed starts to run down its portfolio of Treasury bonds and mortgage-backed securities amassed during three rounds of large-scale asset buying under the QE programme. As the Fed sells bonds back into the market, it will start to soak up surplus liquidity.
The Fed’s US$4.5 trillion balance sheet yielded a big slug of new money for the economy and the markets. While the cash obviously helped shore up sagging domestic demand, a very large chunk also found its way into ramping up financial markets. With the injection accounting for up to a quarter of the S&P 500 Index’s total market capitalisation, the Fed needs to give good guidance on what happens next.
So far, the Fed’s guidelines have left markets in a potential fog. Staying coy is no strategy and only puts stocks and bonds at risk. Wall Street estimates suggest a reasonably sanguine taper, with a median view looking for the Fed to eventually shrink its balance sheet back to the US$2.75 trillion mark. But, there are darker Fed hints of a much more vicious paring back to less than US$2 trillion longer term.
Bottom line for the markets is that the days of plenty are over. The outlook for US equities will be critically dependent on whether President Donald Trump comes up with the goods on sustained economic reflation going forwards. But the outlook for US interest rates and yields will be entirely dependent on just how tough the Fed wishes to be.
One very clear trend is the 35-year super-cycle for falling interest rates and bond yields is over. The bear market for money markets and bonds has already begun and the expected upward trend in rates and yields is likely to extend for years to come.
The Fed will be desperate to avoid any short-term jump in mortgage rates and long-term borrowing costs which might dent growth prospects, but it won’t stand in the way of the inevitable rise in the cost of money as the economy continues to make forward progress.
With bonds flooding back into the market, 30-year US treasury yields could easily make the jump from the current 3 per cent back to pre-crash levels around 5 per cent plus. The bond market’s glory days are over.
David Brown is chief executive of New View Economics