Investors watch out: US Fed may be more hawkish than markets realise
Nicholas Spiro says the Fed is signalling that it expects inflation to pick up and will push ahead with raising rates, undeterred by market volatility. Investors should question whether buoyant markets are pricing in the risks of a more aggressive Fed
Over the past few weeks, the conduct of US monetary policy has been something of a sideshow in financial markets.
The third, and most troubling, development is the much-discussed flattening of the US bond market’s “yield curve”, which shows the difference between yields on short and longer-dated debt. Last Friday, the gap between 2- and 10-year yields (the former is sensitive to monetary policy while the latter reflects future economic conditions) shrank to its lowest level since 2007, as the two-year yield surged to its highest level since 2008 while its 10-year equivalent remains stuck below 3 per cent, and has even fallen recently. This suggests that investors believe the Fed will raise interest rates too sharply in the next two years, dampening growth and causing yields to fall in the ensuing years.
Make no mistake, the bond market is signalling that the Fed is about to commit a major “policy mistake”, in the words of JPMorgan, as the economic outlook becomes more uncertain.
This is debatable, especially since Powell himself has stressed the importance of maintaining the gradual approach to lifting rates introduced by his predecessor, Janet Yellen, and has conceded that wage growth – the key determinant of the degree of inflationary pressure – remains subdued for the time being.
What is clear, however, is that markets, whose predictions of where interest rates are heading have only recently begun to converge with those of the US central bank, are underpricing the risk of a more hawkish-than-anticipated Fed.
While the flattening of the US yield curve – and the possibility that it may soon invert – could reflect a variety of factors, it is more indicative of investor complacency about rising inflation and tighter monetary policy than concerns about a sharp downturn in the US economy.
Yet markets still doubt whether consumer prices will rise significantly. The so-called 10-year break-even rate, a market-derived gauge of investors’ expectations for inflation over the next decade, is only slightly above 2 per cent. This is partly because the forces that have been holding down inflation, such as demographic trends and technological disruptions, remain in place.
But with the Fed increasingly confident that inflation will continue to pick up, and having signalled that interest rates will need to rise at a faster pace, it is striking that valuations in bond and (significantly more volatile) equity markets remain at such lofty levels.
Investors would be well advised to position themselves for a more hawkish-than-expected Fed.
Nicholas Spiro is a partner at Lauressa Advisory