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.
International investors have been far more concerned about the escalation in trade tensions between America and China, the resurgence in geopolitical risk centred around the war in Syria and, crucially, the implications of the dramatic increase in volatility in US stock markets.
Yet several important financial developments in the United States and abroad over the past several days suggest investors would do well to shift their gaze back to the Federal Reserve.
The most recent one is last Thursday’s decision by the Hong Kong Monetary Authority, the city’s de facto central bank, to start intervening to prop up the Hong Kong dollar, which has slumped to its weakest level since the current trading band was implemented in 2005, partly because of the widening gap between local interest rates and their US equivalents. The move has tightened liquidity, throwing into sharp relief the vulnerability of the city’s booming property market to strongly divergent monetary policies.
The second development last Wednesday was a notable pick-up in US inflation, with the core rate (which strips out volatile food and energy prices) rising to 2.1 per cent last month, slightly above the Fed’s target and its highest level in a year.
The same day, the Fed released the minutes of its meeting in March, the first under its new chairman Jerome Powell, which not only revealed that some policymakers favour a faster pace of interest rate hikes, but also that the recent surge in volatility has not dissuaded the Fed from pushing ahead with further tightening.
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.
Although, as I pointed out in my earlier column, there are increasing fears about global growth, these are mainly centred around Europe. The US economy is proving more resilient and is benefiting from a huge fiscal stimulus following the recent enactment of aggressive corporate tax cuts. In the minutes of last month’s Fed meeting, policymakers stressed that the stimulus was likely to provide a “significant boost” to output, helping drive up inflation.
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.
The figure to keep a close eye on is the monthly data on US wages. Earlier this month, a report from the Labour Department showed that wages picked up in March, rising to 2.7 per cent year on year. Lest it be forgotten, it was faster-than-expected wage growth in January that triggered the surge in volatility in stock markets in early February.
Investors would be well advised to position themselves for a more hawkish-than-expected Fed.
Nicholas Spiro is a partner at Lauressa Advisory