US economy

Fed communication triggers market turbulence


The recent bout of global market turbulence has apparently come out of a clear blue economic sky, with little sign of deterioration in the inflation or recession risks in any of the major economies. 

Certainly, there has been a nagging undercurrent of “bad” economic news throughout the year, especially from geopolitics. However, American equities have still produced positive returns. The consistency and strength of the US economic upswing has been working its magic.

That seems to have changed, at least for now. After a few days of gentle slide in US equities, last Wednesday saw the worst daily decline in the Nasdaq since 2016. The change of mood on Wall Street rapidly spread to other equity markets, which were already performing badly. Global equities (in local currencies) have fallen by 7 per cent this month, and are now slightly down on the year.

The proximate cause of the mini crash in equities is clearly to be found in the US bond market. The rise in long bond yields, and the steepening in the yield curve in US treasuries, were responsible.

Despite President Donald Trump’s claims that the Federal Reserve has “gone crazy” on short rates, the market sell-off was not caused by any change in the pace of Fed tightening. Expected short rates over the next few quarters have barely changed, but longer term bond yields have nevertheless risen quite sharply. Contrary to the president’s remarks, higher short rates are an appropriate response to recent economic success, not a mark of failure.

If the Fed has made a mistake, it relates to its guidance on the path for interest rates in the longer term. As discussed here last week, Chairman jay Powell and New York Fed President John Williams, the two most important members of the Federal Open Market Committee from the markets’ standpoint, may have confused investors about a key element of monetary strategy in their recent statements.

The issue revolves around the “neutral” rate of interest, known by economists as r-star (r*), which is the rate that is neither expansionary nor contractionary for the economy when it is in equilibrium. Under Janet Yellen, the FOMC frequently emphasised the importance of this neutral rate in their thinking, and the Powell-led committee initially seemed happy with this approach.

In his latest press conference, however, Mr Powell surprised everyone when he said that the FOMC would in future place little emphasis on the concept of the neutral rate, because in practice it can be estimated only with considerable uncertainty. Loosely translated, this implied that the Fed Chairman does not really have a strong conviction about where and when monetary policy might turn restrictive.

John Williams, the FOMC’s technical expert on r-star and until recently its strongest proponent, chimed in with a telling metaphor in a speech last month. He said r-star had appeared to be a bright point of light when the Fed was a great distance away from it, but increasingly looks like a fuzzy blur as policy shifts closer to it.

From this bout of stargazing, he concluded that the Fed could discover the exact location of r-star only by observing changes in actual economic data as the voyage towards it continues.

While these are little more than statements of the obvious, they nevertheless removed the anchor on which the bond market had previously relied for the terminal interest rate at the end of the present economic cycle, generally thought to be a couple of years away. 

Under previous guidance about the neutral rate, this anchor was firmly in place, so variations in expectations about short rates had relatively little effect on longer-term rate expectations. When short rates went up, the yield curve moved towards inversion (see graph below)

With the demotion of r-star as an anchor, the long-term rate was free to move upwards in response to faster economic growth, and that is what happened in recent weeks. The curve steepened, instead of inverting, as rate expectations rose. 

Examining the bond sell-off in more detail, it was focused on real interest rates, with little evidence of any rise in inflation expectations. 

Furthermore, much of it stemmed from a jump in the real-term premium on long bonds, not the inflation risk premium. All of these symptoms are consistent with greater uncertainty about the future for real interest rates. At the risk of over-interpreting a minor change in language, it seems that all this was probably caused by the Fed’s changed attitude towards r-star.

Intentionally or not, Mr Powell and Mr Williams made unscripted statements last week that back-tracked slightly on the downgrading of r-star. Mr Powell said that policy remains very accommodative, which implies that he knows where neutral is. Mr Williams said the present pace of tightening will take rates back to neutral in about a year, which again implies a prior knowledge of where neutral lies. They may try to back-track still further in forthcoming statements.

The question is whether they can now put the genie back in the bottle and restore confidence to the markets. They probably can. This has been only a minor communications wobble, not a major strategy error. 

Furthermore, although US equities are very expensive relative to bonds, this mis-step should not result in a bear market, as long as corporate earnings keep rising strongly, and subdued price inflation keeps the lid on interest rate expectations. Last week’s consumer price inflation data remained comfortably in line with the 2 per cent target and Fulcrum forecasts suggest inflation will actually undershoot the target next year.

The US economy is still in excellent health, and it would need to deteriorate much further before this episode of market turbulence turns into a major meltdown on Wall Street.



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