Markets Insight

August 22, 2013 5:50 pm
Big fall in US equities could mean Yellen is next Fed chairman
Dovish candidate likely to be preferred in that scenario, writes Stephen Foley
Amid all the speculation over whether Larry Summers or Janet Yellen has the edge in the race for Federal Reserve chairmanship, amid the hunt for clues on their monetary policy philosophies and the debate over the relevance of their respective leadership styles, it may be that there is a simpler way to look at this.
If there is a 10 per cent correction in the US equity market, Ms Yellen gets the job.

The intriguing idea, as set out by the chief US economist at Moody’s, John Lonski, is that a stock market sell-off would signal a loss of confidence in the economic recovery. It would suggest that higher interest rates are more likely to trigger a downturn than they are to reflect an economy achievingescape velocity” from recession.

In turn, that would require the White House to appoint the candidate perceived as most dovish.

If that seems a hair-trigger for a decision of such long-term import, it would also be a recognition that the Fed is losing control of long-term interest rates and that signals matter if it wants to maintain what grip is left.

Consider the events of the past 48 hours.

You had to scrabble around pretty hard to find anything new in the minutes of the July meeting of the Federal Open Market Committee.
There was no discussion of September versus December for tapering quantitative easing, or of $10bn versus $20bn for the reduction in monthly bond purchases. And yet the absence of dovish signalling was enough to move the yield on the benchmark 10-year Treasury decisively above 2.90 per cent in subsequent trading.

Nothing has brought the rate down, not mixed economic data, not the weak corporate earnings outlook, not even the prospect of financial turmoil in emerging markets that usually brings money back into havens.

Nothing now seems to stand in the way of a 3 per cent yield on the 10-year.

Clearly the “naturallevel of interest rates is substantially higher than markets had previously believed. As recently as June, primary dealers surveyed by the Fed gave no more than a one-in-10 chance of the 10-year being above 3 per cent by year-end. Fewer than half thought it would breach that level even before the end of 2014. That was already factoring in an expected end to QE by the middle of next year.

Bond markets are hurting. Professional investors in the $1.3tn-a-year market for mortgage-backed securities have seen big losses on their portfolios, and their need to hedge by selling five-year, seven-year and 10-year Treasuries is adding to the upward pressure on rates.

Investment grade corporate bonds, which are among the most sensitive to interest rates, have generated returns of minus 4.3 per cent so far this year, according to Barclays data.

Retail investors who clamoured for a slice of Apple’s $17bn bond issue in April are sitting on paper losses of up to 17.5 per cent, as the value of the 30-year tranche has slumped. The iPhone maker’s 10-year debt, of which it raised $5.5bn, is now down 11 per cent.
This might not matter to someone intending to hold the bonds to maturity, but for most investors seeing the value of their mutual funds or exchange traded funds eroding, it is prompting a reassessment.

TrimTabs estimates that, across the whole universe of bond funds and ETFs, some $30bn has already been withdrawn this month, setting August on course to be the third-most-negative month for the industry in the past 30 years.

The evaporating demand for bonds adds to the downward pressure on prices and the upward pressure on rates. It raises the cost of buying a house Freddie Mac said on Thursday that rates on 30-year fixed-rate mortgages jumped to a two-year high last week – and it changes the calculus for business investment. It has all but eliminated the possiblity of refinancing an existing mortgage, and a long period of lucrative financial restructuring by companies tapping the bond market may also be coming to a close.

The Fed’s minutes revealed officials still believe the US economy can withstand these higher rates, and while they sounded more nervous about their conclusion, they also showed no sign of backing away from tapering QE.

The pick of the next Fed chairman this autumn cannot now be separated from these signals. Rightly or wrongly, Mr Summers’ previous scepticism about QE has put him to the hawkish side of Ms Yellen, whose commitment to the full-employment half of the Fed’s mandate has been absorbed by the market.
The equity market had a schizophrenic response to the Fed minutes, first falling, then recovering on Thursday. It does not have enough data yet to judge the impact of the higher rates the Fed has unleashed. But that data will come, and the equity market may be a harbinger of what – and whocomes next.

Copyright The Financial Times Limited 2013.

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