Wisdom wanes for ‘don’t fight the Fed’


Janet Yellen Fed rates rise©Getty


For generations, “Don’t fight the Fed” was a mantra beaten into market neophytes by Wall Street’s grizzled veterans. Now the tables seem to have turned.

The Federal Reserve’s unexpectedly dovish stance, reiterated by chair Janet Yellen last week, contrasts sharply with relatively firm economic data, and is stirring a longstanding debate over what really influences central bank officials.

The US bond market, through low yields, has long reflected the wider market view that the Fed’s outlook for the economy, inflation and interest rate policy was optimistic.

Now it appears the Fed is coming around to the market’s view, as the central bank worries more about the negatives than the positives in the economy.

No matter the robust headline job-creation numbers from March. Or how despite market turmoil, US growth continues to trundle on at an underwhelming but respectable rate, the labour market is performing strongly and inflation is cautiously picking up.
 
Friday’s mixed employment data only underlines Ms Yellen’s apprehension and keeps investors fretting about a renewed market volatility.

After a dramatic V-shaped performance in asset prices during the first quarter, investors are on the defensive, led by sinking equities and sharply lower oil prices.
 
That defensive posture has much to do with the market’s draining confidence in the Fed.
Gnawing at investor sentiment is what central banks can do to offset fundamental forces, led by weaker emerging market growth and supply gluts for many commodities, while highly levered companies face falling revenues and lower profitability.
 
‘’Unfortunately for Yellen, risk is trading increasingly like they are losing faith with the big central banks, because central banks can’t create value where there is ‘none’, in growth dependent commodities, or relatively rich, earnings depleted equities,’’ says Alan Ruskin, Deutsche Bank strategist.

“We feel too close to the market fearing central bank ineffectiveness for comfort. The market rejoices in Yellen’s dovishness, but with a fear about how long the impact will last.”

Ostensibly, the data still matters. Speaking to the Economic Club of New York, Ms Yellen reiterated the Fed mantra that “our actions are data-dependent”.

Many analysts and investors, however, have seized on the dichotomy between the reasonable economic fundamentals and Fed dovishness as proof the US central bank is more influenced by markets than it dares admit.

Fed officials bridle at suggestions they can be pushed around by markets. Ms Yellen is the official who matters, so when she speaks of the need to “take into account the potential fallout from recent global economic and financial developments, which have been marked by bouts of turbulence since the turn of the year”, it is fair to assume the Fed no longer treats market mood with blithe disregard.

Some feared the market turmoil was severe enough to raise the risk of a US recession. But the US economy has proved resilient and markets have snapped back. That is largely thanks to the market anticipating Fed caution and its retreat from the prospect of four interest rate rises in 2016, as Ms Yellen herself noted.

According to Steven Englander at Citigroup, this suggests she regards this hair trigger reaction as “not only correct but desirable and likely to be confirmed by subsequent Fed action”.

This offsetting theme is one Ms Yellen likes. The market is helping to act as an “automatic stabiliser” for the economy because incoming data surprises “typically induce changes in market expectations about the likely future path of policy, resulting in movements in bond yields that act to buffer the economy from shocks”, she said.

But is Ms Yellen in danger of letting markets dictate Fed policy? After all, she recognised that the headwinds of weak global growth, low oil and China uncertainty were likely to ease, and yet despite efforts by hawkish Fed members to talk up rate-rise prospects, the dovish tone of Ms Yellen prevails.

The Fed is mistaken if it shifts to a market-dependent strategy, says Steven Barrow, foreign exchange G10 strategist at Standard Bank. “Financial markets are very fickle things and sometimes when you want things to happen they don’t always work the way you want. That’s how any central bank can get tripped up,” he says.
 
The argument that the Fed is overly influenced by markets goes back decades. Many have long argued there has been a tacit “Fed put” lasting two decades whereby officials will quickly seek to quell turmoil through dovish coos or policy action.

The Fed’s caution in the face of arguments supporting rate normalisation suggests that “the put still seems to be in place”, says BNY Mellon strategist Simon Derrick. The difference this time around is the context of pressure from policymakers globally for the Fed to go beyond its domestic remit and be sensitive to the impact of policy on other markets.
 
“If the Fed is becoming, by default, the global central bank and the ‘Yellen put’ is effectively there to support global markets (even if not intentionally) then that introduces a whole new dynamic to this 20-year-old story,” says Mr Derrick.

Acute sensitivity to market ructions follows the financial crisis, when the Fed was slow to track parts of the bond market. Nonetheless, some investors are wary that the central bank’s ability and inclination to support the market — in the face of the economic data — could in the long run prove unhealthy as it introduces a more fickle dynamic into policymaking.

For example, if markets continue to heal from the early-year fright, it could force the Fed to restore its initial rate outlook for 2016. If that sends markets back into a tailspin it may spur the Fed to once again reverse course.

“It’s a delicate balancing act they [the Fed officials] have to figure out,” says Gregory Peters, a bond fund manager at Prudential.

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