Markets Insight

Summer Fed lull has investors ‘whistling past the graveyard’


August has a history of turning ugly, but there could be deeper trouble further ahead
 
 
Periods of calm across markets rarely last long and August has a history of turning decidedly ugly for investors.

The summer has been distinguished by very supportive central banks, with the Bank of England’s kitchen sink effort in the wake of the Brexit vote just the latest example of the “central bank put” pumping up asset prices.
 
With many central banks still looking to ease policy, one stands apart and holds the key to whether global equities can keep climbing, led by US share prices setting a record pace.
 
In the wake of last week’s robust employment data, the shadow of tighter US Federal Reserve policy and, by extension, that of a firmer dollar remains faint with little prospect of a sharper outline emerging over the coming weeks.
 
For now, complacency reigns, with the US bond market and many investors convinced the Fed will stick to the policy sidelines and keep interest rates low for a long time.

Two solid months of job gains in June and July falls into the camp of constituting the best of both worlds for markets. US equities are rising on the idea that second-half activity may gather pace and hopefully ignite earnings growth, while the bond market shrugs off a strong jobs print and continues to expect no action from the Fed.
 
Market expectations of a US interest rate tightening only rise above 50 per cent by March of 2017. The current two-year Treasury note yield of 0.72 per cent remains below last December’s level of 1 per cent, when the Fed finally began tightening policy.

Such a belief in the mantra of “lower for forever” against the backdrop of aggressive bond purchases by other central banks has compressed global bond yields and spurred a stampede into emerging market sovereign debt that sport higher fixed returns because they also reflect a greater degree of risk.
 
As measures of market volatility compress ever tighter and the search for yield embraces risqué areas of bond land, investors are largely viewing the world through the lens of secular stagnation.
 
The idea that the US economy will shift into a higher gear and trigger a reappraisal of the dollar with dangerous consequences for elevated EM prices, let alone US assets, notably expensive looking bond proxies — the shares of high dividend paying companies — appears a dim prospect to investors. One can’t blame them for whistling past the graveyard at this juncture, however.

Playing a role is the calendar, with the Fed not meeting until well into next month. As Lou Crandall at Wrightson Icap notes: “There is still plenty of time for events to undermine the case for a rate hike, as they have done repeatedly in recent quarters. It is much too early to say with confidence that the data will line up in favour of a rate hike on September 21.”

The annual gathering of central bankers at Jackson Hole in late August, with a speech from Janet Yellen, will probably offer little new information about the policy outlook.
 
Not until we see the tone of the August jobs data early next month, does the potential beckon for a stronger reaction from investors and the dollar. This is when things might become interesting. Based on employment and inflation considerations, a tightening of US policy from a meagre 0.25 to 0.5 per cent range is warranted.

Longview Economics makes the point that two forces — growing wages via a tightening jobs market and accelerating credit and money supply growth — support higher US service sector inflation.

“The risks to the consensus view are therefore skewed to the upside, with the growing likelihood that the Fed is forced, at some stage, to once again begin talking up the prospect of rate hikes,” says Chris Watling at Longview.

Such talk, however, raises the prospect of a stronger dollar, and as we have often heard, Fed officials do worry about financial market turmoil stemming from a rejuvenated reserve currency tightening financial conditions.

At some point and perhaps sooner than the market thinks, US policy officials need to break this impasse. The longer the Fed stays on the sidelines, the more distorted markets become, storing up a much more painful outcome for investors.

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