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 If this test goes like all of the others, then if markets fall hard,
the Fed will step in.
Friday’s U.S. jobs data painted a picture of an economy creating
jobs, increasingly professional jobs, at a good pace and with
reasonable wage growth. Yet financial markets took the news calmly,
despite knowing full well that should the Fed move to hike earlier
than expected in 2015, risky assets like equities and emerging
markets will almost certainly take a pummeling.
The simplest explanation, investors’ belief in the 'Fed Put,' is
probably the best. This is the idea that the Federal Reserve stands
ready to take steps to rescue markets if they decline sharply, in
essence offering investors what is known on financial exchanges as a
'put,' the right but not obligation to sell a security below a
certain price.
William Dudley, President of the New York Fed, became the latest
last week to deny that such a thing exists.
“Let me be clear, there is no Fed equity market put. To put it
another way, we do not care about the level of equity prices, or
bond yields or credit spreads per se,” Dudley said in a speech.
“Instead, we focus on how financial market conditions influence the
transmission of monetary policy to the real economy.”
These protestations are somewhat undermined by recent events, not to
mention history and the data.
The most recent equity market palpitation in October was arrested
when St Louis Fed President James Bullard deployed the defibrillator
by saying that QE3 could be extended.
“Fed officials can confidently say what Dudley said when equities
are at record highs,” hedge fund manager Stephen Jen of SLJ Macro
Partners said in a note to clients.
“I would take them more seriously if they say things like this in
the midst of a 10 percent sell-off in equities.”
On several critical occasions in the last two decades the Fed has
eased interest rates or otherwise provided succor to financial
markets when they were in distress. This happens not just in times
of sharp sell-offs: research from the New York Fed shows that since
1994 equity market returns are essentially flat if you exclude the
three-day window around rate decision announcements. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1923197)
NEXT YEAR’S ISSUE
This may well put the Fed in a difficult spot in 2015.
Despite quite low inflation, the overall run of data in the U.S. has
been pretty good, and may well continue. Pressure on the Fed to
prepare the way for a rate rise soon will mount, something that
record-high and still rising equity prices will accentuate.
That’s despite a growing contrast between the U.S. and the rest of
the world. In Europe, Japan and China growth is disappointing and
central banks are in easing mode.
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All of this has helped to propel the dollar’s quite startling rally,
as investors put their money where they expect the highest returns.
Should the Fed add to this with hawkish talk or interest rate rises,
the dollar's rise may accelerate and effects will be felt keenly
outside the U.S.
The Bank for International Settlements warned in its most recent
quarterly report released over the weekend that the strong dollar
may pose a threat.
“The appreciation of the dollar against the backdrop of divergent
monetary policies may, if persistent, have a profound impact on the
global economy, in particular on emerging market economies,” the BIS
said.
"For example, it may expose financial vulnerabilities as many firms
in emerging markets have large U.S. dollar-denominated liabilities."
The threat is a self-fulfilling cycle: Fed tightens, dollar rises,
emerging market companies find it more expensive to borrow and repay
and become less attractive borrowers, prompting loans to get yet
more expensive.
Given that offshore lending in dollars has risen sharply and now
totals about $9 trillion, this has the capacity to become the kind
of problem which might influence the Fed.
What’s notable here is how self-perpetuating the entire mechanism
is. Since markets have confidence that the Fed won’t upset the apple
cart, borrowers take on risk, in this case currency risk. Since the
Fed knows this, and many other examples of the same type of
phenomenon, it is inhibited from raising rates and, apparently,
willing to clean up if matters get rough.
As it has arguably been for each of the past seven years, at least,
the Fed put will be one of the prime movers of 2015.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be an
owner indirectly as an investor in a fund. You can email him at
jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by James Dalgleish)
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