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 And even if, as we might, we get all three, the good news story of
stronger-than-expected U.S. growth might prove the hardest for the
market to handle. One prime risk: the Fed brings forward interest
rate hikes and bond investors suddenly realize they are holding a
massive amount of debt yielding very little in interest.
Last week’s quite strong U.S. jobs report underlined the extent to
which the recovery is coming along, with both good job creation and
respectable hourly wage growth. The Fed’s own labor market
conditions index has made up almost 90 percent of its recession
losses and is on course to return to pre-crisis levels by the end of
the year.
And yet markets continue to expect the Fed to wait at least until
this summer to hike rates and to be quite slow in further rises.
That’s despite the Fed itself forecasting something quite different:
with the median Fed official expecting interest rates at 2.5 percent
by January 2017, against the 1.375 percent priced in by futures
markets.
“The biggest risk to equities now is strong growth in the U.S.,
which will alter the policy trajectory of the Fed,” hedge fund
manager Stephen Jen of SLJ Macro Partners wrote in a note to
clients.
“Strong growth in the U.S. could force the Fed to abandon the
'patient' wording at the March FOMC meeting, and I suspect that
would lead to some volatility similar to the 'Taper Tantrum' in May
of 2013.”
Bad things happen in financial markets not simply when they are hit
by the unexpected, but particularly when the market has, for
whatever reason, largely ceased to consider and insure against the
possibility of a particular outcome.
After all, a strong U.S. economy and the hikes by the Fed that would
come with it can’t really qualify as a surprise in the grand scheme
of things. While this economy post-crisis has been slow to recover,
the job market has been recovering steadily, if bumpily, for years.
Investors partly don’t think the Fed will raise rates when inflation
is as low as it has been recently. That perhaps is besides the
point. The issue rather being what magnitude of move we might see if
inflation is strong enough to allow or require the Fed to begin to
tighten, possibly quickly.
BOND MARKET, WHAT BOND MARKET?
Financial markets, particularly bond markets, have been deliberately
manipulated, with interest rates suppressed by official buying. That
may have been a necessary policy, but it implies two forces
currently at work, both of which may be mutually reinforcing.
The first is very low interest rates, even for what may be
relatively high risk. As consultants McKinsey point out, global debt
has actually risen by $57 trillion since the financial crisis,
racking up a compound annual growth rate of 5.3 percent, or more
than the rate of global economic growth. And the interest rates on
bonds, with few exceptions, have trended much lower. Indeed,
according to JP Morgan data, $3.6 trillion of bonds now carry
negative interest rates.
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The second factor is that the bond market itself, because of
official intervention, is no longer working very effectively to
discount future growth or price the risk of inflation. Investors, by
and large, work to mandates which tell them to beat the market
rather than to walk away from the market when it no longer offers
fair value.
“Bonds used to be considered the ‘smartest’ of all asset classes.
But they are no longer reliable because of financial repression,”
Jen of SLJ wrote.
So what would happen if the Fed, the most powerful central bank in
the world, sent a clear signal that rates were now on the way up? A
large number of investors will suddenly realize that they are being
paid a risible rate of interest on bonds which will, as rates go up,
rapidly fall in value. The bond market would sell off, sharply and
rapidly.
Equities too would suffer, even if the underlying fundamentals for
their economies and businesses did not. As interest rates rise, not
only does the value of future earnings fall in present terms, the
entire investment biosphere becomes more competitive. The price of a
given dollar of future earnings, or future interest, has been
unnaturally repressed by monetary policy. Change the policy and you
change the price, rapidly and perhaps amid a bit of market
dislocation.
Central bankers know this and will do their best to prepare the way,
employing their best bedside manner.
Investors, to judge by markets, haven't much of a clue and may take
the good news very badly.
(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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