Comment: Fed move leaves markets feeling vulnerable
For weeks, stock markets in the US and UK have drifted – “range-bound” in market parlance – waiting for more clarity on interest rate prospects. Now it looks as if they will have a long wait – and the clarity when it comes may not be to their liking.
Expectations had been allowed to build that the Federal Reserve would begin its long-awaited “tapering” this month – cutting the amount by which it was pumping money into the economy. Few expected any dramatic move to scale down the $85 billion-a-month life support that the Fed was providing – a reduction of between $10bn and $15bn was all that was looked for. But last week Bernanke stood pat and announced “no change”.
That was a big surprise for markets. They chose to ignore the reasons why the Fed had arrived by a narrow majority to continue with its stimulus programme, and surged. The S&P 500 index hit a record high – a rally echoed round the world – and bond yields came down. The great money boon with its ultra-low interest rates would continue to prop up the rally in asset prices such as stocks, bonds and property for some time yet. But by the following morning, doubters and profit-takers had moved in.
The Fed cited concern that a tightening of financial conditions could impede improvement in the economy and labour market. It would await more evidence that progress could be sustained before making any change to its asset-purchase programme.
As “forward guidance”, last week did not impress. A key concern of central bank policy here and in America is to reduce policy surprises and thus market volatility. The immediate reaction last week was one of surprise – and its legacy will be a hit to the credibility of the Federal Reserve.
The big debate now is between those who believe that this is a mere postponement – tapering could still begin in October or November and last week’s market rollercoaster reduced to an insignificant blip – and those who fear we are now in an era of “quantitative easing infinity”. It will be an era impossible to end until an upsurge in inflation compels the Fed to act – and in a brutally painful manner.
Another reason behind the no-change decision may have been concern over the looming stand-off in the US Congress over the budget and further delay in action to reduce America’s colossal debt pile. Another Congressional rammy could unnerve holders of US debt and spark a flight out of the dollar. The currency would slump and inflation fears would be back centre-stage.
Little wonder markets are in a state of apprehensive time-marking, torn between a concern not to miss out on an economic recovery, however anaemic, and fear that its financial system has still not recovered from the Lehman collapse and its toxic legacy.
Here, too, doubts are growing over the forward guidance of Bank of England governor Mark Carney that rates would stay at 0.5 per cent for some two to three years. The FTSE 100 should surely be surging on this prospect of rock-bottom money costs for households and businesses alike.
But doubts are rising. Over the weekend, Citi Group announced a significant change in its interest rate forecasts. Its influential UK economist Michael Saunders has brought forward his expectation of the first hike in interest rates from 2017 to 2015. He now believes that Bank Base Rate will be at 0.75 per cent by the end of 2015 and 1.75 per cent at the end of 2016, with the 2017 average revised up to 2.25 per cent from 1.0 per cent previously. The rate will then “level off” at about 3-3.5 per cent in 2018.
Hardly earth-shattering. And these revisions reflect a view that growth will be stronger than previously thought, hitting 1.4 per cent this year (the previous forecast was 1.1 per cent) and 3 per cent in 2014 (from 2.1 per cent). The jobless rate should also be down to 7 per cent around the end of next year. Good news, surely?
But with interest rates still at historically low levels the idea of the economy revving up cannot but invite concerns over inflation. Less important here than the turning of the rate cycle is the gradient once it has turned – and that could prove steep.
For the moment we can only guess, and it is the size and imminence of the imponderables that explain the uncertain mood in markets. There is no compelling case for investors to rush in at this time. Bargains will be there for the patient.