This week all eyes were on the US, and specifically Jerome Powell, Janet Yellen’s replacement as Chairman of the Federal Reserve (Fed). On Tuesday, Powell made his first Congressional Testimony in the role. His remarks were interpreted as bullish on the economy and, therefore, hawkish on the trajectory of interest rates. Consequently, the market is now pricing in three rate rises for the remainder of 2018, and the perceived chance of four rises has risen too. Both credit and equity markets reacted accordingly; the 10 Year Treasury Bond Yield has crept up toward 3%, while the S&P 500 Index is down nearly 4% since the Testimony. It has long been believed that the Fed will slow the pace of rate rises if markets exhibit volatility, commonly known as the “Fed put”. However, many have speculated that Powell is likely to show greater tolerance for bouts of market turmoil compared to the previous two Fed Chairs, because the economy is now “late cycle” and there is risk of overheating if monetary action is not taken.
Indeed on Thursday, we received confirmation of the rude health of the US economy via an unexpected rise in the ISM manufacturing index in February to 60.8 from 59.1. This latest reading brings the index to a 13-year high. Could the Fed be behind the curve in raising rates? Many would argue: Yes. In the words of The Economist “If a Rip Van Winkle had woken up after 20 years, to be told the American economy had grown by 2.3% in 2017, that unemployment was 4.1% and headline inflation was 2.1%, he would have been astounded to hear that short-term rates were only 1.25-1.5%. He might be even more astonished, given these numbers, to find that Congress had just passed a tax-cutting stimulus plan.”
That said, inflation is hardly spiralling out of control. The Core Personal Consumption Index, the Fed’s favoured inflation measure, climbed 1.5% year-over-year in January. The move was in line with consensus expectations and still comfortably short of the Fed’s 2% target. Moreover, the labour force participation rate remains significantly below the level seen between the mid-1980s and the Great Financial Crisis. In theory, this leaves ample scope for presently inactive people of working age to enter the jobs market as the economy expands, which will help keep a lid on wage inflation. Nonetheless, Mr Powell has enough economic justification to purse a normalisation of interest rates, and various “experts” have warned that this will spell trouble for investors. Yesterday, former Fed Chairman Alan Greenspan joined well-known fund managers Ray Dalio and Bill Gross in predicting the end of a multi-decade bond-market rally, which in turn could remove the buttress supporting the equity market.