Investors continue to try to find parallels in history with the current US interest rate cycle with worries the current cycle could mirror 1994, when bond prices fell, as US Treasury bond yields shot upwards. However, this time is truly different. Recently, President Trump confirmed Governor Jay Powell would be Chairman of the Federal Reserve (Fed). Powell has voted in line with present incumbent, Janet Yellen, at every meeting since he joined the Federal Open Market Committee (FOMC) in 2012. On policy therefore he is expected to continue her profile of interest rate increases. However, his appointment is different as he is the first Fed chair in modern times not to have a PhD in economics. Critics of the Fed argue that the 200 or so PhD’s it employs have a forecasting record that is dreadful. By way of example, Ben Bernanke in 2007 described the issue of subprime mortgage defaults as being ‘contained’, but we all know what happened thereafter. So, the Fed can have an enormous impact on markets and the world economy for better or most likely worse. It was interesting, therefore, to see comments attributed to Allianz advisor Mohamed A. El-Erian where he noted US monetary policy tightening is “amazing” as “it’s been a very calm normalisation so far” and that the market needs to “judge the new tram that’s put in place…The next six months sees the FOMC on auto-pilot…a hike in December and a hike next March…but afterwards the new team will be in place…that is the key”. The key takeaway here being that Wall Street has one set of interest rate expectations going into 2018, but the current FOMC may well have another and given its composition is changing so materially next year it is difficult to forecast what will happen. It begs the question as to why markets are so calm.
We do know that US interest rates are going up, but we remain under the spell of a US Treasury market yield curve that has been emasculated by Quantitative Easing (QE). The US Treasury yield curve has flattened (i.e. the gap between short and long-term interest rates has narrowed) due to the combination of QE and investors’ duration extensions. This is the impact of monetary policy distortion. The Fed has driven short-term interest rates down to unattractive levels, forcing investors to buy Treasuries maturing way into the future to secure a reasonable yield (rate of interest). Remember though that the longer a bond’s lifespan (over 10 years, in particular) the more it is sensitive to changes in interest rate and inflation expectations – so the price of these bonds can drop precipitously, if interest rate expectations suddenly rise. Recent increases in the Fed funds interest rate have seen the US Treasury yield curve flatten. This means that the short-term (2 year) yield has risen to meet the yield of 10 year duration Treasuries. Historically, if long-term interest rates fall below short-term interest rates, it is a strong indicator of impending recession. However, this relationship has been distorted by QE. So, the US Treasury yield curve may have lost its predictive powers and, as Mohamed A. El-Erian goes onto say, the flattened yield curve is (probably) “underestimating the synchronised pickup (in global growth) that’s going on”. Critically he concludes that the “NEW FED” has a lot of issues to contend with: “we don’t understand productivity well, we don’t understand inflation dynamics well, we don’t understand wages well…the lack of understanding has driven short-termism and data dependency”. This complex backdrop is a recipe for a potential policy mistake. A misreading of the Fed’s intentions by the market would introduce volatility and the potential for a marked decline in US Treasury prices that could trigger a significant equity market sell off.
In the meantime volatility remains low and the appetite for risk taking and momentum investing has rarely ever been greater.