One takeaway from the US Labour Department December 12 report showing consumer price inflation moving closer to the Federal Reserve’s 2 per cent target is that the central bank has scope to continue raising interest rates. Another is that keeping market rates under control is no longer within the remit, or the power, of the Fed, making for a more perilous environment for investors as the central bank seeks to bring its monetary policy closer to normal levels.
There are already signs that the Fed is losing control of the markets. Despite five rate increases this cycle, the start of balance-sheet tapering, and three more rate hikes projected for 2018, financial conditions have eased in both the US and globally. In addition, the dollar has weakened, stocks are soaring, volatility is low and investors show unwavering appetite for high-yield assets.
Not only is there no sign of tightness, risk markets look positively euphoric, and, significantly, are moving in the opposite direction to the Fed’s actions.
One could argue this is exactly what the Fed has desired, which is an environment of reflationary stimulus amid a normalisation of monetary policy. Loose financial conditions are also a sign that the Fed’s policy rate is below the neutral level that would neither stimulate nor restrict growth.
Still, the conspicuous lack of market responsiveness to Fed tightening despite historically rich bond and equity valuations raises questions about the central bank’s ability to control market volatility when inflation does return.
The flip-side of tolerating easier financial conditions while US growth is robust is valuation distortions in markets.
In theory, market pricing reflects investor expectations about the future state of the economy. But in practice, it is hard to square a sub 2.60-per cent yield on 10-year US Treasuries — up less than a quarter of a percentage point over the past year — with the three Fed rate hikes in 2017, an economy that grew in excess of 3 per cent in real gross domestic product terms in the second and third quarters of last year, and a labour market that is near full employment.
Nor is it apparent that static long bond yields tally well with the robust pace of corporate earnings growth or household sector data.
The recently approved tax cuts will bring additional support for earnings in 2018, but they will also add to public borrowing even as the willingness of China and Japan to fund US deficits to the same extent as in the past has come into question. Even after last week’s rise in longer-term yields, there are no signs that bond markets are pricing economic strength or geopolitical risk efficiently.
A big part of market psychology has been the faith that the Fed will be inclined to repeatedly intervene in markets with more stimulus to hedge against financial volatility at the expense of controlling inflation.
To the extent that longer-term bond yields reflect the expected trajectory of real short-term rates plus inflation compensation and a term premium — the amount that investors would be prepared to accept to part with cash today — then the current flatness of the yield curve reflects a deeply negative term premium discount. This may be a legacy of the Fed’s massive balance-sheet expansion via quantitative easing, but it is far removed from the current economic reality.
As growth, jobs and now inflation return to more normal levels, expect the markets to follow. Since the US 10-year discount rate provides the basis for an entire constellation of financial valuations, including stocks and credit, the implications will reverberate across assets and markets, well beyond the US.
Perhaps the catalyst for a change will be when inflation finally reaches the Fed’s 2 per cent target. We’re not there yet, but a core CPI rate of 1.8 per cent in December signals that US inflation is alive and well, and the policy target is closer than investors may have assumed.
But if the Fed is no longer in control of markets — or the path of inflation — the long road to squaring current financial euphoria with a more “normal” economic and policy reality may prove to be a bumpy ride.
