Is the US Fed on the right track?

Maarten Mittner is a freelance financial journalist and a markets expert.
Maarten Mittner is a freelance financial journalist and a markets expert.

The present volatility in global markets bears an uncanny resemblance to the “taper tantrum” of mid-2013. 

But this time, the outcome is likely to be different.

Then US Fed chair Ben Bernanke threatened to “taper” or curtail the easy money environment following the 2008 global financial crisis that sent markets into a tailspin – to the extent that the Fed blinked, and shelved plans to start hiking interest rates at year-end.

Then, as now, emerging markets were major victims of the Fed’s “normalisation” plans, exacerbated by slowing Chinese growth and growing indebtedness among emerging market countries. 

But, with these plans put on the backburner, emerging and global markets soon recovered and, after dipping strongly, the Dow ended 2013 26.5% higher, again awash in cheap money.

Now the Fed seems set to continue hiking rates, despite renewed market “tantrums”. 

For 2018 the Dow is showing flat to negative growth, with US lending rates at a ten-year high of 2.5%. 

That may not be the end: The Fed pencilled in another hike in December, and possibly three more in 2019.

Only at end-2015 did the Fed feel confident enough to commence with its hiking strategy. 

It has been very gradual since then, as the Fed has remained mindful of subdued inflationary pressures in the US economy, despite some uptick in GDP growth.

There is a perception that the era of cheap money has ended. 

But, in fact, the present level of interest rates in the US equates to present inflationary levels, and is still lower than economic growth, meaning the US economy is still in a technically stimulatory environment. 

What spooked markets, was the Fed’s removal of the word “accommodative” from its last monetary policy statement. 

That entails the reality that the rate environment has moved to at least a “neutral” situation, with further hikes sure to create a “restraining” environment, where rates will begin to rise above inflation and growth, which is expected to lose steam under the new scenario.

That is when the rubber hits the road, and the real end of the Fed’s stimulatory trajectory. 

The practical effect is anybody’s guess, but past experience shows that higher interest rates usually end in tears, as rising financial costs over a wide spectrum of economic activities has a deleterious effect on overall economic activity. 

This “overkill” mode has a negative effect on equity markets. 

It usually forces central banks to start lowering rates.

In 2013 the Fed deemed the economic environment to be too unstable to commence with tapering. 

But now, with US growth at 3% to 4%, unemployment at 3.7% and wage growth edging above 3%, the environment is much more conducive to hike rates. 

(Notwithstanding President Donald Trump’s recent criticism of the Fed’s strategy.)

In June 2013, the JSE All Share tumbled 10%, much in line with this year’s performance. 

But, as with the Dow, it recovered sharply toward year-end, again illustrating the local market’s strong correlation with global trends.

Should the Fed proceed with its present stance, it is unlikely that the JSE will recover strongly in 2018. 

But should the Fed recant, and ease on the braking, the JSE is sure to benefit.

Previous attempts by the Fed to navigate a “soft landing” by hiking rates after a period of easing often ended in failure. 

In 1937 the US was plunged into a renewed recession, after the central bank misjudged the environment to be favourable for higher rates following the 1933 Depression. 

Another classic case of “overkill” was before the onset of the 2008 crisis, when Fed chair Alan Greenspan hiked rates to a “restraining” level, eventually leading to an implosion in the US property market, where bad debt in suspect financial instruments caused banks and other financial institutions to come under severe strain.

Will it be different this time? Bonds provide some clues. 

Until recently, short-term rates in the US were rising faster than long-term rates, indicating market scepticism that the Fed would succeed.

A rise in short-term rates to above levels relative to long-term rates, is a sure sign of trouble ahead, as investors hold on to relatively longer-term debt at rates which are deemed more realistic.

The US 10-year yield has spiked to 3.2%, from 2.8% at mid-year, and higher than the 1.8% when Trump was elected. 

Interestingly, the 10-year has remained stuck at this level, despite many reputable financial institutions predicting that it would hit 3.5%, or even 4%, at the end of the present hiking cycle.

This illustrates that the market is not in a hurry to re-adapt to the new climate created by the Fed. 

A lingering suspicion remains that it may all end badly. Hence the caution to take the Fed at its word that it knows what it is doing.

There is, of course, another possibility: That the Fed does achieve success. 

There was considerable scepticism when Bernanke saved the world in 2008 by opening the floodgates and printing money to boost markets with the Fed’s easing stance. 

That was exactly opposite to the way authorities reacted in 1929. 

The world enjoyed the fruits of Bernanke’s moves ever since.

This time, the Fed might be able to hike rates to just above neutral, with markets falling somewhat before gradually recovering, as inflation remains subdued and economic growth steady − the envisaged soft landing.

But it is likely to be a close call. 

Maarten Mittner is a freelance financial journalist and a markets expert.

This article originally appeared in the 22 November edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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