There are several reasons for why 2018 has been a tough year for many investors. Near the top of that list is a more active US Federal Reserve under the leadership of Jay Powell.
Since assuming the role of Fed chairman in February, Mr Powell has set a different tone to his predecessors. It may upset President Donald Trump and momentum-based strategies, but fiscal stimulus has required the response we have seen from the Powell Fed. We saw the first sign of this in March when the Fed raised interest rates after the equity market stumbled during the previous month.
After today’s hardly surprising anodyne policy statement, the Powell Fed remains on course next month to tighten policy for a fourth time in 2018. This will lift the Fed funds band to a 2.25-2.5 per cent range.
That’s a possibility the bond market, let alone many investors owning emerging market exposure and those selling the dollar, was definitely not anticipating back in January.
The pace of US tightening this year — alongside the Fed’s balance sheet now shrinking at a peak monthly pace of $50bn — has shaken markets.
The message that this Fed wasn’t going to hold the market’s hand has taken time to register says Bill O’Donnell, a venerable Treasury market strategist. This week we grabbed a coffee in New York and talked about the market, his take on the Fed and the cycle and what we should be watching.
With the real 10-year yield at 1.14 per cent — its highest level since early 2011 and up from about 0.45 per cent at the start of the year — we have, as Bill says, soundly taken out the taper tantrum peak 0.925 per cent.
He says the bond market is being dragged along by Mr Powell and his risk management view of applying policy, which goes up a notch in 2019 when every Fed meeting is followed by a press conference.
One thing to keep an eye on is term premia, a measure of the compensation from owning long-dated bonds versus shorter maturities. The New York Fed’s 10-year Treasury term premia model has been rising and becoming less negative since Mr Powell spoke in Jackson Hole at the end of August. That was a speech notable for how Mr Powell compared the challenges of US monetary policy to “navigating by the stars”.
Bill thinks term premia has room to rise further given Mr Powell’s “risk-managed” approach.
A higher term premium over time means a steeper yield curve, argues Bill, and why he’s watching for confirmation of that trend through a further strengthening in the dollar and greater global market dispersion in the form of emerging markets lagging.
At this juncture, the bond market expects only a few more tightenings in policy. Through the January 2020 Fed funds future contract, traders see the Fed’s overnight benchmark around 3 per cent by late 2019 as shown here:
The expectation of a slower pace of US tightening in 2019 by the market reflects the view that the tailwind of tax reform ebbs next year and, moreover, inflation sticks near the Fed’s current 2 per cent target.
The Fed is not so sure and anticipates three rate increases next year, followed by another in 2020. That’s not hard to see given the strength of the US labour market with annualised wage growth now north of 3 per cent. Add the inflationary threat of tariffs and perhaps more to come should US-China trade tension climb another gear, there are grounds to think bond traders may face another year of having to catch up with Fed policy.
Don’t expect a departure from the recent risk management script when Mr Powell speaks next week.
Up in the air
I’m flying back to London on Friday, so the next Market Forces will be published on Monday. But here’s something on the pound and Brexit — a topic that is also up in the air — and which would have been the main read today, if not for a chance to riff on the Powell Fed.
As the prospect of a Brexit deal grows, the sticking point comes down to whether the UK parliament ultimately votes in favour of the UK’s divorce terms with the EU.
The recent recovery in the pound — which flagged a little today from an earlier high of $1.3150 — shows that the currency market is leaning towards a deal, but a strong sense of caution also prevails when we look at f/x options trading.
The implied volatility of GBP/USD for one month is just shy of January’s peak and has climbed appreciably since August.
Analysts at Bank of America Merrill Lynch say:
“A lot could still go wrong, but the willingness by both sides to look at creative solutions to the [Irish] backstop suggest to us that no-deal still remains a tail risk despite being talked up by both sides.”
As the bank shows here, the relationship between the trade-weighted pound and UK interest rates versus the G10 major currencies has strengthened. Previously, the pound was being influenced more by the bank’s poxy for political risk:
“Our base-case scenario remains that a deal will be reached that should provide a significant lift to GBP against the backdrop of an increasingly hawkish Bank of England.”
Quick Hits — What’s on the market radar
Oil prices swamped by supply — Brent crude today approached its August intraday low of $70.30 as the threat of a supply squeeze from US sanctions on Iran has been erased. A month ago, oil was Icarus, the best-performing major asset for the year. Today West Texas Intermediate, the US crude benchmark, entered a bear market.
Wall Street momentum — The S&P 500 index remains above its 200-day moving average, but for now a rise above the 100-day measure at 2,820 points is on hold. The dollar bounce today after the Fed statement is checking the glow from the US midterm elections for equities.
Eurozone banks on the rebound? — Here’s one sector that is deeply unloved and in a profound bear market, but enjoying a bounce. The Euro Stoxx bank index is up 6 per cent from its late October nadir. BCA Research think the sector is due a “countertrend burst of outperformance” and note:
“This year, European banks sank by 35 per cent versus European healthcare. However, the sharp deceleration in global credit growth which dragged them down has now clearly reversed.”
The FT’s mental health investigation
And here’s one thing to end on. Some of my FT colleagues are investigating what employers are doing to support employees’ mental health, and we need your help. There’s growing evidence that a lack of concern about burnout, anxiety and depression is costing companies a fortune in lost productivity. We think it’s an under-reported story. Does your company do enough to help employees? Are you and your colleagues at risk of burnout? Tell us about it here.
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