Truth be told, I’m a little annoyed with myself for being as surprised as I was. The statement by the Federal Reserve was largely what I would have hoped it would be, but not quite what I expected. The statement was what I hoped it would be, because it dealt with the economic reality the US economy is experiencing at the moment – tightening labour markets and robust if not spectacular growth. I didn’t expect this, because so often over the last decade the reaction function of this central bank has seemed to be influenced ty the financial markets, and just a few weeks ago we saw significant market turmoil. I’m annoyed because excepting the recent market turmoil, there really wasn’t anything too surprising in the FOMC statement, and I’ve said all along.. why would a competent central banker care about a sub- 10% correction in equity markets? Clearly these chaps at the Federal Reserve are reasonably competent! Future decisions will be data dependent as they should be.
This was a hawkish statement, no question about it – there was no reference to under-utilisation of the labour force and the FOMC have paved the way to dropping the use of the phrase “considerable time” when discussing the outlook for the currently low level of interest rates. The implication is clear for all to see… if the US economy continues to perform as it is, then the first interest rate hike should be in the middle of next year.
The reaction of the market was fascinating. The dollar rallied sharply, and most of the gains made by currencies like the euro and New Zealand dollar since the start of the month have been vaporised as I sit here typing. This was the trade! But, here’s the thing, equity markets are relatively unscathed by this, as are US bond markets. Have we all been worried about nothing? The concern has been that asset markets would fall in anticipation of normalisation in the US, we saw it with the “taper tantrum” this time last year, but here we are, the Federal Reserve has made its intentions clear, and equities have, so far, taken the news in their stride. What are we to make of this? On the face of it, it seems as if the markets are happy to believe that the US economy is strong enough to function without support, this would be fantastic news, but I’m not convinced. For a start Emerging Markets are now exposed, easy money from the US is ending and liquidity from developed economies could leave at any time. These less developed economies really do now have to justify continued financing at the rates they have been able to enjoy over the last 5 years. I believe the search for vulnerabilities has begun and the markets will be merciless. It’s going to be that much tougher going forward, and the risk of cascading crises is growing. This could be 1994 all over again, but this time on steroids. Be very very careful.
There are a number of flags to watch out for now:
- Continuing falls in the unemployment rate in the US – this will lead to fears that wage growth is about to take off
- Evidence of accelerating wage growth in the US – this will be a signal that cannot be ignored, as the US economy begins to experience capacity constraints. You simply can’t operate with zero interest rates in such a scenario
- Crude oil prices falling below $75 – this is the level at which further expansion of Shale oil production in the US starts to look impractical
- Signs that Draghi will be thwarted in his attempt to implement quantitative easing in the Eurozone
- Japan giving up on quantitative easing
- Further evidence of slowing economic activity in China
Any or all of the above could be the fuel that causes market instability at this point. For now I’m keeping an eye on the equity markets, and they are slowly weakening, there may come a point later on today where markets start to sell off aggressively, but we’re not there yet. For now the clearest change after the Federal Reserve’s statement has been the aggressive recovery in the dollar. This is the path of least resistance, and we fully expect this to persist in the weeks and months to come