Gathering for the first time after their epoch-ending decision to raise interest rates in December, the backdrop couldn't be more different for Federal Reserve policy officials.
The long-awaited rate increase went smoothly, but simmering concerns over China, the global economy as a whole, deflating commodities and financial market valuations have since risen to the fore. Even fund managers that were relaxed about slightly tighter monetary policy last month are now wondering whether that was complacent.
“It is reasonable for investors to wonder whether Fed’s December rate hike was a policy error,” admits Bob Michele, chief investment officer of JPMorgan Asset Management. “Historically the Fed has raised rates because either growth or inflation was uncomfortably high. This time is different – growth is slow; wage growth is limited; deflation is being imported.”
Perhaps most of all, many investors now fret that they are operating without a safety net they had grown attached to during the post-financial crisis era.
Markets have been buffeted by powerful headwinds since 2008-09, ranging from predictable Middle East strife to the spectre of the disintegration of the European common currency. But central banks have been a constant source of comfort in hard times, suppressing interest rates and market volatility, thereby reinforcing the view among investors of a ‘central bank put’, or downside protection.
Such an assurance now appears less certain given the recent approach from central banks.
The Bank of Japan has failed to expand its quantitative easing programme as expected; the European Central Bank dashed unrealistically high hopes of more eurozone QE in December; the People's Bank of China has failed to calm concerns over China through aggressive action; and the Fed has started tightening monetary policy.
As a result, the “era of asset price reflation, fuelled by both post-crisis undervaluation and aggressive central bank easing, is over”, according to Jeffrey Knight, global head of asset allocation at Columbia Threadneedle.
“It was fun while it lasted, as the recovery of financial asset prices from the nadir of the great financial crisis has been dramatic, one of history’s most fruitful periods for investors. But 2015 returns were rather different, and the early experiences of 2016 only reinforce the likelihood of a new investment climate,” he wrote in a note.
Indeed, Stephen Jen, a hedge fund manager, argues that this year’s sudden bout of concern over China has merely been the trigger for a broader reappraisal of central banking puts and omniscience by investors.
“My guess is that the new strike prices for these central bank puts are probably 10 to 20 per cent below where the markets are now,” he recently told clients. “It is the presence of this ‘air pocket’ that was the main trigger for the equity sell-off at the start of the year, in my humble opinion.”
The danger is that turbulent financial markets become a self-fulfilling prophesy by underlining confidence and weakening the global economy. That could trigger a feedback loop where turmoil hurts growth, which in turn fuels more choppiness.
Most economists maintain the risk of a US recession this year are slim, but markets are now pricing roughly even odds of one, and that in itself has consequences. As Larry Fink, the head of BlackRock, said last week, the ferocity of the stock market rout "puts a negativity across the economy, a negativity to every CEO looking at his or her stock price, a negativity about business".
Should financial turbulence infect the real economy, the US central bank’s plans to raise rates another four times this year becomes extremely challenging. Investors have long doubted this rate path, but now they are virtually laughing at it.
The interest rate futures market indicates the Fed may only raise rates one more time this year, and not until well into the second half of 2016. The “yield curve” – the slope derived from various bond maturities – has flattened sharply this year, as the likelihood of tighter monetary policy has receded.
Nonetheless, investors should be careful not to throw in the towel and plough their money into guns, gold and agrarian land, assuming that the era of the central banking put is dead.
As the ECB showed in timely fashion last week, central banks are still able to calm nerves when needed. While Mario Draghi did not produce any more monetary easing his hints of action to come in March were strong enough to trigger a relief rally on Thursday and Friday, which could receive some more fuel this week.
In addition to the Federal Reserve’s meeting, the Bank of Japan’s policymakers will get together on Thursday and Friday. Even if there is little concrete action on the monetary front, most analysts expect clear signals that central banks remain on guard.
Jordi Visser, chief investment officer of Weiss Multi-Strategy Advisors, a hedge fund, says: “I don’t expect any sign from the Fed this month, but I expect a gradual shift in the tone if financial conditions continue to weaken . . . If fear gets to a high enough level to affect financial stability I think the Fed would still step in to calm things down.”
Copyright The Financial Times Limited 2016
