Bond markets to call tune on US rates – again
Since mid-2015 investors have experienced some of the wildest market volatility since the 2008 global financial crisis. In fact, the final throes of Year of the Goat represented the worst start to a calendar year for markets since the Great Depression in the 1930s, with equity prices plunging globally amid concerns over China.
So as we enter a fresh lunar cycle, there are plenty of questions to keep investors awake at night. Will depreciation of the renminbi and further US interest rate rises spark an emerging market crisis? Will the oil price continue its slide? Will Japan be able to hit its 2% inflation target? Does increased volatility mean this will be the year that active managers outperform passive? Will Asian equity markets stand out? Which alternative asset class will provide the best risk-adjusted returns?
AsianInvestor’s editorial team set out to ask and answer 10 key questions for the Year of the Monkey, having consulted a range of industry experts. We thank them for their views. The article will appear in full in the forthcoming (February) issue of AsianInvestor magazine.
1. Will the US Federal Reserve raise interest rates again in 2016?
Answer: Yes
Meeting notes from the Federal Open Market Committee in December last year reiterated the board of governors' intention to raise the federal funds rate four times over the course of 2016, perhaps at 25 basis points a time. According to futures on money markets and Treasuries, the market has priced in only one or two such increases.
This discrepancy is nothing new. Ever since the Fed launched quantitative easing (QE) in 2009, its pronounced expectations have been consistently over-optimistic. It has always held more bullish views than bond markets regarding job creation, wage growth and the return of headline inflation. And the bond markets have consistently been proven right. Yet portfolio managers routinely defer to the Fed’s superior access to data. Why?
Central banking began to change under previous Fed chairman Ben Bernanke (and at other central banks), who ditched the oracle-like obfuscation of previous governors in favour of market guidance. Perhaps this reflected the dwindling tools in the Fed’s box after it could no longer stimulate through interest rate cuts, or the size and sophistication of bond markets.
What matters is that Bernanke began using transparency and direction as a way to enhance the bank’s credibility, and to use that to guide markets. Get the markets to do a central bank's work for it, the thinking goes.
This has had mixed results. When the Fed declined to raise rates in September 2015 because of concerns about China, markets were surprised. They were also surprised in 2013 when the Fed first suggested it would end QE, which led to the ‘taper tantrum’. This bout of volatility scared the Fed’s 12 governors, which is why chairwoman Janet Yellen took such care to ensure last December’s hike proceeded without a hitch.
The Fed is still talking bullishly to communicate its ultimate desire, which may help contain asset bubbles. If it were to acknowledge the inability for it to raise rates, that would send a negative signal on the US economy, but would also encourage investors to assume that QE or other tools would continue to fuel asset prices. The Fed wants to temper that sort of risk-taking without expressing an opinion that would accidentally spook people. This exposes the limits to forward guidance.
Given the volatility in the dying days of the Year of the Goat, the Year of the Monkey will belong to the bond market, not the Fed.