Potential for US Fed to wrong-foot markets on interest rates

The US Federal Reserve and markets have long had a tempestuous relationship, codependent, often replete with disagreement, miscommunication and the occasional tantrum. Could they be heading for another one this week?

Last week was marked by whipsawing expectations on whether officials will lift the bank’s key short-term rate. A sudden anxiety that they might was tempered after Lael Brainard, a Fed governor, used the final speech before policymakers entered their official pre-meeting purdah to urge caution.

Thanks to recent market turmoil and lacklustre US retail and services data, interest-rate futures gauge the odds of tighter policy only at below 20 per cent. While just six of 46 economists surveyed by the Financial Times expected a rise this week, some believed the willingness to move may be underestimated by markets, and a few notable investors smelled complacency.

Jeffrey Gundlach, the founder of DoubleLine Capital, warned that Fed officials “want to show that they are not guided by the markets” and the only way to do so is to tighten policy when it is not fully expected.

That sentiment was echoed by Bill Gross at Janus Capital, who said the Fed may defy expectations and move.

By contrast, Ray Dalio, founder of the $154 billion hedge fund Bridgewater, did not think the Fed was paying enough attention to markets.

“In my humble opinion, I think the Fed is putting too much emphasis on the business cycle and not enough on the debt cycle. And I don’t think they are paying enough attention to how markets react,” he said.

Mr Gundlach doubted the Fed would attempt to tighten monetary policy as long as the market-implied odds on a move were below 40 per cent, and by attempting to prove its independence from investor expectations it would risk “blowing itself up”.

Risk of turmoil

Should the Fed defy market consensus, it risks arousing turmoil at a time when investors are already nervous about the direction of the bond-buying programmes of the European Central Bank and the Bank of Japan.

For those at the Fed wary of tightening, there are other reasons for caution. Some investors point to the continuing rise in the London interbank offered rate, an important gauge of bank borrowing costs. Libor also sets a floor for trillions of dollars’ worth of loans and mortgages and has climbed steadily since before summer because of reforms unfolding in the US money market fund industry.

While the rise is technical and undramatic in nature, it still reflects a de facto tightening of financial conditions, and a Fed rate increase would exacerbate that at a sensitive time, one hedge fund manager argued.

“People should be worried,” he says. “Why throw gasoline on the fire ahead of this important date [October 14th, when the money-market funds reforms come into effect]? Thinking of raising rates when there are these tensions in the bank funding market is mad.”

Then there is the presidential election, which offers officials another reason not to act this week. Almost all economists and fund managers discount a move at the November meeting, which happens just days before Americans go to the polls.

“There’s not a lot of risks to just sitting on your hands and not doing much for a few months,” says Jim Sarni, managing principal at Payden & Rygel Investment Management. “They don’t need to do anything.”

Market tantrum

Of course, there has always been a strand of opinion that tighter monetary policy is long overdue even if it triggers a market tantrum. An uptick in core US inflation to 2.3 per cent in August is ammunition to those who believe the Fed is behind the curve.

“It’s time to let the markets – and companies dependent on low rates – writhe a bit, kick the habit, lose the crutch, learn to walk without the assistance that is now crippling normal function,” says Adrian Helfert, head of global fixed income at Amundi Smith Breeden.

“Don’t be persuaded by those screams: they’re only the sound of a return to feeling without anaesthesia.”

Others fret that the Fed staying on the sidelines might itself be a cause for concern.

The stop-start, slow-motion interest rate normalisation cycle, coupled with ever-gloomier forecasts and a ratcheting down for the peak in interest rates, is a sign that officials are growing increasingly concerned the economy may indeed be trapped in "secular stagnation", a theory posited by Larry Summers, former treasury secretary.

“The fact that [the Fed] apparently cannot hike more than once a year is a reason to worry,” said Elga Bartsch at Morgan Stanley.

“Why? First and foremost because it likely speaks to how the natural rate of interest has fallen and how little it has increased over the course of what has already been a long, albeit shallow, economic recovery in the US.”– (The Financial Times Limited)