Fed Changes the Script, But Not the Ending…

24th September 2013

“I am perplexed and baffled. I do this for a living. I shouldn’t be so confused and confounded.” Strategist at a leading investment bank last week, after the Fed ‘shocked’ markets

Maybe he should book some therapy or a career break, but his dismay is a reminder of the remarkable faith investors still have in the elaborate general equilibrium macroeconomic models that drive central bank policies, despite proving hopelessly inaccurate both pre and post crisis. Macro forecasting, particularly at economic inflection points, is as much art as (pseudo) science. Of course, investors understandably crave certainty and predictability, but as I highlighted last week looking at the employment market, there are huge uncertainties which generate confusion even among Fed researchers. Regardless of which month a Fed exit begins, higher yields largely reflect a reduction in perceived global tail risks and related inflows to ‘safe haven’ assets. The broad dynamic is similar to that which has seen gold plummet this year. It seems inevitable that central bankers will squander hard won credibility if they fumble the exit from this period of extraordinary intervention and/or attempt to reverse underlying market forces driving higher yields higher from unsustainably negative real terms back in May.

With TIPS break-evens suggesting long term inflation expectations in the order of 2.4%, it is clear that a 10-yr bond yield sub 3% reflects extraordinarily low implied risk premiums. Implied long-term bond yields are so low partly because of the Fed’s dominance of incremental Treasury issuance, but also by very bearish medium term growth expectations and hence inflation risks, both reflected in portfolio positioning and net flows. Most observers assume that interest rates were abnormally low until May because of QE, but investor liquidity preference/risk aversion reflected in $1.2trn in bond fund inflows from 2008-12 was a bigger factor. As I’ve highlighted, the US labour market is not as strong as the headline number suggests and the fall in the unemployment rate has probably surprised most Fed members, who would have expected the participation rate to start picking up by now. Ahead of last week’s Fed meeting, the average rate for a 30-year fixed mortgage had risen to 4.5% from 3.4% in May so the market has already tightened credit conditions meaningfully. Overall, the endless tapering speculation by investors has usefully reduced the froth that had developed in risk assets like EM debt and HY credit/MBS over the first half of 2013, and highlighted structural GEM vulnerabilities to tighter policy.

I went to a lunch last week with a very prominent central banker, who expressed the frustration of his peers that bond markets have simply refused to follow the script in recent months and from the UK to US, efforts to manage medium term interest rate expectations via ‘forward guidance’ are meeting growing scepticism. We’re seeing a very gradual asset reallocation shift from ‘safe haven’ precious metals/government paper i.e. this year’s bond sell-off largely reflects normalizing bond risk premia rather than a change in central bank rate or inflation expectations and there is little central banks can (or should) do about it. The recent jump in rates appears to be the first step in restoring the normal relationship between interest rates and inflation and the Fed will be unable to stop that ultimately healthy process with further QE over the next couple of years, so may as well make a virtue of an inevitability and wind down the current stimulus program in an orderly fashion.