Stuart Ralph – Investment Manager
From the interest rate lows of 0.25% under Ben Bernanke and Janet Yellen, the benchmark rate of the US Federal Reserve[“the Fed”] began to rise from December 2015 as historically low levels of unemployment and tight labour markets prompted fears that inflation would spike higher. Following President Trump’s appointment of Jerome Powell as Fed Chair, the rhetoric continued to point towards further rate rises, such that by December 2018, the rate had increased to 2.5% – where it currently stands today. In addition to further rate rises, the Fed also signalled its intent to reduce the $4 trillion of Quantitative Easing (QE) debt held on its books, a legacy of the Financial Crisis. In effect, to begin a slow reversal of the stimulative monetary policy put in place following the financial crisis.
While cautionary tales of fighting the Fed are plentiful, the market became increasingly rattled with their intent, citing policy mistake and highlighting associated economic risks. These and other concerns prompted a deterioration of investor confidence and the sharp decline of equity markets over the 4th Quarter 2018. Combined with President Trump’s criticism of its monetary policy, the Fed has since moderated its language and tone. US-Chinese trade tensions, benign wage growth and contained inflationary pressures have allowed the Fed to signal that it will keep rates at 2.5% until 2021 and hint that it may lower the rate if economic conditions deteriorate.
Since the start of the year, yields have steadily fallen, resulting in a lower and flatter yield curve. In the illustration below, we can see that in the past few days, the yield on the 10 year US Treasury Benchmark Bond has fallen markedly below the Fed Funds rate of 2.5%.
A similar dynamic has been played out in the UK, with the UK 10 Year Gilt having fallen below the Bank of England Base Rate of 0.75%
The graphs above indicate renewed concern and suggest that financial markets anticipate a Fed forced to cut interest rates as growth disappoints and inflationary forces fail to materialise. In the UK, the market believes further rate rises unlikely.
There is little doubt that global Central Banks have recently re-appraised economic conditions and tempered plans to reverse the monetary policy of the QE era and there are times the Fed (and others) have been behind the curve, and eventually moved towards the market view. However, there is clearly a risk that markets are putting too much store in a weak US growth scenario, by expecting an aggressive rate cut to 2.0% (a reduction of 0.5% points). In other words, Government Bond Yields may have overshot the mark, particularly given tentative signs of a fragile de-escalation in trade tensions between the US and China.
With the recent reassessment of monetary policy, investors should gain some comfort that Central Banks are positioned to support growth if and when required, and such action should help underpin financial markets over the medium term.