Markets get a sinking feeling: maybe the “Powell put” doesn’t exist
The US central bank, the Federal Reserve, did what it always said it was going to do and raised interest rates. Markets promptly threw a fit. John Stepek explains why.
The US central bank, the Federal Reserve, raised interest rates yesterday.
The move was well-telegraphed. It was even expected.
Yet markets threw a hissy fit.
What's the problem?
No more Mr Nice Guy
If we ever needed confirmation that markets have grown far too comfortable with the idea of the "Greenspan put", then we got it yesterday.
The Federal Reserve, put interest rates up by 0.25%. The key US interest rate now sits in a range of 2.25%-2.5%, up from 2.0%-2.25% previously.
That was no surprise at all. It's what the market expected. However, there's often a difference between what the market expects, and what it's secretly hoping for.
The market certainly had expected a rate hike. A cautious hope had been creeping in that the Fed would pause this time, but in all, investors really would have been surprised if Fed boss Jerome Powell had decided not to raise them (although that would have been a dead cert under Ben Bernanke or Janet Yellen).
But they did expect Jay to at least throw them a bone. To pat them on the head and tell them that they'd been good boys and girls, they'd had a tough 2018, and maybe now it was time for a little rest.
That's not what happened.
The funny thing is, Powell probably did think he was playing nice. The communication after the event made it clear that the central bank now expects to raise rates fewer times (two to be precise) next year than it did before (it had previously hinted at three).
The problem is, the market had already bought its own hype. One thing you could guarantee under both Yellen and Bernanke was that you should never underestimate the Fed's capacity to be dovish. So if you were a smart trader, it paid to take the market's expectations and then undershoot them, because that's exactly what the central bank would aim to do.
It increasingly appears that the game has changed, and I'll admit it surprises me too. The Fed didn't even nod to the recent market turmoil.
No wonder the market was sulky: "I go to all the effort of staging a correction and you don't even pay attention? No Santa Claus rally for you!"
The other issue that appears to have rattled the market was the idea that quantitative tightening (QT) is on autopilot. Under quantitative easing (QE), the Fed printed money to buy government bonds (and other bonds). Even when it stopped QE, it kept reinvesting the proceeds. Now it is allowing that money to run off at a rate of $50bn a month. In other words, that money is coming out of markets rather than being pumped into markets.
If you believe that QE artificially inflated markets (and I think that's a fair interpretation), then it's hard not to expect that QT will remove any of the overvaluation that's down to QE.
Why are bonds rising?
The thing is, what's interesting about all this is that the Fed is no longer buying bonds, while the US Treasury is issuing as many as it can pump out. That should drive their prices down (because there's more supply) and yields higher. Yet that's not what's happening.
That seems weird, doesn't it? But not if you think about how QE actually worked.
The best description for QE (one I'm pretty sure originated with James Ferguson of the MacroStrategy Partnership) created a "hot potato" effect. The Fed bought government bonds. This drove down yields and drove up prices. So people who'd normally own government bonds bought high-quality corporate bonds instead. They bounced the usual owners out into high-yield (junk) bonds or equities instead. And so on up the risk chain.
If you agree that this is how QE worked, then the implication is this: the main asset that benefited from QE-driven price inflation was not the least speculative asset (government bonds), but the most speculative asset (bitcoin).
This whole year has been a story of how QT is affecting the asset market. Bitcoin has cratered. Emerging markets then took a pasting. High-yield credit is starting to hurt. Basically, everyone is retreating back down the risk spectrum, as Jim Leaviss of M&G put it at the latest MoneyWeek roundtable (which is in Friday's issue of MoneyWeek subscribe now, it's absolutely stuffed with tips for the year ahead).
In other words, as the speculative froth is blown off, a lot of money that was "crowded out" of government bonds by central bank action is rolling back into them now. So the US may be able to get away with running its big deficit for a while longer (though not indefinitely).
So what happens now?
Let's go back to the post-crash environment. The point of QE was to prevent deflating asset values from undermining the banking system (specifically) and give banks time to fix their balance sheets. To be fair, that's happened now (although not in Europe, which means the end of QE at the European Central Bank promises to be tricky).
If Powell sees no systemic risk to markets and thinks that the labour market is still strong and that wages are still going to rise, then there's no real reason to expect him to go much easier on rates than he's already promised.
If the economic data holds up, then markets might well decide that he's right. They might then adjust to a world where the Fed is ever so slightly tougher than they've been used to.
And it's worth remembering that a recession is not the end of the world. Not every recession is 2008. Sometimes your economy just slows down to work through some lags or work off excesses. Sometimes you need to adjust.
Really, the Fed is warning investors warning us that we are returning to a world where you have to be picky about your investments. You can't just buy any old thing and expect it to go up. It may be the biggest threat to the indexing industry in the coming year.
And this is not a bad thing sensible allocation of scarce resources relies on people using their judgement to differentiate between investments.
My one concern is about what might break on the way from here to there.
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