Has the Federal Reserve fallen victim to bond market bullies?
The bond market “vigilantes” of old used to bully wastrel governments. Now they appear to have moved on to a grander target — the US Federal Reserve.
Traders are betting that the US central bank is certain to trim interest rates when it meets this month. Whatever doubts remained were largely dismissed by Fed chairman Jay Powell on Wednesday, when he focused on persistently low inflation in the world’s largest economy, and a fading global growth outlook.
But the prospect of monetary easing still looks odd when set against mostly decent US economic data. Richard Barwell, head of macro research at BNP Paribas Asset Management, argues that investors have browbeaten the central bank into a defensive posture.
“The market has seemingly spooked the Fed into changing strategy twice in the space of six months, first capitulating on the hiking cycle and then embracing an easing cycle,” he said. “It is becoming increasingly difficult to make the argument that this Fed would be cutting rates this month . . . in the absence of the relentless pressure from the market to act now.”
The crucial question confronting the Fed and investors is whether markets are right — and what this means for the longer-term, often tempestuous, relationship between the central bank and investors.
The message from the market is clear: interest rate futures indicate traders think the Fed could unravel all of last year’s four rate increases by 2020. But officials themselves seem uncertain about what to do.
The latest projections indicate seven policymakers expect 50 basis points of rate cuts by the end of the year, and Mr Powell has indicated that many of the remaining 10 members of the rate-setting Federal Open Market Committee thought the case for easier policy had strengthened. Analysts say the Fed is boxed in and will have to cut to avoid a nasty bout of turbulence in asset prices.
“The market has acted as if the Fed has already cut. If the Fed does not deliver, financial conditions will tighten, creating a headwind for the economy,” said Michelle Meyer, chief US economist at Bank of America.
“This puts the Fed in a difficult position,” she added. “On the one hand, they don’t want to be bullied by the markets. But, on the other hand, markets have information that the Fed cannot ignore.”
Although US economic data has worsened over the past year, it remains reasonably solid — something even Mr Powell highlighted in his otherwise dovish comments this week.
Indeed, “nowcasting” models made by the St Louis and New York arms of the Fed indicate that growth is now rebounding, and the trade war is at least temporarily on hold, after a tentative truce engineered at the recent G20 meeting.
Moreover, the latest employment data were glowing, and core inflation accelerated last month as some of the “transitory” factors that Mr Powell had previously highlighted started to wane. “The market is bullying them and the data are now trolling them,” Mr Barwell said.
Of course, current data says little about the future, and the lingering uncertainty caused by trade tensions is likely to drag on global economic growth in the coming months, economists say. But even some former central bankers are questioning the Fed’s willingness to cut rates.
Vitor Constâncio, the dovish former vice-president of the European Central Bank, last week argued that monetary policy “should be decided based on the relevant economic variables, not on the basis of financial markets’ dominance as they want to artificially prolong a lengthy bull market”.
The classic argument against blindly following markets came from former Fed chair Ben Bernanke in 2004. He argued that while markets “aggregate enormous amounts of information and thus provide a rich hunting ground for central bankers trying to learn about the economy”, trying to follow them is a strategy that “quickly degenerates into a hall of mirrors”.
In other words, if the Fed simply moves rates around in response to market prices, those prices would be affected by expectations of the Fed following, creating feedback loops, potentially leading to terrible mistakes. Jan Hatzius of Goldman Sachs sees three potential pitfalls.
“First, the hall of mirrors effect would surely degrade the information content of bond yields. Second, the temptation to satisfy market expectations asymmetrically — to avoid delivering hawkish surprises — could undermine financial stability. Third, the bond market could become a channel for political pressure on Fed decisions,” he said.
On the other hand, some analysts argue that the Fed is not only right to follow markets but should do so more often.
The US central bank may have an army of economists, sophisticated models refined by generations of staffers and access to data that most hedge funds can only dream of. But even the Fed’s brainpower is dwarfed by the collective wisdom of millions of investors who shape the bond market, argues Jim Paulsen, a strategist at the Leuthold Group.
“I’m not saying that markets don’t make mistakes, but I think they make fewer mistakes than a committee of central bankers,” he said.