Federal Reserve cues leave investors mildly bewildered

26/8/2016

By Robin Wigglesworth in New York and Sam Fleming in Jackson Hole

Financial markets took a ride on the Federal Reserve rollercoaster on Friday, as comments from senior officials at the Jackson Hole economics jamboree left investors feeling mildly discombobulated.

In her keynote speech, Fed chair Janet Yellen said that there was a growing case for an interest-rate increase, but that initially prompted a remarkably sanguine reaction from markets. The market-implied odds of a September move — which the Federal Reserve chair’s words left firmly in play — actually receded after the speech, while stocks rallied and Treasury yields fell sharply.

“Yellen isn’t keen on aggressive policy pronouncements at Jackson Hole, she sees it more as an academic forum,” points out Dominic Konstam, head of interest rate strategy at Deutsche Bank. “I didn’t see it as her goal to ram home a rate hike.”

However, the market’s phlegmatic initial reaction changed when Stanley Fischer, Fed vice-chair, subsequently doubled down on Ms Yellen’s message, telling CNBC that it meant a move was on the table at the September 21 Federal Open Market Committee meeting.

That verbal intervention caused the market rally to unravel, as traders suddenly digested the possibility of a second rate move after December’s one. The 10-year Treasury yield jumped from a low of 1.52 per cent after Ms Yellen’s speech to a two-month high of 1.62 per cent, while the chances of a September increase implied by interest rate futures jumped to 40 per cent, up from 28 per cent earlier on Friday.

Many traders and investors are still on holiday, exacerbating the moves, but the confused, volatile market response highlights the difficulties the Fed is facing in getting its messages through. After repeated false starts on rates, many traders and investors are taking a sceptical view of Fed communications — complicating its job.

“There’s a clear communication problem, and it’s been growing for some time,” says Gregory Peters, senior investment officer at Prudential Fixed Income. “No one believes them any more. Markets have become brazen in dictating to the Fed, and it needs to take back control.”

A number of policymakers suggested in the spring that a rate increase was looming, only to back away in June amid worries about the impending UK referendum on its EU membership. And whereas the Fed’s last interest rate projections suggested there would be two increases this year, investors think that a single quarter point move is the maximum rise that is likely in 2016. The markets-implied odds on two increases currently stands at just 15 per cent.

In addition, the Fed is handling two broad and apparently conflicting messages. It is both reducing its view of the longer-term outlook for the US economy — and as a result paring back its estimates of the level official rates will eventually reach — while insisting it remains on track to deliver further rate increases in the short term.

The conundrum was highlighted in Ms Yellen’s speech. She suggested that amid sagging productivity growth and abundant global savings the Fed’s “terminal rate” might be closer to 2 per cent than the 3 per cent median projection released in the central bank policymakers’ most recent estimates.

This is much closer to the market’s own view on where the “neutral”, long-term US interest rate should be, and has implications for present-day monetary policy. As Ben Bernanke, the former Fed chair, wrote in his blog ahead of the Jackson Hole conference, a lower long-term interest rate forecast “implies that current policy is not as expansionary as thought. With a shorter distance to travel to get to a neutral level of the funds rate, rate hikes are seen as less urgent even by those participants inclined to be hawkish.”

However, a handful of senior Fed officials have talked up the possibility of a September rate increase in recent weeks, including William Dudley, the New York Fed’s dovish head. Hammering home the point, Mr Fischer’s intervention on Friday appears to have been a counterreaction to investors initially shrugging off Ms Yellen’s guarded hints that a September interest rate increase is on the table.

The most likely interpretation is that the Federal Reserve wants to ensure that markets are prepared for tighter monetary policy, without promising it firmly and tying their hands in case economic data once again flags, as it did last spring. “The Fed doesn’t want markets to assume that [September] is a dead meeting,” Deutsche Bank’s Mr Konstam says.

The latest bout of central bank jawboning therefore elevates the importance of the next US jobs report, due on September 1, to an even greater level. The average estimate of economists polled by Bloomberg is that 265,000 jobs will be created, and anything over the 200,000 mark is likely to further strengthen the case for another interest rate increase.

“I don’t know if they will move in September, but I think they want to be able to,” Mr Peters says. “If the next payrolls report is strong then it will really bring September into play.”

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