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Investors risk getting tangled up in feedback loop between Fed, markets
THE Federal Reserve is preparing to deliver what the market expects to be the first of multiple interest-rate cuts. The others are sure to follow if policy makers can't break what's starting to look like a vicious circle.
The Fed isn't simply bending to the market's will with this cut: It highlighted the risks of weak inflation and global trade hostilities to explain a series of dovish pivots this year. But the shift started in the teeth of a market uproar, and a big worry is that traders will keep wanting more. As futures traders have boosted bets on easing, a rate cut has gone from an outlier call among economists to a certainty.
While markets have always been an input in Fed policy, concerns are growing that a feedback loop between the two could be creating distortions that will lead to asset bubbles.
"The approach today is one that is quite sensitive to market conditions - for better or for worse," said Stephen Stanley, the chief economist at Amherst Pierpont Securities in New York. In January he expected three rate hikes this year, but has since changed his forecast to one quarter-point cut.
If it indeed eases in July, the Fed will be looking past decent domestic growth and the lowest jobless rate in a half-century. Many investors have expressed surprise that in just seven months the majority on the Fed could have switched from supporting at least three more hikes, to a cut.
A Fed that abandons its rate projections and other policy normalisation plans following December's serious brush with volatility in stocks may leave investors wondering how far it will bend to the market's will, and at what cost.
There's nothing wrong with policy makers factoring financial conditions into their thinking, since, for instance, stocks are a guide to investors' views about the future, and the dollar and rates reflect ease of funding. The potential trap is when conditions are easy only because markets are expecting a cut, and could reverse quickly if they're disappointed.
Questions lurk. Should stocks begin to dip after the rate cut that everyone expects this month, or financial conditions tighten, will the Fed move to ease conditions further? And if not, does that mean markets could be due for a sudden sell-off when investors realise the Fed is actually just as attuned to economic data as it has always been?
Investors struggled with the Fed's thinking in particular on Thursday, piling up bets on a larger cut this month after Vice-Chairman Richard Clarida told Fox Business Network, "You don't need to wait until things get so bad to have a dramatic series of rate cuts."
This followed the New York branch's president, John Williams, saying that "when you only have so much stimulus at your disposal, it pays to act quickly to lower rates at the first sign of economic distress".
Those wagers receded after a spokeswoman for the bank said Mr Williams' comments didn't relate to this month's meeting.
Expanding corporate leverage and the shrinking yield premium on riskier debt is starting to ring alarm bells for Lisa Hornby, a fixed-income money manager at Schroders.
"Probably the single biggest risk out there is the fact that there's been a massive inflation in asset prices over the last decade, and lowering rates again just puts fuel on that fire," she said in an interview. "We are probably seeing the seeds of the next bubble being sown in front of our eyes."
Her concerns resonate with many of her peers. The latest Bank of America fund manager survey, released on July 16, showed 73 per cent of respondents considered the business cycle a risk to financial market stability - the highest percentage in eight years - and almost half of them expressed concerns about corporate leverage.
With this in mind, Ms Hornby favours securitised markets, such as agency mortgages, and she believes government bonds are well supported. "This is not a Fed that wants to see rates back 100 basis points higher, because they thought that that was too restrictive," she said. "And yes, there was some evidence that the more interest-rate sensitive sectors of the economy were slowing in the second half of last year, so that's a fair point." That said, she's not taking big positions in the Treasuries market, on the basis that there's not much money to be made unless you are convinced a recession is around the corner and the Fed is embarking on a full easing cycle.
Investors seeking clarity on the path of interest rates will parse the Fed's take on the economy and progress of US-China trade negotiations. But it will help them to be more attuned to the Fed's broader policy perspective, according to Jim Caron at Morgan Stanley Investment Management.
"What's confusing to the markets right now is that the Fed is changing its policy response function" to factor in more global financial conditions, he said. He cited a recent New York Fed staff research paper as a hint that policy makers are increasingly focused on external factors.
As for the current implications, Mr Caron says a moderate Fed easing can keep the economy expanding, and he's looking for a half-point cut this month. He sees the next couple of months as "another bite of the apple" for investors in riskier assets.
Policy makers hinted at the dilemma they face in minutes from the Fed's June meeting: "While overall financial conditions remained supportive of growth, those conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy in the near term."
That could be read as, appease the market in July or it could force us to later. BLOOMBERG
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