AEQUITAS

Why in­vestors must keep an eye on the Fed­eral Re­serve

Shares - - CONTENTS - By Russ Mould, in­vest­ment di­rec­tor, AJ Bell

'The most ex­pen­sive words in the English lan­guage are “this time it’s dif­fer­ent”.’ This as­ser­tion from in­vestor John Tem­ple­ton has stood the test of time for a rea­son, so it is with a shiver that this col­umn sees no less an in­sti­tu­tion than the US Fed­eral Re­serve ar­gu­ing that the tra­di­tional mea­sure of the yield curve should be ig­nored and a new one con­sid­ered.

In­stead of look­ing at the premium yield of­fered by 10-year Trea­suries (US Govern­ment bonds) over a two-year pe­riod, the Fed is now say­ing we should look at the gap be­tween the equiv­a­lent of 21-month Trea­suries (three months plus six quar­ters ahead) and three-month Trea­suries them­selves.

This is very con­fus­ing, par­tic­u­larly as the av­er­age mem­ber of pub­lic can­not ac­cess in­for­ma­tion on 21-month Trea­suries.

The premium yield of­fered by 10-year Trea­suries is just 0.22% (down to a 2007 low) and close to in­vert­ing, when the two-year yield is higher.

While there have been false sig­nals, an in­verted yield curve gen­er­ally warns of eco­nomic and fi­nan­cial mar­ket trou­ble ahead and as we ne­go­ti­ate the tenth an­niver­sary of the col­lapse of Lehman Brothers with mar­kets at new all-time highs, it may be worth con­sid­er­ing what could – even­tu­ally – end the multi-year bull mar­ket in most as­set classes.

WAGES VER­SUS WEALTH

We are over­due a cor­rec­tion of mag­ni­tude and this can be seen in how growth in US house­hold in­come, in real terms, has been mas­sively out­stripped by growth in US house­hold net worth.

The me­dian US house­hold in­come, in real terms, has just got back to the lev­els seen in 1999 and 2007 at around the $61,000 mark.

But US house­hold net worth has just crossed the $100 tril­lion mark for the first time ever, a

mark 50% higher than at the cycli­cal high of a decade ago.

The dif­fer­ence is likely to be ac­counted for by the surge in the value of fi­nan­cial and other as­sets – eq­ui­ties, bonds, prop­erty and frankly ev­ery­thing from vin­tage cars to art to wine to base­ball cards – and this is one warn­ing that at some stage an­other col­lapse in fi­nan­cial mar­kets will sweep around the globe.

AS­SET IN­FLA­TION

Surely house­hold net worth can­not sus­tain­ably grow this much faster than in­comes? The ques­tion then is what could trig­ger a cor­rec­tion in as­set prices?

Lofty val­u­a­tions and in­creased debt are both clas­sic pre­con­di­tions for any fi­nan­cial mar­ket calamity and they are in place, judg­ing by the US house­hold net worth fig­ures and data from the In­sti­tute of In­ter­na­tional Fi­nance which show global bor­row­ing now mas­sively ex­ceeds the high of 2007.

That means one pos­si­ble cat­a­lyst for dis­as­ter is a clas­sic one – a pol­icy er­ror from a cen­tral bank and par­tic­u­larly the US Fed­eral Re­serve.

POL­ICY PICKLE

The US cen­tral bank is, in fair­ness, in a bit of a bind. In­fla­tion is tick­ing up in the US, and frankly across de­vel­oped mar­kets (and that’s be­fore as­set price in­fla­tion is taken into ac­count), so chair Jerome Pow­ell and his team will want to nip this in the bud.

The US cen­tral bank will also want to nor­malise pol­icy so it can build up some am­mu­ni­tion for the next down­turn. The Fed has cut in­ter­est rates by an av­er­age of 5.25% since 1970 in re­sponse to re­ces­sions, once it has em­barked upon a down­cy­cle in bor­row­ing costs. It is hard to cut by that much when the head­line Fed Funds rate is 2.00%.

But even a mod­est – and slow – in­crease in US bor­row­ing costs, from 0.25% in Novem­ber 2014, is start­ing to dam­age fi­nan­cial mar­kets, es­pe­cially now the US cen­tral bank is with­draw­ing quan­ti­ta­tive easy (just as the Euro­pean Cen­tral Bank is about to stop adding to it and even the Bank of Ja­pan is be­ing ac­cused of stealth ta­per­ing).

Cryp­tocur­ren­cies blew up first, fol­lowed by low-volatil­ity strate­gies and then emerg­ing mar­kets – the cur­ren­cies of Ar­gentina, Turkey, Brazil, In­done­sia and In­dia, all among the world’s 25 largest economies, are at or near all-time lows against the dol­lar, which is re­spond­ing to tighter pol­icy in the US.

The Fed seems de­ter­mined to press ahead with rate hikes and the dan­ger is that they overdo it – this is one ex­pla­na­tion for why the yield curve is so flat, with US 10-year Trea­suries yield­ing only 0.22% more than two-year pa­per.

The flat­ten­ing curve means in­vestors seem to be­lieve that while the Fed is keen to drive rates up now it will have to re­cant and cut sharply later.

That in turn could be why the Fed does not want mar­kets to lis­ten to it. Watch out for any dis­cus­sion of this is­sue when Jerome Pow­ell de­liv­ers the next in­ter­est rate de­ci­sion on 26 Septem­ber.

Pol­icy er­ror in the Mar­riner S. Ec­cles build­ing in Wash­ing­ton there­fore re­mains a key risk, es­pe­cially as Fed of­fi­cials are now ped­dling the line of ‘it’s dif­fer­ent this time’. It is not for noth­ing that Ger­man econ­o­mist Rudi Dorn­busch once noted: ‘No post­war recovery has died in bed of old age – the Fed­eral Re­serve has mur­dered ev­ery one of them’.

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