Are financial markets flashing a red light to policy makers?

Edge Capital - Are financial markets flashing a red light to policy makers?

Are financial markets flashing a red light to policy makers? That is what investors are wondering this week as two major central banks announced actions. The US Federal Reserve followed through on expectations to raise the Fed Funds rate by another 0.25% – the seventh time they have done so this cycle increasing the target range from 0% – 0.25% to 1.75% – 2.00%. Since the action was confidently expected, it should have had little effect on the market. What was not expected was the shift in language in the statement accompanying the decision and the adjustment to policy makers’ forecasts for the future indicating a potentially more aggressive path of tightening. Granted, the stance should not be that much of a surprise since the Fed has said they are “data dependent” in their decision making. The data has looked pretty good. Unemployment is down, wages are up, and the two different algorithmic GDP forecasting tools operated by the Fed (one from Atlanta and the other in New York) are both saying there is strong growth in Q2. That said, the 10yr Treasury yield fell roughly 0.1% from the 3% level it was at a day or so before. That means the flat yield curve (the difference in short-term versus long-term interest rates) went even flatter. Clearly the bond market does not have the same confidence that growth will sustain an increase in demand for money or inflation in the future.

Following the US playbook, but only a few years behind, the European Central Bank (ECB) also decided this week to stop their bond buying program. Just like their US counterparts, the ECB used the bond buying program to increase monetary support beyond the traditional cuts in interest rates (which they actually took below the zero-bound on a nominal basis). Discussion to end the program has floated around for a while given the economic recovery which has taken hold in Europe, but accelerated since the recent increase in influence by an anti-establishment political party in Italy. Italy is one of the largest European issuers of debt bought by the central bank and ECB policymakers likely want to avoid their actions being perceived as political. The action to stop bond purchases is, in effect, a modest tightening of European monetary conditions.

In the bigger picture, the risk of policy mistakes both monetary and fiscal are looming over financial markets and are the likely cause of the sideways volatility we have seen since the correction starting in February despite solid corporate performance. Will there be a fiscal cliff in 2019/2020 once the stimulative effect of US tax cuts wear off? Will central banks choke out the growth they fought so hard to enable? To us, the concern is natural. Capital markets do not get awards for bravery. They worry. A lot. Part of investing is looking through the worry to focus on the long term. That the economic cycle will eventually turn down is inevitable. The timing, cause, and magnitude is unknowable. But what we do know is that, when it happens, we will all be better off if central banks have some of their traditional tools on the shelf to counter the cycle and soften the impact to the extent possible. Is there risk that they get the timing of their policies wrong? Absolutely, but the traffic signal on policy support is definitely not on go (green). The question is whether we are on caution (yellow) or stop (red). We keep our eyes on a look out.