Cautious welcome for Fed surprise

By Eoin Fahy, Thursday, 19th September 2013 | 0 comments

Cautious welcome for Fed surprise

Last night’s announcement from the Fed that it would not change the pace of “money creation” was a complete surprise.  While good for markets, certainly in the short-term at least, we caution against excessive optimism until the reasons behind the decision are fully clear, not least because markets like certainty – something that is clearly now absent in relation to future US monetary policy.

For many years now, the US Federal Reserve has gone a long way out of its way to carefully manage expectations of its actions.  Except in times of emergencies such as the failure of Lehmans, all its major policy moves were signposted well in advance.  Typically the Fed Chairman would give a speech or press conference outlining that a change in policy was being considered.  Then the minutes of the following Fed meeting would show that the committee had discussed the change in great detail, with a very strong hint that the change would be put in place at the next meeting.  Finally, the change would be implemented at that subsequent meeting.  It was predictable, transparent, and ensured that markets had plenty of time to digest significant policy changes and to understand why they were being made.

So when last May/June the Fed began to talk about “tapering” its monthly injections of liquidity, it set out on what seemed to be a very clear path towards actually beginning that tapering at its September meeting.  At no stage in the last several months, as the markets became completely convinced that that tapering would start in September, was there any effort by the Fed to tell the market that it was wrong to expect that.

Genuine shock

So it was a genuine shock when the Fed last night announced that it would not begin tapering this month, and might not begin next month either.  In a huge reversal of long-standing policy, it basically said, “never mind what we’ve told you to expect for several months, we’ve changed our mind.”  The immediate market reaction has been very positive – the $85bn per month of “money creation” from the Fed will continue, instead of gradually reducing.  That, at its most simple, means more money washing around the global financial system, and thus higher asset prices, all other things being equal.  Emerging markets in particular may gain from this impact, as they were clearly the worst affected in May and June when the Fed began to signal that it would start to taper.

Nothing is straightforward

However, nothing in the financial markets is entirely straightforward, and we would warn against excessive or simplistic optimism, for the reasons below:

• The Fed changed its mind about tightening policy because of “the tightening of financial conditions observed in recent months which if sustained could slow the pace of improvement in the economy.”  But that is a reasonably weak reason for such a significant change of mind.  Does the Fed know something that we don’t?  Might it conceivably be aware of a difficulty in some part of the US banking system, for example,  that the markets are unaware of?  That seems very unlikely but can’t be entirely ruled out.  Alternatively, is it aware of weakness (current or future) in the US economy that the markets are overlooking?  There are hundreds of economists working for the Fed around the US – if they are worried about the economic outlook, maybe we should be as well?

• "Markets hate uncertainty.”  And one thing that has definitely risen today, relative to yesterday, is uncertainty.  Before the Fed’s announcement we knew, or thought we knew, that the Fed was embarking on a straightforward, gradual “glide path” towards ending its monthly liquidity creation.  Yesterday we thought we knew why the Fed was doing that, when it was going to start and finish, and indeed what would happen after the process finished and what would have to happen before the Fed started to raise interest rates.  Today, we don’t know any of those things, and that increases risk and uncertainty in the markets.

• If the US economy continues grow at a relatively strong pace, there is a genuine risk that the markets will see the Fed as being “behind the curve” in terms of preventing inflation in the future.  The bond markets, in particular, worry about future inflation.  If the Fed is still creating vast amounts of liquidity while growth is quite strong, bond investors may think that they are risking a substantial build up of inflationary pressures in the economy that would be very damaging to bonds.  So – in this scenario – bond markets could sell off quite sharply.

Full clarity still to emerge

We believe that over the next few weeks the full reasons behind the Fed’s surprising, even amazing, change of policy will become clearer.  Until we know more, our welcome to this change of policy is somewhat guarded.  Our multi-asset portfolios are generally positioned to benefit from the Fed’s announcement and will benefit from the gains in the market following the announcement last night, but we do not propose at this stage to make significant changes to our allocations until the uncertainty reduces.



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