Don’t fight the Fed

Author: Valentijn van Nieuwenhuijzen, Head of Strategy, at NN Investment Partners

Valentijn van Nieuwenhuijzen

Do the names Stanley Fischer or Lael Brainard say anything to you? Maybe not. Yet most of the followers of the financial markets treat their words like gold. They are in fact members of the board of the Federal Reserve, the most powerful central bank in the world, chaired by Janet Yellen. You’ve probably heard of her. All central bankers’ speeches are pored over by investors for signs of future policy changes. Their statements are often obvious, yet markets react to them.

If Fischer, known to be a hawk, says the economy is ready for a rate hike, the market more often than not reacts as if stung by a wasp. Interest rates go up, the dollar appreciates and equity prices move lower. And when somewhat later, the notorious dove Brainard says there is no need to hurry, the market calms down again.

The policies of central banks, especially the Fed, are clearly an important guide for the financial markets. Markets have been pushed up after the height of the financial crisis in 2009, for a large part due to the policies of the central banks; unconventional measures such as quantitative easing have released a flood of liquidity into the markets, which has greatly benefited both stocks and bonds.

In most developed economies, the yields on ‘safe’ government bonds have fallen so low that it seems like investors don’t ever expect them to go up again. They are even willing to pay to invest in Swiss or German government bonds. The statements of a hawk could then suddenly trigger a reversal and lead to significant losses on those government bonds. Emerging markets, for example, have performed well this year, because investors expected the Fed to stay on hold. This kept the US dollar and long-term interest rates in check, making an investment in emerging markets more attractive. Has the recovery in emerging asset markets now suddenly come to an end?

As expected, the Fed decided to leave its policy rate unchanged at the September meeting, but Yellen signalled that a rate hike before the end of the year is on the cards. Two more meetings are scheduled for this year, in November and December. As the November meeting is only one week before the elections, the probability of a hike then is low. This leaves December open, although the market does still not seem to be very convinced as a probability of about 65% is priced in now.

The election result will likely be the key variable for market expectations and for now the market will be occupied by the polls until November 8. My take is that a Clinton victory will almost certainly be followed by a December rate increase; a Trump win may result in heightened market uncertainty and therefore delay a rate hike. ‘Fed watching’ will thus be the name of the game again after the elections and, as one of the most widely followed investment adages says, don’t fight the Fed.