The gloves are coming off.
US Federal Reserve chair Janet Yellen sat down in front of American politicians yesterday and warned them that interest rates are going to have to keep rising this year.
The economy looks good. Inflation is rising. The labour market just keeps picking up. “It’s our expectation that rate increases this will be appropriate.”
The dollar jumped. So did US Treasury bond yields. All in all, Yellen was a lot punchier than anyone had expected.
So is this the end of the line for the Fed-fuelled good times?
Brace yourself – rates could actually rise this year
For a long time, the safest bet you could make in the market was that the Federal Reserve would always err on the side of caution.
But yesterday, Yellen hinted that – just maybe – there would have to be some more interest rate rises this year. Maybe even more than the market currently expects.
It’s for your own good, said Yellen. After all, “waiting too long to remove accommodation would be unwise, potentially requiring the [Fed] to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession”.
Sure, she said, maybe Donald Trump will come out with some big spending plans and the Fed will have to take those into account (I’m paraphrasing, by the way). But if things keep going the way they’re going – rates will have to rise this year.
Markets didn’t seem too phased. At the moment, they’re in a mood where they want to hear good things about the US economy and they’re happy to be reassured that America is, indeed, great again. So even as the dollar rose, gold dipped, and US government bond yields picked up, the stockmarket hit a fresh record high.
But it’ll be interesting to see how they react if rates go up a little faster than they expect.
Yellen insisted that every meeting is “live”. In other words, rates could go up at the next meeting in March. And if she wants to squeeze three in by the end of the year – as currently forecast – then next month might be a good time to start.
Yet so far, the market reckons there’s only a 30-odd percent chance of that happening. It would only take a few decent economic data releases to make that look complacent.
And even if rates don’t rise in March, they’ll surely have to start before the second half of the year.
No more Mrs Nice Guy?
So are we seeing the end of the “Greenspan put”? (The Greenspan put is the implicit promise by the US central bank to underpin stockmarkets by always being ready to loosen monetary policy at the drop of a hat.)
Lord, no. Don’t be silly.
I realise that it’s hard to remember now, but once upon a time, interest rates in most of the developed world were well above 0%.
The horrible truth – one that market participants must reconcile themselves to – is that occasionally, even the most Wall Street-friendly central banker has to put interest rates up. Even if it’s only so that they can come down again in the future.
The key thing to remember is that even back in the days when interest rates sometimes hit the heady heights of 4%-plus (imagine!), the Fed (and other central banks) almost always erred on the side of overly loose, rather than tight, monetary policy.
And for anyone wondering why markets aren’t freaking out about this already, it’s worth remembering that the pace of rate rises so far has been incredibly slow. There are tectonic plates that have moved faster than the Fed.
Remember back when the taper tantrum kicked off (way back in 2013, when the Fed first warned that it would be ditching quantitative easing)? Well, out of curiosity this morning, I had a quick glance at the Fed meeting minutes from September of that year.
Would you believe that more than half of the 17 participants in that meeting believed that by the end of 2015, the Federal Funds rate would be at 1%? And that by the end of last year, all but three believed the rate would be at least 1.75% (and three of those optimists believed it would be at 4%-plus)?
That should cast a bit of perspective on today’s rate – 0.75% – and on the fact that even in “aggressive” mode, Yellen is only promising three more rate rises in 2017. That would only take us to 1.5% by the end of this year (assuming quarter-point rises each time).
The reality is that regardless of how tough Yellen talks right now, the Fed is going to stay “behind the curve” deliberately. That’s why I’m comfortable hanging on to gold, for example, even although it will probably struggle when rates start to pick up – because I just don’t expect the Fed to get scared of inflation until it’s way too late.
And meanwhile, if the dollar can stay where it is against the yen and the euro – supported by an apparently hawkish Fed – then it should be good news for stockmarkets in both of those regions (weaker currencies tend to mean higher share prices).
If anything, the bigger risk to the market is that Trump’s plans will either result in a drastically stronger dollar (various manifestations of the border tax could do that), or somehow send inflation higher much more rapidly than anyone expects. So keep your eyes peeled for when he gives his first big speech to Congress on 28 February, which should give us all a better idea of his plans.