So, the Federal Reserve missed another opportunity to raise rates last Thursday.
I know what you’re thinking. Rates were never going up. We all know they’ll warn us for weeks before pulling the trigger—and besides, there was no press conference, and rates never change unless there’s a press conference.
But this is precisely the problem. The Fed’s script has become so predictable over recent years—and predictably wrong—that no one really listens anymore.
Listen to Markets, Not FOMC Members
Last week’s statement was no cut-and-paste from the month before. There was hawkish new wording about “near-term risks” having “diminished,” and “strong” job growth and household spending. But markets pushed Treasury yields down—the opposite of what one might expect. Fed Funds futures did raise the implied probability of a rate hike in December, but you needed a microscope to see it.
Since the bungled messaging around the Jackson Hole conference in August last year and the subsequent FOMC meeting in September, we’ve been urging investors to ignore what the Fed says and focus instead on what the market predicts it will do. Markets have proven better forecasters of how stalling productivity growth and the global economic slowdown would work their way into U.S. monetary policy.
This matters because, for central banks to maintain control, they need their messaging to be strong enough to lead markets.
From Mystery to Messaging
To understand how we got here, it’s helpful to go back to the summer of 1982, when I was a trainee at Salomon Brothers and Paul Volcker was in the chair at the Fed.
Things were different then, and not only in the sense that overnight rates were at 20% and inflation was running at 12%. Volcker’s policy was innovative, radical and aggressive enough to beat inflation and usher in the bond-market bull that charges to this day; but it was also non-transparent to the point of being mysterious. FOMC members didn’t drop hints on 24-hour news. We understood that short-term money supply was important, so we’d hang on that data once a week and T-Bill rates would gyrate wildly, literally by hundreds of basis points.
The 1980s Fed could shock markets into obedience, and it worked: By the time Volcker retired, inflation was at 3%.
The “great moderation” he bequeathed enabled Alan Greenspan to pursue a more measured approach. Part of that was introducing greater transparency and guidance. As a believer in efficient markets, his view was that he could mitigate market and business volatility by giving people more information.
But Greenspan’s ideological imperative grew into a necessity under Ben Bernanke and Janet Yellen. When interest rates approach zero and quantitative easing loses traction, messaging quickly becomes the only effective policy tool left.
And yet, the last time the Fed was able to rattle markets with its messaging was three years ago, when Bernanke set off the “taper tantrum” by warning of tighter policy on the way. Since then the Fed has raised rates once. If you cut your teeth in the Volcker era, that is pretty sleepy stuff. No wonder the markets have tuned out.
The Fed Will Need to Drop the Script if We Get Stagflation
That’s worrying. My hope is to see a Fed courageous enough to surprise the market again—and I suspect that circumstances may one day force the issue.
After all, the European Central Bank and the Bank of Japan still occasionally show us how it’s done. Last Tuesday was the fourth anniversary of Mario Draghi’s “whatever it takes” intervention—the ultimate in central bank policy-by-messaging. Its announcements in March this year approached those heights, too, as did the Bank of Japan’s plunge into negative rates.
That aggressive and shocking action was forced by the precarious states that Europe and Japan were in. The Fed, by contrast, has for too long been in too comfortable a position, with decent job creation and at least some growth and inflation.
With that in mind, last Thursday’s media comments from one of the leading characters in our story bear repeating. Alan Greenspan attributed slowing productivity growth to the impact of an aging society on entitlement spending, which he argued is crowding out investment. As long as politicians remain unwilling to address that, economies will continue to stagnate. At the same time, however, Greenspan warned about signs of inflation.
If Greenspan is right and we are seeing the beginning of an era of stagflation, the great bull market in bonds could be about to end, and the Fed may have to turn its focus back to inflation again rather than growth stimulation—and do things that are radical and aggressive enough to surprise the markets. How radical will it need to be to regain the market’s attention? Now, that is a good question.
In Case You Missed It
- U.S. New Home Sales: +3.5% to SAAR of 592,000 units in June
- U.S. Consumer Confidence: -0.1 to 97.3 in July
- Case-Shiller Home Prices: May home prices increased 0.9% month-over-month and increased 5.2% year-over-year (NSA); -0.1% month-over-month (SA)
- U.S. Durable Goods Orders: -4% in June (excluding transportation, durable goods orders decreased 0.5%)
- Federal Open Market Committee Decision: The FOMC made no changes to its policy stance
- U.S. 2Q16 GDP (first estimate): +1.2% annualized rate
- Eurozone Consumer Price Index: +0.2% in July month-over-month and +0.9% year-over-year
What to Watch For
- Monday 8/1: ISM Manufacturing Index
- Monday 8/1: Eurozone Purchasing Manager Index
- Tuesday 8/2: U.S. Personal Income & Outlays
- Wednesday 8/3: ISM Non-Manufacturing Index
- Thursday 8/4: Bank of England Policy Meeting
- Friday 8/5: U.S. Employment Report
Statistics on the Current State of the Market – as of July 29, 2016
|S&P 500 Index||0.0%||3.7%||7.7%|
|Russell 1000 Index||0.0%||3.8%||7.7%|
|Russell 1000 Growth Index||0.4%||4.7%||6.1%|
|Russell 1000 Value Index||-0.3%||2.9%||9.4%|
|Russell 2000 Index||0.6%||6.0%||8.3%|
|MSCI World Index||0.9%||4.3%||5.3%|
|MSCI EAFE Index||2.4%||5.1%||0.8%|
|MSCI Emerging Markets Index||0.5%||5.1%||12.0%|
|STOXX Europe 600||2.4%||4.4%||-1.6%|
|FTSE 100 Index||-0.1%||3.4%||10.3%|
|CSI 300 Index||-0.5%||2.6%||-12.4%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.1%||-0.1%||1.2%|
|Citigroup 10-Year Treasury Index||1.0%||0.4%||8.4%|
|Barclays Municipal Bond Index||0.3%||0.1%||4.4%|
|Barclays US Aggregate Index||0.5%||0.6%||6.0%|
|Barclays Global Aggregate Index||1.7%||0.8%||9.8%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.0%||1.6%||7.1%|
|BofA Merrill Lynch U.S. High Yield Index||-0.4%||2.5%||12.1%|
|BofA Merrill Lynch Global High Yield Index||0.2%||2.5%||11.3%|
|JP Morgan EMBI Global Diversified Index||-0.2%||1.8%||12.3%|
|JP Morgan GBI-EM Global Diversified Index||0.9%||0.6%||14.7%|
|U.S. Dollar per British Pounds||1.5%||-0.7%||-9.9%|
|U.S. Dollar per Euro||1.9%||0.7%||2.9%|
|U.S. Dollar per Japanese Yen||3.7%||0.1%||17.4%|
|Real & Alternative Assets|
|Alerian MLP Index||-1.1%||0.6%||15.3%|
|FTSE EPRA/NAREIT North America Index||0.8%||4.4%||18.1%|
|FTSE EPRA/NAREIT Global Index||1.5%||5.0%||14.3%|
|Bloomberg Commodity Index||-0.4%||-5.1%||7.5%|
|Gold (NYM $/ozt) Continuous Future||2.6%||2.8%||28.0%|
|Crude Oil (NYM $/bbl) Continuous Future||-5.9%||-13.9%||12.3%|
Source: Factset, Neuberger Berman LLC.