Greater Forces Buffet Markets as Fed Seeks 'Normal'
(Bloomberg View) -- There is a common clause in contracts that essentially frees both parties from liability, or obligation, when an extraordinary event or circumstance beyond their control comes into play. This clause is known as "force majeure," a French term that means "greater force." Markets are being buffeted by three greater forces, and their collision may create something entirely new and unexpected for investors.
The first is the Federal Reserve and its desire to raise interest rates in a theoretical return to "normalcy." We have had almost 10 years of very low rates that bolstered the economy and financial markets. It seems odd that the Fed is now declaring that "normal" is more important than a burgeoning economy, as higher rates will likely cause the current expansion to slow, if not stop.
Virtually no one seems to be considering what is taking place right under our noses, which is the central bank of the U.S. calling for the elected government's ambitions to be stymied. Congress passed the Tax Cuts and Jobs Act, which is certainly directed at trying to grow the economy, and the Fed, under some ideological banner, is heading in the other direction by seeking higher borrowing costs. At Tuesday's congressional testimony Representative Carolyn Maloney, a New York Democrat, posed a straightforward question to Fed Chairman Jerome Powell: "What would cause the Federal Reserve to hike more than three times that the central bank's guidance currently calls for?"
Here's Powell's full response:
Thank you, Ms. Maloney. You're right that every quarter, every participant in the FOMC submits a projection of what they feel is going to happen to the economy and also their projection for appropriate monetary policy. And at the December meeting, the median participant called for three rate increases in 2018. Now, since then, we will submit another projection, all of us, in three weeks but, since then, what we've seen is incoming data that suggests that strengthening in the economy. We've seen continuing strength in the labor market. We've seen some data that will, in my case, add some confidence to my view that inflation is moving up to target. We've also seen continued strength around the globe, and we've seen fiscal policy become more stimulative. So, I think each of us is going to be taking the developments, since the December meeting into account, and writing down our new rate paths as we go into the March meeting, and I wouldn't want to prejudge that.
The markets seem focused on how many increases there will be in rates. I ask a more fundamental question: Why will there be any increases at all, when elected officials are clearly trying to boost economic growth? In my view, the Fed is at loggerheads with the government it represents. This is odd and troublesome, and can be considered as the second force buffeting markets.
The third major force that is pushing on the bond, equity and currency markets is the actions of other central banks. The Bank of Japan, European Central Bank and People's Bank of China are all still engaged in monetary easing of one sort or another. Financial markets are global, and the pushing and shoving that happens in one place has implications elsewhere. Spreads between U.S., European and Japanese bond yields continue to blow out, and I increasingly wonder about the eventual consequences. At some point, we may see a significant amount of U.S. bonds issued in foreign markets as companies and municipalities seek cheaper financing. If this happens, then the wake-up call will be loud and clear.
Markets are arriving at a place where the careening forces of the U.S. government, the Fed and other major central banks are all in opposition to one another. One reason that borrowing costs are not likely to head higher in any meaningful fashion is that U.S. rates are so much higher than everyone else's and so there is a sort of a cap on U.S. yields as a result. This could cause a flatlining of the yield curve, or even an inversion.
I continue to think that the "Big Short" for 2018 will be negative yielding bonds, as the historical aberration evaporates. But the "Big Long" might be U.S. interest rates, as the distortion in international bond markets begins to unravel. The relative value of the dollar will also come into play if this distortion becomes magnified.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mark Grant is a managing director and chief global strategist at the investment bank B. Riley FBR Inc.
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