Because there is an armada of analysts and business media out there, hanging on every word of the main financial players, we tend to focus inordinately on the minutia.
We celebrate or hand wring about a news item one day, only to disregard it and move on to the next report a day later.
For example, new Federal Reserve Chief Jay Powel gave a speech overnight and ‘OMG he’s going to raise rates faster than expected!’ Or so the Financial Times would have you believe.
‘Jay Powell gave a markedly bullish assessment of the US economic outlook in his first congressional testimony as Federal Reserve chair, triggering speculation that he could preside over a quicker pace of interest rate increases as the economy accelerates.
‘Addressing the House financial services committee, Mr Powell said the economy had been stronger this year than he expected in December as he vowed to forge ahead with gradual increases in interest rates to avoid an “overheated economy”.’
Hang on, the bloke has just sat down and rearranged the pens on his desk, and now we think he’s going to raise rates faster than expected?
In fact, the second paragraph says that he’s going to ‘forge ahead with gradual increases’.
Which is it?
I think you can safely assume the direction of US interest rates is up. But the Fed is unlikely to spring any surprises on the market by increasing rates faster than expected. For example, you’re not going to see a 50 basis point increase.
The next rise will be 25 basis points, in March. From there, the market currently expects two more rate rises, but the odds are increasing (from 10% to 30%…so still a 70% chance that they won’t) that the Fed will lift rates four times in 2018.
Remember though, that the Fed is at the same time reducing the size of its balance sheet. That is, it is selling bonds back into the market in exchange for ‘federal reserve funds’, which is in effect, virtual cash.
This process is known as ‘quantitative tightening’, and has the effect of reducing liquidity in the market. But it need not be a bad thing. In the post-2008 environment, increased levels of risk aversion mean market participants have sat on higher than normal levels of cash.
As confidence returns, this cash becomes unnecessary. In a confident market, cash is like a hot potato. No one wants to own it, so they pass it on to someone else. This behaviour manifests as higher asset prices in financial markets, and higher goods and services prices in product markets.
Clearly, there has been too much cash in asset markets over the past few years…especially in fixed income markets.
But now, the Fed is concerned that this excess cash will show up in consumer price inflation — which is, apparently, a lot worse than asset price inflation.
Bond market to feel the pinch
The bond market will feel the biggest impact of this tightening, as more bonds will come onto the market at a time when the demand for them is falling. And as bond yield rise, it will have an impact on stocks too.
Just how much remains to be seen. It will be a tug-of-war between reduced market liquidity and an increase in confidence in a strong economy, which reduces the need for excess liquidity.
That is what the stock market is grappling with now. It sold off sharply earlier this month, and has spent the last few weeks recovering. Today it slipped as attention came back to the pace of interest rate rises.
My guess is that the correction that started a few weeks ago isn’t over yet. Perhaps today’s pullback represents the start of another, deeper correction. We’ll see.
Perhaps I’m just channelling Warren Buffett and his lament about reasonable asset prices, as reflected in his latest letter to Berkshire shareholders. I’ll leave you today with this excerpt:
‘In our search for new stand-alone businesses, the key qualities we seek are durable competitive strengths; able and high-grade management; good returns on the net tangible assets required to operate the business; opportunities for internal growth at attractive returns; and, finally, a sensible purchase price.
‘That last requirement proved a barrier to virtually all deals we reviewed in 2017, as prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers.
‘Why the purchasing frenzy? In part, it’s because the CEO job self-selects for “can-do” types. If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life.
‘Once a CEO hungers for a deal, he or she will never lack for forecasts that justify the purchase. Subordinates will be cheering, envisioning enlarged domains and the compensation levels that typically increase with corporate size. Investment bankers, smelling huge fees, will be applauding as well. (Don’t ask the barber whether you need a haircut.) If the historical performance of the target falls short of validating its acquisition, large “synergies” will be forecast. Spreadsheets never disappoint.’
Editor, Crisis & Opportunity