Tuesday, September 29th, 2015

Disgruntled Economists

P G Wodehouse, the English author, memorably described one of his characters as “if not actually disgruntled, he was very far from being gruntled.” This phrase aptly describes the mood of several economists we know, and the reason for their lack of gruntle is the decision by the Fed not to raise interest rates at their last meeting. They were told that the decision would be data-dependent and spent literally months analysing the data so that they could provide the right call to their clients and to their dealing desks. Then, almost at the last minute they were told that the Fed had introduced a series of market-related factors, such the futures curve and the performance and volatility of emerging market equities. A decision which looked easy and correct on conventional metrics was ducked, and the very thing which the Fed wanted to avoid – further volatility – ensued.

Part of the disgruntlement is down to injured self-esteem. What is the point of macro-economists if not to forecast and explain movements in interest rates? Many of them are also cross because the Fed appears to have been spoofed by traders who refused to price a rate rise into the futures curve. But underneath the emotion there is an important issue, which boils down to two questions. First, has the Fed re-interpreted its mandate to include the prospects for growth and financial stability outside the US? If so, this is mission-creep which is unsanctioned by Congress and as dangerous financially as the original phenomenon in Vietnam and Iraq was militarily. Second what expertise does the Fed have in analysing the financial systems and economies of the rest of the world? Why for instance does it think it can do a better job than the Bank for International Settlements, which earlier this summer used its annual report to warn that “[ultra-low rates] are the most remarkable symptom of a broader malaise in the global economy” which “runs the risk entrenching instability and chronic weakness”? To be fair to the Fed, the BIS always says something like this, but equally the BIS has a better record of spotting financial crises in advance.

None of this would matter if the reaction to the decision had been as the Fed expected, but it hasn’t. Realised and implied volatility in developed equity markets has risen; medium- and long-dated Treasury yields have fallen. On our observation it would take a decline of only 2 bps in the 10-year yield for it to break down through the rising trend that has been in place since the beginning of this year. Trends get broken every day, but if this one goes we could revisit a 10-year yield of 1.8% or even 1.65%. When our US asset allocation model increased its exposure to fixed income to 60% in August we interpreted it as a flight from equities. The recent move to 80% may reflect the probability that Treasuries will produce some attractive risk-adjusted returns in their own right.

By its actions, the Fed has validated the growth concerns of every bear, discouraged the bulls and increased uncertainty about its future policy. It will take more than a couple of speeches by Janet Yellen to put this right. A 25 bps rate rise, clearly explained in accordance with economic data and its domestic mandate, may well have avoided this problem. Whatever the situation, lower Treasury yields are not part of the solution, and yet this may be about to happen.

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