Economy can handle rate rise, but can markets?: James Saft
Nov 6 (Reuters) – The economy can handle a rate rise. It
remains to be seen if financial markets can.
Following on from today’s robust U.S. jobs report, an
interest rate hike from the Federal Reserve in December is
looking highly likely.
That’s the easy part; much more difficult is foreseeing the
reaction of a financial system with the accumulated buildup of
risks from seven years of zero rates and a Fed balance sheet
equal to 25 percent of annual output.
The jobs report had something for everyone. Not only did the
economy create 271,000 jobs in October, taking the unemployment
rate down to a flat 5.0 percent, but wages showed surprising
signs of strength. They are now rising at a 2.5 percent annual
rate, up from the 2 percent area we’ve typically seen during a
long and tepid recovery.
So this report is not only red meat to the hawks, who
already advocate getting rates up off of the floor, but it
answers most of the questions posed by centrists like Fed Chair
Janet Yellen and even some of the concerns of doves.
Financial markets immediately moved to raise expectations of
a December rate hike, to more than 70 percent from 58 percent
yesterday and only about 5 percent a month ago. Stocks fell, not
violently, with the S&P 500 down about 0.3 percent while
two-year U.S. Treasury yields spiked nearly 10
percent higher, touching levels not seen in 5-1/2 years.
For long months financial markets have disregarded Fed
future projections of interest rates, the “dot chart,”
preferring instead to bet that rates will rise much more slowly.
Until now, those bets have been justified.
“What is happening today is that investors for the first
time in months are thinking that there is a risk that the
complacency on the Fed rates path needs to be re-examined,”
Citigroup strategist Steven Englander wrote to clients.
“However, if the data keep coming in on the strong side,
investors will assume that hikes will come quicker. Ironically,
the market ‘dots’ will converge to the FOMC dots.”
The Fed will doubtless do what it can to ensure a “dovish
liftoff,” talking down the rate of ascent. Despite the central
bank’s track record of being pushed about by movements in
financial markets, and usually pushed towards being more
accommodative, there may be a limit to this should more signs of
wage and inflation pressures emerge in coming months.
That’s not entirely likely in the few weeks before the Fed
meeting on Dec. 15-16, though we will see one more jobs report.
PHILLIPS CURVE RESURRECTION?
Potentially the most important implication of the data is
the idea that perhaps the Phillips curve, the traditionally
assumed relationship between employment and inflation, may
actually be coming back into force. Two Fed officials, Lael
Brainard and Daniel Tarullo, both advanced arguments recently to
the effect that its effects seem no longer to hold in current
circumstances, a conclusion which would support waiting longer
If wage pressure is taking hold, then the only issue becomes
how much “catch up” – overshooting on inflation to the upside –
the Fed might tolerate. That’s an idea that is profoundly scary,
rightly or not, to many in financial markets, especially given
the sheer weight of money now sitting in very low-yielding
instruments, or in strategies which depend on low yields to make
their own mechanics work.
If rates do need to rise more rapidly than the market has
thought, perhaps even more rapidly than the Fed itself has
predicted, then there is a good deal of repricing needed across
While total credit market debt to GDP in the U.S. has fallen
gently since the financial crisis, at 331 percent it is still at
extremely high levels historically. That’s part of the plan of
zero rates: investment and speculation as a means to goose
growth. The problem is that interest rates look likely to rise
much more rapidly than the cashflows which must service the
debts. This is probably true even if the economy shrugs off
global weakness and carries on strongly.
The finance and insurance sector has done well under these
conditions. Those industries contributed real value added growth
of 12 percent in the second quarter, or about a quarter of real
output. In nominal terms banking and insurance is now bigger
than it was in 2007.
If we accept that little innovation of true value has come
from the sector since the invention of the cash machine, it is
hard to see this growth as anything but artificial.
As rates rise, as they now look like doing, insurance and
finance will come back down to earth.
The Fed put, the idea that it stands guarantor against sharp
market falls, may be tested.
(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at email@example.com and find more columns at blogs.reuters.com/james-saft)
(Editing by James Dalgleish)