For some time, we have flagged that volatility in markets has been subdued, underpinned by a wave of liquidity being pumped into global economies by central banks in the form of Quantitative Easing (QE). We have seen bond yields trade at historic lows and the subsequent low interest rate environment has led to increasing debt levels among both corporates and households.
With central banks unwinding their QE programs and interest rates in the US going up, from an equities perspective the focus will increasingly be on future earnings growth, which to date has been trading above nominal GDP, partly due to low wage growth. The unwinding of the Fed’s balance sheet—which began around a year ago—has been a catalyst for rising yields, as has the prospect of growth with inflation.
US equity market performance and size of Fed balance sheet
Source: Lonsec, Bloomberg
An important factor recently has been uncertainty regarding the so-called ‘neutral’ Fed funds rate. The FOMC has for some time suggested that the neutral rate—meaning the rate that is consistent with full employment and inflation at target—would rise to around 2.9% over coming years. Markets had also implicitly priced in a peak of around 2.9% for the Fed funds rate by mid-2019.
However, Fed Chair Jay Powell surprised markets by commenting that there would be less emphasis on the neutral rate going forward, given that the funds rate is likely converging on the neutral level and that the actual neutral rate cannot be calculated with a high degree of accuracy. New York Fed President John Williams—considered the expert on the neutral policy concept and its measurement—noted that, going forward, the Fed would determine proximity to the neutral rate by observing changes in growth and inflation data. Sensible enough, but hardly the kind of solid forward guidance that markets have become accustomed to.
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