Global markets were hoping for a Janet Yellen induced bounce overnight, but they got nothing. Instead, the head of the US Federal Reserve gave everyone a commentary on what’s been happening in global markets lately.
Worse though (for the punters at least) Yellen didn’t give any hints that the recent market carnage would warrant a change in monetary policy stance from the Fed. In fact, she thinks monetary policy is still quite loose:
‘It is important to note that even after this increase, the stance of monetary policy remains accommodative. The FOMC anticipates that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.
‘Of course, monetary policy is by no means on a preset course. The actual path of the federal funds rate will depend on what incoming data tell us about the economic outlook, and we will regularly reassess what level of the federal funds rate is consistent with achieving and maintaining maximum employment and 2 percent inflation.’
Blah, blah, blah. The Dow finished down 99 points. I’m surprised it wasn’t more.
The question and answer session that followed didn’t offer up too much hope for traders either. When asked about the need to cut interest rates soon, Yellen said she doesn’t see any need:
‘I do not expect that the FOMC is going to be soon in a situation where it’s necessary to cut rates. Let’s remember that the labor market is continuing to perform well, to improve. I continue to think that many of the factors holding down inflation are transitory. So while there is always some risk of recession and I recognize and have just stated that global financial developments could produce a slowing in the economy, I think we want to be careful not to jump to a premature conclusion about what is in store for the U.S. economy. So I don’t think it’s going to be necessary to cut rates.’
There are a few things wrong with the Fed’s thinking. Firstly, global monetary conditions are not loose. At least they’re not as loose as the Fed thinks. The recent performance of global banking stocks tells you there is something wrong out there. It tells you that credit conditions are tightening.
If left like this for a few more months, tighter credit will feed into the real economy and, given the amount of debt in existence, you’ll see a nasty feedback loop develop.
The other problem with the Fed is that it remains fixated on employment. Employment is a lagging indicator. If you’re trying to set a course for monetary policy and you want to do it in a proactive way, you do not watch the employment numbers.
The stock market leads, the economy follows, and the labour market brings up the rear. That the Fed does not consider this is embarrassing.
The message here is to not expect the Fed to act until it’s too late. Which is not such a bad thing. The market is in its predicament right now precisely because of its actions over the years.
The one bright spot in Yellen’s Q&A session was her scepticism of the efficacy of negative interest rates. She said:
‘…Could the plumbing of the payment system in the United States handle it? Is the institutional structure of our money markets compatible with it? We’ve not determined that.’
The Bank of Japan certainly didn’t determine it. But it didn’t stop them from acting. Ever since they announced the policy on 29 January, it’s been a debacle. Bonds on 10 year Japanese bond yields are now negative.
There are many issues with a negative interest rate policy. Here’s just one. Take insurance companies, for example. They receive insurance premiums and invest it in ‘safe’ government bonds. They need to keep the money safe to satisfy future claims. The income yield from these bonds is also an important source of returns for insurers.
So what happens if they can’t achieve these returns? Well, have a look at the recent performance of QBE Insurance [ASX:QBE] for the answer. Soon after Japan made its negative interest rate announcement, QBE’s share price plummeted to lows last seen in 2003.
I’m not saying that QBE invests in Japanese bonds. But bond yields plummeted across the globe following Japan’s announcement. QBE’s returns will suffer because of it.
For The Daily Reckoning