How much is too much when it comes to US monetary tightening?

Weight stops trains (and for that matter horses once the handicapper has had their say, as many a punter in last week's Cheltenham Festival will attest).

And just as shovelling additional kilos onto a train or into a saddle will eventually slow down a locomotive or a quadruped, rising interest rates eventually stop stock markets from rising.


In all cases it’s just a matter of how much weight or monetary stimulus is too much. And that, unfortunately, is something that we only discover after the fact.

In light of Wednesday’s (15 March 2017) 0.25% interest rate hike, the third such increase of this upcycle, this is a burning issue that is only going to become hotter as Federal Reserve chair Janet Yellen and the Federal Open Markets Committee’s (FOMC) so-called ‘dot plot’ flags two more rate hikes for 2017 and three for 2018.

The futures market seems to agree, judging by the CME Fedwatch tool:

Futures markets are pricing in two more interest rate hikes in 2017

Source: CME Fedwatch

That Fed rate hike begs five questions, all of which have implications for the short- and long-term performance of the US economy, the global economy and therefore advisers and clients’ portfolios:

  • What degree of interest rate increase has historically been needed to stop US stocks in their bull-market tracks?
  • Will the US Federal Reserve start to sterilise Quantitative Easing (QE) and reduce its $4.5 trillion balance sheet? And if so, what are the implications for US equity valuations?
  • What is the dollar going to do, if the Fed continues to tighten?
  • Will the dollar’s historically inverse relationship with emerging equity markets assert itself once more?
  • Will the dollar’s historically inverse relationship with commodity prices assert itself once more?

To spare advisers and clients from doing the research, this column will cover all of these subjects, albeit briefly to spare everyone from information overload.

What degree of interest rate increase has historically been needed to stop US stocks in their bull-market tracks?

This column has frequently referenced the old saying about “three steps and a stumble” in recent weeks, whereby stock market lore has it that the US equity market has tended to lose momentum after the third interest rate increase of an upcycle.

With apologies to regular readers, that table bears repeating now the US Federal Reserve has confirmed the third 0.25% hike, taking the headline Fed Funds target range to 0.75% to 1.00%.

There does look to be a grain of truth in the old saying about “three steps and a stumble”

Source: Thomson Reuters Datastream

The average performance data does suggest the old saying has some basis in fact, even if the range of returns from cycle to cycle is wide.

What is also noticeable is how US equities regain their balance relatively speedily, providing the underlying US economy and corporate earnings remain strong (which is presumably why the Fed would be raising rates in the first place).

The exceptions here were 1971 and 1999 when the US economy slowed and then tipped into recession.

If three rate hikes (or 0.75% of extra headline borrowing costs) are not enough to derail the US economy, US corporate earnings or US stocks, then how much is?

The eight peaks in the S&P 500 stock index witnessed since 1971 suggest the figure is an interest rate increase of 1.84% - or between seven and eight one-quarter point rate increases, even including the brutal tightening pushed through by the Volcker Fed between 1977 and 1981.

If the Fed follows through on its dot-plot and hikes rates twice more in 2017 and three times more in 2018, then the final increase next year will be the eighth of this upcycle, so next year could see monetary policy provide a key test of the nine-year-old bull run.

History suggests seven or eight one-quarter point rate hikes has tended to prove too much for US stocks

Source: Thomson Reuters Datastream

Nor should the experiences of 1994 be forgotten. The S&P 500 peaked at 482 right before an unexpected rate rise from then Fed chair Alan Greenspan on 4 February 1994.

An 8-10% correction swiftly followed and it took just over a year for the S&P 500 to regain the lost ground, by which time headline US interest rates had rocketed from 3% to 6%.

A strong US economy then helped steady the ship but the volatility witnessed then suggests there is room for complacency now, even if the US central bank is doing everything it can under chair Janet Yellen to flag any policy shifts well in advance, unlike Greenspan 23 years ago.

The Fed will be keen to avoid the volatility of 1994 when a surprise series of rate hikes roiled markets (even if it all worked out in the end)

Source: Thomson Reuters Datastream

Will the US Federal Reserve start to sterilise Quantitative Easing (QE) and reduce its $4.5 trillion balance sheet? And if so, what are the implications for US equity valuations?

If the Fed is serious about tightening monetary policy then this question is not going to go away, even if no mention of it was made in the statement released on 15 March.

Since the launch of QE-I in late 2008 the Fed has bought around $3.8 trillion of bonds of various shapes and kinds.

It could try to sell them, though that might not be easy, especially as bond markets are not always particularly liquid, especially when it comes to mortgage-backed securities. The alternative, especially for the Government bond holdings, is to simply let them mature and not buy replacements upon redemption.

Whichever route is taken – assuming one is taken – there are potential implications for US stocks (and therefore global ones, as where America leads the others tend to follow).

This chart suggests why, as there has been an apparently close correlation between the size of the Fed’s balance sheet and the S&P 500.

Perverse as it sounds this makes sense. QE was designed to flatten bond yields, not just to make borrowing cheaper but to drive advisers and clients into stocks and other riskier assets, in the belief that rising prices would create a wealth effect. The crushing of interest rates also means that net present values (NPVs) rise in discounted cashflow calculations, as future earnings are discounted back at a lower rate, increasing their value.

In theory, sterilising QE could see that reverse – as interest and discount rates rise, NPVs will mathematically fall, posing a challenge to stocks, unless strong earnings growth can take up the slack.

This may be one reason why stocks (and bonds) reacted so favourably to the rate rise and mild announcement issued on 15 March.

Any comments by the Fed on sterilising QE will also take on growing importance

Source: Thomson Reuters Datastream, FRED St. Louis Federal Reserve database

What is the dollar going to do, if the Fed continues to tighten?

Even allowing for the fact that the dollar fell after the 0.25% rate rise initiated by the FOMC, the consensus view on this is simple – the dollar will rise, especially if the Bank of Japan, Bank of England, European Central Bank and Swiss National Bank keep running their QE programmes and do not move to raise rates themselves.

None of the quartet seems to be dashing to tighten policy. Although any move to do so could be the potential surprise that might stop the dollar in its tracks their current reticence does in theory point to dollar gains, as this chart going back to 1975 suggests, although the greenback did a very good job of ignoring the 2004 to 2007 rate tightening cycle:

Rising US interest rates could further boost the dollar

Source: Thomson Reuters Datastream, Bank of England

Will the dollar’s historically inverse relationship with emerging equity markets assert itself once more?

Note that the trade-weighted dollar index from the Bank of England shown in the chart above still only stands at around 106 (the better-known DXY basket, or ‘Dixie’ trades at 101.6).

That compares to the mid-1980s peak above 160 and the early 2000s one north of 120, so if it really starts to motor the buck could go further yet.

Greenback gains to match those would be potentially worrisome for some asset classes. Since President Richard M. Nixon took America off the gold standard and smashed up Bretton Woods in 1971 there have been two major dollar bull runs – and both ended in severe market dislocations, in the form of the Latin American debt crisis of the mid-1980s and the Russian and Asian debt crises of the late 1990s.

Other, lesser spikes in the dollar coincided with the American Savings & Loan crisis of the early 1990s and the popping of the tech bubble in 2000, although the collapse of the housing and sub-prime bubble ushered in dollar strength (as advisers and clients sought out a haven) rather than following it.

The rise of the Eurodollar market, and borrowing by non-US-based governments and corporations means a strong dollar tightens global liquidity, as those dollar-debts become more expensive to service in local currency terms.

This helps to explain why emerging market equities in particular have tended to struggle when the dollar is strong, so another key test may face this asset class if the Fed keeps raising interest rates through 2017 and beyond.

Sovereign governments seem to have learned their lessons from the mid-1980s and late 1990s but corporations have piled on the debt over the past decade, so they may have forgotten them.

This helps to explain why markets greeted dollar weakness so warmly on Thursday 16, given the dollar weakness which resulted from the Fed’s continued preference for careful baby steps rather than a sudden gallop higher in rates.

The dollar and emerging market equities have historically had an inverse relationship

Source: Thomson Reuters Datastream, Bank of England

Will the dollar’s historically inverse relationship with commodity prices assert itself once more?

Another reason why the dollar and emerging markets seem to make uneasy bedfellows is the US currency has also had an inverse relationship with commodity prices, as this next graphic suggests:

The dollar and emerging market equities have historically had an inverse relationship ...

Source: Thomson Reuters Datastream, Bank of England

The Bloomberg Commodity index dataset has a relatively short history (less than 30 years anyway) so to get a good 50-year-plus look we need to use the oil price.

The final chart suggests the dollar and oil have tended to move in opposite directions.

... A view also suggested by its interaction with crude oil

Source: Thomson Reuters Datastream, Bank of England

While the past is by no means a guarantee for the future, this does make sense. With the exception of cocoa, commodities are priced in dollars, so a rising dollar makes it more expensive to buy them in local currency terms for non-dollar-pegged nations, potentially crimping demand.

Commodities are a big export for many emerging markets (though not all, with India a glaring exception) so raw materials price weakness could again be a burden for some, notably Brazil, South Africa and Russia.

Equally, commodity price rises would be potentially good news for them, and on Thursday 16 these markets did well as raw material prices surged and the dollar fell.

Summary

Few if any of these global market issues are of any concern to the Federal Reserve. Its mandate is to maximise US employment and control inflation. What goes on beyond America’s border is someone else’s problem, to paraphrase Nixon’s Treasury Secretary John Connally’s quote from 1971 after the demise of Bretton Woods.

Chair Yellen and the Federal Open Markets Committee are using these two yardsticks in particular and as such a string of rate increases is no certainty.

As flagged in prior columns, US indebtedness stands at record highs, industrial capacity utilisation rates at recession-style record lows and business and wholesale inventory levels remain at uncomfortable levels, especially in key areas like autos, where increased production and demand has done so much to drag America out of the mire since 2009.

In addition, core inflation remains well below the 2% target and oil prices even stand still at around $50 for the rest of the year then crude will begin to act as a drag on the headline number that currently exceeds that threshold by autumn.

Yes, unemployment is low and wage growth accelerating but the former is a lagging indicator, owing to the lead times involved in the hiring process, so it is not an ideal trigger for policy changes.

The Fed therefore has a tricky balancing act ahead of it and any slip could have ramifications for the US and global economy. This may explain why the US central bank continues to move at a gentle pace.

It is only going to be when rates start to normalise and the QE sterilisation process begins that we will really know whether these extraordinary monetary experiments have worked – or not, as the case may be.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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