(The opinions expressed here are those of the author, a
columnist for Reuters)
By James Saft
Sept 12 As the Federal Reserve wakes up to the
"new normal" in policy, investors will have to do the same.
Having enjoyed months of nearly unexampled tranquility,
global markets staged a modest sell-off last week, with jumpy
traders somehow convincing themselves that Federal Reserve
arch-dove Lael Brainard would play the role of grim reaper in a
Rather than hinting at a September surprise interest rate
hike, Brainard argued for a "new normal" in monetary policy,
implying a very slow rate of increasing interest rates.
"Asymmetry in risk management in today's new normal counsels
prudence in the removal of policy accommodation," Brainard said,
noting that the "risk of being unable to adequately respond to
unexpected weakness is greater."
Brainard was also blunt in highlighting the lessons of Japan
and Europe, where extraordinary policy has failed to gain the
"It is striking that despite active and creative monetary
policies in both the euro area and Japan, inflation remains
below target levels. The experiences of these economies
highlight the risk of becoming trapped in a low-growth,
low-inflation, low-inflation-expectations environment and
suggest that policy should be oriented toward minimizing the
risk of the U.S. economy slipping into such a situation."
Little of this is new, but as the last scheduled Fed speaker
ahead of a blackout period before next week's Fed policy
meeting, Brainard did not present as someone preparing the way
for an unexpected rate hike.
Risk markets loved it, with stocks and bonds rallying and
the dollar falling. Perceived chances of a September hike, as
implied by futures trading, fell to 15 percent from 24 percent
yesterday, with the first increase not priced in until December,
after the Nov. 8 presidential election.
Just because the Fed will go slowly, and may not normalize
rates for an extended period, does not mean strong returns
The European Central Bank and Bank of Japan are buying up
bonds at a roughly $2 trillion annual pace, absorbing
essentially all net new sovereign, corporate and asset-backed
bond issuance in dollars, yen and euros over the past year,
according to Barclays.
That's helped the broad U.S. stock market to rise 6 percent
on the year but there are good reasons to think these, and the
gains of the past few years, have been borrowed from the future.
Remember that as bond yields have fallen, liquidity has
flowed into other higher-yielding and riskier instruments, such
as low-volatility stocks.
Marko Kolanovic, global head of derivatives and quantitative
research at JP Morgan, argued in a note last week that
normalization of interest rates will pose difficulties for
markets even if it is extremely gradual.
"For instance, if central banks normalize policy very
gradually over three years and the economy doesn't stall, one
could see near-zero returns for equities over that time period,"
Kolanovic wrote in a note to clients.
A roughly 20 percent withdrawal of central bank liquidity
over that period would, thus, more or less cancel out the
typical annual return of 7 percent or so on stocks. Bonds,
especially, at current yields, would have negative total
That's the more positive scenario.
If central banks move quickly, or investors try to get in
front of a tightening cycle, we might get all of our losses out
of the way at once.
This, of course, is very much part of the reason central
banks won't start normalizing in September, and even if, as
expected, December brings with it a hike, it is unlikely to be
followed up by many next year.
Which is not to say that the Fed is simply managing market
risk. The arguments for going slowly, as enunciated by Brainard,
are good. Inflation has now been below the Fed's 2 percent
target for more than 50 months. Judging by inflation and growth,
the current very low interest rates are not what they would have
been 10 or 15 years ago. It is understandable that the Fed has
been wrong about this on the way down, but now that we've had a
very long period of very low growth and an apparently lower
neutral interest rate, trying to normalize soon makes little
sense, and has even less merit from a risk perspective.
Just as the Fed itself has had difficulty waking up to the
"new normal" of economics, so have investors. They
understandably have moved out the risk spectrum in response to
very low rates, but they've not recalibrated their expectations
That process, a painful one, will be one of the big stories
of the next few years.
(Editing by James Dalgleish)