Implicit forward guidance on asset prices?

Outside Japan, global inflation measures have over the last 8 months been rising as fast as at any time in the previous 25 years on a headline basis. The US Fed has kept real interest rates much lower for much longer than in previous cycles and the orthodoxy in central bank circles still appears to be that interest rates should stay accommodative in order to avoid the risk of deflation with rates still close to zero. Keeping rates low as inflation and growth accelerates may feel pleasant for now but also runs the risk of Fed Chair Yellen’s “nasty surprise”.

“Waiting too long to begin moving toward the neutral rate could risk a nasty surprise down the road–either too much inflation, financial instability, or both. In that scenario, we could be forced to raise interest rates rapidly, which in turn could push the economy into a new recession.” – Fed Chair Yellen, January 2017.

If we are to decipher these mixed messages and taking “financial instability” to be a code word for an asset price bubble, we believe the Fed is trying to keep rates low while jawboning the market to expect a forced and significant interest rate response in the event that US equity markets rise significantly above current levels.

We form this view as the FOMC’s most recent statement did not drop any hints for a rate increase in March, which leaves June as the most likely date for the next US rate increase. Today the concept of financial instability was mentioned again by Cleveland Fed President Mester so asset prices do seem to be a current Fed concern.

If this is the intended signalling, it points to modest returns on US equity markets, at least until valuations ease as earnings catch up with prices. In other words, the Fed does not wish to see an asset price bubble stymie its accommodative monetary policy and the intended beneficiaries, which are first firmly anchored inflation expectations close to the target level of 2% and second the real economy.

While potentially an elegant strategy of using verbal guidance to achieve a specific trajectory for several financial parameters – including the equity market, interest rates and the value of the US dollar – for investors it would imply US equity market upside is somewhat capped.

Therefore, even if this theory is correct it does not make us more positive towards global equity markets with valuations as stretched as they are. However, the recent run of dovish central bank statements over the last week, even as inflation accelerates, does point to the possibility of market volatility staying somewhat lower than we originally expected, at least during Q1 17.