Latest job numbers give Fed leeway to tighten rates this month — if it so chooses
What a long strange trip it’s been. The year is almost over. Its biggest event as far as markets are concerned — the first rise in US target interest rates in almost a decade — is still ahead, but now seems a virtual racing certainty.
Key markets are on course to end 2015 roughly as was expected, and much in line with each other. The route to get here, however, has been surprising. And it has required some huge shifts in foreign exchange markets.
At the outset of 2015, there was a cosy consensus that the Federal Reserve would start to raise rates, and that the European Central Bank, far more reluctant to resort to easy money, would be obliged to resort to unorthodox measures to jolt life into its economy.
Indeed, as the year ends, two-year government yields — highly sensitive to interest rate expectations — in the US have gained about a quarter of a percentage point (to 0.93 per cent) and in Germany have lost about a quarter of a percentage point (to the stunningly low level of minus 0.3 per cent). The Fed, following the broadly positive US employment report for November on Friday, is almost certain to raise rates this month. The ECB, as confirmed on Thursday, has cut rates, resorted to quantitative easing, and then extended QE.
For stock markets, as the chart shows, the German and US markets are almost exactly where they started the year, and identical with each other, in dollar term performance. On the key questions of interest rates in the main developed economies, and of equities, 2015 has seen a steady and small adjustment.
But that does not account for all that happened in between. At the year’s outset, many thought the Fed would be well into its tightening cycle by now. Two months ago, after the summer panic over China, all thought of a rate rise this year had been abandoned. European equities were poised for more impressive gains, before the China crisis, the midsummer imbroglio over Greece, the Volkswagen scandal and some dreadful corporate profit numbers cut them back down to size.
Also, of course, it ignores the currency effect, which has played a critical balancing role as the world tries to resolve its divergences. The dollar has strengthened by almost 9 per cent for the year. It had gained about 11 per cent before the extraordinary events of Thursday, when disappointment at the ECB’s announcement on QE led to the second-strongest daily gain for the euro against the dollar in its history.
The gentle adjustment has happened, but only after some huge moves in currencies, and some epic misunderstandings as central banks attempt to communicate their plans to markets.
What are the key points? First, the world economy is not very exciting at present, however it is spun. China’s growth is slower than it was. Europe’s flirtation with disaster over Greece did nothing to lift the gloom, even if things appear to be improving a little at the end of the year. In the US, even if the unemployment rate is stabilising at a historically acceptable rate, the rate of improvement has stalled, and the figures are flattered by the historically high numbers who have abandoned attempts to find work. The manufacturing sector is slumping, and the economy is reliant for growth on services, where employment is more volatile.
The latest employment numbers left the way open for the Fed to tighten rates this month as it wishes. They did not prompt any great excitement.
Secondly, money is fungible, and investors’ confidence is still so weak that they require regular new doses of it from central banks. The S&P 500 went negative for the year on Thursday in the wake of the ECB disappointment, because traders had been banking that some of the money injected into Europe would cross the Atlantic. That the US market has stayed so close to its record high set in May, despite likely Fed tightening, was largely because of expected infusions from other central banks.
Third, expectations matter. The second greatest daily appreciation of the euro in its history came on a day when the ECB cut rates and extended QE — a move that should unambiguously weaken the currency by making it less attractive for foreigners to park funds there. For context, the only day when the euro rose more against the dollar came in 2009 when it was the Fed that resorted to QE.
As with some of the year’s other big market switchbacks, such as China’s unheralded currency devaluation, the move was driven by investors’ surprise. Mario Draghi has a history of surprising investors when he wants to make a point. The package he announced on Thursday was radical — but investors had placed big bets on his cutting rates by even more, and on his expanding monthly bond purchases, rather than merely extending the period over which they would continue.
It has taken Sturm und Drang, some huge misunderstandings and a big shift in the foreign exchange market to engineer even the modest divergence in monetary policy that 2015 now seems set to deliver. It is as well to brace for volatility to continue, and to intensify.
MONEYFLOW 