Market Turbulence and Monetary Policy

by George Hatjoullis

A week is a long time in politics. It is even longer in financial markets! I had expected what happened this week to happen next month. An expensive mistake. The question now arises as to whether this is what I was expecting or is there more turbulence to come? I am inclined to think that the markets are not about to resume a steady rally, as they have done after similar wobbles in the last 5 years and will go lower. We are about to enter a shallow bear market. The reason is the Federal Reserve of the US and the reason I was expecting turbulence next month.

September is typically a poor month for equities. This would have been combined with a well signalled rate hike from the Federal Reserve. It would not have been a very large increase and would have been hedged with lots of caveats. Nevertheless, it would have created sufficient concern to knock markets lower. The US market was primed to go lower having moved sideways and lost momentum for some months. It made the first move this month but it is quite capable of having another two poor months (see chart). If the Fed now goes ahead and raises rates there will be another month or two of lower prices before stability returns and even some recovery. In the great scheme of things this would be healthy.

S&P 500

The US equity market is quite capable of rallying in the face of rising interest rates. It rather depends upon whether it deems the rate increases appropriate. At the moment there is some doubt about whether rate increases are appropriate and this is why the event is problematic. Is the Fed committing a serious policy error? The only way of finding out is to start the process and see how the economy responds. The market will quickly adjust its view on whether policy ‘normalisation’ has been appropriate or premature. Much will depend upon what happens to corporate earnings and the value placed on such earnings. The latter depends upon the bond markets. In short what happens in equities will depend in part on how bonds respond to the rate increases. In particular how long dated bonds respond in relation to short dated bonds. This will in turn depend upon the inflation path. If the US economy continues to flirt with deflation as the rate increases progress then long bond yields will rise less quickly than short dated bond yields and this will help support equity prices. Any equity market correction should thus be shallow. This is the most likely outcome if the Fed moves in September. However, if it does not things could get messy.

The problem is that the Fed signalled a rate hike in September. It went to elaborate lengths to prepare the ground. It resurrected the equilibrium real interest rate in order to separate the rate decision from near term economic conditions. Data may well influence the pace of rate increases but the process was indicated to begin in September. So what has changed? The slowdown in the China economy and the knock on effect for commodities did not occur last week. This has been evident all year. The Chinese stock market did go into meltdown this month but should that concern the Fed? Indeed should market turbulence per se ever concern monetary policy? The risk for the Federal Reserve now is that in backing off from a well signalled strategy it risks leaving monetary policy a hostage to markets. If every time equity markets wobble the Fed backs off rate increases then the markets control policy. This is not how financial stability is achieved. In short we should not worry too much about the Fed raising rates in September. If it does not may be when the real problems begin.