This article first appeared in the Telegraph
When Jerome Powell walks into the imposing Federal Reserve building this morning as its new chairman, he will inherit a strong economy, with low inflation, unemployment at a 17-year low and a booming stock market. On the face of it, he could not ask for a better time to take over the most powerful economic job in the world. The reality may look a little different when, like his predecessor Janet Yellen this weekend, he comes to assess his time in office.
Ms Yellen is widely seen to have had a good four years at the helm of America’s central bank. The Fed has a twin mandate to promote full employment while keeping a lid on inflation. On both fronts, she can look back with some pride: at just over 4%, the jobless rate stands at its lowest level since the early 2000s and well below the 10% peak it reached soon after the financial crisis; meanwhile, inflation has remained at or below the Fed’s 2% target.
Those are the measures on which she is officially judged. But looking at her tenure through other lenses, too, she has reason to be pleased. The housing market has recovered nicely from its post-crisis slump but has not yet risen to the frothy levels that ultimately triggered the credit crunch. Wage growth may be weaker than expected, but it is heading in the right direction. She has put in place measures such as bank stress tests to ensure that the US can weather the next crisis. Above all, she has begun the process of normalising monetary policy, raising interest rates and reining in the Fed’s $4trn balance sheet, without spooking the financial markets. The S&P 500 has risen by half since she took office.
As investors know, however, the best time to put money to work in the market is not when the sky is blue and the outlook set fair. The best returns are achieved by those brave or lucky enough to invest when no-one else wants to. It is often better to travel than to arrive. When the Yellen tenure is measured against her successor’s, we may well conclude that becoming the first Fed chair in 40 years not to be granted a second term was a blessing in disguise.
Powell is the first Fed chair in that 40-year period not to have an advanced economics degree. He is a lawyer and an investor, which is just as well because his first year in the job may well test his feel for the markets. The remarkable calm that hung over Wall Street during the Yellen years is unlikely to last. Indeed the market backdrop in the week of the Fed transition could hardly be more jittery.
The consensus view of Powell is that he will deliver more of the same, picking up where Yellen left off with a slow and steady increase in interest rates and a gentle withdrawal of quantitative easing. That benign assessment makes a big assumption about the outlook for inflation which this week’s surge in Treasury yields suggest the markets do not necessarily share.
The yield on the benchmark 10-year Treasury bond rose last week above 2.8%, a level it has not breached since April 2014. The yield has risen from 2.4% since the turn of the year. Bond yields rise when prices fall and the reason for investors turning their backs on the fixed income markets are not hard to fathom. They are worried that the Fed may have fallen behind the curve under the naturally cautious Janet Yellen.
Those investors are starting to worry that, scarred by the economy’s near-death experience ten years ago, and guided by a president determined to deliver economic growth ahead of November’s mid-term elections, fiscal and monetary policy may combine to pour fuel on an already smouldering inflationary fire.
With the jobs market close to effective full employment, you would expect the Government to lean against the recovery with tighter policy. In fact, it is doing the opposite. The White House and Congress have agreed to cut taxes when unemployment is at a historically low level. Paying for this will involve the issue of a whole lot more bonds at a time when the Fed has decided to stop buying them back off the market.
This is a recipe for both inflation and potentially much higher bond yields. Fixed income investors sense this. Mr Powell understands it too, but whether a rookie Fed chair will have the confidence to speed up the clearly laid out path to the new normal, risking a churlish market reaction, remains to be seen.
There are many unknowns here for investors. Within the bond market, we don’t know how evenly spread the pain might be. The demand for fixed income investments from pension funds and other institutions with long-term liabilities remains high. While rising interest rates may push yields higher on short- and medium-dated bonds, the appetite for those maturing in 30 years’ time may well keep a lid on long bond yields. Higher short-term yields than longer-term ones typically signal a recession. This time they may not and markets may well struggle to understand what is going on.
The second big unknown is whether rising bond yields will spill over into equity market volatility. Higher yields imply increased borrowing costs for companies and make fixed-income alternatives to an already highly-priced stock market look more attractive. After the strongest start to a year since 1987, investors may conclude that the stock market is priced for a perfection that is no longer on offer. Good luck, Mr Powell.
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