A FEW days ago, I attended a financial conference with a large collection of some of the most powerful and savvy asset managers in America. When asked to vote about the likely path of US interest rates, almost two-thirds of the participants suggested that the Federal Reserve would cut rates this year, rather than keep them neutral (or raise them).
Yes, you read that right. Less than two months ago, the Fed finally embarked on its long-awaited (and heralded) tightening move. It then signalled that it expected to see four rate rises this year. While investors did not entirely accept this, the Fed Funds futures market suggested that two, not four, rises were likely in 2016.
But if the group of investors I saw was representative (and I think they are), a US rate cut is now the majority view. Talk about a mood swing; this makes a teenager look consistent.
Is this justified? In economic terms, I would argue not. After all, the fundamental US economic data have not moved so wildly in recent weeks. On the contrary, as Janet Yellen, the Fed chair, pointed out in testimony to Congress on Wednesday, growth is still fairly steady and the wider global picture is far from disastrous. Unsurprisingly, she emphasised on Friday that she still thinks that rates are on a modest upward trend.
But what is also clear is that this swing in views does not just reflect macroeconomic signals. On the contrary, subtle shifts in global capital flows are creating volatility. Moreover, market sentiment is now displaying what George Soros has described as ‘reflexivity’ — prices fall, so people get frightened, and then prices fall further.
Behind all this is a debate about whether the US could soon follow Japan and Switzerland and produce negative interest rates.
That used to be the stuff of late night bar-room chats between economists. But the fact that Japan has moved into negative territory (after Switzerland) has changed all that. Another development has also had an enormous symbolic effect: the Fed has just launched its annual stress test of the banks, and asked the largest ones to model for the first time how their balance sheets could look with negative rates. (Specifically, they have been asked to model an ‘adverse market scenario’ where three-month treasury bills tumbled to 0.5pc for a long period.)
The Fed has stressed that this is ‘hypothetical’. And it is not an entirely unprecedented idea: short-term rates have tumbled briefly below zero in the US before. No matter. The symbolism of this in the Wall Street echo chamber is extraordinarily powerful: what was once almost unimaginable is actually being imagined — and tangibly measured. And this is frightening for investors for at least two reasons.
First, and most obviously, a world with rates below zero is one in which normal economic relationships are apt to break down. In such a world, it feels as if all manner of taboos might tumble, so it is hard to set mental boundaries.
Until recently, it was widely assumed among investors that even if central banks did cut rates, these could not fall below minus 1pc. But this week JPMorgan issued a piece of research which suggests that central banks now have the technical tools to cut rates to minus 4.5pc in the eurozone, minus 3.45pc in Japan, minus 2.7pc in the UK and minus 1.3pc in the US. But nobody knows any more if even that (unlikely) scenario is the floor.
Secondly, as investors confront this bewildering Alice in Wonderland world, they are also discovering great ‘known unknowns’ in the system: nobody knows what this means for banks. Or as the Bank of America Merrill Lynch observed: “Modelling the negative rate scenario is extraordinarily difficult . . . [since] predicting how Libor would behave in a negative environment is a difficult question.”
The good news is that investors may eventually adapt; the idea of negative rates in Switzerland, for example, no longer shocks. The bad news, however, is that this could take a long time.
Either way, two things are now clear: first, this volatility is unlikely to vanish any time soon in a world of increasing reflexivity; and second, the Fed will need to play an astonishingly canny hand in the coming weeks.
One place to start would be for it to commit to publishing the results of those novel stress tests on negative rates as quickly as possible — and with all the details. The Fed cannot afford to let market imaginations run (any more) wild.
Published in Dawn, Business & Finance weekly, February 15th, 2016
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