Investors encounter Fed stuck on autopilot

Last updated: January 30, 2014 9:12 pm

Investors encounter Fed stuck on autopilot

By Michael Mackenzie and Vivianne Rodrigues in New York

Equity and bond investors have long been accustomed to a plethora of information whenever the US Federal Reserve holds one of its policy meetings.

This week they encountered a central bank stuck on autopilot, with a circumspectpolicy statement confirming an expected $10bn reduction in its monthly bond purchases to $65bn and no follow-up press conference marking the final meeting chaired by Ben Bernanke.

With the Federal Open Market Committee barely tweaking its assessment of the economy’s prospects and outlook for inflation, the main conclusion drawn by economists was a central bank expressing its faith in the recovery gaining velocity during 2014.

For markets, nearing month end, the FOMC’s anodyne statement initially failed to arrest what has been a rough start to the year for equities and a surprising rally in Treasury debt, led by long-dated bonds.

After slipping on Wednesday the S&P 500 rebounded strongly on Thursday, trimming its losses below 3 per cent during January. Meanwhile, news of less bond buying from the Fed left the 10-year Treasury yield camped at around 2.7 per cent, marking a substantial drop from its peak of 3.03 per cent at the start of the year.

This divergence between stocks and bonds may well be a temporary hangover in the wake of 2013’s stellar performance by equities and the rise in Treasury yields.

A pick-up in the economy, marked by stronger jobs growth that facilitates a steady tapering from the Fed, is widely viewed as resulting in stocks ultimately outperforming bonds again in 2014.

“Last year we saw the largest equity multiple expansion since 1998 and so investors are mindful that while stocks are a better long-term bet than bonds, they are no longer as cheaply valued,” says Russ Koesterich, chief equity strategist at BlackRock.

Worries that the equity market’s big gains last year have borrowed from 2014’s performance are clouding the judgment of investors, with pronounced outflows from popular US equity exchange traded funds, a barometer of retail and hedge fund appetite, so far this month.

While the central bank says it plans to keep overnight rates near zero into next year, a steady taper will allow equity volatility to normalise from low levels.

“Stocks have been under pressure this month and there is a feeling that as goes January, so goes the year,” says Michael Kastner, managing principal at Halyard Asset Management. “I think both stocks and bonds are getting it wrong here, yields should be higher and I suspect investors like last year will be rewarded for buying stocks as they pull back.”

The wild card in all this and a big catalyst behind this month’s moves in equities and bonds is the spectre of financial contagion from emerging markets.

In a week marked by emergency rate increases in Turkey, South Africa and India made to defend their beleaguered currencies, the silence from the Fed about emerging market stress was not surprising.

“The Fed is sending a clear message that unless a much larger scale crisis emerges, do not expect the Fed to deviate from its current policy path,” says Jonathan Lewis, chief investment officer at Samson Capital Advisors.

This spells further weakness in equities, that in turn bolsters bonds.

“Equity market weakness and a developing slowdown in China and certain EM economies gives investors good reasons to maintain healthy bond allocations,” says Mr Lewis.

In the past, the FOMC has referenced “strains in global financial markets” in its statements, but only at the juncture when it threatened US growth prospects or financial institutions such as in 2012 when the eurozone crisis escalated.

Before the next FOMC meeting in March, Janet Yellen, the incoming Fed chairwoman, will address Congress. That leaves the central bank on autopilot for some time as investors watch data and earnings, and gauge whether signs of financial contagion emerge from emerging markets.

For now the central bank remains set on its flight plan of trimming bond purchases in clips of $10bn at each meeting.

But at some point, it may well have to flick the switch and reclaim the controls should the flight plan encounter turbulence.

“The Fed will not overreact to the volatility we have seen recently, unless equities fall sharply and we get a decline of some 15 per cent, then the tapering may warrant a delay,” says Ajay Rajadhyaksha, co-head of FICC research at Barclays.