Investors tune out US Federal Reserve’s warnings at their peril

Markets have been guilty of wishful thinking and complacency over two of the main issues facing them this year.

In relation to both Greece and the timing of the US Fed’s interest rate lift-off, the markets are taking a relatively sanguine view of both, accepting at face value the promises of policymakers that a debt deal over Greece would be secured and that the Fed will approach monetary policy normalisation gradually.

Now faced with the prospect of a hastily arranged referendum on a bailout, Greeks are voting again with their bank balances and forming queues outside ATMs in the time-honoured tradition of countries that are about to go bust.

As far as attitudes towards the Fed are concerned, the markets have been selective about what they are prepared to believe as well.

Back in February, I wrote that Greece was still not out of the woods after yet another 11th-hour deal to keep it in the euro zone.

Fast forward a few months and the situation is a lot worse. A referendum now stands between the reform proposals of the European Union, European Central Bank and IMF, and the alternative of capital controls and possible euro-zone expulsion.

Unfortunately the solution on offer is not materially different from the last. Without a substantial debt restructuring, the piling of more austerity on to an already enfeebled economy will have little chance of returning Greece to stability, let alone prosperity. The markets wanted to believe that a workable solution was around the corner, but now, like the Greek people, they have to wake up to the probability that it is not.

In terms of the US Fed, the markets reacted to the Federal Open Market Commission’s message recently as if they did not believe that the Fed would raise interest rates at all this year. Bond yields eased and Fed funds futures dipped lower than the projections implied in the FOMC’s dots – even more so in 2016 and 2017, where the futures market predicts a much slower pace of Fed tightening even after the Fed had already lowered its own gradualist forecasts for where rates will end up.

Not only is the market probably wrong in assuming that the Fed will stay on the sidelines in the second half of the year, but the Fed itself is probably even too relaxed about where rates are likely to go, especially in 2016 and 2017. The risks are that rates may have to rise a lot further and faster than the dot plot implies.

It seems as if the markets will not believe the Fed is prepared to tighten the strings until it finally happens. In some ways, by encouraging a belief in its gradualism, the Fed might be doing too good a job of reducing the chances of another taper tantrum. In its effort to prevent another bond market sell-off, the Fed has promoted such a soporific environment in markets that an eventual rate rise, when it comes, will be a major shock. The danger now is that the Fed has lost credibility with the markets, with its forward guidance no longer believed or respected.

When it comes to interpreting the votes of FOMC members, it’s all about perspective. To some, seven or so out of 17 FOMC voters at this month’s meeting believed that there should either be no hike this year or only one. To others, 15 out of 17 members advocated for a minimum of one rate hike, with the majority urging two.

Boiling this down the futures market still took it to imply a more than 50 per cent probability that rates will be unchanged at the end of this year. According to the futures market, there is a 34 per cent probability of a single 25-basis point hike, also significantly below the Fed’s own median expectation of a 0.63 per cent funds rate by December. The use of the Fed chairwoman Janet Yellen’s dots next year and in the following one can be debated, but there should be some level of confidence in what Fed officials are saying about the coming six months.

For the markets to ignore this is potentially very dangerous, and stands the risk of hurting them very badly before long.

Tim Fox is the head of research and the chief economist at Emirates NBD.

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