Fed policy: nothing has changed but everything has changed.

Anthony Rayner

Premier Miton Macro Thematic Multi Asset Team

 

The Japanese Yen hit its lowest level against the US dollar in 32 years last week. Another sign, if we needed one, that not all is well in markets. There are a number of trends that have been clear and consistent this year. Traditional risk assets like equities have been trending lower all year, while corporate bond spreads and emerging market government bond spreads have been trending wider this year too.

The source of friction is uncomfortably high inflation, not just leading to higher US official rates but to higher rates along the US government bond curve which, in turn, has fanned out to blight other assets and other geographies.

In a way, nothing has changed but everything has changed. Just like Fed policy was at the heart of quantitative easing, which inflated financial assets, so it is at the heart of deflating financial asset this year. More recently, we have seen material intra-day (within a day of trading) moves in the S&P 500, reflecting lower liquidity and economic volatility.

So, whilst most assets are suffering, with the notable exception of the US dollar, key has been how they are suffering relative to each other and relative to their history. As long as inflation is uncomfortably high, so the key expression of risk will be through government bonds. In this way, the risk hierarchy has been turned on its head. The chart below illustrates this well.

For the last five years, UK government bonds have been less volatile than the FTSE 100, as conventional wisdom would have us believe is always the case. However, more recently UK government bonds have been much more volatile than UK equities. Indeed, sterling vs the US dollar has been more volatile than equities too.

Source: Bloomberg 25.09.17 – 26.10.22

The backdrop for these moves is that the UK is economically weak and in a political mess, which has recently brought its monetary policy into the spotlight. Indeed, higher US rates and a higher energy price are highlighting an increasing number of vulnerable economies globally, while politicians are struggling to come up with solutions.

Some answers, in the short term at least, have been provided through increasing interventions, for example in currency markets. This has a number of implications. Most obviously that fundamentals are being muddied but also that policy makers are exposing themselves to failure and loss of credibility. If this happens, fundamentals will freely express themselves, most likely in a dislocating fashion. Policy makers will be hoping that markets can muddle through.

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