Fed on sidelines should let risk run free

Central bank on the sidelines will keep the dollar at bay for investors chasing performance

A pedestrian walks past the Marriner S. Eccles Federal Reserve building stands in this photograph taken with a tilt-shift lens in Washington, D.C., U.S., on Tuesday, Sept. 1, 2015. Bill Gross said the Federal Reserve has waited so long to raise interest rates that any move now may be labeled "too little too late" as market turmoil restricts the room for policy makers to act. Photographer: Andrew Harrer/Bloomberg©Bloomberg

The sounds of silence. The prospect of tighter Federal Reserve policy and a disorderly slide in China’s renminbi have dominated fearful market conversations for much of the year. Now, as the frightened chatter quietens to barely a whisper, investors are playing catch-up on performance.

Many began the week embracing a disappointing US jobs report for May as another example of bad news being a good thing.

Commonly known as the central bank put, it’s when weaker economic news prompts investors to buy equities, commodities and corporate debt in the belief that interest rate policy will remain loose, or in the case of the US Fed this summer, happily unchanged.

The dousing of an imminent shift higher in US borrowing costs has followed signs of a firmer appetite for risk taking this month, notably across emerging markets, commodities and credit.

This week, global equities as measured by the FTSE All World Index, oil prices, currencies led by Brazil and Russia all registered fresh peaks for the year. Measures of US investment grade and high yield credit also reached their richest levels for 2016, with the average yield on Moody’s BAA index back under 4.60 per cent for the first time in more than a year.

As Wall Street took a shot at setting a new record high for the S&P 500 and oil’s momentum sought traction beyond $ 50 a barrel, a canary in the form of the 10-year Treasury note yield, was also chirping.

Slipping below 1.70 per cent, the benchmark yield has broken through the floor that prevailed in the wake of market stress peaking back in February. Given how we have moved well beyond the new year fears over global growth prospects, the message from the bond market appears to challenge the current mood in riskier assets such as equities.

In a world where $ 10.4tn of bonds currently yield below zero, and the average yield of German government debt for the first time this week turned negative, US Treasury and corporate paper stands out as a high yielder.

Foreign demand for Treasury bonds sold last month was robust, and a strong reception for this week’s sale of 10-year notes suggests no shortage of buyers outside the US.

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The Long View

Richer US Treasury prices clearly reflect the global hunt for yield and the distortions created by negative interest rate policy in Japan and Europe.

For investors embracing risk assets, the grim message of ever lower government bond yields can thus be downplayed. Rather than suggesting a sharp economic downturn looms, the risk chasers can contend that top tier government bond yields are artificially low. Moreover, the paltry yields on offer pale beside the current dividends of companies.

It means a falling 10-year Treasury yield can be reconciled with swelling risk appetite that views May’s sudden deceleration in US job growth as a typical mid-cycle blip, rather than a harbinger of something more troubling.

That argument, helped by firmer oil prices and a weaker dollar, set the tone until Thursday, when the steady shift lower in top tier US, German and UK bond yields finally placed a brake on risk appetite for equities and emerging markets.

Market trends, however always fluctuate and flirt with moments of doubt.

Certainly, buyers of gold and Treasury debt are also looking at falling US corporate profits, lofty valuations and the declining quality of company debt around the world — particularly in China and the US — as classic late-cycle warnings flags. At some point, winter beckons for the shareholder friendly era of corporate dividends and buybacks.

Before such a reckoning emerges, the general trend of rising risk appetite appears to have further room to run even if there will be potholes and bumps in the road. Talk of a melt-up in equities, that steadily pushes up prices, echoes among research analysts and investors.

With three weeks remaining in the current quarter, investors whose performance has lagged behind their benchmarks can be expected to buy and push valuations higher.

True, a UK rejection of EU membership later this month will test risk appetite, however the global consequences of an actual Brexit appear limited, while that outcome would also prompt monetary easing from the Bank of England, with other central banks standing ready to shore up sentiment.

Of all the central banks, a relatively silent Fed this summer is the most influential factor for asset prices, as it will keep any potential dollar rally at bay.

As Alan Ruskin at Deutsche notes: ‘’The market will need some convincing that a July rate hike is warranted. An alternative delay in Fed tightening to September or December feels like a long time to wait for the most obvious risk negative event to intercede.’’

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